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Dynamic Business Law THE ESSENTIALS Third Edition

Dynamic Business Law THE ESSENTIALS Third Edition

Nancy Kubasek Bowling Green State University

M. Neil Browne Bowling Green State University

Daniel J. Herron Miami University

Lucien J. Dhooge Georgia Institute of Technology

Linda Barkacs University of San Diego

DYNAMIC BUSINESS LAW: THE ESSENTIALS, THIRD EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous edition © 2013, 2010. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 RMN/RMN 1 0 9 8 7 6 5 ISBN 978-0-07-802384-2 MHID 0-07-802384-X Senior Vice President, Products & Markets: Kurt L. Strand Vice President, General Manager, Products & Markets: Marty Lange Vice President, Content Design & Delivery: Kimberly Meriwether David Managing Director: Tim Vertovec Brand Manager: Kathleen Klehr Senior Director, Product Development: Rose Koos Product Developer: Jaroslaw Szymanski Marketing Director: Brad Parkins Director of Digital Content Development: Patricia Plumb Digital Product Analyst: Xin Lin Director, Content Design & Delivery: Linda Avenarius Executive Program Manager: Faye Herrig Content Project Managers: Heather Ervolino; Lisa Bruflodt; Sandy Schnee; Angela Norris Buyer: Laura M. Fuller Cover Design: Tara McDermott Content Licensing Specialist (Text): Rita Hingtgen Compositor: Laserwords Private Limited Typeface: 10/12 Times Roman Printer: R. R. Donnelley GLOBAL Context icons: 18, 35, 44, 89, 109, 119, 138, 145, 157, 176, 187, 208, 234, 236, 245, 254, 284, 344, 369, 414, 450, 469, 482, 485, 498, 527, 539, 543: Getty Images/Comstock Images; 154, 237, 299: © Digital Archive Japan/Alamy; 198, 315, 340: Doug Armand/Getty Image. All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Proudly sourced and uploaded by [StormRG] Kickass Torrents | TPB | ET | h33t Library of Congress Cataloging-in-Publication Data Dynamic business law: the essentials / Nancy K. Kubasek, Bowling Green State University; M. Neil Browne, Bowling Green State University; Lucien J. Dhooge, Scheller College of Business, Georgia Institute of Technology; Daniel J. Herron, Miami University; Linda L. Barkacs, University of San Diego Diego.—Third edition. pages cm. ISBN: 978-0-07-802384-2 (alk. paper) 1. Commercial law—United States. I. Browne, M. Neil, 1944- author. II. Dhooge, Lucien J., author. III. Herron, Daniel J., author. IV. Barkacs, Linda L., author. V. Title. KF889.85.K83 2015 346.7307—dc23 2014028223 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.


About the Authors Nancy K. Kubasek

received her JD from the University of Toledo College of Law in 1981 and her BA from Bowling Green State University in 1978. She joined the BGSU faculty in 1982 and became an associate professor in 1988 and a full professor in 1993. During her tenure at Bowling Green State University, she has primarily taught courses in business law, legal environment of business, environmental law, health care law, and moral principles. She has published over 75 articles, primarily in law reviews and business journals. Most of her substantive articles focus on environmental questions, and she writes a quarterly column about environmental issues for the Real Estate Law Journal. She has helped get students involved in legal research, and a number of her articles are co-authored with students. She has also published a number of pedagogical articles in teaching journals, focusing primarily on teaching critical thinking and ethics. She wrote the first environmental law text for undergraduate students, Environmental Law, and co-authored The Legal Environment of Business: A Critical Thinking Approach. She has written supplemental materials, such as study guides, test banks, and instructors’ manuals. Active in many professional organizations, she has served as president of the Academy of Legal Studies in Business, the national organization for professors of legal studies in colleges of business. She has also served as president of the Tri-State Academy of Legal Studies in Business, her regional professional association. In her leisure time, she and her husband, Neil Browne, fish for halibut and salmon in Alaska and large-mouth bass in Florida. In addition, they are regular participants in polka, waltz, zydeco, and Cajun dance festivals in Europe and the United States. For almost 30 years, they have been successful tournament blackjack players as well. Both are avid exercisers—lifting weights, doing yoga, and running almost every day.

M. Neil Browne

is senior lecturer and research associate and a distinguished teaching professor emeritus at Bowling Green State University. He received his BA in history and economics at the University of Houston, his PhD in economics at the University of Texas, and his JD from the University of Toledo. He has been a professor at Bowling Green for more than four decades. Professor Browne teaches courses in jurisprudence, ethical reasoning, critical thinking, and economics at both the undergraduate and graduate levels. He has received recognition as the Silver Medalist National Professor of the Year, the Ohio Professor of the Year, and Distinguished Teacher

and Master Teacher at Bowling Green State University, as well as numerous research awards from his university and from professional organizations. His consulting activities with corporate, government, and educational institutions focus on improving the quality of critical thinking in those organizations. In addition, he serves as a Rule 26 expert with respect to the quality of the reasoning used by expert witnesses called by the party opponent in legal actions. Professor Browne has published 20 books and more than 130 professional journal articles in law journals and economics, sociology, and higher education journals. His current research interests focus on the relationship between orthodox economic thinking and legal policy. In addition, he is in the midst of writing books about the power of questionable assumptions in economics, the usefulness of asking questions as a learning strategy, and the importance of critical thinking in environmental arguments. Professor Browne tries to find time for a broad array of outside activities. He and his wife, Nancy Kubasek, fish for halibut and salmon in Alaska and large-mouth bass in Florida as frequently as possible. In addition, they are regular participants in polka, waltz, zydeco, and Cajun dance festivals in Europe and the United States. For almost 30 years, they have been successful tournament blackjack players as well. Both are avid exercisers—lifting weights, doing yoga, and running almost every day.

Daniel J. Herron is a professor of business legal studies at Miami University in Oxford, Ohio. He received his law degree from Case Western Reserve University School of Law in 1978 and is a member of the Ohio and federal bars. He has taught at Miami University, his alma mater, since 1992 and previously taught at the University of Wyoming, Western Carolina University, the University of North Carolina–Wilmington, and Bowling Green State University. He has been a member of the Academy of Legal Studies in Business for nearly 25 years and has served as its executive secretary since 1991. His research interests focus on law and ethics, employment law, and legal history. He has been married for more than 30 years to his wife Deborah, and they have two children, Elisabeth and Christopher, and a daughter-in-law, Amanda, and one grandchild, Jack. Herron and his wife reside in Oxford, Ohio, with their two beagles, Max and Missy. Lucien J. Dhooge is the faculty director of the Global Executive MBA Program and is the Sue and John Staton Professor of Law at the Georgia Institute of vii


About the Authors

Technology. He teaches business law, real estate law, and ethics. After completing an undergraduate degree in history at the University of Colorado in 1980, Professor Dhooge attended the University of Denver College of Law, where he received his JD in 1983. He received his LL.M. in 1995 from Georgetown University Law Center, where he specialized in international and comparative law. Before coming to the College of Management at the Georgia Institute of Technology, Professor Dhooge spent 11 years in private law practice and 12 years serving on the faculty of the University of the Pacific in California. Professor Dhooge has authored more than 50 scholarly articles, co-authored seven books, and presented research papers and courses throughout the United States as well as in Asia, Europe, and South America. Professor Dhooge is the recipient of numerous research awards given by the Academy of Legal Studies in Business, including seven Ralph C. Hoeber Awards for excellence in research. He was designated the outstanding junior business law faculty member in the United States by the Academy in 2002 and received the Kay Duffy Award for outstanding service in 2005. He was designated as an International Scholar by the Soros Foundation in 2006. Professor Dhooge was the program chair for the Academy’s 2009 international conference in Denver and served as the Academy’s president from 2009 to 2010. He is a past editor-in-chief of the American Business Law Journal and the Journal of Legal Studies Education. A native of Chicago but raised in Denver, Professor Dhooge enjoys spending time with his family and following the fortunes of the Chicago Cubs and Colorado Rockies professional baseball teams.

Linda L. Barkacs

received her JD from the University of San Diego in 1993. She also has a BA in political science from San Diego State University and an AA in accounting from Irvine Valley College. Upon graduating from law school and passing the California bar exam, Professor Barkacs became an associate

at a downtown San Diego law firm. During her time with that firm, she was involved in a number of high-profile trials, including a sexual harassment case against the City of Oceanside that resulted in a $1.2 million verdict. In 1997, Professor Barkacs and her husband Craig (also a professor at USD) started their own law firm specializing in business and civil litigation (in both federal and state courts), employment law cases, and appeals. They were also involved in numerous mediations and arbitrations. Professor Barkacs began teaching at USD in 1997 and was tenured in 2011. As an educator, she has designed and taught numerous courses on law, ethics, and negotiation. She teaches in USD’s undergraduate and graduate programs, including the Master of Science in Executive Leadership (a Ken Blanchard program), the Master of Science in Global Leadership, and the Master of Science in Supply Chain Management. Professor Barkacs often teaches in USD’s study-abroad classes and has traveled extensively throughout Europe, Asia, and South America. Professor Barkacs has received numerous awards for her teaching at USD, including USD’s 2010 Professor Impaact (MSCM Program); the 2008 USD School of Business Outstanding Undergraduate Business Educator of the Year; and the 2008 and 2007 Professor of the Year, USD Senior Class (universitywide). She and her husband are principals in The Barkacs Group (www.tbgexecutivetraining.com), a consulting firm that provides negotiation, ethics, and team training for the private sector. Professor Barkacs has published numerous journal articles in the areas of law, ethics, and negotiation. She and her husband are co-authoring a book on negotiation. She has been the president, vice president, conference chair, and treasurer for the Pacific Southwest Academy of Legal Studies in Business (www.pswalsb. net). Professor Barkacs currently spends her time teaching, publishing, consulting for The Barkacs Group, and doing volunteer work for various civic causes. She enjoys walking, weight-lifting, and spending her free time with her husband and their three cats, Phoenix, Violet, and Vanessa.

Preface We wrote this book because our primary sense of who we are as professionals is that we are teachers. We play various roles in our careers, but we are especially dedicated to our students. We want them to listen, read, create, and evaluate more effectively as a result of their experience in a business law class. Above all, we want them to sense the importance and excitement of the law. We tried to construct a book that contains the basics of business law but does not get bogged down in the kind of details that would be more appropriate in an upper-level law class. It is our pedagogical features that provide the distinctive value of this book. Each feature stands by itself as an aid to the kind of learning we hope to encourage. Yet the features are also a cohesive unit, contributing both to the liberal education of the students who read it and to their skills as decision makers in a market economy. Specifically, we provide what competing texts deliver, an examination of the basic questions, concepts, and legal rules of business law. Our text must address the power and authority of constitutions, statutes, case law, and treaties as sources of law. Together, the various elements of what we call “the law” make up the foundation and structure of the market exchange process. Decisions to trade and produce require trust—trust that consumers, firms, workers, financial institutions, and asset owners will do as they promise and that violations of such promises will be unacceptable in the marketplace. Without guarantees that promises will be kept, market exchanges would grind to a halt. Business law provides these guarantees and the boundaries within which certain promises can be made and enforced. Market decisions are made in a context—a persistently changing context. The law, in turn, is dynamic in response. New technologies and business practices bring new disputes over rights and responsibilities in a business setting. Future business leaders need knowledge of existing business law as well as a set of skills permitting them to adjust efficiently and effectively to new legal issues as they arise over the course of their careers. We are excited about the contents of our features and want to explain the function of each of them in preparing students for leadership positions in business.

A. WHAT IF . . . Business law is a set of rules BUT WHAT I F .   .   . and regulations that modern managers must obey, but those Recall that in the Case Opener, Catepillar filed a motion to exercise its right of removal to move the rules and regulations apply in case to federal court. If it had not filed that motion, would the case have been held in state court, even specific situations to particular though it fell under concurrent jurisdiction? facts. Those facts create a special setting, one not exactly like any other business decision. We added a But What If feature to highlight for readers the need to think about the implications of specific facts for the application of business laws. In addition, this feature provides a reminder that applying the law is a complex activity, requiring a thorough knowledge of the law. An alert business manager needs to consider how each of the facts in the dilemma she or he faces may have legal implications that are not always clear when simply reading the law for the first time. The facts of a case guide the application. Those who have formal legal training know that a common form of teaching law is to pose hypotheticals. The But What If feature mimics that approach. In other words, at first glance the law seems to point in a certain direction, thereby giving business decision makers confidence that they know what is legally permissible or required, but changing a single fact can sometimes dramatically alter the eventual application of the law. An awareness of the significance of facts in the law can greatly enhance legal compliance and save firms huge expenses. ix



B. Global Boxes This feature highlights the emerging, interconnected market. Where relevant, the chapters contain Global Context boxes. Because so many market decisions are made in an international context, learners need to familiarize themselves with the likelihood that a particular legal principle essential to doing business in one country may not be appropriate in other countries. The Global Context boxes illustrate how unique the law GLOBAL Context in a certain country often is. After reading these stories of difference, Civil cases are first heard in the county courts (for The Court Structure in England readers will certainly understand minor claims) or the high court, which is divided into three Even though we trace the roots of the U.S. legal system divisions: Queen’s Bench, Family, and Chancery. Cases back to England, changes have occurred in both countries’ may be appealed to the court of appeal (Civil Division). better the need to discover relcourt structures; as a result, the court structures in the Cases may also be appealed from the county court to the evant law in all jurisdictions where United States and England share similarities but also have high court. distinct features. The lowest criminal courts in England are their market decisions have legal The House of Lords is the supreme court of appeal. the magistrates courts, which hear minor offenses. More Its cases are heard by up to 13 senior judges known as serious cases are tried before a judge and jury in the crown law lords. In addition to the courts, there are specialized implications. court, which also hears cases appealed from the magistrates tribunals, which hear appeals on decisions made by variWe believe that students learn courts on factual points. The high court (in the Queen’s ous public bodies and government departments in areas Branch Division) hears appeals on points of law, and the such as employment, immigration, social security, tax, innumerable valuable lessons about court of appeal in the Criminal Division hears appeals on and land. sentences and convictions. American business law by contrasting the concepts of our business law system with those of our primary trading partners. We typically use Canada, Japan, China, Russia, Mexico, and the European Union for our comparisons because modern business managers will more likely be interacting with the law in those particular jurisdictions.

C. Critical Thinking After each case in the book, we have provided critical-thinking questions to highlight CASE 3-1 the need to think critically about the reasoning the court used. In addition, we include in every chapter a Point/Counterpoint problem CRITICAL THINKING that encourages the reader to evaluate the conflicting reasoning surrounding a key issue Why is the court reluctant to extend in personam jurisdiction whenever a firm with online presence offers to make a sale of products in the state in question? Why is there a reluctance to extend in the chapter. in personam jurisdiction broadly? But we do much more than just ask a lot of critical-thinking questions at particular locations throughout the chapters. We encourage the use of a step-by-step critical thinking approach kub2384x_ch03_025-053.indd 27 9/26/14 4:09 PM that has been developed and used in classrooms in many countries. We do not just repeatedly urge students to think critically. Instead, we describe for them what is meant by that phrase in the context of business law. We include this step-by-step approach in Appendix 1A at the end of Chapter 1. Instructors who wish to emphasize critical thinking can use that appendix as a structured approach for learning how to evaluate legal reasoning. ILLINOIS v. HEMI GROUP LLC 622 F. 3d 754 (2010)

D. Ethical Reasoning

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Our book emphasizes consideration of all stakeholder interests in every market decision. Business ethics should never be an afterthought or something firms consider only because they think they must. In response to requests from our users, we created a separate chapter, Chapter 2, devoted entirely to business ethics. We expanded the discussion of business ethics while simplifying the framework for applying ethical reasoning. Instead, business ethics is what provides the social legitimacy for markets, what distinguishes markets from the life of the jungle. Although market decisions are calculating and purposeful, they must at the same time reflect awareness that the good and the right provide social borders that elevate those decisions above simple greed and egoism. 11/4/14 7:41 AM



Ethical discussion focuses on the basic observation that we are socially and globBUSINESS Ethics Flashpoint 2.1 ally interdependent as entrepreneurs, asset owners, workers, businesspeople, contaminants with which Texaco polluted the area. The Chevron in Ecuador and consumers. Our inescapable contact people of the Oriente reported higher rates of cancer than In 1964, Texaco Petroleum (now known as Chevron), along the general population of Ecuador and in other Amazonian with one another requires our aspirations with the Gulf Oil Corporation (Gulf), was invited by the provinces. Birth defects were also attributed to the environEcuadoran government to conduct exploratory activities in mental pollution. However, despite these adverse effects to be defined, at least in part, by their the eastern region of Ecuador. This region was known as on the surrounding population, Texaco did not endeavor to the Oriente. address these problems during its operations. impact on others. In 1967, Texaco and Gulf discovered large quantities In addition to suffering from diseases related to toxic of oil in the Oriente. After building a pipeline that would contaminants, the indigenous population in the Oriente Our text has several ethical reasonallow for the transfer of oil to the Pacific coast, Texaco suffered economic losses. For example, 75 percent of Oribegan exporting the oil. ente residents reported that they had suffered from loss of ing possibilities in each chapter. But for Texaco acted as the operator in a partnership, known as a their crops as well as loss of animals on which they relied consortium, between Texaco and Gulf. In 1973, production because of Texaco’s toxic discharges into the environment. the reader to use this emphasis requires a reached 200,000 barrels of oil per day. During this period, Texaco’s clearing substantial parts of natural habitat to practical step-by-step approach. In other ETHICAL DECISION MAKING words, students need more than just a discussion about values or ethics. What ethical considerations do you think the judge relied on in making the decision in this case? They need to have some sense that the discussion is headed somewhere. They want to know, “How will my behavior be any more ethical after I have read the chapter and participated in the class discussions?” Our text answers their question. Chapter 2 provides a clear explanation of our approach—an approach that students can use on a regular basis. The language and organization of our model of ethical reasoning leans implicitly on standard ethical theories, but it meets the challenge of a fast-paced business world. It pushes stakeholders to the forefront of market decisions, where they belong, and does so in a manner that is both powerful and doable without becoming tedious. Business ethics serve as the guidelines we use to shape the world we wish to create. As such, they provide guidance for the kind of business behavior we want to reinforce. After each case discussion, we pause to think about the ethics of business law by asking a question derived from the practical approach to business ethics developed in Chapter 2. kub2384x_ch13_241-269.indd 249

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E. E-Commerce Boxes A central feature of modern business decisions is new technology, specifically the rapid spread of electronic commerce. This development has created new challenges and opportunities that were unforeseeable until very recently. By including boxes that call attention to these challenges, we think we can convince students most effectively of the pervasive influence of this new, complicating aspect of business decisions.

E-COMMERCE and the Law The Sliding-Scale Standard for Internet Transactions Does a business that has Internet contact with a plaintiff in a different state satisfy the minimum-contacts standard? A federal district court established the following slidingscale standard in a 1997 case:*

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[T]he likelihood that personal jurisdiction can be constitutionally exercised is directly proportionate to the nature and quality of commercial activity that an entity conducts over the Internet. This sliding scale is consistent with well developed personal jurisdiction principles.

At one end of the spectrum are situations when a defendant clearly does business over the Internet. If the defendant enters into contracts with residents of a foreign

jurisdiction that involve the knowing and repeated transmission of computer files over the Internet, personal jurisdiction is proper. At the opposite end are situations when a defendant has simply posted information on an Internet website that is accessible to users in foreign jurisdictions. A passive website that does little more than make information available to those who are interested in it is not grounds for the exercise of personal jurisdiction. The middle ground is occupied by interactive websites through which a user can exchange information with the host computer. In these cases, the exercise of jurisdiction is determined by examining the level of interactivity and the commercial nature of the exchange of information that occurs on the website. *

Zippo Mfg. Co. v. Zippo Dot Com, Inc., 952 F. Supp. 1119 at 1124 (1997).

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Walkthrough We have designed our features around the things we do in our classes to encourage excitement about business law. We believe they provide Business Law Plus. We also have a variety of supplementary material available for instructors, to aid in course development, and for students, to provide additional study.

Instructor’s Manual

Written by our co-author Lucien Dhooge, this resource includes lecture notes, case briefs, answers to all questions in each chapter, assignment ideas, teaching assistance (emphasizing practical tips that new or part-time teachers can try right away), and suggested handouts.

Test Bank Prepared by Lisa Mayer, of Bergen Community College, our test bank contains a variety of true/false, multiple-choice, and essay questions as well as scenario-based questions, which are application-based and use a situation described in a narrative, with three to five multiple-choice test questions based on the situation. EZ Test Online McGraw-Hill’s EZ Test Online is a flexible and easy-to-use electronic testing program. The program allows instructors to create tests from book-specific items, accommodates a wide range of question types, and enables instructors to add their own questions. Multiple versions of the test can be created, and any test can be exported for use with course management systems such as WebCT, Blackboard, or any other course management system. EZ Test Online is accessible to busy instructors virtually anywhere via the web, and the program eliminates the need for them to install test software. Using EZ Test Online also allows instructors to create and deliver multiple-choice or true/false quiz questions by using iQuiz for iPod. For more information about EZ Test Online, please see the website at www.eztestonline.com. PowerPoint Presentation Slides

Developed by Jeff Penley at Catawba Valley Community College, two sets of slides are available for instructors. The Basic set consists of an outline of each chapter. The Premium set expands on this outline to include hypotheticals and ethical dilemmas, allowing the instructor to incorporate application into the lecture.


You Be the Judge Online (www.mhhe.com/ybtj) This interactive product includes 18 hypothetical business law cases. All the cases are based on real cases within our business law texts. Each case allows you to watch interviews of the plaintiff and defendant before the courtroom argument, see the courtroom proceedings, view relevant evidence, read other actual cases relating to the issues in the case, and then create your own ruling. After your verdict is generated, you can view what an actual judge ruled (unscripted) in the case and then get the chance to defend or change your ruling.

McGraw-Hill Connect® Business Law Less Managing. More Teaching. Greater Learning. McGraw-Hill Connect Business Law is an online assignment and assessment solution that connects students with the tools and resources they’ll need to achieve success. McGraw-Hill Connect Business Law helps prepare students for their future by enabling faster learning, more efficient studying, and higher retention of knowledge.

McGraw-Hill Connect Business Law Features Connect Business Law offers a number of powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect Business Law, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. Connect Business Law offers you the following features. Simple Assignment Management With Connect Business Law, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to: • • •

Create and deliver assignments easily with selectable end-of-chapter questions and test bank items. Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient than ever. Go paperless with the eBook and online submission and grading of student assignments.

Smart Grading When it comes to studying, time is precious. Connect Business Law helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. When it comes to teaching, your time also is precious. The grading function enables you to: • • •

Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons with correct answers. Access and review each response; manually change grades or leave comments for students to review. Reinforce classroom concepts with practice tests and instant quizzes.


Instructor Library The Connect Business Law Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. The Connect Business Law Instructor Library includes: • • • • • •

eBook. Instructor’s Manual. PowerPoint files. Videos and Instructional Notes. Business Law Newsletter archives. Access to interactive study tools.

Student Study Center The Connect Business Law Student Study Center is the place for students to access additional resources. The Student Study Center: • • •

Offers students quick access to lectures, practice materials, eBooks, and more. Provides instant practice material and study questions, easily accessible on the go. Gives students access to the Personalized Learning Plan described in the sections that follow.

Student Progress Tracking Connect Business Law keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables you to: • • •

View scored work immediately and track individual or group performance with assignment and grade reports. Access an instant view of student or class performance relative to learning objectives. Collect data and generate reports required by many accreditation organizations, such as AACSB.

Lecture Capture Increase the attention paid to lecture discussion by decreasing the attention paid to note taking. For an additional charge, Lecture Capture offers new ways for students to focus on the in-class discussion, knowing they can revisit important topics later. Lecture Capture enables you to: • • • •


Record and distribute your lecture with a click of a button. Record and index PowerPoint presentations and anything shown on your computer so that it is easily searchable, frame by frame. Offer access to lectures anytime and anywhere by computer, iPod, or mobile device. Increase intent listening and class participation by easing students’ concerns about note taking. Lecture Capture will make it more likely you will see students’ faces, not the tops of their heads.

McGraw-Hill Connect Business Law McGraw-Hill reinvents the textbook learning experience for the modern student with Connect Business Law. Connect Business Law provides the following: • • •

An integrated eBook, allowing for anytime, anywhere access to the textbook. Dynamic links between the problems or questions you assign to your students and the location in the eBook where that problem or question is covered. A powerful search function to pinpoint and connect key concepts in a snap.

In short, Connect Business Law offers you and your students powerful tools and features that optimize your time and energies, enabling you to focus on course content, teaching, and student learning. Connect Business Law also offers a wealth of content resources for both instructors and students. This state-of-the-art, thoroughly tested system supports you in preparing students for the world that awaits. For more information about Connect, go to www.mcgrawhillconnect.com, or contact your local McGraw-Hill sales representative.

Tegrity Campus: Lectures 24/7 Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture in a searchable format for students to review when they study and complete assignments. With a simple one-click start-and-stop process, you capture all computer screens and corresponding audio. Students can replay any part of any class with easy-to-use browserbased viewing on a PC or Mac. Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus’s unique search feature. This search helps students efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn all your students’ study time into learning moments immediately supported by your lecture. To learn more about Tegrity, watch a 2-minute Flash demo at http://tegritycampus.mhhe.com.

Assurance of Learning Ready Many educational institutions today are focused on the notion of assurance of learning, an important element of some accreditation standards. Dynamic Business Law: The Essentials, Third Edition, is designed specifically to support your assurance of learning initiatives with a simple, yet powerful, solution. Each test bank question for Business Law maps to a specific chapter learning outcome/objective listed in the text. You can use our test bank software, EZ Test and EZ Test Online, or Connect Business Law to query easily for learning outcomes/objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test to aggregate student results in similar fashion, making the collection and presentation of assurance of learning data simple and easy.


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Brief Contents



The Legal Environment of Business chapter 1 chapter 2 chapter 3 chapter chapter chapter chapter chapter P A R T

4 5 6 7 8

An Introduction to the Fundamentals of Dynamic Business Law 1 Business Ethics and Social Responsibility 13 The U.S. Legal System and Alternative Dispute Resolution 25 Administrative Law 54 Constitutional Law 75 Criminal Law and Business 99 Tort Law 125 Real, Personal, and Intellectual Property 150


Contract Law chapter chapter chapter chapter chapter chapter P A R T

9 Introduction to Contracts and Agreement 173 10 Consideration 192 11 Capacity and Legality 206 12 Reality of Assent 225 13 Contracts in Writing and Third-Party Contracts 241 14 Discharge and Remedies 270


Domestic and International Sales Law chapter 15 chapter 16


Formation and Performance of Sales and Lease Contracts 291 Sales and Lease Contracts: Performance, Warranties, and Remedies 312


Negotiable Instruments and Banking chapter 17 chapter 18

Negotiable Instruments: Negotiability and Transferability 331 Holder in Due Course, Liability, and Defenses 359



Brief Contents



Creditors’ Rights and Bankruptcy chapter 19 P A R T

Secured Transactions and Bankruptcy 384


Agency chapter 20 P A R T

Agency and Liability to Third Parties 410


Business Organizations chapter 21 chapter 22 chapter 23 P A R T

Forms of Business Organization 439 Corporations: Formation and Organization 461 Securities Regulation 493


Government Regulation chapter 24 chapter 25

Employment and Discrimination Law 514 Consumer Law 536

APPENDIXES appendix A The Constitution of the United States of America A-1 appendix B Sarbanes-Oxley Act of 2002 B Glossary G Index I-1


3 The U.S. Legal System and

Preface ix

Alternative Dispute Resolution 25 P A R T


The Legal Environment of Business 1

An Introduction to the Fundamentals of Dynamic Business Law 1 Law and Its Purposes 3 Classification of the Law 3 Sources of Business Law 4 Constitutions 4 Statutes 4 Cases 5 Administrative Law 6 Treaties 7 Executive Orders 7 Schools of Legal Interpretation 7 Global and Comparative Law 9 Questions & Problems 10 Appendix 1A: Critical Thinking and Business Law 11


Business Ethics and Social Responsibility 13 Business Law and Business Ethics 14 Business Ethics Flashpoint 2.1: Chevron in Ecuador 15 What Are Values? 16 How do Values Provide a Starting Point for Thinking about Business Ethics? 16 Business Ethics Flashpoint 2.2: Dole Food Company and Its Workers 17 The WH Framework for Business Ethics 18 Who Are the Relevant Stakeholders? 18 Business Ethics Flashpoint 2.3: The WorldCom Accounting Scandal 19 Business Ethics Flashpoint 2.4: The Health Focus of Revolution Foods 21 How Do We Make Ethical Decisions? 21 Business Ethics Flashpoint 2.5: The Dofasco Steel Company’s Approach to Workers 22 Questions & Problems 23

Case Opener: Questionable Jurisdiction over Caterpillar 25 Jurisdiction 26 Original versus Appellate Jurisdiction 26 Jurisdiction over Persons and Property 26 Case 3-1: Illinois v. Hemi Group LLC 27 Subject-Matter Jurisdiction 29 Case 3-2: Hertz Corporation v. Friend 30 Venue 32 The Structure of the Court System 32 The Federal Court System 32 State Court Systems 34 Threshold Requirements 35 Standing 35 Case or Controversy 36 Ripeness 36 Steps in Civil Litigation 37 The Pretrial Stage 37 The Trial 41 Case 3-3: J.E.B. v. Alabama, ex. rel. T.B. 41 Posttrial Motions 44 Appellate Procedure 44 Alternative Dispute Resolution 45 Primary Forms of ADR 46 Negotiation 46 Mediation 46 Arbitration 47 Other ADR Methods 49 Med-Arb 49 Summary Jury Trial 50 Minitrial 50 Early Neutral Case Evaluation 50 Private Trials 50 Summary 50 Point/Counterpoint 51 Questions & Problems 52

4 Administrative Law 54 Case Opener: Does the EPA Have an Obligation to Regulate Automobile Emissions? 54 Introduction to Administrative Law 55 What Is Administrative Law? 55 Why and How Are Agencies Created? 55 xxi



Types of Administrative Agencies 56 How Are Agencies Run? 57 Informal Rule Making 58 Formal Rule Making 58 Hybrid Rule Making 59 Exempted Rule Making 59 Regulated Negotiation 61 Problems Associated with Rule Making 61 Other Administrative Activities 62 Case 4-1: Yan Ju Wang v. George Valverde 62 Limitations on Agency Powers 63 Political Limitations 63 Statutory Limitations 63 Judicial Limitations 64 Case 4-2: Northwestern University and College Athletes Players Association (CAPA) 64 Informational Limitations 66 Case 4-3: Electronic Privacy Information Center v. National Security Administration 67 Federal and State Administrative Agencies 70 Summary 70 Point/Counterpoint 71 Questions & Problems 72


Constitutional Law 75

Case Opener: The Constitutionality of the Affordable Care Act 75 The U.S. Constitution 76 Judicial Review 77 The Supremacy Clause and Federal Preemption 77 The Commerce Clause 78 The Commerce Clause as a Source of Authority for the Federal Government 78 Case 5-1: Christy Brzonkala v. Antonio J. Morrison et al. 79 The Commerce Clause as a Restriction on State Authority 80 Case 5-2: Black Star Farms, LLC, et al. v. Jerry Oliver, Arizona Department of Liquor License and Control et al. 81 Taxing and Spending Powers of the Federal Government 82 Other Constitutional Restrictions on Government 83 The Privileges and Immunities Clause 83 The Full Faith and Credit Clause 83 The Contract Clause 84 The Amendments to the Constitution 84 The First Amendment 84 Case 5-3: Bad Frog Brewery v. New York State Liquor Authority 87 The Fourth Amendment 89 The Fifth Amendment 91

The Ninth Amendment 93 The Fourteenth Amendment 94 Summary 94 Point/Counterpoint 96 Questions & Problems 96

6 Criminal Law and Business 99 Case Opener: Untenable Trading 99 The Nature and Elements of a Crime 100 Elements of a Crime 100 Classification of Crimes 101 White-Collar Crime 101 Specific White-Collar Crimes 102 Case 6-1: United States of America v. Svete 105 Corporate Criminal Liability 111 Case 6-2: United States v. Park 112 Criminal Procedure 113 Pretrial Procedure 114 Trial Procedure 114 Posttrial Procedure 116 Tools for Fighting Business Crime 117 RICO 117 The False Claims Act 118 The Sarbanes-Oxley Act 118 State Whistle-Blower Protection Laws 119 Summary 120 Point/Counterpoint 121 Questions & Problems 122

7 Tort Law 125 Case Opener: Plastic Surgeon Defamation 125 Introduction to Tort Law 126 Classification of Torts 127 Intentional Torts 127 Intentional Torts against Persons 127 Case 7-1: Aaron Olson v. CenturyLink 132 Intentional Torts against Property 133 Intentional Torts against Economic Interests 134 Negligence 135 Duty 135 Breach of Duty 137 Causation 137 Damages 138 Plaintiff’s Doctrines 138 Res Ipsa Loquitur 139 Case 7-2: Sandra Morris v. Walmart Stores, Inc. 139 Negligence per Se 140 Defenses to Negligence 141 Contributory Negligence 141 Comparative Negligence 142


Assumption of the Risk 142 Special Defenses to Negligence 143 Strict Liability 143 Damages Available in Tort Cases 143 Compensatory Damages 144 Nominal Damages 144 Punitive Damages 144 Case 7-3: Clark v. Chrysler Corporation 146 Summary 147 Point/Counterpoint 147 Questions & Problems 148


Real, Personal, and Intellectual Property 150 Case Opener: Technology Companies at War 150 The Nature of Real, Personal, and Intellectual Property 151 Real Property 152 Extent of Ownership 152 Interests in Real Property 153 Property Transfer 154 Case 8-1: Kelo v. City of New London 156 Personal Property 157 Voluntary Transfer of Property 158 Involuntary Transfer of Personal Property 159 Other Means of Acquiring Ownership of Propety 159 Intellectual Property 159 Trademarks 160 Case 8-2: Toys “R” Us, Inc. v. Canarsie Kiddie Shop, Inc. 161 Copyrights 163 Case 8-3: Gaylord v. United States 165 Patents 166 The America Invents Act 168 Trade Secrets 168 Summary 169 Point/Counterpoint 169 Questions & Problems 170 P A R T


Contract Law 9 Introduction to Contracts and Agreement 173 Case Opener: The Problematic Promotion 173 The Definition of a Contract 174 Elements of a Contract 174 Defenses to the Enforcement of a Contract 174 Sources of Contract Law 175 Common Law 175 Uniform Commercial Code 175


Classification of Contracts 176 Bilateral versus Unilateral Contracts 176 Case 9-1: Zappos.com Inc. 176 Express versus Implied Contracts 178 Quasi-Contracts 178 Valid, Void, Voidable, and Unenforceable Contracts 178 Executed versus Executory Contracts 179 Formal versus Informal Contracts 179 The Agreement 180 Elements of the Offer 180 Intent 180 Case 9-2: Lucy v. Zehmer 180 Definite and Certain Terms 183 Case 9-3: Janky v. Batistatos, Lake County Conventions & Visitations Bureau et al. 183 Communication to the Offeree 184 Termination of the Offer 184 Revocation by the Offeror 184 Rejection by the Offeree 185 Death or Incapacity of the Offeror 185 Destruction or Subsequent Illegality of the Subject Matter 185 Lapse of Time or Failure of Another Condition Specified in the Offer 185 Elements of the Acceptance 186 Manifestation of Intent to Be Bound to the Contract 186 Acceptance of Definite and Certain Terms: The Mirror-Image Rule 186 Communication to the Offeror 187 Summary 188 Point/Counterpoint 189 Questions & Problems 189

10 Consideration 192 Case Opener: Upper Deck—Contract Liability or Gift? 192 What Is Consideration? 193 Rules of Consideration 193 Lack of Consideration 193 Case 10-1: Hamer v. Sidway 194 Adequacy of Consideration 196 Case 10-2: Thelma Agnes Smith v. David Phillip Riley 196 Illusory Promise 197 Past Consideration 197 Case 10-3: Jamil Blackmon v. Allen Iverson 198 Preexisting Duty 199 Partial Payment of a Debt 200 Summary 202 Point/Counterpoint 203 Questions & Problems 203




Capacity and Legality 206

Case Opener: Liability of Minors for Purchase of Game Apps 206 Capacity 207 Minors 207 Mentally Incapacitated Persons 210 Intoxicated Persons 211 Legality 211 Contracts That Violate State or Federal Statutes 212 Case 11-1: King v. Riedl 213 Agreements That Violate Public Policy 215 Case 11-2: John Miller, Appellant v. Jay Preefer, Richard Preefer, Compromised Management, Inc., and Palm Beach Ale House and Raw Bar, Inc., Appellees 216 Case 11-3: Eric Lucier and Karen A. Haley v. Angela and James Williams, Cambridge Associates, Ltd., and Al Vasys 219 Effect of Illegal Agreements 221 Summary 222 Point/Counterpoint 223 Questions & Problems 223


Reality of Assent 225

Case Opener: Disagreement over an Agreement 225 The Importance of Genuine Assent 226 Mistake 227 Unilateral Mistake 227 Mutual Mistake 228 Case 12-1: Simkin v. Blank 229 Misrepresentation 230 Innocent Misrepresentation 230 Negligent Misrepresentation 231 Fraudulent Misrepresentation 231 Case 12-2: Manderville v. PCG&S Group, Inc. 232 Undue Influence 235 Duress 235 Case 12-3: Telekenex IXC, Inc. v. Charlotte Russe, Inc. 236 Summary 238 Point/Counterpoint 238 Questions & Problems 239


Contracts in Writing and ThirdParty Contracts 241 Case Opener: Fallout from a Forgettable Fight 241 Statute of Frauds 242 Contracts Falling within the Statute of Frauds 242 Contracts Whose Terms Prevent Possible Performance within One Year 243 Promises Made in Consideration of Marriage 243 Contracts for One Party to Pay the Debt of Another If the Initial Party Fails to Pay 244

Contracts Related to an Interest in Land 244 Contracts for the Sale of Goods Totaling More than $500 246 Further Requirements Specific to Certain States 246 Exceptions to the Statute of Frauds 246 Admission 246 Partial Performance 247 Promissory Estoppel 247 Exceptions under the UCC 247 Sufficiency of the Writing 248 Case 13-1: Martha A. Nix and Charles E. Upham v. Skip Wick, Christie Wick, and James Oldfield 248 Parol Evidence Rule 250 Exceptions to the Parol Evidence Rule 250 Contracts That Have Been Subsequently Modified 251 Contracts Conditioned on Orally Agreed-On Terms 251 Nonfinalized, Partially Written and Partially Oral, Contracts 251 Contracts Containing Ambiguous Terms 251 Incomplete Contracts 251 Contracts with Obvious Typographical Errors 252 Void or Voidable Contracts 252 Evidence of Prior Dealings or Usage of Trade 252 Integrated Contracts 252 Third-Party Rights to Contracts 253 Assignments and Delegations 253 Assignment 253 Delegation 256 Assignment of the Contract 258 Third-Party Beneficiary Contracts 258 Intended Beneficiaries 258 Case 13-2: Allan v. Nersesova 259 Case 13-3: Lawrence v. Fox 261 Incidental Beneficiaries 263 Summary 264 Point/Counterpoint 266 Questions & Problems 266

14 Discharge and Remedies 270 Case Opener: The Battle of the Pharmacies 270 Methods of Discharging a Contract 271 Conditions 271 Discharge by Performance 272 Discharge by Material Breach 273 Case 14-1: Hamilton v. State Farm Fire & Casualty Insurance Company 273 Discharge by Mutual Agreement 275 Discharge by Operation of Law 276 Case 14-2: Thrifty Rent-A-Car System v. South Florida Transport 277 Remedies 279 Legal Remedies (Monetary Damages) 280


Case 14-3: S. Brooke Purll, Inc., T/A Purll Construction v. Patrick Darrell Vailes 283 Equitable Remedies 284 Summary 286 Point/Counterpoint 286 Questions & Problems 287 P A R T


Domestic and International Sales Law 291 15

Formation and Performance of Sales and Lease Contracts 291 Case Opener: Dropped Calls or, More Appropriately, Dropped Towers: Are Cell Towers Goods or Services? 291 The Uniform Commercial Code 292 The Scope of the UCC 292 The Significance of the UCC 292 Articles 2 and 2(A) of the UCC 293 Article 2 of the UCC 293 Article 2(A) of the UCC 296 Contracts for the International Sale of Goods 297 The Scope and Significance of the CISG 297 How Sales and Lease Contracts Are Formed under the UCC 297 Formation in General 297 Offer and Acceptance 298 Consideration 299 Battle of the Forms 299 Requirements under the Statute of Frauds 299 Unconscionability 300 Title 300 Three Kinds of Title 300 Acquiring Good Title 300 Case 15-1: Alfonso Candela, Appellant v. Port Motors, Inc., Respondent, et al., Defendant 300 Voidable Title 301 Entrustment 302 Title versus Other Interests in the Goods 302 Types of Sales Contracts 302 Simple Delivery Contract 303 Common-Carrier Delivery Contract 304 Goods-in-Bailment Contract 305 Conditional Sales Contract 306 Risk of Loss during a Breach of Contract 306 When the Seller Is in Breach 306 When the Buyer Is in Breach 306 Summary 306 Point/Counterpoint 308 Questions & Problems 309

16 Sales and Lease Contracts: Performance, Warranties, and Remedies 312 Case Opener: How Much Is That Doggie in the Window? 312 The Basic Performance Obligation 313 Good Faith 313 Specific Obligations of Sellers and Lessors 314 The Perfect Tender Rule 314 Exceptions to the Perfect Tender Rule 316 Case 16-1: Alaska Pacific Trading Co. v. Eagon Forest Products Inc. 316 Specific Obligations of Buyers and Lessees 318 The Basic Obligation: Inspection, Payment, and Acceptance 318 Exceptions to the Basic Obligation 318 Warranties 318 Warranties of Title 319 Express Warranties 319 Implied Warranties of Quality 319 Case 16-2: Priscilla D. Webster v. Blue Ship Tea Room, Inc. 320 Warranty Rights of Third Parties 321 Warranty Disclaimers and Waivers 322 The Goal of Contract Remedies 322 Remedies Available to Sellers and Lessors under the UCC 323 Cancel the Contract 323 Withhold Delivery 323 Resell or Dispose of the Goods 323 Sue to Get the Benefit of the Bargain 323 Stop Delivery 323 Reclaim the Goods 323 Remedies Available to Buyers and Lessees under the UCC 324 Cancel the Contract 324 Obtain Cover 324 Sue to Recover Damages 324 Recover the Goods 324 Obtain Specific Performance 324 Reject Nonconforming Goods 326 Revoke Acceptance of Nonconforming Goods 326 Accept the Nonconforming Goods and Seek Damages 326 Modifications or Limitations to the Remedies Otherwise Provided by the UCC 326 Summary 326 Point/Counterpoint 328 Questions & Problems 329






Negotiable Instruments and Banking 17 Negotiable Instruments: Negotiability and Transferability 331 Case Opener: Oral Agreements and Negotiable Instruments 331 The Need for Negotiable Instruments 332 Contracts as Commercial Paper 332 Problems with Commercial Paper 332 Types of Negotiable Instruments 333 An Overview of the Law of Negotiable Instruments 333 Case 17-1: Reger Development, LLC v. National City Bank 334 Requirements for Negotiability 335 Negotiation 339 Delivery 339 Endorsement 339 Noncriminal Endorsement Problems 339 Banking 341 Checks 342 Cashier’s Checks 343 Traveler’s Checks 343 Money Orders 344 Certified Checks 344 Why Use Cashier’s or Certified Checks? 345 Lost, Stolen, or Destroyed Cashier’s or Certified Checks 345 Accepting Deposits 345 The Check Collection Process 345 Electronic Check Presentment 346 Availability Schedule for Deposited Checks 347 The Truth-in-Savings Act 347 When a Bank May Charge a Customer’s Account 348 Wrongful Dishonor 348 Case 17-2: The Twin City Bank v. Kenneth Isaacs 348 Stop-Payment Order 350 Postdated Checks 350 Stale Checks 350 Forgeries and Alterations 350 Electronic Fund Transfers 352 Consumer Fund Transfers 352 Commercial Fund Transfers 353 E-Money and Online Banking 353 Online Banking Services 353 Regulatory Compliance 354 Privacy Protection 354 Summary 354 Point/Counterpoint 356 Questions & Problems 357

18 Holder in Due Course, Liability, and Defenses 359 Case Opener: Dishonored Check and Holder-in-Due-Course Status 359 Holder-in-Due-Course Doctrine 360 Reason for Holder-in-Due-Course Status 360 Requirements for Holder-in-Due-Course Status 360 Be a Holder of a Complete and Authentic Negotiable Instrument 362 Take Instrument for Value 363 Take Instrument in Good Faith 363 Case 18-1: Wawel Savings Bank v. Jersey Tractor Trailer Training, Inc. 364 Take Instrument without Notice 365 The Shelter Principle and HDC 367 Abuse of the Holder-in-Due-Course Doctrine 368 Liability 368 Signature Liability 369 Primary Liability of Makers and Acceptors 369 Secondary Liability of Drawers and Endorsers 369 Accommodation Parties 371 Unauthorized Signatures and Endorsements 372 Warranty Liability 373 Transfer Warranty 374 Presentment Warranty 374 Avoiding Liability for Negotiable Instruments 375 Defenses to Liability 375 Discharge of Liability on Instruments 377 Summary 379 Point/Counterpoint 380 Questions & Problems 381



Creditors’ Rights and Bankruptcy 19 Secured Transactions and Bankruptcy 384 Case Opener: A Commercially Reasonable Sale? 384 Important Definitions Associated with Secured Transactions 385 Creation of Secured Interests 386 Written Agreement 386 Value 386 Debtor Rights in the Collateral 386 Purchase-Money Security Interest 387 Perfected Security Interest 387 Perfection by Filing 387 Perfection by Possession 388


Automatic Perfection 388 Perfection of Movable Collateral 388 Perfection of Security Interests in Automobiles and Boats 388 The Scope of a Security Interest 389 After-Acquired Property 389 Proceeds 390 Termination of a Security Interest 390 Priority Disputes 390 Secured versus Unsecured Creditors 390 Secured versus Secured Creditors 390 Secured Party versus Buyer 391 Case 19-1: In re Girolamo Afonica, Debtor 392 Default 393 Taking Possession of the Collateral 394 Proceeding to Judgment 395 Bankruptcy and Reorganization 395 The Bankruptcy Act and Its Goals 395 Title 11 of the United States Code 395 Bankruptcy Proceedings 396 Specific Types of Relief Available 396 Chapter 7: Liquidation Proceedings 396 Case 19-2: Rousey v. Jacoway 399 Chapter 11: Reorganizations 402 Chapter 13: Individual Repayment Plans 403 Chapter 12: Family-Farmer and Family-Fisherman Plans 404 Summary 405 Point/Counterpoint 406 Questions & Problems 407 P A R T


Agency 20

Agency and Liability to Third Parties 410 Case Opener: FedEx and Independent Contractors 410 Introduction to Agency Law 411 Creation of the Agency Relationship 411 Expressed Agency (Agency by Agreement) 412 Agency by Implied Authority 413 Apparent Agency (Agency by Estoppel) 414 Agency by Ratification 415 Agency Relationships 416 Principal–Agent Relationship 416 Employer–Employee Relationship 416 Employer–Independent Contractor Relationship 416 Duties of the Agent and the Principal 418 Principal’s Duties to the Agent 418 Agent’s Duties to the Principal 419


Case 20-1: International Airport Centers v. Jacob Citrin 420 Rights and Remedies 422 Principal’s Rights and Remedies against the Agent 422 Agent’s Rights and Remedies against the Principal 422 Authority of the Agent: The Link to the Principal’s Liability 423 Express Authority 423 Implied Authority 424 Apparent Authority and Estoppel 424 Contractual Liability of the Principal and Agent 424 Classification of the Principal 424 Authorized Acts 425 Unauthorized Acts 426 Tort Liability and the Agency Relationship 426 Principal’s Tortious Conduct 427 Case 20-2: Iglesia Cristiana la Casa del Senor, Inc., etc. v. L.M. 428 Agent Misrepresentation 429 Principal’s Liability and the Independent Contractor 429 Termination of the Agency Relationship 430 Termination by Acts of Parties 431 Termination by Operation of Law 432 Summary 434 Point/Counterpoint 435 Questions & Problems 437 P A R T


Business Organizations 21 Forms of Business Organization 439 Case Opener: The Dunkin’ Donuts Franchise Agreement 439 Major Forms of Business Organization 440 Sole Proprietorship 440 Partnership 441 Different Types of Partnerships 445 Corporation 446 Limited Liability Company 447 Specialized Forms of Business Organization 449 Cooperative 449 Joint Stock Company 450 Business Trust 450 Syndicate 450 Joint Venture 450 Case 21-1: Meyer v. Christie 451 Franchise 452 Case 21-2: Mary Kay, Inc., a/k/a Mary Kay Cosmetics, Inc. v. Janet Isbell 454 Case 21-3: Cousins Subs Systems, Inc. v. Michael R. McKinney 456 Summary 457 Point/Counterpoint 457 Questions & Problems 458




Corporations: Formation and Organization 461 Case Opener: The Formation of the Facebook Corporation 461 Characteristics of Corporations 462 Legal Entity 462 Rights as a Person and a Citizen 462 Creature of the State 462 Limited Liability 462 Free Transferability of Corporate Shares 462 Perpetual Existence 462 Centralized Management 463 Corporate Taxation 463 Liability for Officers and Employees 463 Corporate Powers 463 Express and Implied Powers 464 Ultra Vires Act 464 Classification of Corporations 464 Public or Private 464 Profit or Nonprofit 464 Domestic, Foreign, and Alien Corporations 465 Publicly Held or Closely Held 465 Subchapter S Corporation 465 Professional Corporation 466 Formation of the Corporation 466 Organizing and Promoting the Corporation 466 Selecting a State for Incorporation 466 Legal Process of Incorporation 467 Selection of Corporate Name 467 Incorporators 467 Articles of Incorporation 467 First Organizational Meeting 467 Potential Problems with Formation of the Corporation 468 Responses to Defective Incorporation 468 Corporate Financing 470 Debt Securities 470 Case 22-1: J-Mart Jewelry Outlets, Inc. v. Standard Design 471 Equity Securities 472 Importance of Regulating Interactions among Directors, Officers, and Shareholders within a Corporation 472 Roles of Directors, Officers, and Shareholders 472 Directors’ Roles 473 Officers’ Roles 473 Shareholders’ Roles 474 Duties of Directors, Officers, and Shareholders 475 Duties of Directors and Officers 475 Duties of Shareholders 478 Case 22-2: McCann v. McCann 478 Liabilities of Directors, Officers, and Shareholders 479 Liability of Directors and Officers 479 Liability of Shareholders 480

Rights of Directors, Officers, and Shareholders 481 Directors’ Rights 481 Officers’ Rights 481 Shareholders’ Rights 481 Introduction to Mergers and Consolidations 484 Mergers 484 Consolidations 484 The Rights of Shareholders 485 Appraisal Rights 485 Purchase of Stock 486 The Nature of Takeovers 486 Types of Takeovers 486 Response to Takeovers 486 Case 22-3: Campbell, Kesser, and Williams v. Pothas Corporation 487 Response to Termination 488 Dissolution 488 Summary 488 Point/Counterpoint 490 Questions & Problems 491

23 Securities Regulation 493 Case Opener: The Martha Stewart Case 493 What Is a Security? 494 Case 23-1: Securities and Exchange Commission v. Mutual Benefits Corp. 494 Securities Regulation 496 The Securities and Exchange Commission 496 The Securities Act of 1933 497 Registration Statement 497 Prospectus 497 Periods of the Filing Process 497 Special Registration Provisions 498 Exemptions under the 1933 Act 498 Violations and Liability 501 The Securities Exchange Act of 1934 501 Case 23-2: Steven Klein, Warren Brandwine v. General Nutrition Companies, Inc. 502 Section 10(b) and Rule 10b-5 503 Insider Trading 504 Case 23-3: Securities and Exchange Commission v. Texas Gulf Sulphur Co. 504 The Private Securities Litigation Reform Act of 1995 506 Outsiders and Insider Trading 506 Section 16(b) 506 Proxy Solicitations 507 Violations of the 1934 Act 508 Regulation of Investment Companies 508 State Securities Laws 509 Summary 510 Point/Counterpoint 511 Questions & Problems 512




Government Regulation 24

Employment and Discrimination Law 514 Case Opener: Brad Gets Fired from So Clean! 514 When May an Employee Be Fired? 515 Federal Employment Discrimination Laws Governing Employers 515 Civil Rights Act—Title VII 516 Disparate-Treatment Discrimination under Title VII 516 Disparate-Impact Discrimination under Title VII 517 Sexual Harassment under Title VII 518 Case 24-1: Teresa Harris v. Forklift Systems, Inc. 519 Harassment of Other Protected Classes under Title VII 520 Pregnancy Discrimination Act of 1987—An Amendment to Title VII 520 Defenses to Claims under Title VII 520 Remedies under Title VII 521 Procedure for Filing a Claim under Title VII 522 Discrimination Based on Sexual Orientation— Actionable? 522 Discrimination Based on Marriage 522 Age Discrimination in Employment Act of 1967 523 Americans with Disabilities Act 523 May an Employer Discriminate against a Smoker? 524 Equal Pay Act of 1963 524 Additional Laws Governing the Employment Relationship 525 Fair Labor Standards Act 525 Family and Medical Leave Act 526 Unemployment Compensation 526 Workers’ Compensation Laws 526 Consolidated Omnibus Budget Reconciliation Act of 1985 526 Employee Retirement Income Security Act of 1974 527 Occupational Safety and Health Act of 1970 527 Employee Privacy in the Workplace 527 Electronic Monitoring and Communication 528 Labor Laws and Unions 528 The Wagner Act of 1935 529 The Taft-Hartley Act of 1947 530 The Landrum-Griffin Act of 1959 530 The National Labor Relations Board 531 The Collective Bargaining Process 531 Summary 531 Point/Counterpoint 533 Questions & Problems 534


25 Consumer Law 536 Case Opener: Deceptive Advertising and the Ultimate Weight Loss Cure 536 The Federal Trade Commission 537 How the FTC Brings an Action 537 Trade Regulation Rules 538 Deceptive Advertising 538 Case 25-1: Goltin v. Lederman 539 Bait-and-Switch Advertising 540 FTC Actions against Deceptive Advertising 542 Telemarketing and Electronic Advertising 542 Tobacco Advertising 543 Labeling and Packaging Laws 544 Sales 545 Door-to-Door Sales 545 Telephone and Mail-Order Sales 545 FTC Regulation of Sales in Specific Industries 546 Credit Protection 547 The Truth in Lending Act 547 The Fair Credit Reporting Act 549 Case 25-2: Richard D. Kennedy and Sally S. Kennedy v. Chase Manhattan Bank, USA, N.A., et al. 550 The Fair Debt Collection Practices Act 551 The Credit Card Fraud Act 551 The Fair Credit Billing Act 552 The Fair and Accurate Credit Transactions Act 552 The Credit Card Holders’ Bill of Rights Act 552 Consumer Health and Safety 553 The Federal Food, Drug, and Cosmetic Act 553 Case 25-3: Food and Drug Administration et al. v. Brown & Williamson Tobacco Corporation et al. 554 The Consumer Product Safety Act 555 Summary 556 Point/Counterpoint 557 Questions & Problems 557

Appendixes APPENDIX A The Constitution of the United States of America A-1 APPENDIX B Sarbanes-Oxley Act of 2002 B Glossary G Index I-1

List of Cases The U.S. Legal System and Alternative Dispute Resolution

Introduction to Contracts and Agreement

chapter 3

chapter 9

Illinois v. Hemi Group LLC .................................................... 27 Hertz Corporation v. Friend .................................................. 30 J.E.B. v. Alabama, ex. rel. T.B. .............................................. 41

In re Zappos.com Inc. ....................................................... 176 Lucy v. Zehmer ................................................................. 180 Janky v. Batistatos, Lake County Conventions & Visitations Bureau et al. ........................ 183

chapter 4

Administrative Law

Yan Ju Wang v. George Valverde .......................................... 62 Northwestern University and College Athletes Players Association (CAPA) ............................................. 64 Electronic Privacy Information Center v. National Security Administration .................................................. 67

chapter 5

Constitutional Law

Christy Brzonkala v. Antonio J. Morrison et al. ..................... 79 Black Star Farms, LLC, et al. v. Jerry Oliver, Arizona Department of Liquor License and Control et al. ........................................................... 81 Bad Frog Brewery v. New York State Liquor Authority .......... 87

chapter 10


Hamer v. Sidway ............................................................... 194 Thelma Agnes Smith v. David Phillip Riley ......................... 196 Jamil Blackmon v. Allen Iverson ........................................ 198

chapter 11

Capacity and Legality

King v. Riedl ...................................................................... 213 John Miller, Appellant v. Jay Preefer, Richard Preefer, Compromised Management, Inc. and Palm Beach Ale House and Raw Bar, Inc., Appellees ........................ 216 Eric Lucier and Karen A. Haley v. Angela and James Williams, Cambridge Associates, Ltd., and Al Vasys ...... 219

chapter 12

Reality of Assent

chapter 6

Criminal Law and Business

Simkin v. Blank ................................................................. 229 Manderville v. PCG&S Group, Inc. ...................................... 232 Telekenex IXC, Inc. v. Charlotte Russe, Inc. ........................ 236

United States of America v. Svete ...................................... 105 United States v. Park ......................................................... 112

Contracts in Writing and Third-Party Contracts

chapter 7

Tort Law

Aaron Olson v. CenturyLink ............................................... 132 Sandra Morris v. Walmart Stores, Inc. ................................ 139 Clark v. Chrysler Corporation ............................................. 146

Real, Personal, and Intellectual Property

chapter 8

Kelo v. City of New London ................................................ 156 Toys “R” Us, Inc. v. Canarsie Kiddie Shop, Inc. ................... 161 Gaylord v. United States .................................................... 165 xxx

chapter 13

Martha A. Nix and Charles E. Upham v. Skip Wick, Christie Wick, and James Oldfield ................................ 248 Allan v. Nersesova ............................................................. 259 Lawrence v. Fox ................................................................ 261

chapter 14

Discharge and

Remedies Hamilton v. State Farm Fire & Casualty Insurance Company ..................................................... 273 Thrifty Rent-A-Car System v. South Florida Transport ........ 277 S. Brooke Purll, Inc., T/A Purll Construction v. Patrick Darrell Vailes .................................................... 283

List of Cases

Formation and Performance of Sales and Lease Contracts chapter 15

Alfonso Candela, Appellant v. Port Motors, Inc., Respondent, et al., Defendant ...................................... 300

Sales and Lease Contracts: Performance, Warranties, and Remedies chapter 16

Alaska Pacific Trading Co. v. Eagon Forest Products Inc. ............. 316 Priscilla D. Webster v. Blue Ship Tea Room, Inc. ................. 320

Negotiable Instruments: Negotiability and Transferability chapter 17

Reger Development, LLC v. National City Bank .................. 334 The Twin City Bank v. Kenneth Isaacs ................................ 348

Holder in Due Course, Liability, and Defenses chapter 18

Wawel Savings Bank v. Jersey Tractor Trailer Training, Inc. ......... 364

Secured Transactions and Bankruptcy chapter 19

In re Girolamo Afonica, Debtor ........................................... 392 Rousey v. Jacoway ............................................................ 399

Agency and Liability to Third Parties

chapter 20

International Airport Centers v. Jacob Citrin ....................... 420 Iglesia Cristiana la Casa del Senor, Inc., etc. v. L.M. ........... 428


Forms of Business Organization chapter 21

Meyer v. Christie ............................................................... 451 Mary Kay, Inc., a/k/a Mary Kay Cosmetics, Inc. v. Janet Isbell ........................................................ 454 Cousins Subs Systems, Inc. v. Michael R. McKinney ................................................................ 456

Corporations: Formation and Organization chapter 22

J-Mart Jewelry Outlets, Inc. v. Standard Design ................ 471 McCann v. McCann ........................................................... 478 Campbell, Kesser, and Williams v. Pothas Corporation ...................................................... 487

chapter 23


Regulation Securities and Exchange Commission v. Mutual Benefits Corp. .................................................. 494 Steven Klein, Warren Brandwine v. General Nutrition Companies, Inc. ................................ 502 Securities and Exchange Commission v. Texas Gulf Sulphur Co. ................................................. 504

Employment and Discrimination Law chapter 24

Teresa Harris v. Forklift Systems, Inc. ................................ 519

chapter 25

Consumer Law

Gotlin v. Lederman ............................................................ 539 Richard D. Kennedy and Sally S. Kennedy v. Chase Manhattan Bank, USA, N.A., et al. ...................... 550 Food and Drug Administration et al. v. Brown & Williamson Tobacco Corporation et al. ............ 554


The Legal Environment of Business

1 1


An Introduction to the Fundamentals of Dynamic Business Law LEARNING OBJECTIVES After reading this chapter, you will be able to answer the following questions:

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What is business law?

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How does business law relate to business education?

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What are the purposes of law?

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What are alternative ways to classify the law?

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What are the sources of the law?

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What are the various schools of jurisprudence?



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The Legal Environment of Business

This book is for future business managers, especially those who wish to be leaders. An essential factor in preparing for that career is awareness of the legal issues arising in business. Businesses need to finance capital growth, purchase inputs, and hire and develop employees. In addition, they must sell to consumers, please owners, and comply with government rules. All these activities are full of potential legal conflicts. A theme of this book will be a surprising number of legal implications that result from what on the surface might look like a simple, everyday business decision. Think along with us about the desire of a young entrepreneur who has a new idea and wants to develop its market potential. In the seemingly ever-expanding market for smart phone apps, individuals are often rewarded for creating apps that make lives simpler or that entertain people. You have watched the business success of hundreds of smart phone applications. You have certainly downloaded your share of them. You have an idea for a phone app that you believe has the potential to become the next Vine or Instagram. Your proposed app will allow users to search for lawyers based on the location and specialization that the user desires. The app will also rate different lawyers and provide personal information about the lawyers who are being rated. Your goal is to make it easier for uninformed consumers to locate the lawyer best suited for their needs. You and a friend, who has a background in computer science, develop software to run the application. You also create a design for the app: what the app will look like and how it will function. After you complete the design of the app, you decide that you would like to upload it to the Apple App Store. You contact Apple, and a representative tells you that you will be able to upload the application if you pay a fee and sign a few forms.

In this textbook, you will find legal concepts and terms that will allow you to see this scenario with different eyes. What you will learn will warn you about the dangers of letting the excitement of the moment—your big moment—cause you to forget that business is a series of conflicts in part. And in those struggles, you need to understand your interests and responsibilities. From the instant you first interact with another party in a business relationship, insights from your study of business law should kick in to protect you. Let’s walk through just a small sample of the legal issues you will face as you try to make your app the next big thing. Because you need a platform on which to sell your app, you will need to establish a contract with an app store such as the Apple App Store. This book will teach you about the elements required to establish a legal contract. In other words, only certain kinds of legal agreements will provide legal protection if a later dispute arises. Whether these elements are met will dictate whether the party with whom you are contracting is obligated to perform a certain duty. For example, if you believe that Apple has a legal duty to put your app in its App Store or, perhaps, place your app in a particular position in its online store, you would have to prove that a contract creating such a duty exists. The knowledge you will gain regarding contract law will also help you understand the complexity of the relationship between you and the user purchasing your app. For example, if the app you created malfunctions after a user has purchased it, how will you and the customer settle a dispute? Will you go to court, or would you prefer disputes to be settled through alternate dispute resolution methods such as arbitration? Will you create a binding arbitration clause to require consumer disputes to be resolved through arbitration? After reading this textbook, you will become more aware of the various conflict resolution mechanisms available to businesses and consumers. In addition to the contractual issues underlying your app business, you will also need to be aware of possible tort issues related to your app. (A tort at its simplest level is legal language for a civil [non-criminal] harm committed against another in which the injured party can sue for damages.) For example, because your app will compare the desirability of certain lawyers to others, the lawyers whom you are rating might feel threatened by your app. Will these lawyers be able to file a suit in tort against you for defamation or privacy torts such as false light or public disclosure of private facts? Alternatively, what can you do when a competing business writes a column in a newspaper mocking and generally trashing your new app? To answer that question, you need a good understanding of the torts of disparagement or slander of quality, two torts that you might be able to use to defend your business against fraudulent claims. The sections in this textbook on tort law will enable you to ask questions about potential tort claims related to the eventual marketing of your app.

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Later, when you market your app, you will also have to be aware of the restrictions on advertising that exist under consumer protection laws. Will you make any promises to consumers regarding your app in your advertisements? Will these advertisements constitute legally permitted puffery, or will they be deceptive advertisement under the Federal Trade Commission Act? As you read about consumer law in this textbook, you will learn about the restrictions the law places on advertising. When you design your app, you will have to make sure that you do not infringe on the intellectual property—such as patents or trademarks—of other app businesses. What words and symbols will you use? Do those words and symbols constitute trademark infringement? This book will explain the intellectual property law that governs the invention of an app. Finally, once you have studied this book, you will realize the importance of carefully selecting the form of business organization you and your friend choose for operating this app. For example, will you operate the app under a sole proprietorship or a partnership agreement? As you will learn, each of these forms of business organization provide you with different advantages and disadvantages. Business law consists of the enforceable rules of conduct that govern commercial relationships. In other words, buyers and sellers interact in market exchanges within the rules that indicate the boundaries of legal business behavior. Constitutions, legislatures, regulatory bodies, and courts spell out what market participants may or may not legally do. Understanding business law is necessary for future businesspeople because there simply is no market transaction that occurs outside legal guidelines. All contracts, employment decisions, and payments to a supplier are limited and protected by business law. Each of the six functional areas of business—management, production and transportation, marketing, research and development, accounting and finance, and human resource management—sits on a foundation of business law.

business law The enforceable rules of conduct that govern the actions of buyers and sellers in market exchanges.

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Law and Its Purposes Many of us might like to impose rules on others, defining their rights and responsibilities. Few of us can do this as individuals, but a majority of citizens in a democracy can agree to establish rules for business behavior. They can permit certain authorities to make and enforce rules describing what behavior is permitted and encouraged in their community. These rules are what we refer to as the law, and they are enforceable in the courts of that community. Exhibit 1-1 lists a few of the numerous purposes fulfilled by the law. Exhibit 1-1 is a reminder of why we are very proud when we say we are a society of laws. The respect we give to the law as a source of authority is in part a recognition of the fact that in the absence of law, we would rely solely on the goodwill and dependability of one another. Most of us greatly prefer the law to that option.

Classification of the Law There are many ways of thinking about the law. For example, we can divide law into national versus international law, federal versus state law, and public versus private law. Private law involves disputes between private individuals or groups. As an illustration, if a businessperson owns a computer equipment store and is delinquent in paying rent to the landlord, the dispute

• • • • • •

Providing order such that one can depend on a promise or an expectation of obligations. Serving as an alternative to fighting. Facilitating a sense that change is possible, but only after a rational consideration of options. Encouraging social justice. Guaranteeing personal freedoms. Serving as a moral guide by indicating minimal expectations of citizens and organizations.

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law Rules of conduct in any organized society that are enforced by the governing authority of the community.

LO 1-4 private law Law that involves suits between private individuals or groups.

Exhibit 1-1 Purposes of the Law


Part I

public law

between them entails private law. Public law involves disputes between private individuals or groups and their government. For instance, if a computer store dumps waste behind its building in violation of local, state, or federal environmental regulations, the resulting dispute focuses on public law. Another distinction among types of laws is civil law versus criminal law. Civil law involves the rights and responsibilities found in relationships between persons and between persons and their government. It also involves the remedies available when someone’s rights are violated. One example of a civil law case involving a large business organization occurred in 1993. The Jack-in-the-Box restaurant chain was ordered to pay damages after a two-year-old child died of food poisoning from E. coli and several other people became ill from eating the tainted meat. In contrast to civil law, criminal law applies to situations in which someone commits an act against the public as a unit. These crimes are prosecuted not by individuals but by the state or federal government. One example of a criminal law is the prohibition against insider trading on the stock exchange. Insider trading occurs when an individual uses insider, or secret, company information to increase her or his own finances or those of family or friends. For example, several years ago an IBM secretary allegedly told her husband, who told several other people, that the company was going to take over operations of Lotus Development. This information was spread among a number of individuals before it was publicly announced. On the basis of this leak, 25 people bought stock that increased greatly in value following IBM’s public announcement. The Securities and Exchange Commission filed charges against the 25 stock purchasers because they were creating an unfair trading environment for the public.

Law that involves suits between private individuals or groups and their government.

civil law The body of laws that govern the rights and responsibilities either between persons or between persons and their government.

criminal law The body of laws that involve the rights and responsibilities an individual has with respect to the public as a whole.

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The Legal Environment of Business

Sources of Business Law How is law created, and where do we look to find the laws?

CONSTITUTIONS constitutional law The general limits and powers of a government as interpreted from its written constitution.

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

STATUTES statutory law The assortment of rules and regulations put forth by legislatures.

model laws Laws created to account for the variability of laws among states. These laws serve to standardize the otherwise different interstate laws. Also called uniform laws.

Legislative actions, called statutes, are another important source of law. The assortment of rules and regulations put forth by legislatures is what we call statutory law. These legislative acts can be found in the U.S. Code when they are passed by Congress or in the various state codes when they are enacted by state legislatures. The codes are a collection of all the laws in one convenient location. Because so much business activity occurs within the jurisdiction of state courts, business managers must be familiar with the local city and county ordinances that govern matters not covered by federal or state codes. These ordinances address important business considerations such as local taxes, environmental standards, zoning ordinances, and building codes. For example, if you want to open a Krispy Kreme franchise in Santa Fe, New Mexico, you must follow local guidelines regarding the area where you may build your store, the materials that you may use to build, and the state minimum wage that you must pay to employees making donuts. The regulations will be different if you want to open your franchise in Toledo, Ohio, or in Seattle, Washington. Although they are not a source of law in the same sense as constitutions and statutory law, model or uniform laws serve as a basis for some statutory law at the state level. Business activity is made more difficult when state laws vary. To prevent such problems, a group of legal

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scholars and lawyers formed the National Conference of Commissioners on Uniform State Laws (NCC). The NCC regularly urges states to enact model laws to provide greater uniformity of law. The response is entirely in the hands of the state legislatures. They can ignore a suggestion or adopt part or all of the proposed model law. The proposals of the NCC, though not laws themselves, have been adopted on more than 200 occasions by state legislatures. The NCC is an especially important influence on business law. Paired with the publications of the American Law Institute, the NCC became the source of the Uniform Commercial Code (UCC). The UCC is a body of law so significant for business activities that it will be the focus of intensive study in several chapters of this text. The UCC laws include sales laws and other regulations affecting commerce, such as bank deposits and collections, title documents, and warranties. For example, these laws govern the different types of warranties that companies such as Microsoft, Sony, and Honda provide with their products.

CASES Constitutions, legislatures, and administrative agencies encourage certain behavior and prevent other actions. But the boundaries of these laws are seldom self-explanatory. Consequently, law must be interpreted. Case law is the collection of legal interpretations made by judges. An alternative name for case law is common law. These interpretations are law unless they are revoked later by new statutory law. Case law is especially significant for businesses because a modern business often operates in multiple legal jurisdictions. Because statutory laws are subject to interpretation, one court may have interpreted particular laws one way at one business location, and a second court may interpret a similarly worded statute differently at a second business location. Courts issue judicial decisions that often include interpretations of statutes and administrative regulations. These decisions contain the reasoning the courts use to arrive at their decisions. The reasoning depends heavily on precedent, the use of past decisions to guide future decisions. An earlier decision in a similar fact pattern is a precedent that guides later decisions, thereby providing greater stability and predictability to the law. The 2014 case of Air Wisconsin Airlines Corp. v. Hoeper (No. 12-315, slip op. Sup. Ct. January 27, 2014) provides an illustration of how important knowledge of business law and precedent can be. Mr. Hoeper was a pilot for Wisconsin Air. He needed to be certified to fly a new kind of aircraft his employer bought. At the conclusion of his fourth failed attempt to be certified, Mr. Hoeper raised his voice, tossed his headset, used profanity, and accused the instructor of railroading him. The manager who booked a return flight for Hoeper discussed Hoeper’s behavior with officials of Wisconsin Air. They knew that Hoeper was licensed to carry a firearm. Consequently, an airline executive warned the TSA (Transportation Security Administration). During the call, the executive said that the airline was concerned about Hoeper’s mental stability and the whereabouts of his firearm. The TSA removed the pilot from the airplane, searched him, and questioned him about the whereabouts of his firearm. Hoeper sued for defamation. The jury found for Hoeper, and the Colorado Supreme Court agreed with the jury on appeal. When the U.S. Supreme Court heard the case, it reversed the decision, finding against Hoeper’s defamation claim. In the course of that opinion, Justice Sotomayor, writing for the Court, relied heavily on the earlier Masson v. New Yorker Magazine, Inc., 501 U.S. 496 (1991) case for precedent. Hoeper maintained that the Wisconsin Air executive who warned the TSA should have qualified the concern about the location of Hoeper’s weapon by saying that “it had no reason to think he actually was armed.” But Justice Sotomayor pointed out that Masson provided that in a defamation action, a materially false statement would have to be one that would have had a different effect on the mind of the listener from that which the truth would have produced and, in this case, a reasonable TSA officer would have searched the pilot for a gun after hearing that the pilot was upset. It is crucial for business managers to pay attention to changes in the law and cases in which new precedents are set. These precedents must be taken into account when making future

case law The collection of legal interpretations made by judges. They are considered to be law unless otherwise revoked by a statutory law. Also known as common law.

precedent A tool used by judges to make rulings on cases on the basis of key similarities to previous cases.


stare decisis “Standing by the decision”; a principle stating that rulings made in higher courts are binding precedent for lower courts.

Restatements of the Law Summaries of common law rules in a particular area of the law. Restatements do not carry the weight of law but can be used to guide interpretations of particular cases.

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business decisions. For instance, courts sometimes make new rulings regarding the kinds of warnings companies should be required to provide to consumers about potential harm that could result from their products. One example was a case filed against McDonald’s. After a woman was severely burned by very hot coffee, the company was found negligent for failing to provide a warning label on its hot-beverage cups. Now many retailers of hot beverages provide warning labels on their beverage cups because of the precedent that was set by this case. When courts rely on precedent, they are obeying stare decisis (“standing by the decision”). Following stare decisis creates greater predictability for both businesses and individuals that look to the courts for the rules on which they should rely when they engage in market exchanges. In accordance with stare decisis, rulings that are made in higher courts become binding precedent for lower courts. Even though this practice is meant to create a consistent and reliable justice system, different judges may view the facts of a case in different ways. In addition, courts are sometimes presented with a new issue and do not have a binding decision to follow. In such instances, they may look to decisions made in similar cases by nonbinding courts in other states or jurisdictions. If a new issue comes before two state courts and there is no binding decision from the state supreme court, both state courts need to look for other rulings on similar cases. They are not bound by each other’s decision, so they might have different decisions on the same subject. The decisions in these lower courts can be appealed to the state appeals court, however, and the appeals court’s decision can be appealed to the state supreme court. One example of a case that has been used in accordance with stare decisis as a binding precedent is Brown v. Board of Education,1 which abolished discriminatory policies for individuals of different racial backgrounds. For instance, in Regents of the University of California v. Bakke,2 the plaintiff, a white male, had applied to the University of California at Davis medical school 2 years in a row and been denied admittance. He alleged that the admissions process was discriminatory because out of 100 slots, 16 were reserved for members of minority races. The U.S. Supreme Court found that the school’s admissions policy was not legal, referencing Brown and stating that the basic principle behind it and similar cases was that individuals could not be excluded on the basis of race or ethnicity. The Court wrote, “Preferring members of any one group for no reason other than race or ethnic origin is discrimination for its own sake.” Just as state statutes have been strongly influenced by the suggestions of the NCC, common law evolves with the assistance of a mechanism called Restatements of the Law. These Restatements are summaries of the common law rules in a particular area of the law that have been enacted by most states. In addition to the Restatements, many influences are at work in the minds of judges when they interpret constitutions, statutes, and regulations. For example, the values and social backgrounds of the judges function as lights and shadows, moving the judges toward particular legal decisions.


administrative law The collection of rules and decisions made by administrative agencies to fill in particular details missing from constitutions and statutes.

Constitutions and statutes are never complete in the sense of covering all the detailed rules that affect government and business relations. The federal government, as well as state and local governments, has dozens of administrative agencies whose task is to perform a particular government function. For example, the Environmental Protection Agency (EPA) has broad responsibilities to enforce federal statutes in the area of environmental protection. Administrative law is the collection of rules and decisions made by all these administrative agencies. Just glance at Exhibit 1-2 to get a sense of the scope of a few of the major federal administrative agencies. Businesses function within the rules established by agencies like these. For example, the Occupational Safety and Health Administration (OSHA) oversees health and workplace safety and makes sure that employees are working in conditions that are not hazardous. One instance in which OSHA exercised its authority occurred in 1994, when OSHA settled a complaint with 1 2

347 U.S. 483 (1954). 438 U.S. 265 (1978).

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Commodity Futures Trading Commission (CFTC) Consumer Product Safety Commission (CPSC) Equal Employment Opportunity Commission (EEOC) Federal Trade Commission (FTC) Federal Communications Commission (FCC) Interstate Commerce Commission (ICC) National Labor Relations Board (NLRB) National Transportation Safety Board (NTSB) Nuclear Regulatory Commission (NRC) Securities and Exchange Commission (SEC)

Federal Deposit Insurance Corporation (FDIC) Occupational Safety and Health Administration (OSHA) General Services Administration (GSA) National Aeronautics and Space Administration (NASA) Small Business Administration (SBA) International Development Cooperative Agency (IDCA) National Science Foundation (NSF) Veterans Administration (VA) Office of Personnel Management (OPM)

Exhibit 1-2 Major Federal Administrative Agencies

United Parcel Service (UPS). The company was not providing adequate safety measures and equipment for workers who handled hazardous waste, and OSHA was responsible for making sure that UPS adapted its practices to follow federal safety guidelines.

TREATIES A treaty is a binding agreement between two states or international organizations. Treaties may be called several things: international agreements, covenants, exchanges of letters, conventions, or protocols. In the United States, a treaty is generally negotiated by the executive branch. To be binding, it must then be approved by two-thirds of the Senate. A treaty is similar to a contract in two important ways. Both treaties and contracts are attempts by parties to determine rights and obligations among themselves. In addition, when a party fails to obey a treaty or an international contract, international law imposes liability on that party.

EXECUTIVE ORDERS The president and state governors can issue directives requiring officials in the executive branch to perform their functions in a particular manner. The Code of Federal Regulations (CFR) contains all the executive orders created by the president. (The CFR is online at www.gpoaccess.gov/ cfr/index.html) Presidents claim the power to issue such orders on the basis of their Article II, Section 1, constitutional power to “take care that the laws be faithfully executed.” An illustration of an especially controversial executive order is Order 9066, issued by President Franklin Roosevelt during World War II. On the basis of this order, Japanese-Americans on the West Coast, as well as thousands of Italian-American and German-American families, were sent to internment camps for the duration of the war.

SCHOOLS OF LEGAL INTERPRETATION When legislators or courts make law, they do so guided by certain habits of mind and specific beliefs about human nature. These views guide them toward particular legal solutions and away from others. This section briefly describes several of the more common guides to legal interpretation. The point of learning about these alternative methods for interpreting the implications of particular legal facts is to encourage you to see the law as a human creation shaped by many perspectives and approaches to what a court decision or statute means. Natural Law The term natural law refers to the idea that there are certain ethical laws and principles that are morally right and above the laws devised by humans. This concept suggests

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natural law A school of jurisprudence that recognizes the existence of higher law, or law that is morally superior to human laws.


Part I

The Legal Environment of Business

that individuals should have the freedom to disobey a law enacted by a majority of people if their individual conscience goes against the law and they believe the law is wrong. The idea that people have basic human rights, for example, is rooted in the concept of natural law. For instance, Dow Chemical wants its suppliers to conform to U.S. environmental and labor laws, not just the local laws in the supplier’s country, where regulations may not be as stringent. This reaction reflects the beliefs that people have a right to be treated fairly in their jobs and that they have a right as human beings to a clean environment. legal positivism A school of jurisprudence that holds that because society requires authority, a legal and authoritarian hierarchy should exist. When a law is made, therefore, obedience is expected because authority created it.

identification with the vulnerable A school of jurisprudence that holds that society should be fair. Particular attention is therefore paid to the poor, the ill, and the elderly.

historical school A school of jurisprudence that uses traditions as the model for future laws and behavior. Also called tradition or custom.

legal realism A school of jurisprudence that holds that context must be considered as well as law. Context includes factors such as economic conditions and social conditions.

Legal Positivism Legal positivism is an interpretive guide that urges us, as its followers, to design our legal system on the basis of the belief that legitimate political authority deserves our obedience when it issues a rule. This idea stresses that society requires authority and the hierarchy that such authority demands. When a duly authorized branch of government issues a law, positivism would urge us to see our proper role as obedience. The law is then a set of appropriate commands. This view sees law as something quite distinct from morality. Moral questions about the law should not interfere with our inclination to obey it. A judge with leanings in the direction of legal positivism, for example, might write that she is deciding to enforce the law in question but that her decision does not necessarily mean that she sees the law as the morally correct rule. Identification with the Vulnerable Closely linked to pursuing legal change through natural law is pursuing change through identification with the vulnerable. Some members of our society can take care of themselves in terms of most life situations. Others, especially the ill, children, the aged, the disabled, and the poor, require assistance to meet their fundamental needs of life, health, and education. This guide to legal change is tied closely to the pursuit of fairness in our society. The metaphor of a level playing field is linked with some higher law or body of moral principles that connects all of us in the human community. We might look at a particular employment contract, for example, and react by observing that “it is just not fair.” Our caring impulse as a human feels outrage at that legal arrangement. That outrage can be a stimulus for legal change. One example of identification with the vulnerable is minimum-wage laws. They reflect the beliefs that workers should receive a minimum hourly wage and that employers should not be allowed to pay them less. Historical School: Tradition One of the most often used guidelines for shaping the law is tradition, or custom, which is also called the historical school. Stare decisis is rooted in this perspective. When we follow tradition, we attempt to link our future behavior to the behavior of those who faced similar problems in earlier historical periods. The logic of the approach is that we need not reinvent the wheel each time a legal problem arises. Past practice is assumed to have been the product of careful thought. Legal Realism Legal realism is based on the idea that, when ruling on a case, judges need to consider more than just the law. This school of thought dictates that they also take factors such as social and economic conditions into consideration when making a judgment. Followers of legal realism argue that the law must not be the sole factor in deciding a case since legal guidelines were designed by humans and exist in an ever-changing society. Judges who follow this school of thought are more likely to depart from past court decisions to account for the fact that our society is constantly shifting and evolving. Those who subscribe to legal realism also believe that the law can never be enforced with complete consistency. They argue that because judges are human, they will bring different methods of reasoning to very similar cases. One example of a law that has been enacted to reflect changes in our society is the Family and Medical Leave Act (FMLA). This act mandates that businesses employing more than 50 people must provide their workers with up to 12 weeks’ unpaid leave every year to take care of family-related affairs such as caring for ill parents, adopting a child, or having a child. The FMLA protects pregnant women who take time off work because their employers must provide them with the same pay and the same or an equivalent job when they return to work. This act

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reflects the fact that more mothers are working outside the home and more women are returning to work soon after they have a child. The FMLA also protects new parents against some types of employer discrimination that might occur after they return to work. Cost–Benefit Analysis From this perspective, we need to examine all the costs and benefits for alternative laws or decisions and place monetary values on those costs and benefits. If we possessed those calculations, we could use cost–benefit analysis as a guide to legal change, choosing the legal alternatives that maximized the ratio of benefits to costs. For instance, in a contract dispute, someone using this approach would attempt to attach responsibility for the problem in such a way that total benefit is maximized in relation to costs. This approach to legal change is tied closely to the pursuit of efficiency. If a law yields more benefits than costs, then we have saved resources. Those resources can, in turn, be used to provide us with more goods and services. Our economy is thus more efficient in the sense of producing more for less. For example, regulations enacted by the EPA can affect costs and benefits in the national economy. Polluted land is an economic loss because it cannot be used for farming or recreation. Polluted water can be toxic for fish and cannot be used for drinking. Polluted air can cause health problems and result in higher health care costs. Although EPA regulations may end up costing companies more initially to control pollutants, the cost of environmental cleanup, and the loss of productivity in the economy as a whole, may be greater than the resources companies expend to control pollution.

Global and Comparative Law Comparative and international law is extremely important for future business managers. Because of advances in technology and transportation, trade with other countries is far easier today than it was in past years. Now it is possible to make different components for the same product in various countries all over the world and then assemble them in another country. It is possible to operate an antique store in Poughkeepsie but sell to customers in Moscow or Taipei through a website. As a result of this ease in trade, business managers must be familiar with global trade laws that regulate business practices among nations. For instance, the United States and other countries have entered into agreements such as the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT). These agreements help establish the conditions of trade between countries. It is also important for future business managers to understand comparative law, comparing and studying the laws in different countries. Business managers need to be aware of various trade laws and restrictions in different countries so that they can act accordingly when they set out to do business in those countries. The European Union, for example, has laws that differ from those of the United States in terms of regulating the taxes on Internet sales and the amount of pollution that can be released into the environment. Companies doing business in the EU must take these standards into account. An example of a company that has conformed to a foreign country’s laws is the search engine company Google, which has agreed to restrict the content of searches performed on Google.cn, the Chinese version of the company’s search engine. Google took this action to satisfy regulations set by the Chinese government, which did not want its citizens to have access to certain websites or pieces of information. To do business in China, Google had to conform to these standards. This loss of freedom of information or access to information was considered by some to be such an evil that they felt Google had violated its own mission statement: “Do no evil.” As an illustration of the importance of being aware of the diversity of law in different countries, just imagine the problems that could arise if you were to need space for your business in Vietnam, but the only property law you knew was U.S. property law. In the United States, we take for granted the right to purchase a piece of property if we have the money to do so. Property is not so freely available and transferable in all nations. Vietnam’s new constitution, written in 1992, provides guidelines for the allocation, transfer, and sale of private property. However, it still asserts that the people, or the state, own all the land.

cost–benefit analysis An economic school of jurisprudence in which all costs and benefits of a law are given monetary values. Laws with the highest ratios of benefits to costs are then preferable to those with lower ratios.


Part I

The Legal Environment of Business

Thus, if individuals or private enterprises want to use land, they must pay tax on it as a form of rent and are granted a “use of right” that entitles them to extended use and the freedom to transfer the property. Technically, they are transferring not the property but, rather, the right to use it. Transference of property can occur only with the approval of a state official. The official ensures that the new owner intends to use the land for the original, state-approved purpose. Moreover, the new owner can never be given a longer term of right or more extensive rights over the land than the original owner had. Finally, the state official determines the price that the property will be transferred for. The government has specified certain prices depending on how the land is used. Modern business managers must have an ongoing fascination with the law to function effectively. Business law tells business managers the basic rules of the business game. Play any game without having first studied the rules, and you will probably fail. But, unlike an ordinary game, the business game has a rule book that is changing dynamically. In addition, increased globalization requires business leaders to be alert to legal differences among national jurisdictions.

Questions & Problems 1. What is the difference between private law and public law? 2. What are the main distinctions between the different schools of legal interpretation? 3. If there are different ways to interpret statutes and case decisions, would it make sense to say that all interpretations of the law are equally appropriate? 4. Presidential elections are partially about who will be able to select Supreme Court judges. As you look at the various alternative ways to interpret and apply the law, which of those methods of interpretation would you hope is held by your favorite candidate for President? 5. Most business managers know they need to consult a lawyer when they make important business decisions. If that assumption is correct, why would a manager or entrepreneur need to have any knowledge of business law? Couldn’t she or he just ask the lawyer? 6. Appendix 1A provides guidance for becoming a better critical thinker. A recent Forbes poll of business leaders found that the most important skill business leaders are seeking in their employees is critical thinking. As you study the appendix, why do you think this skill of critical thinking is so valuable to business managers? 7. This chapter distinguishes between private and public law. Why are the interests of the public identified with the behavior of the government? Why would

public law not be a term referring to the interests of corporations, for example? 8. What is the need for a special area of law for administrative agencies? Why would not the law as it applies to businesses apply just as well to administrative agencies? 9. Choose an area of law that fascinates you. Spend some time on the Internet searching for differences between how the United States and other countries respond to conflicts among people within that area of law, just as we did in the text in the illustration of real property law in Vietnam. 10. Jarold Daniel Friedman worked as a temporary computer contractor for a pharmaceutical warehouse. The warehouse offered him a permanent position, but the warehouse required him to get a mumps vaccine, grown in chicken embryos, as a condition of his permanent employment. Friedman, a vegan, believed that the vaccination would violate his religious beliefs and declined to be vaccinated. As a result, the warehouse withdrew its offer of employment. Friedman claimed that the warehouse discriminated against him on the basis of religion. Do you agree with Friedman? Do employers have a duty to respect the beliefs of their employees? If so, what happens when that duty conflicts with employers’ duty to provide a safe and healthy work environment? [Friedman v. Southern California Permanente Medical Group, 102 Cal. App. 4th 39 (2002).]

Critical Thinking and Business Law Success in the modern business firm requires the development of critical-thinking skills—the ability to understand what someone is saying and then to apply a set of evaluative criteria to determine the worth of what was said. In other words, businesspeople need to be able to sort sense from nonsense by evaluating arguments about relevant business law. A critical thinker is always asking, “Now does that make sense?” And there is no better context in which to develop critical-thinking skills than in the study of the laws that affect business. Critical-thinking skills learned in the study of business law will be easily transferred to the decisions of business stakeholders. Legal reasoning is similar to other reasoning in some ways and different in others. When people, including lawyers and judges, reason, they do so for a purpose. Some problem or dilemma bothers them. The stimulus that gets them thinking is a legal issue. It is stated as a question because it is a call for action. It requires us to do something, to think about answers. For instance, we may be interested in such issues as the following: • • •

APPENDIX 1A critical-thinking skills The ability to understand the structure and worth of an argument by evaluating the facts, issue, reasons, and conclusion of that argument.

When are union organizers permitted under the National Labor Relations Act to trespass on an employer’s property? Do tobacco manufacturers have liability for the deaths of smokers? Must a business fulfill a contract when the contract is made with an unlicensed contractor in a state requiring all contractors to be licensed?

Each of these questions has several potential answers. Which answer best accomplishes a particular business objective? Which answers are consistent with the law? Here is where critical thinking is essential to business success. Some answers can get the decision maker into trouble; others will advance the intended purpose. Each answer is called a conclusion. Business firms often come into contact with such conclusions in the form of laws or court decisions. Business managers are therefore both consumers of and contributors to these legal conclusions. As businesspeople learn about and react to decisions or conclusions made by courts, they have two primary methods of response: 1. Memorizing and understanding the conclusions or rules of law as a guide for future business decisions. 2. Making judgments about the quality of the conclusions. This book encourages you to do both. There are many forms of critical thinking, but they all share one characteristic: They focus on the quality of someone’s reasoning. Critical thinking is active; it challenges each of us to form judgments about the quality of the link between a set of reasons and the conclusion supposedly derived from them. In particular, we will be focusing on the link between a court’s reasons and its conclusions. Our reactions to legal arguments shape our efforts either to support the status quo in the legal environment of business or offer support for particular changes. The following structure for critical thinking is a thoroughly tested method that successful market decision makers use. Every time you read a case, try to follow this pattern of careful thinking. 1. Find the facts. Facts: Here, we are looking for the most basic building blocks in a legal decision or argument. These building blocks, or facts, provide the environment or context in which the legal issue is to be resolved. Certain events occurred, certain actions were or were not taken, and particular persons behaved or failed to behave in specific ways. All of these and many more possibilities together make up the intricate setting for the playing out of the issue in question. We always wonder, What happened in this case? 2. Look for the issue. Issue: In almost any legal conflict, finding and expressing the issue is an important step in forming our reaction. The issue is the question that caused the lawyers and their clients to enter the legal system. Usually, there are several reasonable perspectives concerning the 11


Part I

The Legal Environment of Business

correct way to word the issue in dispute. Don’t let the possibility of multiple useful ways to word the issue cause you any confusion. The legal issue is certainly not just anything that we say it is. 3. Identify the judge’s reasons and conclusion. Reasons and conclusion: Judges do not form legal conclusions on the basis of whim. They have support for their decisions. That support consists of their reasons. When we ask someone why a judge formed a particular conclusion, we are showing our respect for reasons as the proper basis for any assertion. We want a world rich with opinions so that we can have a broad field of choice. But we should agree with only those legal opinions that have convincing reasons supporting the conclusion. Asking “Why?” is our way of saying, “I want to believe you, but you have an obligation to help me by sharing the reasons for your conclusion.” 4. Locate in the decision the rules of law that govern the judge’s reasoning. Rules of law: Judges cannot offer just any reasoning that they please. They must always look back over their shoulders at the laws and previous court decisions that together provide an anchor for current and future decisions. What makes legal reasoning so complex is that statutes and legal findings are never crystal clear. They may seem very clear, but judges and businesspeople have room for interpretive flexibility in their reasoning.

critical thinking in the legal context Examining a legal opinion to search for potential problems in the reasoning.

5. Apply critical thinking to the reasoning. Evaluation of the reasoning: A judge’s reasoning, once it has been laid before us by following the steps discussed here, is a message that we may either accept or reject. One of the most exciting things about our legal system is its potential for change. Critical thinking in the legal context consists of examining the legal opinion in search of potential problems in the reasoning. Here is a small sample of some especially useful critical-thinking guidelines for business managers to apply when thinking about business law: •

Look for potential ambiguity in the reasoning. The term ambiguity refers to a lack of clarity in a word or phrase in the reasoning. Many words have multiple meanings; until the intended meaning is discovered, we cannot tell whether we want to agree or disagree with the reasoning. Ask whether the analogies used in the decision are strong. When judges follow particular precedents, they are saying that the key similarities between the facts in the precedent and those in the case at hand are so similar that it makes sense to apply the same rule of law in both. Are there key differences in the factual situations that raise questions about the quality of that analogy? Check the quality of the judge’s use of evidence in his or her reasoning. Is the evidence used by the judge to support the opinion both abundant enough and reliable enough that we should agree with the reasoning? Think about the extent to which important missing information prevents you from being totally confident about the judge’s reasoning. Is there important missing information that you would need to have before making up your mind? Consider the possibility of rival causes. When the judge claims that one action caused another, think about whether some alternative cause may have been responsible.


The Legal Environment of Business

1 2


Business Ethics and Social Responsibility LEARNING OBJECTIVES After reading this chapter, you will be able to answer the following questions:

LO 2-1

What are business ethics and the social responsibility of business?

LO 2-2

How are business law and business ethics related?

LO 2-3

What are values?

LO 2-4

How do values provide a starting point for thinking about business ethics?

LO 2-5

How can we use the WH framework to make ethical business decisions?



Part I

LO 2-1

ethics The study and practice of decisions about what is good or right.

business ethics The use of ethics and ethical principles to solve business dilemmas.

ethical dilemma A question about how one should behave that requires one to reflect on the advantages and disadvantages of the optional choices for various stakeholders.

social responsibility of business The expectations that a community places on the actions of firms inside that community’s borders.

LO 2-2

The Legal Environment of Business

A business has a huge assortment of responsibilities. Each responsibility involves a relationship with other people in the community. Some of the responsibilities are more obvious than others. Firms have a responsibility to devote their energies to fulfilling the interests of their owners, certainly. In addition, they owe safe working conditions to the employees who make it possible for the firm to thrive. Other responsibilities are just as real but perhaps less obvious. A business firm must obey the laws in the countries where it offers its products and services. This course spells out many of those responsibilities, and the list is quite extensive. In addition, firms have a much more abstract ethical responsibility to obey the standards of conduct consistent with prevailing ethics and expectations in the communities where they practice their trade. Ethics is the study and practice of decisions about what is good or right. Ethics guides us when we are wondering what we should be doing in a particular situation. Business ethics is the application of ethics to the special problems and opportunities businesspeople experience. An ethical dilemma is a problem about what a firm should do for which no clear, right decision is available. Reasonable people can expect to disagree about optimal solutions to ethical dilemmas. Closely related to ethical dilemmas arising in business situations is the concept of the social responsibility of a business. The social responsibility of business consists of the expectations the community imposes on firms doing business within its borders. These expectations must be honored to a certain extent, even when a firm wishes to ignore them, because firms are always subject to the implicit threat that legislation will impose social obligations on them. So, if the community expects businesses to obey certain standards of fairness even when the standards interfere with profit maximization, firms that choose to ignore this expectation do so at their peril. The definition of business ethics refers to standards of business conduct. It does not result in a set of correct decisions. Business ethics can improve business decisions by serving as a reminder not to simply choose the first business option that comes to mind or the one that enriches the firm in the short run. But business ethics can never produce a list of correct business decisions that all ethical businesses will make.

Business Law and Business Ethics Before business managers consider the social responsibilities of firms in their communities, they need to gather all the relevant facts. Experienced managers know that assembling the facts is just the beginning of a thoughtful business decision. Next, it makes sense to ask, Is it legal to go forward with this decision? The legality of the decision is the minimal standard that must be met. But the existence of that minimum standard is essential for the development of business ethics. To make this point, let’s take a look at the growing practice of bribery in the absence of legal standards. In some countries, businesses must pay bribes to receive legitimate supplies. Although the businessperson may be morally opposed to paying the bribes, the supplies are necessary to stay in business, and there may be no other means of obtaining them. Thus, foreign companies face an ethical dilemma: They must decide whether to pay bribes or find alternative sources of supplies. For instance, when McDonald’s opened its doors in Moscow, it made arrangements to receive its supplies from foreign providers. These arrangements ensured that the franchise did not have to engage in questionable business practices. At the same time that business ethics guides decisions within firms, ethics helps guide the law. Law and business ethics serve as an interactive system—informing and assessing each other. For example, our ethical inclination to encourage trust, dependability, and efficiency in market exchanges shapes many of our business laws. The principles of contract law, for instance, facilitate market exchanges and trade because the parties to an exchange can count on the enforceability of agreements. Legal rules that govern the exchange have been shaped in large part by our sense of commercial ethics. Of course, different ethical understandings prevail in different countries. Thus, ethical conceptions shape business law and business relationships uniquely in each country. Increasingly, business leaders require sensitivity to the differences in legal guidelines in the various countries in which they operate. These differences are based on somewhat different understandings of ethical behavior among businesspeople in diverse countries. As we mentioned earlier, business ethics does not yield one correct decision. So how are business managers to chart their way through the ethical decision-making process? One source

BUSINESS Ethics Flashpoint 2.1 Chevron in Ecuador In 1964, Texaco Petroleum (now known as Chevron), along with the Gulf Oil Corporation (Gulf), was invited by the Ecuadoran government to conduct exploratory activities in the eastern region of Ecuador. This region was known as the Oriente. In 1967, Texaco and Gulf discovered large quantities of oil in the Oriente. After building a pipeline that would allow for the transfer of oil to the Pacific coast, Texaco began exporting the oil. Texaco acted as the operator in a partnership, known as a consortium, between Texaco and Gulf. In 1973, production reached 200,000 barrels of oil per day. During this period, Ecuador’s gross national product (GNP) had doubled. During the early 1970s, the military seized control of the Ecuadoran government. This takeover resulted in a series of governmental reforms that limited the size of concession areas granted to foreign oil companies such as Texaco. Texaco, therefore, relinquished some of its concessions to Ecuador’s state-run oil company, Petroecuador. In addition, Petroecuador joined the consortium between Texaco and Gulf. Soon after Petroecuador joined the consortium, Gulf left. The consortium, now consisting of only Texaco and Petroecuador, lasted from 1977 until 1990. In 1992, Ecuador did not renew Texaco’s concessions. As a consequence, Texaco’s interest in the oil industry came to an end. During the period in which it operated in Ecuador, Texaco’s oil-related operations exacted a great toll on the residents of the Oriente. For example, Texaco dumped billions of gallons of toxic wastewater into surrounding rivers and streams of the Amazon. Texaco is also reported to have spilled about 17 million gallons of crude oil into surrounding lands in the Oriente. Another source reports that about 2.5 million acres of land were affected by the leaking of oil into soil and groundwater as well as by oil discharges into wetlands, streams, and rivers. In addition, Texaco had allegedly stored toxic chemicals in hundreds of unlined pits. The waters that indigenous groups relied on for drinking, cooking, bathing, and fishing became receptacles for Texaco’s garbage. Another source of environmental damage in the Oriente region was gas flaring and the burning of crude oil. These acts resulted in toxic fumes that polluted the air. The contaminated water and polluted air in the region of the Oriente had significant effects on the health of the residents living in the Oriente. A little more than 8000 residents suffered one or more diseases attributable to the

contaminants with which Texaco polluted the area. The people of the Oriente reported higher rates of cancer than the general population of Ecuador and in other Amazonian provinces. Birth defects were also attributed to the environmental pollution. However, despite these adverse effects on the surrounding population, Texaco did not endeavor to address these problems during its operations. In addition to suffering from diseases related to toxic contaminants, the indigenous population in the Oriente suffered economic losses. For example, 75 percent of Oriente residents reported that they had suffered from loss of their crops as well as loss of animals on which they relied because of Texaco’s toxic discharges into the environment. Texaco’s clearing substantial parts of natural habitat to make room for oil operations also contributed to the elimination of the region’s forests. Thus, the contamination of the natural habitat in the Oriente led not only to disease but also to economic and cultural losses. In 1993, forty-six residents of Ecuador who belonged to numerous indigenous tribes in the Oriente filed a suit against Texaco (now known as Chevron due to a merger) seeking redress for Texaco’s actions. Texaco denied allegations of a causal connection between its oil operations and the diseases reported. Additionally, Chevron endeavored to exclude Ecuador from trade negotiations with the United States until Ecuador shut down the lawsuit. To this action, then Senators Barack Obama and Patrick Leahy responded: “While we are not prejudging the outcome of the case, we do believe the 30,000 indigenous residents of Ecuador deserve their day in court . . .” After numerous proceedings that began in New York and then moved to Ecuador, the plaintiffs were awarded $19 billion in damages—later reduced to $9.5 billion—in February 2011, for purposes of restoring the environment, providing health care treatment, and obtaining clean water. However, Chevron refused to pay this fine. On March 4, 2014, a U.S. federal judge blocked U.S. courts from being used to collect the $9.5 billion judgment against Chevron. The U.S. court concluded that the Ecuadoran courts had been influenced by corrupt relations between judges and attorneys representing the indigenous groups. As a consequence, Chevron’s fine was essentially revoked. Sources: Trudie Styler, “Seeking Justice in Ecuador,” March 5, 2014, http://www .huffingtonpost.com/trudie-styler/chevron-lawsuit-ecuador-justice_b_4902925.html Lucien J. Dhooge, Aguinda v. Chevrontexaco: Mandatory Grounds for the NonRecognition of Foreign Judgments for Environmental Injury in the United States, 19 J. of Transnational Law & Policy 1 (2009).

of assistance consists of the general theories and schools of thought about ethics. Each ethical system provides a method for resolving ethical dilemmas by examining duties, consequences, or virtues. In the interest of providing future business managers with a practical approach to business ethics that they can use, we suggest a three-step process: the WH approach. This approach



Part I

WH approach (to ethical decision making)

provides future business managers with some ethical guidelines, or practical steps, that serve as a dependable stimulus to ethical reasoning in a business context. In their drive to fulfill some of their responsibilities, business firms can trample on other ethical responsibilities they have. What is your reaction to Chevron’s behavior in Ecuador? How do we begin to think about what is right and wrong in a situation like this one? The starting point in wrestling with dilemmas about what is right and good is the idea of values.

A set of ethical guidelines that urges us to consider whom an action affects, the purpose of the action, and how we view its morality.

ethical guideline A simple tool that helps determine whether an action is moral.

LO 2-3 values Positive abstractions that capture our sense of what is good and desirable.

LO 2-4

The Legal Environment of Business

What Are Values? When we think about the ultimate reason or purpose for which we make decisions in a business firm, we turn to the basic unit of business ethics—values. Values are positive abstractions that capture our sense of what is good or desirable. They are ideas that underlie conversations about business ethics. We derive our ethics from the interplay of values. Values represent our understanding of the purposes we will fulfill by making particular decisions. For example, we value honesty. We want to live in communities where the trust we associate with honesty prevails in our negotiations with one another. Business depends on the maintenance of a high degree of trust. No contract can protect us completely against every possible contingency. So we need some element of trust in one another when we buy and sell. If we think about the definition of values for a moment, we realize two things. First, a huge number of values pull and push our decisions. Second, to state that a value is important in a particular situation is to start a conversation about what is meant by that particular value. To return to the Chevron case, when someone says we wanted to maximize efficiency, environmental sustainability, or justice, we are only slightly closer to any understanding of the complexity of the dilemma.

How do Values Provide a Starting Point for Thinking about Business Ethics? To help make WH useful to you as a manager, Exhibit 2-1 makes clear the central role of clarifying what version of a value one feels loyalty toward. Without that clarification, we lose sight of why something is said to be good or right. The exhibit identifies four of the most important

Exhibit 2-1 Primary Values and Business Ethics




1. To act without restriction from rules imposed by others 2. To possess the capacity or resources to act as one wishes 3. To escape the cares and demands of this world entirely


1. To possess a large-enough supply of goods and services to meet basic needs 2. To be safe from those wishing to interfere with your property rights 3. To achieve the psychological condition of self-confidence to such an extent that risks are welcome


1. To receive the products of your labor 2. To treat all humans identically, regardless of race, class, gender, age, and sexual preference 3. To provide resources in proportion to need 4. To possess anything that someone else is willing to grant you


1. To maximize the amount of wealth in society 2. To get the most from a particular output 3. To minimize costs

BUSINESS Ethics Flashpoint 2.2 Dole Food Company and Its Workers Dole Food Company (Dole) dominates the market for bananas, holding a 25 percent share in the world market for bananas. The majority of bananas from Dole come from Latin America. Specifically, Dole operates banana plantations in several Latin American countries, including Ecuador, Nicaragua, Costa Rica, Guatemala, Honduras, and Panama. An important step in the process of growing bananas is the application of pesticides to prevent disease and pathogens. Fumazone is among the most toxic pesticides used in banana cultivation during the 1960s through the 1980s. The main ingredient in Fumazone is dibromochloropropane (DBCP). DBCP is known to have harmful effects on male reproductive organs and sperm counts. However, despite knowledge of this danger, the U.S. government approved its use on farms in 1964. During a brief period after 1964, about 60 workers in California that manufactured Fumazone were found to be sterile. As a consequence, in 1979, the U.S. Environmental Protection Agency banned the use of DBCP in the United States. However, Dole continued using DBCP in its Latin American plantations well into the mid-1980s. Dole admitted to knowing that DBCP could harm the workers but chose not to inform its workers in Latin America. As a consequence of Dole’s use of DBCP on its plantations, the health of Latin American plantation workers was threatened. DBCP posed a health hazard to plantation workers in that it was known to cause male sterility as well as genetic disorders in the children of men and women exposed to DBCP. In fact, the National Institutes of Health claims that DBCP is toxic, carcinogenic, and mutagenic. Further, the State of California’s Safe Drinking Water and Toxic Enforcement Act of 1986 concluded that DBCP caused reproductive and developmental harm. Although the toxicity of DBCP was well-known, banana plantation workers were reportedly not given equipment or training to minimize exposure to the harmful chemical. Unfortunately, the task of applying DBCP on banana plants fell to the most marginalized of workers because few workers desired to risk exposure to DBCP.

Another problem with DBCP is that it negatively affected the environment. For example, the application of Fumazone to banana roots caused DBCP to seep into the groundwater. This contamination of the environment killed organisms living in the surrounding habitat, including fish, mammals, and plants. In 2004, a small breakthrough was made. Twelve banana plantation workers filed a suit against Dole in a Californian court. Six of these workers were found to have been made sterile due to the poor working conditions of Dole’s banana plantations. During these proceedings, evidence was presented, showing that Dole knew that DBCP could harm the workers and nevertheless insisted on using DBCP. In addition, Dole had ignored safety recommendations by the manufacturer of the pesticide Fumazone. On November 5, 2007, the suit filed by the twelve workers resulted in Dole being ordered to pay damages to six of the twelve workers. Specifically, the Los Angeles Superior Court awarded the plantation workers $3.3 million in damages. On November 15, 2007, a jury ordered Dole also to pay $2.5 million in punitive damages to five of the workers— that is, damages paid in excess of the plaintiffs’ proved injuries. Later, however, a judge vacated the punitive damages and lowered the actual damages of $3.3 million to $1.58 million. As a result of the use of DBCP on banana plantations, thousands of banana pickers have filed suits against produce companies, such as Dole Food Co., Chiquita Brands International Inc., Fresh Del Monte Produce Inc., and chemical companies such as Dow Chemical Company and Shell Chemical Company. However, thousands of workers continue to suffer from their work in the banana industry in Latin America. In addition, many of the banana workers are children; roughly 70 percent of these children work on Dole plantations, according to a Human Rights Watch report. Sources: Armin Rosencranz, Stephen Roblin, and Nicole Balloffet, “Doling Out Environmental Justice to Nicaraguan Banana Workers: The Jose Adolfo Tellez v. Dole Food Company Litigation in the U.S. Courts,” 3 Golden Gate U. Envtl. L.J. 161 (2009). Human Rights Watch, “Ecuador: Widespread Labor Abuse on Banana Plantations,” April 25, 2002, available at: http://www.hrw.org/news/2002/04/24/ecuador-widespreadlabor-abuse-banana-plantations

values influencing business ethics and presents alternative meanings for each. This table should not only help clarify the importance of values in your own mind but also enable you to question others who claim to be acting ethically. For instance, a manager might be deciding whether to fire an employee whose performance is less than impressive. In making the decision, the manager explores alternative visions of key values such as justice and efficiency and then makes choices about which action to take. Values and their alternative meanings are the foundation for different ethical decisions. Where do our value priorities come from? That question is another way of asking: At the foundational level, what causes us to place a higher weight on decisions that reflect some values rather than others?


GLOBAL Context Business Ethics and Swedish Advertising Law Recall from the WH approach to ethical decision making that when businesses make decisions, they should consider all the relevant stakeholders. One relevant stakeholder is the customer, or consumer. In Sweden, consumers are assumed to be vulnerable in the marketplace; therefore, protecting the consumer is considered the job of the government. Unlike the case in the United States, in Sweden public policy acknowledges that “there exist large groups of consumers who, owing to low incomes, deficient education and knowledge of the market, etc., are less well equipped than the average citizen for their role as consumers.” One group of consumers less equipped than the average citizen in Sweden is children.

stakeholders The groups of people affected by a firm’s decisions.

The government considers children extra vulnerable and impressionable and thus in need of even more protection than the average consumer. Swedish laws ban all television advertising targeting children below the age of 12. The ban includes not only toy advertisements but also commercials for foods high in fat and sugar, such as sweets and fast food. Advertisements for such products can be aired if the targets of the advertisements are not children. For example, commercials for toys, sweets, and foods high in fat may be aired if they are designed to attract and inform adults as opposed to children. What may surprise many Americans is that almost 90 percent of Swedish advertising professionals are in favor of the ban on advertising to children because they recognize that such advertising is misleading since children do not understand the commercial nature and purpose of advertising.

Value priorities can stem from many sources. Tradition, family, culture, reasoning about the consequences of alternative choices, and a sense of duty or obligation can all fuel the value priorities we bring to an ethical dilemma. For many people, their preeminent values derive from religious teachings. For example, Catholic social doctrine teaches that the moral quality of a society depends on how it treats its most vulnerable members. Similarly, the United Methodist Church in its 2009–2012 Social Principles document pledges Methodists “to support the poor and challenge the rich.” Take a look at another business situation. Try to express the struggle between Dole and its workers as a struggle between two sets of values rather than simply a contest between people in white hats and villains in black hats. If you can, you will be more fair in your assessment of Dole’s behavior. To be fair is not to condone but, rather, to be open to understanding the logic and purposes of all the relevant players in the ethical flashpoint.

The WH Framework for Business Ethics Exhibit 2-2 The WH Process of Ethical Decision Making

1. W—WHO (Stakeholders): Customers Owners or investors Management Employees Community Future generations

2. H—HOW (Guidelines): Public disclosure Universalization Golden rule


A useful set of ethical guidelines requires the recognition that managerial decisions must meet the following primary criteria (Exhibit 2-2): • •

The decisions affect particular groups of stakeholders in the operations of the firm. The pertinent question is, thus, Whom would this decision affect? The decisions must meet the standards of action-oriented business behavior. Managers need a doable set of guidelines for how to make ethical decisions.

WHO ARE THE RELEVANT STAKEHOLDERS? The stakeholders of a firm are the many groups of people affected by the firm’s decisions. Any given managerial decision affects, in varying degrees, the following stakeholders: 1. Owners or shareholders. 2. Employees.

BUSINESS Ethics Flashpoint 2.3 The WorldCom Accounting Scandal WorldCom Inc. was a telecommunications company that began operating in the state of Mississippi in the 1980s. In 1989, WorldCom became a publicly traded corporation; that is, it began selling shares of its company to investors. In the 1990s, WorldCom became the second largest U.S. long-distance telephone service carrier. In addition, it was a leading operator of Internet services and placed forty-second among the Fortune 500 companies in 2001. As the 1990s came to an end, the telecommunications was expanding and becoming more competitive. Numerous telecommunications companies entered the long-distance communications market, including the local telephone companies and the Regional Bell Operating Companies, and many companies entered the market for Internet services. Eventually, the supply of telecommunications services outgrew the demand for those services, and the industry experienced a recession—that is, a drop in economic activity. WorldCom’s revenue began to fall. During this time, WorldCom used fraudulent accounting methods that allowed it to overstate its financial status to its shareholders. Specifically, CEO Bernard Ebbers presented a false picture of WorldCom’s net worth, informing the Board of Directors of WorldCom that the company would continue growing vigorously. However, Ebbers knew that his projections were inconsistent with WorldCom’s declining position. One reason for boosting the reported revenues of WorldCom is to increase shareholder confidence. In other words, the logic behind Ebbers’s fraudulent accounting methods was that if he could deceive shareholders into believing

3. 4. 5. 6.

that WorldCom was growing, shareholders would continue to inject money into the company. The fraud at WorldCom was propagated not just by Ebbers but also by several other officials at WorldCom, including CFO Scott Sullivan and WorldCom’s comptroller, David Myers. Both of these individuals aided in secretly making entries of hundreds of millions of dollars into WorldCom’s accounting report without any basis for such entries. The fraud committed by the executive officials at WorldCom resulted in overstating the company’s income by $11 billion. In 2005, Ebbers was found guilty in federal court of fraud and received a sentence of twenty-five years in prison. Scott Sullivan received five years in prison, pleading guilty to fraud, conspiracy, and making false financial statements. David Myers received a sentence of one year and one day in prison. As a result of the accounting fraud that occurred in the early 2000s, WorldCom was forced to declare bankruptcy. When this occurred, thousands of workers at WorldCom lost their jobs, and shareholders lost billions of dollars as the worth of WorldCom plummeted. WorldCom not only affected its workers and shareholders but the entire telecommunications industry. Specifically, competing telecommunications companies that had once trusted WorldCom’s false accounting reports now realized that they had been duped into relying on false data when making business decisions. Sources: Dennis R. Beresford, Nicholas deB. Katzenbach, and C. B. Rogers, “Report of Investigation by the Special Investigative Committee of the Board of Directors of Worldcom, Inc.” (March 31, 2003), available at http://news.findlaw .com/hdocs/docs/worldcom/bdspcomm60903rpt.pdf Jennifer Bayot and Roben Farzad, “Ex-WorldCom Officer Sentenced to 5 Years in Accounting,” August 12, 2005, available at http://www.nytimes.com/2005/08/12/ business/12worldcom.html?pagewanted5all&_r50

Customers. Management. The general community where the firm operates. Future generations.

Managers should make sure they consider all relevant stakeholders when they engage in ethical reasoning. Study the following Business Ethics Flashpoint. First, identify the stakeholders directly affected by the behavior of WorldCom and then tackle the harder task of identifying the many stakeholders who are in the background, perhaps, but were nevertheless affected immensely by WorldCom’s actions. Here is another practice exercise to get you into the habit of looking for the values involved in a dilemma and the stakeholders affected by the dilemma.


E-COMMERCE and the Law Technological Records and Ethics Journalists use different technological media to contact and store information about confidential sources, including government whistleblowers. One of the most important parts of journalism is to protect confidential informants so that news sources can still enlighten the public with important and sensitive information. Ethical issues arise from this challenge. Documents containing information about informants’ identities may not be collected by the government without permission from the Deputy Attorney General. In other words, the First Amendment protects the privacy and individual ownership of these e-mail and phone records. For example, in 2004, the Federal Bureau of Investigation (FBI) illegally obtained phone records related to the confidential informants of the New York Times and Washington Post’s bureaus in Indonesia. The executive editors of both newspapers were called by the FBI, and both

received apologies. The Justice Department looked into the illegal investigation by the FBI after the FBI went ahead with what it called “emergency” gathering of private information related to an alleged terrorist investigation. The editors were never told why their records were needed. Now, news corporations are putting numerous security barriers and encryptions around their records so that nobody could have access to them even if they tried. In fact, Wikileaks, the website that publicizes secret government documents, has probably the strongest security procedures protecting its sources. Instant messages are expertly encrypted, as are all files passed between people. A tool that enables users to communicate completely anonymously, the Tor Project, completely hides all servers. Other news companies are attempting to mimic such standards and adjust privacy policies to not reserve the right to release any information about a source “to law enforcement authorities or to a requesting third party without notice.”

CASE Nugget TYSON FOODS’ BRIBERY CHARGES In 2004, memos containing information regarding illegal bribes were sent from a Tyson Foods plant manager in Mexico to corporate officials in the United States. Basically, company officials in Mexico were sending roughly $2,700 a month to the wives of two veterinarians involved in safety and quality of the food produced at the plant. At the time, Tyson Foods was attempting to increase its national export. However, countries involved in the importation of these products require experts to certify that these food products meet certain safety and sanitary standards. Essentially, the two veterinarians were being sent extra payments so that they would sign off on the quality of the products produced at the plant regardless of whether the products were actually up to par with the standards imposed. This act is especially dangerous considering the reputation poultry products have of passing on disease, including salmonella, to consumers. The company officials in Arkansas, including the president of Tyson International and vice president of operations, realized that bribing foreign officials, the biggest issue at hand, was a felony according to the Foreign Corrupt Policies Act. Faced with the option of investigating the allegations and bringing the illegal activities to light, the company officials instead found a way to keep sending the bribes but make the payments look legal. Two years later, Tyson officials finally hired a law firm to do an internal investigation of the bribery. In 2011, Tyson was charged with conspiracy and violating the Foreign Corrupt Practices Act. To avoid trial, Tyson was forced to pay $4 million as a criminal penalty and $1.2 million to the Securities Exchange Commission for the charge of maintaining illegal records.

Some of the more perplexing ethical dilemmas have emerged as a result of our increasing dependence on e-commerce. 20

BUSINESS Ethics Flashpoint 2.4 The Health Focus of Revolution Foods Revolution Foods started as a small business venture in Oakland, California. The start-up’s objective is to provide healthy prepackaged lunch meals for children. Currently, the market for prepackaged lunch meals is dominated by Kraft Foods. Kraft Foods sales of Lunchables account for approximately 76 percent of sales in the prepackaged lunch market niche. Kids love Lunchables because these meals allow them to create their own food. Simply, these meals are fun. Parents also benefit from Lunchables in the sense that these meals require no preparation. However, Lunchables are not necessarily healthy. According to food critics, including the founders of Revolution Foods, Lunchables contain an excess of fat, sugar, salt, and preservatives that are unhealthy. For example, Kraft previously had a Maxed Out line of Lunchables that was considered one of the Five Worst Packaged Lunchbox Meals by the Cancer Project. Kraft eventually stopped producing this line of Lunchables— with a whopping 660 calories and 22 grams of fat—and endeavored to create more healthy meals. In response to the apparent need for more nutritious lunch kits, Revolution Foods claims to offer a healthy alternative. Kristin Richmond, one of the founders of Revolution Foods, believes that the objective of Revolution Foods is to provide higher-quality ingredients to cultivate healthier lifestyles. Making foods with real meat, real cheese, and

other recognizable ingredients appears to be the driving force behind the company. In other words, rather than focusing solely on profits, Revolution Foods attempts to focus on what will also help the consumer lead a healthier lifestyle. One example of the types of prepackaged lunch kits that Revolution Foods offer is the Ham and Cheddar Meal Kit, consisting of ham from animals raised with no antibiotics. This lunch kit also has no preservatives, no high-fructose corn syrup (a commonly used artificial sweetener), and no artificial coloring. On average, Revolution Foods’ Meal Kits are lower in fat, salt, and sugar than Kraft’s Lunchables. The director of nutrition policy at the Center for Science in the Public Interest has claimed that Revolution Foods, although not necessarily healthy, is nutritionally improved. The fact that Revolution Foods provides foods that are locally grown, natural, and organic without preservatives appeals to those consumers who desire to cultivate healthy dietary habits. Revolution Foods’ Meal Kits can now be found in more than 1,000 stores, including Kroger’s, Target, and Whole Foods. Sources: Stephanie Strom, Lunchables, The Lunchbox King, Faces a Rival Vowing Higher-Quality Fare, N.Y. Times, August 21, 2013, http://www.nytimes.com/2013/ 08/22/business/lunchables-king-of-the-lunchbox-faces-another-challenger. html?pagewanted5all&_r50 Marc Gunther, Revolution Foods: a healthier competitor to Lunchables, March 11, 2014, http://www.theguardian.com/sustainable-business/lunchables-kraft-revolutionfoods-healthy-lunch-children

HOW DO WE MAKE ETHICAL DECISIONS? Making ethical decisions has always been one of our most confusing and important human challenges. In the process of meeting this challenge, we have discovered a few general, ethical guidelines to assist us. An ethical guideline provides one path to ethical conduct. Notice that all three of the following ethical guidelines reflect a central principle of business ethics: consideration of stakeholders. The Golden Rule The idea that we should interact with other people in a manner consistent with the way we would like them to interact with us has deep historical roots. Both Confucius and Aristotle suggested versions of that guideline. One scholar has identified six ways the Golden Rule can be interpreted: 1. 2. 3. 4. 5. 6.

Do to others as you want them to gratify you. Be considerate of others’ feelings as you want them to be considerate of yours. Treat others as persons of rational dignity like you. Extend brotherly or sisterly love to others, as you would want them to do to you. Treat others according to moral insight, as you would have others treat you. Do to others as God wants you to do to them.

Regardless of the version of the Golden Rule we use, this guideline urges us to be aware that other people—their rights and needs—matter. The focus on others that is the foundation of the Golden Rule is also clearly reflected in a second ethical guideline: the public disclosure test. 21

BUSINESS Ethics Flashpoint 2.5 The Dofasco Steel Company’s Approach to Workers Dofasco is the second-largest steel producer in Canada and sells a wide range of steel products. In the 1980s, Dofasco experienced shrinking profits and decided to change its approach to business. One of the ways that Dofasco changed was in its approach to its workers. Specifically, Dofasco attempted to implement a philosophy taking into account the whole person at work. In other words, this approach sought to include wellness as an important characteristic of the employee experience. In line with this new philosophy, the Dofasco management claimed it would abide by the following policy statement issued in its 1996 guides of the company’s health, safety, and lifestyle activities: “At Dofasco, there is nothing more important than the health and safety of our people.” Consistent with this policy statement, Dofasco provided training for employees in problem solving, manufacturing processes, and customer service. Dofasco also built on its tradition of providing its workers with ergonomic and fitness resources as well as preventive medical services. Yet another way that Dofasco sought to focus its energies on employee needs was by encouraging healthy lifestyle practices at work. A healthy lifestyle at work would be achieved by preventing workplace accidents and maintaining a safe environment. In addition, Dofasco assessed employee needs in response to worker suggestions. Dofasco believes that its focus on a safe and healthy workplace has improved its business. Specifically, the

company claims that its policies have reduced lost time associated with work injuries and minimized Workers Safety Insurance Board payments. In addition to focusing on worker safety and wellbeing, Dofasco also has a history of being environmentally responsible. For example, Dofasco was the first corporation in Canada voluntarily to sign an Environmental Management Agreement with Environment Canada and Ontario’s Ministry of the Environment. In this agreement, Dofasco made commitments to abide by specific air and water quality standards and sustainable energy use and waste management. Through this agreement, Dofasco expressed its commitment to the community. In addition, Dofasco created a Sustainable Development Strategy Team and is a founding sponsor of the Sustainable Enterprise Academy at York University’s Schulich School of Business. The mission of this academy is to provide executives with training in how to manage businesses with an eye for sustainability. Dofasco’s organizational practices resulted in being named one of the world’s most sustainable companies in the Dow Jones Sustainability Group Index. Sources: Dan Corbett, “Excellence in Canada: Healthy Organizations—Achieve Results by Acting Responsibly,” Journal of Business Ethics 55, no. 2 (December 2004), pp. 124, 130. Joan Enric Ricart, Miguel Angel Rodriguez, Pablo Sanchez, and Lara Ventoso, “The Sustainable Enterprise: Learning from DJSI Leaders” (2005), available at: http://books .google.com/books?id=FXkX3fCOosMC&pg=PA49&lpg=PA49&dq=dofasco+sus tai nable&source=bl&ots=ilGp2bmP3P&sig=QcyNRUHavY2DFQWRgdIE6_b-L_ k&hl=en&sa=X&ei=2WAiU4KgBuGSyAHA8oHwBg&ved=0CGgQ6AEwCQ#v= onepage&q=dofasco&f=false

Public Disclosure Test One way to think of the public disclosure test is to view it as a ray of sunlight that makes our actions visible rather than obscured. The public disclosure test is sometimes called the television test, for it requires us to imagine that our actions are being broadcast on national television. The premise behind this general guideline is that ethics is hard work, labor that we might resist if we did not have frequent reminders that we live in a community. Given our role as a member of a community, our self-concept is tied, at least in part, to how that community perceives us.

universalization test The ethical guideline that urges us to consider, before we act, what the world would be like if everyone acted in this way.


Universalization Test A third general guideline shares with the other two a focus on the “other”—the stakeholders whom our actions affect. Before we act, the universalization test asks us to consider what the world would be like if our decision were copied by everyone else. Applying the universalization test causes us to wonder aloud: “Is what I am about to do the kind of action that, if others followed my example, makes the world a better place for me and those I love?” This chapter concludes with two Business Ethics Flashpoint examples. For the first one, try to word what the firm did in terms of the ethical guidelines. Did its behavior show potential consistency with all three of the guidelines? As you study this next Business Ethics Flashpoint, start by asking yourself what values are in conflict in this business scenario. After you have established which values are in tension, work through both steps in the WH process for making ethical business decisions. In summary, business managers can apply the WH approach to most ethical dilemmas. The WH framework provides a practical process suited to the frequently complex ethical dilemmas that business managers must address quickly in today’s society.

Chapter 2

Business Ethics and Social Responsibility


Questions & Problems 1. What ethical guidelines could help an American business manager working in another country decide whether she should engage in behavior that is ethical where she works but unethical in the United States? 2. What is the relationship between business behavior that is legal and business decisions that are ethical? 3. How do business ethics and business law interact with each other? 4. How does the WH approach to ethics respond to an ethical problem? 5. Jarold Daniel Friedman worked as a temporary computer contractor for a pharmaceutical warehouse. The warehouse offered him a permanent position, but the warehouse required that he get a mumps vaccine, grown in chicken embryos, as a condition of his permanent employment. Friedman, a vegan, believed that the vaccination would violate his religious beliefs and declined to be vaccinated. As a result, the warehouse withdrew its offer of employment. Friedman claimed that the warehouse discriminated against him on the basis of religion. Do you agree with Friedman? Do employers have a duty to respect the beliefs of their employees? If so, what happens when that duty conflicts with employers’ duty to provide a safe and healthy work environment? [Friedman v. Southern California Permanente Medical Group, 102 Cal. App. 4th 39 (2002).] 6. Tyco International, a manufacturing company, sued its former CEO, Dennis Kozlowski, in regard to his receipt of unauthorized bonuses from the company profits. Among his other wrongdoings, Kozlowski awarded unauthorized special bonuses to himself and more than 40 other Tyco employees. In sum, he misappropriated from company funds over $100 million that he was not authorized to receive. Included in this misappropriation was the use of company funds for personal expenditures, such as $18 million to buy and redecorate his New York City apartment and $1 million for his wife’s 40th birthday party, held on the Italian island of Sardinia. The extravagant party featured an ice sculpture of the statue of David urinating Stolichnaya vodka. Based on these and other corporate misdeeds in related criminal proceedings, Kozlowski is currently serving 8.33 to 25 years at the Mid-State Correctional Facility in New York. How do you think Kozlowski would have acted had he considered the public disclosure test before engaging in these corporate misdeeds? What if he applied the universalization test? [Tyco Intl, Ltd. v. Kozlowski, 2005 DNH 68; 2005 U.S. Dist. LEXIS 6867 (April 21, 2005).]

7. In Arkansas, methamphetamine (meth) was manufactured primarily in small toxic labs (STLs) located in homes, tents, barns, or hotel rooms. According to the plaintiffs (a number of counties in Arkansas), Arkansas had one of the highest numbers of STLs in the nation. The counties alleged that they had spent significant amounts of taxpayer dollars combating the manufacture of methamphetamine, including law enforcement costs for locating, eliminating, and cleaning up STLs; prison and jail costs for housing illegal users, dealers, and manufacturers; addiction treatment costs for users and addicts; payments to family service agencies for housing and treating children whose parents were arrested on meth-related charges; and costs for treating the physical side effects of meth use and exposure to its production. To recoup these costs, the plaintiffs sought compensation from Pfizer, Inc., and other manufacturers of cold and allergy medicines. They brought the suit against these manufacturers because meth cannot be produced without ingredients from their cold and allergy medicines. What ethical duties, if any, do you think the drug manufacturers owe to the state or people in this case? Apply the WH framework to help reach your conclusions. [Ashley County et al. v. Pfizer, Inc., 552 F.3d 659; 2009 U.S. App. LEXIS 19.] 8. Jennifer Erickson sued her employer, Bartell Drug Company, contending that its decision not to cover prescription contraceptives under its employee prescription drug plan constituted sex discrimination. Bartell argued that its decision was not sex discrimination because contraceptives were preventive, were voluntary, and did not treat an illness. With whom do you agree? Why? What values did you use to reach your conclusion? [Erickson v. Bartell Drug Co., 141 F. Supp. 2d 1266 (2001).] 9. Entertainment Network, Inc. (ENI), a business that provided news, entertainment, and information via the Internet, sued government officials who prohibited the company from filming the execution of Oklahoma City bomber Timothy McVeigh and selling the footage of the execution online. The government officials argued that a Justice Department regulation prohibiting audio and visual recording devices at federal executions applied in the case at hand. ENI, however, argued that the regulation violated the company’s First Amendment right to free speech. How do you think the court should have ruled in this case? Do you think ENI might have altered its decision to broadcast the execution if it had applied the Golden Rule? [Entm’t Network, Inc. v. Lappin, 134 F. Supp. 2d 1002 (2001).]


Part I

The Legal Environment of Business

10. Titan Distribution, Inc., had subcontracted with a company that provided employees, but Titan later decided to hire its own employees and end the subcontracting contract. Robert Chalfant worked for the subcontracted company, and when Titan made this change, Chalfant sought the same position with Titan that he had held while employed by the subcontractor. Although Titan initially indicated that Chalfant passed his physical examination and would be hired, the company subsequently decided that he failed the physical and did not hire him. The evidence indicated that Titan mistakenly believed that Chalfant’s physical ailments

substantially limited his ability to work, that he previously performed and remained able to perform the functions of the job, and that the refusal to hire him on the basis of the allegedly failed physical was linked to his disability. Further, Titan’s inconsistent and unexplained decision-making process, with knowledge of the federal discrimination laws, was sufficient to support an award of punitive damages. Later you will learn about discrimination, but right now, consider the ethical issues of this case. What values are at odds in the dilemma outlined in this case? [Chalfant v. Titan Distribution, Inc., 475 F.3d 982 (2007).]


The Legal Environment of Business

1 3


The U.S. Legal System and Alternative Dispute Resolution CASE OPENER Questionable Jurisdiction over Caterpillar James Lewis, a resident of Kentucky, sustained an injury while operating a Caterpillar bulldozer. He filed suit against Caterpillar, a company incorporated in Delaware but with its principal place of business in Illinois. Lewis also filed suit against the supplier of the bulldozer, Whayne Supply Company, whose principal place of business was Kentucky. Lewis filed his case in a Kentucky state court, alleging defective manufacture, negligence, failure to warn, and breach of warranty. Lewis and Whayne Supply Company agreed to settle out of court. Caterpillar then filed a motion to exercise its right of removal (its right to move the case from the state to the federal court system), arguing that the federal court had jurisdiction over the case because Caterpillar and Lewis were from different states. Lewis disagreed with Caterpillar’s contention, claiming that because he had not completed his settlement with Whayne, the case still included a defendant (Whayne) from Lewis’s state, Kentucky. Thus, Lewis argued, federal courts did not have jurisdiction over the case. The court agreed with Caterpillar’s argument and moved the case to a federal district court. Shortly thereafter, Lewis and Whayne finalized their settlement agreement, and the district court dismissed Whayne from the lawsuit. The federal district court granted Caterpillar a favorable judgment. Lewis, however, appealed the district court’s decision, renewing his argument that the district court did not have jurisdiction over the case. The court of appeals agreed with Lewis, holding that because Whayne was a defendant in the case at the time that Caterpillar moved the case from state to federal court, the diversity of citizenship necessary to give the federal court jurisdiction over the case was absent. Thus, a state court should have resolved the dispute. Consequently, the appellate court vacated the district court’s decision. Caterpillar then appealed to the U.S. Supreme Court. 1. 2.

What factors determine whether the state or federal court system hears a case? If you were a businessperson with Caterpillar, why might you prefer a federal court to hear the dispute with Lewis, rather than a state court?


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

LO 3-1

What types of jurisdiction must a court have to render a binding decision in a case?

LO 3-2

What is venue?

LO 3-3

What are the threshold requirements that must be met before a court will hear a case?

LO 3-4

What are the steps in civil litigation?

LO 3-5

How are the various forms of alternative dispute resolution used by businesses today?

trial court A court in which most civil or criminal cases start when they first enter the legal system. The parties present evidence and call witnesses to testify. Trial courts are referred to as courts of common pleas or county courts in state court systems and as district courts in the federal system. Also called court of original jurisdiction and court of first instance.

appellate court A higher court, usually consisting of more than one judge, that reviews the decision and results of a lower court (either a trial court or a lowerlevel appellate court) when a losing party files for an appeal. Appellate courts do not hold trials but may request additional oral and written arguments from each party; they issue written decisions, which collectively constitute case law or the common law. Also called court of appellate jurisdiction.

question of law An issue concerning the interpretation or application of a law.

LO 3-1 question of fact A question about an event or characteristic in a case.


As the Case Opener illustrates, when a dispute arises, parties in this country do not simply “go to court.” They often must choose between federal and state court systems. This chapter examines these systems as well as the trial procedures that apply in civil cases.

Jurisdiction A useful way to understand jurisdiction is to think of it as courts’ power to hear cases and render decisions that bind the parties before them. A court must have several types of jurisdiction to decide any particular case.

ORIGINAL VERSUS APPELLATE JURISDICTION Trial courts, or courts of original jurisdiction, have the power to hear and decide cases when they first enter the legal system. In these courts, the parties present evidence and call witnesses to testify. In most states, these courts are called courts of common pleas or county courts. In the federal system, these trial courts are called federal district courts. Courts of appellate jurisdiction, or appellate courts, have the power to review previous judicial decisions to determine whether trial courts erred in their decisions. Appellate courts do not hold trials. Instead, appellate judges review transcripts of trial court proceedings and occasionally consider additional oral and written arguments from each party. Appellate courts handle only questions of law, not questions of fact. A question of law is an issue concerning the interpretation or application of a law. In contrast, a question of fact is a question about an event or characteristic in the case. For example, whether a white student yelled racial slurs on a college campus is a question of fact. On the other hand, whether the First Amendment protects the student’s right to utter racial slurs is a question of law. Only judges can decide questions of law. Trial courts determine questions of fact. In a bench trial (a trial with no jury), the judge decides questions of fact; in a jury trial, the jury decides questions of fact. Appellate courts can, however, overrule trial courts’ decisions on questions of fact, but only when the trial court’s finding was clearly erroneous or when no trial evidence supports the trial court’s finding.

JURISDICTION OVER PERSONS AND PROPERTY In personam jurisdiction (literally, “jurisdiction over the person”) is a court’s power to render a decision affecting the rights of the specific persons before the court. Generally, a court’s power to exercise in personam jurisdiction extends only over a specific geographic region. In the state court system, a court’s in personam jurisdiction usually extends to the state’s borders. In the federal system, each court’s jurisdiction extends across its geographic district.

Chapter 3

A court acquires in personam jurisdiction over a person (the plaintiff) when she files a lawsuit with the court. The court acquires jurisdiction over the person the plaintiff is suing (the defendant) when it gives him a copy of the complaint and a summons. The complaint specifies the factual and legal basis for the lawsuit and the relief the plaintiff seeks. The summons is a court order that notifies the defendant of the lawsuit and explains how and when to respond to the complaint. Service of process is the procedure by which courts present these documents to defendants. Traditionally, courts used personal service: An officer of the court handed the summons and complaint to the defendant. Recently, however, courts have employed other methods of service, including residential service, in which a court representative leaves the summons and complaint with a responsible adult at the defendant’s home, and service by certified or ordinary mail. If the defendant is a corporation, courts generally serve either the president of the corporation or an agent whom the corporation has appointed to receive service. Most states require corporations to appoint an agent for service when they incorporate. Corporations are subject to in personam jurisdiction in three locations: the state of their incorporation, the location of their main offices, and the geographic areas in which they conduct business. Courts have in personam jurisdiction over persons only within a specific geographic region. In the past, a state court could not acquire in personam jurisdiction over out-of-state defendants unless it served the defendants within the court’s home state. Thus, defendants who injured plaintiffs could evade legal action by leaving the state and remaining outside its borders. To alleviate this problem, most states have enacted long-arm statutes that enable the court to serve defendants outside the state as long as the defendant has sufficient minimum contacts within the state. Each state has its own minimum-contact requirements, but most state statutes hold that acts such as committing a tort or doing business in the state are sufficient to allow the state to serve a defendant. In the Caterpillar case, the company sold products in Kentucky, and its products caused an injury in that state. These two facts were sufficient minimum contacts to allow the Kentucky court to serve Caterpillar, even though it was an out-of-state company.

in personam jurisdiction The power of a court to require a party (usually the defendant) or a witness to come before the court. The court must have personal jurisdiction to enforce its judgments or orders against a party. In personam jurisdiction extends only to the state’s borders in the state court system and across the court’s geographic district in the federal system.

plaintiff The person or party who initiates a lawsuit (also known as an action) before a court by filing a complaint with the clerk of the court against the defendant(s). Also known as claimant or complainant.

defendant The person or party against whom a civil or criminal lawsuit is filed in a court of law.

complaint A formal written document that begins a civil lawsuit; contains the plaintiff’s list of allegations against the defendant along with the damages the plaintiff seeks.

B UT W HAT IF . .  . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall that in the Case Opener, the company sold products in Kentucky, and its products caused an injury in that state. Let’s say in the Case Opener that Caterpillar did not sell products in the state of Kentucky, but its products did cause an injury in that state. Could a Kentucky court still exercise in personam jurisdiction over Caterpillar and serve the company? Why?

Because of the increasing purchase of products over the Internet, it is sometimes difficult to know whether the court will be able to obtain in personam jurisdiction over the seller of a defective product. Case 3-1 illustrates how the courts are increasingly responding to this problem.

CASE 3-1


The U.S. Legal System and Alternative Dispute Resolution

summons A legal document issued by a court and addressed to a defendant that notifies him or her of the lawsuit and how and when to respond to the complaint. A summons may be used in both civil and criminal proceedings.

ILLINOIS v. HEMI GROUP LLC 622 F. 3d 754 (2010)

FACTS: Hemi Group LLC is a New Mexico–based cigarette company that was selling discounted cigarettes over the Internet to customers. The defendant company pays

federal taxes on the cigarettes that it sells over the Internet, but in the state of Illinois, the law holds buyers accountable for paying the applicable state tax on cigarettes purchased

(continued) over the Internet. The plaintiff, the state of Illinois, filed suit against Hemi Group LLC, asserting that the company was failing to submit monthly reports of sales to Illinois residents as required by the Jenkins Act. The plaintiff also filed suit against the defendant company for shipping cigarettes to Illinois residents who were not licensed distributors or export warehouse operators and, last, for violating the Enforcement Act and the Consumer Fraud Act by selling brands of cigarettes to Illinois residents who were not in the Illinois Directory. Both parties agreed that the defendant company is not a resident of Illinois and that it is not incorporated under Illinois law. Hemi Group LLC filed to dismiss the motion due to lack of personal jurisdiction. The district court denied the defendant’s motion. The defendant company appealed. ISSUE: Should a company be subject to personal jurisdiction in a state if that company’s business is conducted over the Internet, and the company is not a resident of that same state? REASONING: If a company is involved in commercial activities over the Internet and is involved in these activities with a great number of consumers, then the company is thought to have “purposefully availed itself” of the state’s jurisdiction. In this case, the Illinois court decided to apply a test to determine whether the company had enough interactions with Illinois residents to make the company liable in that state. The court must note the legitimate concern that “premising personal jurisdiction on the maintenance of a website, without requiring some level of ‘interactivity’ between the defendant and consumers in the forum state, would create almost universal personal jurisdiction because of the virtually unlimited accessibility of websites across the country.” Courts should be careful in resolving questions about personal jurisdiction involving online contacts to ensure that a defendant is not brought into court simply because the defendant owns or operates a website that is accessible in the forum state, even if that site is interactive.

In this case, the court decided to reference but not to apply the sliding scale test, also called the Zippo test. The Zippo test was created in Zippo Manufacturing Co. v. Zippo Dot Com, Inc., 952 F. Supp. 1119 (W.D. Pa. 1997) and is now most often used as the test that determines whether a company conducting business over the Internet is subject to personal jurisdiction in a certain state. In the Zippo case, the court stated that “the likelihood that personal jurisdiction can be constitutionally exercised is directly proportionate to the nature and quality of commercial activity that an entity conducts over the Internet.” In other words, if a company is involved in commercial activities over the Internet and is involved in these activities with a great number of consumers, then the company is thought to have “purposefully avail[ed] itself” of the state’s jurisdiction. If the purpose of the website is to conduct business transactions, this means the company that runs the website is interacting in online commercial activities. Yet if a website is passive in that its purpose is simply to display information for online users, the company running the website will likely not be subject to personal jurisdiction. The plaintiff provided evidence that the defendant company’s contacts with Illinois were sufficient to satisfy due process. The defendant maintained commercial websites through which customers could purchase cigarettes, calculate their shipping charges by using their zip codes, and create accounts. The defendant stated that it would ship to any state in the country except New York. The defendant stood ready and willing to do business with Illinois residents. And the defendant company, in fact, knowingly did do business with Illinois residents. DECISION AND REMEDY: The court affirmed the district court’s denial of the defendant’s motion to dismiss for lack of personal jurisdiction and remanded for further proceedings. SIGNIFICANCE OF THE CASE: This case provides an illustration of the standard courts’ use to determine whether a company’s business over the Internet will be subject to personal jurisdiction in a given state.

CRITICAL THINKING Why is the court reluctant to extend in personam jurisdiction whenever a firm with online presence offers to make a sale of products in the state in question? Why is there a reluctance to extend in personam jurisdiction broadly?

ETHICAL DECISION MAKING What Illinois stakeholders are especially happy that the court extended in personam jurisdiction in this case?


E-COMMERCE and the Law The Sliding-Scale Standard for Internet Transactions Does a business that has Internet contact with a plaintiff in a different state satisfy the minimum-contacts standard? A federal district court established the following slidingscale standard in a 1997 case:* [T]he likelihood that personal jurisdiction can be constitutionally exercised is directly proportionate to the nature and quality of commercial activity that an entity conducts over the Internet. This sliding scale is consistent with well developed personal jurisdiction principles.

At one end of the spectrum are situations when a defendant clearly does business over the Internet. If the defendant enters into contracts with residents of a foreign

jurisdiction that involve the knowing and repeated transmission of computer files over the Internet, personal jurisdiction is proper. At the opposite end are situations when a defendant has simply posted information on an Internet website that is accessible to users in foreign jurisdictions. A passive website that does little more than make information available to those who are interested in it is not grounds for the exercise of personal jurisdiction. The middle ground is occupied by interactive websites through which a user can exchange information with the host computer. In these cases, the exercise of jurisdiction is determined by examining the level of interactivity and the commercial nature of the exchange of information that occurs on the website. *

Zippo Mfg. Co. v. Zippo Dot Com, Inc., 952 F. Supp. 1119 at 1124 (1997).

If a defendant has property in a state, a plaintiff may file suit against the defendant’s property instead of against the owner. For example, suppose a Utah resident had not paid property taxes on a piece of land she owned in Idaho. Idaho courts have in rem jurisdiction (Latin for “jurisdiction over the thing”) over the property. Thus, an Idaho state court has the power to seize the property and sell it to pay the property taxes in an in rem proceeding. Courts can also gain quasi in rem jurisdiction, or attachment jurisdiction, over a defendant’s property that is unrelated to the plaintiff’s claim. For example, suppose Charlie, a Massachusetts resident, ran a red light while he was vacationing in California and collided with Jessica’s car. Suppose further that Jessica suffered extensive injuries from the accident and successfully sued Charlie for $200,000 in a California state court. The California court can exercise quasi in rem jurisdiction over Charlie’s California vacation home by seizing it, selling it, and transferring $200,000 to Jessica to satisfy her judgment against Charlie. If Charlie’s vacation home is worth more than $200,000, however, the court must return the excess proceeds to Charlie.

SUBJECT-MATTER JURISDICTION Subject-matter jurisdiction is a court’s power to hear certain kinds of cases. Most industrialized countries have a single court system, with courts that have the power to hear both national law cases and local law cases. In contrast, the United States has both a state and a federal court system. Subject-matter jurisdiction determines which court system may hear a particular case. Cases may fall under state jurisdiction, exclusive federal jurisdiction, or concurrent jurisdiction. Figure 3-1 illustrates the subject-matter-jurisdiction divisions. Exclusive Federal Jurisdiction The federal court system has exclusive jurisdiction over very few cases: admiralty cases; bankruptcy cases; federal criminal prosecutions; lawsuits in which one state; sues another state; claims against the United States; and patent, trademark, and copyright cases. Additionally, federal courts have exclusive jurisdiction over claims arising under federal statutes that specify exclusive federal jurisdiction. State Jurisdiction The state court system has a broad range of jurisdiction; state courts have the power to hear all cases not within the exclusive jurisdiction of the federal court system. State courts also have exclusive jurisdiction over certain cases, such as cases concerning adoption and divorce. Most cases, therefore, fall under state court jurisdiction. The Caterpillar case fell under state court jurisdiction because its subject matter—product liability and negligence—did not place the case under the exclusive jurisdiction of the federal court system.

long-arm statute A statute that enables a court to obtain jurisdiction against an out-ofstate defendant as long as the defendant has sufficient minimum contacts within the state, such as committing a tort or doing business in the state.

in rem jurisdiction The power of a court over the property or status of an out-of-state defendant when that property or status is within the court’s jurisdiction area.

quasi in rem jurisdiction A type of jurisdiction exercised by a court over an out-of-state defendant’s property that is within the jurisdictional boundaries of the court. It applies to personal suits against the defendant in which the property is not the source of the conflict but is sought as compensation by the plaintiff. Also called attachment jurisdiction.

subject-matter jurisdiction The power of a court over the type of case presented to it.



Part I

The Legal Environment of Business

Figure 3-1 Subject-MatterJurisdiction Divisions

Exclusive Federal Jurisdiction – Admiralty cases – Bankruptcy cases – Federal criminal prosecutions – Cases in which one state sues another state – Claims against the United States – Other claims involving federal statutes that specify exclusive federal jurisdiction Concurrent Jurisdiction – Federal-question cases – Diversity-of-citizenship cases Exclusive State Jurisdiction – All other cases

Concurrent Federal Jurisdiction Concurrent federal jurisdiction means that both state and federal courts have jurisdiction over a case. Concurrent jurisdiction covers two types of cases: federal-question and diversity-of-citizenship cases. Federal-question cases require an interpretation of the U.S. Constitution, a federal statute, or a federal treaty. For example, suppose a plaintiff alleges that a Florida campaign-financing law violates his First Amendment free speech rights. Because this case raises a federal question, it falls under concurrent jurisdiction, and both state and federal courts have the power to hear it. A diversity-of-citizenship case must satisfy two conditions: (1) The plaintiff(s) does (do) not reside in the same state as the defendant(s) and (2) the controversy concerns an amount in excess of $75,000. Courts use the location of a party’s residence to determine whether diversity of citizenship exists. Most federal court cases are based on diversity of citizenship. A business may reside in two states: the state of its incorporation and the state of its principal place of business. Thus, in the Case Opener, Caterpillar was a resident of Delaware, the state where it incorporated, and of Illinois, the state of its primary place of business. Although the rule for determining what state a defendant is a citizen of may sound simple, determining where a corporation’s principal place of business was caused a lot of controversy initially. Was it where most of the states’ business activities occurred? Or was it where its headquarters was located? In Case 3-2, the Supreme Court finally clarified how courts should determine a corporation’s principal place of business.

CASE 3-2


FACTS: California employees sued their employer, Hertz Corporation, in state court, alleging violations of the state’s wage and hour laws. Defendant Hertz, claiming diversity of citizenship, removed the case to the federal district court. Hertz argued that it was a citizen of New Jersey

because New Jersey is its principal place of business. It is its principal place of business because Hertz has facilities in 44 states, but its leadership is at its corporate headquarters in New Jersey, and its core executive and administrative functions are primarily carried out there. Hertz also

(continued) stated that California accounted for only a small portion of its business activities. The District Court concluded that it lacked diversity jurisdiction because Hertz was a California citizen under Ninth Circuit precedent, which asks whether the amount of the corporation’s business activity is “significantly larger” or “substantially predominates” in one state. Finding that California was Hertz’s “principal place of business” under that test because a plurality of the relevant business activity occurred there, the District Court remanded the case to state court. Hertz appealed, and the Ninth Circuit Court of Appeals affirmed. Hertz then appealed to the U.S. Supreme Court. ISSUE: For purposes of establishing citizenship of a corporation to determine whether there is diversity of citizenship to give the federal court jurisdiction, what test should the courts use to determine a corporation’s principal place of business, a nerve center test or a predominance of business activity test? REASONING: “Principal place of business” is best read as referring to where a corporation’s officers direct, control, and coordinate the corporation’s activities. In practice, it should normally be where the corporation maintains its headquarters—provided that the headquarters is the actual center of direction, control, and coordination, that is, the nerve center and not simply an office where the corporation holds its board meetings. Three reasons support use of the nerve center approach. The first is that the approach is consistent with the language of the jurisdictional statute. The statute’s word “place” is singular, not plural. Its word “principal” requires the main, prominent, or most important place to be chosen. And the fact that the word “place” follows the words “State where” means that the “place” is a place within a State, not the State itself. A corporation’s nerve center, usually its main headquarters, is a single place. The public often considers it the corporation’s main place of business. And it is a place within a State. By contrast, the application of a more

general business activities test has led some courts to look not at a particular place within a State but incorrectly at the State itself, measuring the total amount of business activity the corporation conducts there and determining whether it is significantly larger than in the next-ranking State. Second, administrative simplicity is desired in a jurisdictional statute. A nerve center approach, which ordinarily equates that center with a corporation’s headquarters, is simple to apply, comparatively speaking. Third, the statute’s legislative history suggests that the words “principal place of business” should be interpreted to be no more complex than an earlier, numerical test that was criticized as too complex and impractical to apply. A nerve center test offers such a possibility. A general business activities test does not. This test is relatively easier to apply and does not require courts to weigh corporate functions, assets, or revenues different in kind, one from the other. This test may produce results that seem to cut against the basic rationale of diversity jurisdiction; accepting occasionally counterintuitive results is the price the legal system must pay to avoid overly complex jurisdictional administration while producing the benefits that accompany a more uniform legal system. DECISION AND REMEDY: For purposes of federalcourt diversity jurisdiction, a corporation’s principal place of business refers to the place, often called nerve center, from which the corporation’s high-level officers directed, controlled, and coordinated corporation’s activities. Although it appeared from the evidence that Hertz corporate offices and its nerve center are located in New Jersey, the respondents should have a fair opportunity on remand to litigate this issue in light of this holding as to the applicable rule. SIGNIFICANCE OF THE CASE: The case settles a long-standing conflict among the circuits about what test to apply to determine where a corporation’s primary place of business is.

CRITICAL THINKING Which critical-thinking skill is the focal point of this case? Which words are not clear?

ETHICAL DECISION MAKING What primary value can you hear in the court’s reasoning?

It is important to note that diversity must be complete for a case to fall under concurrent jurisdiction. In the Caterpillar case, Lewis argued that diversity was not complete because both he and the supply company, the second defendant he originally sued, were residents of Kentucky. The appellate court agreed with his argument and overturned the district court’s decision because the district court lacked subject-matter jurisdiction.



Part I

The Legal Environment of Business

When a plaintiff files a case involving concurrent jurisdiction in state court, the defendant has a right of removal. This right entitles the defendant to transfer the case to federal court. Thus, either party to a case involving concurrent jurisdiction can put the case in the federal court system: The plaintiff can file the case in federal court initially; or if the case was initially filed in state court, the defendant can transfer the case to federal court by exercising her right of removal. In the Case Opener, Caterpillar exercised its right of removal, and the state trial court moved the case to a federal district court.

B UT W H AT I F .   .   . Recall that in the Case Opener, Catepillar filed a motion to exercise its right of removal to move the case to federal court. If it had not filed that motion, would the case have been held in state court, even though it fell under concurrent jurisdiction?

LO 3-2 venue (1) The place where a hearing takes place. Its geographic location is determined by each state’s statutes and based on where the parties live or where the event occurred or the alleged wrong was committed. (2) A legal doctrine relating to the selection of a court with subject-matter and personal jurisdiction that is the most appropriate geographic location for the resolution of the dispute.

Venue Once a case is in the proper court system, venue determines which trial court in the system will hear the case. Venue is a matter of geographic location that each state’s statutes determine. Usually, the trial court for the county where the defendant resides is the appropriate venue. If a case involves property, the trial court where the property is located is also an appropriate venue. Finally, if the focus of the case is a particular incident, the trial court where the dispute occurred is an appropriate venue. The plaintiff initially chooses from among the appropriate venues when she files the case. If the location of the court where the plaintiff filed the case is an inconvenience to the defendant or if the defendant believes it will be difficult to select an unbiased jury in that venue, he may request that the judge move the case by filing a motion for a change of venue. The judge has the discretion to grant or deny the motion.

The Structure of the Court System The U.S. legal system has two parallel court structures: a federal system and a state system. Once a plaintiff files a case in one of the systems, the case remains in that system throughout the appeals process. The only exception to this rule occurs when a party to a lawsuit appeals the decision of a state supreme court to the U.S. Supreme Court.

THE FEDERAL COURT SYSTEM The federal court system derives its power from Article III, Section 2, of the U.S. Constitution and consists of three main levels: trial courts, intermediate appellate courts, and the court of last resort. Figure 3-2 illustrates this system. Federal Trial Courts In the federal court system, the trial courts, or courts of original jurisdiction, are U.S. district courts. The United States has 94 districts; each district has at least one trial court of general jurisdiction. Courts of general jurisdiction have the power to hear a wide range of cases and can grant almost any type of remedy. Almost every case in the federal system begins in one of these courts. A small number of cases, however, do not begin in trial courts of general jurisdiction. For cases concerning certain subject matter, Congress has established special trial courts of limited jurisdiction. The types of cases heard by these special trial courts include bankruptcy cases; claims against the U.S. government; and copyright, patent, and trademark cases. In an extremely limited number of cases, the U.S. Supreme Court functions as a trial court of limited jurisdiction. These cases include controversies between states and lawsuits against foreign ambassadors.

Chapter 3


The U.S. Legal System and Alternative Dispute Resolution

Figure 3-2 The Federal Court System

U.S. Supreme Court

Court of Appeals for the Federal Circuit

Patents, Trademarks, and Copyright Office

United States Court of Claims

Court of International Trade

United States Circuit Courts of Appeals (12)

United States District Courts (94)

Administrative Tribunals (FTC, SEC, etc.)

United States Tax Court

Bankruptcy Courts

Intermediate Courts of Appeal The U.S. circuit courts of appeal make up the second level of courts in the federal system. The United States has 12 circuits, including a circuit for the District of Columbia. Each circuit court hears appeals from district courts in its geographic area. Additionally, a federal circuit court of appeals hears appeals from government administrative agencies. Figure 3-3 illustrates the geographic circuit divisions. Figure 3-3 The Circuits of the Federal Court System







ID Eastern

























TX Western






Southern Middle




Middle Eastern







11 FL Middle


4 Eastern



Middle Southern





GA Middle



















Southern Eastern


Southern Western







Northern Northern









Eastern Northern















Part I

The Legal Environment of Business

The Court of Last Resort The U.S. Supreme Court is the final appellate court in the federal system. Nine justices, who have lifetime appointments, make up the high court. Figure 3-4 identifies the nine justices on the U.S. Supreme Court. The U.S. Supreme Court hears appeals of cases from the court of last resort in a state system. The Court will not, however, hear cases considering questions of pure state law. The Court also functions as a trial court on rare occasions.

STATE COURT SYSTEMS No uniform state court structure exists because each state has devised its own court system, but most states have a structure similar to the federal court system’s structure. State Trial Courts In state court systems, most cases begin in a trial court of general jurisdiction. As in the federal system, state trial courts of general jurisdiction have the power to hear all cases over which the state court system has jurisdiction except those cases for which the state has established special trial courts of limited jurisdiction. Most states have a trial court of general jurisdiction in each county. The names of these courts vary by state, but most states refer to them as courts of common pleas or county courts. In some states, these courts have specialized divisions such as domestic relations and probate. Figure 3-4 U.S. Supreme Court Justices

Associate Justice

Associate Justice

Associate Justice

Elena Kagan Appointed in 2010 by President Obama

Antonin Scalia Appointed in 1984 by President Reagan

Anthony M. Kennedy Appointed in 1988 by President G.H.W. Bush

Associate Justice

Chief Justice

Associate Justice

Sonia Sotomayor Appointed in 2009 by President Obama

John G. Roberts Appointed in 2005 by President G.W. Bush

Clarence Thomas Appointed in 1991 by President G.H.W. Bush

Associate Justice

Associate Justice

Associate Justice

Ruth Bader Ginsburg Appointed in 1993 by President Clinton

Stephen G. Breyer Appointed in 1994 by President Clinton

Samuel Alito Appointed in 2006 by President G.W. Bush

(All photos: Steven Petteway, Collection of the Supreme Court of the United States)

GLOBAL Context The Court Structure in England Even though we trace the roots of the U.S. legal system back to England, changes have occurred in both countries’ court structures; as a result, the court structures in the United States and England share similarities but also have distinct features. The lowest criminal courts in England are the magistrates courts, which hear minor offenses. More serious cases are tried before a judge and jury in the crown court, which also hears cases appealed from the magistrates courts on factual points. The high court (in the Queen’s Branch Division) hears appeals on points of law, and the court of appeal in the Criminal Division hears appeals on sentences and convictions.

Civil cases are first heard in the county courts (for minor claims) or the high court, which is divided into three divisions: Queen’s Bench, Family, and Chancery. Cases may be appealed to the court of appeal (Civil Division). Cases may also be appealed from the county court to the high court. The House of Lords is the supreme court of appeal. Its cases are heard by up to 13 senior judges known as law lords. In addition to the courts, there are specialized tribunals, which hear appeals on decisions made by various public bodies and government departments in areas such as employment, immigration, social security, tax, and land.

Most states also have trial courts of limited jurisdiction. Usually, these courts can grant only certain remedies. For example, small claims courts, a common type of court of limited jurisdiction in most states, may not grant damage awards larger than a specified amount. Other courts of limited jurisdiction have the power to hear only certain types of cases. For example, probate courts hear only cases about asset and obligation transfers after an individual’s death. Intermediate Courts of Appeal Intermediate courts of appeal, analogous to federal circuit courts of appeal, exist in approximately half the states. These courts usually have broad jurisdiction, hearing appeals from courts of general and limited jurisdictions as well as from state administrative agencies. The names of these courts vary by state, but most states call them courts of appeal or superior courts. Courts of Last Resort Appeals from the state intermediate courts of appeal lead cases to the state court of last resort. Most states call this court the supreme court, although some states refer to it as the court of appeals. Because approximately half of the states lack intermediate courts of appeal, appeals from trial courts in these states go directly to the state court of last resort.

Threshold Requirements

LO 3-3

Before a case makes it to court, it must meet three threshold requirements. These requirements ensure that courts hear only cases that genuinely require adjudication. The three requirements are standing, case or controversy, and ripeness (see Figure 3-5).

STANDING A person who has the legal right to bring an action in court has standing (or standing to sue). For a person to have standing, the outcome of a case must personally affect him or her. Thus, if you hire a landscaper to mow your lawn every week and he fails to show up every other week, you have standing to sue your landscaper. But if your friend hired the landscaper, you lack the standing to sue on your friend’s behalf because you do not have a personal stake in the outcome of the case. The reason the American legal system requires this personal stake in the outcome is the belief that the plaintiff’s personal stake stimulates her to present the best possible case. The requirements for standing, according to the 2000 U.S. Supreme Court case Friends of the Earth v. Laidlaw Environmental Services,1 are (1) the plaintiff must have an injury in fact that is concrete and 1

120 S. Ct. 923 (2000).

standing The legal right of a party or an individual to bring a lawsuit by demonstrating to the court sufficient connection to and harm from the law or action challenged (i.e., the plaintiff has to demonstrate that he or she is harmed or will be harmed). Otherwise, the court will dismiss the case, ruling that the plaintiff “lacks standing” to bring the suit.



Part I

The Legal Environment of Business

Figure 3-5 Threshold Requirements

Actual or imminent injury Adverse relationship between A decision is able to affect the parties immediately in fact plaintiff and defendant Injury traceable to actions of Actions of one party give rise defendant to a legal dispute Injury will be redressed by Court decision is able to favorable decision resolve the dispute

case or controversy A term used in the U.S. Constitution to describe the structure and requirements of conflicting claims of individuals that can be brought before a federal court for resolution. A case or controversy requires an actual dispute between parties over their legal rights that remains in conflict at the time the case is presented and that is a proper matter for judicial determination. Also referred to as justifiable controversy.

ripeness The readiness of a case for a decision to be made. The goal is to prevent premature litigation for a dispute that is insufficiently developed. A claim is not ripe for litigation if it rests on contingent future events that may not occur as anticipated or may not occur at all.

actual or imminent; (2) the injury must be fairly traceable to the challenged action of the defendant; and (3) it must be likely that the injury will be redressed by a favorable decision.2 In applying those criteria to the Laidlaw case, the Supreme Court found that FOE members’ testimony that they were afraid to fish and swim in a river they previously enjoyed satisfied the first two criteria. The Court held that although the FOE members would not directly receive money from a penalty against Laidlaw, they would benefit because the penalties would deter Laidlaw and other companies from polluting the river in the future.3 The Court ruled in FOE’s favor and assessed Laidlaw a $405,800 penalty payable to the U.S. Treasury.

CASE OR CONTROVERSY The case-or-controversy (or justifiable controversy) requirement ensures that courts do not render advisory opinions. Three criteria are necessary for a case or controversy to exist. First, the relationship between the plaintiff and the defendant must be adverse. Second, actual or threatened actions of at least one of the parties must give rise to an actual legal dispute. Third, courts must have the ability to render a decision that will resolve the dispute. In other words, courts can give final judgments that solve existing problems; they cannot provide rulings about hypothetical situations.

RIPENESS The case-or-controversy requirement is closely linked to the ripeness requirement. A case is ripe if a judge’s decision is capable of affecting the parties immediately. Usually the issue of ripeness arises when one party claims that the case is moot—in other words, there is no point in the court’s hearing the case because no judgment can affect the situation between the parties. In the Laidlaw case, Laidlaw argued that the case was moot because by the time the case went to trial, the company had complied with the requirements of its discharge permits. The Supreme Court disagreed, ruling that the fact that a defendant voluntarily ceases a practice once litigation has commenced does not deprive a federal court of its power to determine the legality of the 2 3

Ibid. Ibid.

Chapter 3


The U.S. Legal System and Alternative Dispute Resolution

practice, because such a ruling would leave the defendant free to return to his old unlawful practices. Thus, the Court found the case was not moot because imposing a penalty on the defendant would have an important deterrent effect.4

Steps in Civil Litigation

LO 3-4

The U.S. litigation system is an adversary system: A neutral fact finder—a judge or jury—hears evidence and arguments that opposing sides present and then decides the case on the basis of the facts and law. Strict rules govern the types of evidence fact finders may consider. Theoretically, fact finders make informed and impartial rulings because each party has an incentive to find all relevant evidence and make the strongest possible arguments on behalf of her or his position. Critics of the adversary system, however, point out several drawbacks: the time and expense each lawsuit requires, the damage a suit may cause to the litigating parties’ relationship, and the unfair advantage to those with wealth and experience using the court system.

THE PRETRIAL STAGE The rules of civil procedure govern civil case proceedings. The Federal Rules of Civil Procedure apply in all federal courts. Each state has its own set of rules, but most states’ rules are very similar to the Federal Rules of Civil Procedure. In addition, each court usually has its own set of local court rules. Informal Negotiations The initial attempt to resolve a business dispute is usually informal: a discussion or negotiation among the parties to try to find a solution. If the parties are unable to resolve their dispute, one party often seeks an attorney’s advice. Together, the attorney and client may be able to resolve the dispute informally with the other party. Pleadings The first formal stage of a lawsuit is the pleading stage. The plaintiff’s attorney initiates a lawsuit by filing a complaint in the appropriate court. The complaint states the names of the parties to the action, the basis for the court’s subject-matter jurisdiction, the facts on which the plaintiff bases her claim, and the relief the plaintiff seeks. The pleadings prevent surprises at trial; they allow attorneys to prepare arguments to counter the other side’s claims. Exhibit 3-1 shows a typical complaint. Service of Process To obtain in personam jurisdiction over a defendant and to satisfy due process, a court must notify the defendant of the pending lawsuit. Service of process occurs when a representative of the court serves (delivers) a copy of the complaint and a summons to the defendant. The complaint explains the basis of the lawsuit to the defendant. The summons tells the defendant that if he or she does not respond to the lawsuit within a certain period of time, the plaintiff will receive a default judgment. A default judgment is a judgment in favor of the plaintiff that occurs when the defendant fails to answer the complaint and the plaintiff’s complaint alleges facts that would support such a judgment. Defendant’s Response The defendant responds to the complaint with an answer. In this document, the defendant denies, affirms, or claims no knowledge of the accuracy of the plaintiff’s allegations. A defendant uses an affirmative defense when his or her answer admits that the facts contained in the complaint are accurate but also includes additional facts that justify the defendant’s actions and provide a legally sound reason to deny relief to the plaintiff. For example, if a woman sued a man for battery because he punched her in the face, he might claim that he hit her only because she aimed a gun at him and threatened to shoot. His claim that he was acting in selfdefense is an affirmative defense. 4


service of process The procedure by which a court delivers a copy of the statement of claim or other legal documents, such as a summons, complaint, or subpoena, to the defendant.

default judgment Judgment for the plaintiff that occurs when the defendant fails to respond to the complaint.

answer The response of the defendant to the plaintiff’s complaint.


Part I

The Legal Environment of Business

Exhibit 3-1


A Typical Complaint

Bob Lyons and Sue Lyons, Plaintiffs v. Christine Collins, Defendant COMPLAINT FOR NEGLIGENCE Case No. _____ Now come the plaintiffs, Bob Lyons and Sue Lyons, and, for their complaint, allege as follows:

1. Plaintiffs, Bob Lyons and Sue Lyons, both of 825 Havercamp Street, are citizens of Clark County, in the state of Nevada, and defendant, Christine Collins, 947 Rainbow Ave., is a citizen of Clark County in the state of Nevada. 2. On May 1, 2001, the defendant built a wooden hanging bridge across a stream that runs through the plaintiffs’ property at 825 Havercamp Street. 3. Defendant negligently used ropes in the construction of the bridge that were not thick enough to sustain human traffic on the bridge. 4. At approximately 4:00 p.m., on May 20, 2001, the plaintiffs were attempting to carry a box of landscaping stones across the bridge when the ropes broke, and the bridge collapsed, causing plaintiffs to fall seven feet into the stream. 5. As a result of the fall, plaintiff, Bob Lyons, suffered a broken arm, a broken leg, and a skull fracture, incurring $160,000 in medical expenses. 6. As a result of the fall, plaintiff, Sue Lyons, suffered two broken cervical vertebrae, and a skull fracture, incurring $300,000 in medical expenses. 7. As a result of the fall, the landscaping stones, which had cost $1,200, were destroyed. 8. As a result of the foregoing injuries, plaintiff, Bob Lyons, was required to miss eight weeks of work, resulting in a loss of $2,400 in wages. 9. As a result of the foregoing injuries, plaintiff, Sue Lyons, was required to miss 12 weeks of work, resulting in a loss of $3,600 in wages. WHEREFORE, plaintiffs demand judgment in the amount of $467,200, plus costs of this action. Harlon Elliot Attorney for plaintiffs 824 Sahara Ave. Las Vegas, Nevada, 89117 JURY DEMAND Plaintiffs demand a trial by jury in this matter. motion to dismiss A request by the defendant that asks a judge or a court in a civil case to dismiss the case because even if all the allegations are true, the plaintiff is not entitled to any legal relief. Also called demurrer.

motion An application by a party to a judge or a court in a civil case requesting an order in favor of the applicant.

If the defendant plans to raise an affirmative defense, he must raise it in his answer to give the plaintiff adequate notice. If he fails to raise an affirmative defense in the answer, the judge will likely not allow him to raise it during the trial. Upon receiving the complaint, if the defendant believes that even though all the plaintiff’s factual allegations are true, the law does not entitle the plaintiff to a favorable judgment, the defendant may file a motion to dismiss, or demurrer. (A motion is a request by a party for the court to do something; in this instance, the request is to dismiss the case.) In deciding whether to grant a motion to dismiss, a judge accepts the facts as stated by the plaintiff and rules on the legal issues in the case. Judges generally grant motions to dismiss only when it appears beyond a doubt that the plaintiff cannot prove any set of facts to justify granting the judgment she seeks.

Chapter 3


The U.S. Legal System and Alternative Dispute Resolution

If the defendant believes he has a claim against the plaintiff, he includes this counterclaim with the answer. As Exhibit 3-2 shows, the form of a counterclaim is identical to the form of a complaint. The defendant states the facts supporting his claim and asks for relief. If the defendant files a counterclaim, the plaintiff generally files a reply. A reply is an answer to a counterclaim. In the reply, the plaintiff admits, denies, or claims a lack of knowledge of the accuracy of the facts of the defendant’s counterclaim. If the plaintiff plans to use an affirmative defense, she must raise it in the reply.

counterclaim A claim made by the defendant against the plaintiff that is filed along with the defendant’s answer.

reply A response by the plaintiff to the defendant’s counterclaim.

Pretrial Motions The early pleadings establish the legal and factual issues of the case. After the pleadings, the plaintiff or defendant may file a motion to conclude the case early, eliminate some claims, or gain some advantage. A party may move, or request, the court to do almost anything pertaining to the case. For example, if the plaintiff files a suit about the right to a piece of

THE COURT OF COMMON PLEAS OF CLARK COUNTY, NEVADA Bob Lyons and Sue Lyons, Plaintiffs v. Christine Collins, Defendant ANSWER AND COUNTERCLAIM FOR BREACH OF CONTRACT Case No. _____ Now comes the defendant, Christine Collins, and answers the complaint of plaintiffs herein as follows:

FIRST DEFENSE 1. Admits the allegations in paragraphs 1 and 2. 2. Denies the allegation in paragraph 3. 3. Is without knowledge as to the truth or falsity of the allegations contained in paragraphs 4, 5, 6, 7, 8, and 9. SECOND DEFENSE 4. If the court believes the allegations contained in paragraph 3, which the defendant expressly denies, plaintiffs should still be denied recovery because they were informed prior to the construction of the bridge that there should be no more than one person on the bridge at one time and that no individual weighing more than 200 pounds should be allowed to walk on the bridge. COUNTERCLAIM 5. On April 15, the parties agreed that defendant would build a wooden hanging bridge across a stream that runs through the defendant’s property at 825 Havercamp Street, in exchange for which plaintiffs would pay defendant $2,000 upon completion of construction. 6. On May 1, 2001, the defendant built the agreed upon ornament, wooden, hanging bridge across a stream that runs through the defendant’s property at 825 Havercamp Street, but plaintiffs failed to pay the agreed upon price for the bridge. 7. By their failure to pay, plaintiffs breached their contract and are liable to defendant for the contract price of $2,000. WHEREFORE, defendant prays for a judgment dismissing the plaintiffs’ complaint and granting the defendant a judgment against plaintiffs in the amount of $2,000 plus costs of this action. Melissa Davenport Attorney for Defendant 777 Decatur Ave. Las Vegas, Nevada 89117

Exhibit 3-2 Defendant’s Answer and Counterclaim


Part I

motion for judgment on the pleadings

property, she may move that the court prohibit the current possessor of the land from selling it. Courts may grant or deny such motions at their discretion. When a party files a motion with the court, the court sends a copy to the opposing attorney, who may respond to the motion, usually by requesting that the judge deny the motion. In many cases, the judge rules on the motion immediately. In other cases, the judge holds a hearing at which the attorneys for both sides argue how the judge should decide the motion. Two primary pretrial motions are a motion for judgment on the pleadings and a motion for summary judgment. Once the parties file the pleadings, either party can file a motion for judgment on the pleadings. The motion is a request for the court to consider that all the facts in the pleadings are true and to apply the law to those facts. The court grants the motion if, after this process, it finds that the only reasonable decision is in favor of the moving party. Either party can file a motion for summary judgment after the discovery process (described below). The motion asserts that no factual disputes exist and that if the judge applied the law to the undisputed facts, her only reasonable decision would be in favor of the moving party. The difference between this motion and a motion for judgment on the pleadings is that in a motion for summary judgment, the moving party may use affidavits (sworn statements from the parties or witnesses), relevant documents, and depositions or interrogatories (a party’s sworn answers to written questions) to support his motion. The judge grants the motion if, after examining the evidence, she finds no factual disputes. If, however, she finds any factual issues about which the parties disagree, she denies the motion and sends the case to trial.

In a civil case, a request made by either party, after pleadings have been entered, that asks a judge or a court to issue a judgment.

motion for summary judgment In a civil case, a request made by either party that asks a judge or a court to promptly and expeditiously dispose of a case without a trial. Any evidence or information that would be admissible at trial under the rules of evidence, such as affidavits, interrogatories, depositions, and admissions, may be considered on a motion for summary judgment. A court may hold oral arguments or decide the motion on the basis of the parties’ briefs and supporting documentation alone.

discovery The pretrial phase in a lawsuit during which each party requests relevant documents and other evidence from the other side in an attempt to “discover” pertinent facts and avoid any surprises in the courtroom during the trial. Discovery tools include requests for admissions, interrogatories, depositions, requests for inspection, and document production requests.

interrogatories A formal set of written questions that one party to a lawsuit asks the opposing party as part of the pretrial discovery process in order to clarify matters of evidence and help determine in advance what facts will be presented at any trial in the case. The questions must be answered in writing under oath or under penalty of perjury within a specified time. Also called requests for further information.

The Legal Environment of Business

Discovery After filing the initial pleadings and motions, the parties gather information from each other through discovery. The discovery process enables the parties to learn about facts surrounding the case so that they are not surprised in the courtroom. Three common discovery tools are interrogatories, requests to produce documents, and depositions. Interrogatories are written questions that one party sends to the other to answer under oath. Frequently, a request to admit certain facts accompanies interrogatories. Attorneys work with their clients to answer interrogatories and requested admissions of facts. Sometimes interrogatories are called requests for further information. A request to produce documents (or other items) forces the opposing party to produce (turn over) certain information unless it is privileged or irrelevant to the case. Parties may request documents such as photographs, contracts, written estimates, medical records, tax forms, and other government documents. In tort cases, the defendant frequently asks the plaintiff to submit a mental- or physical-examination report. Finally, the parties may obtain testimony from a witness before trial through a deposition. At a deposition, attorneys examine a witness under oath. A court reporter (stenographer) records every word the witness and attorneys speak. Both parties receive a copy of the testimony in document form. Depositions provide information and may also set up inconsistencies between a witness’s testimony at the deposition and his testimony at trial. If a party discovers an inconsistency in the testimony of one of the other party’s witnesses, she can bring the inconsistency to the fact finder’s attention to diminish the witness’s credibility. The parties may also use depositions when a witness is elderly, moving, or ill and thus may be unavailable at the time of the trial. If a party does not comply with requests for discovery, the court may admit the facts the other party sought to discover. Attorneys who feel that certain material is outside the scope of the case often argue that the material is irrelevant to the case. If the court disagrees, however, the party must supply the requested information. Although these discovery tools are important in the United States, many countries do not have a discovery process. Pretrial Conference A pretrial conference precedes the trial. A pretrial conference is an informal meeting of the judge with the attorneys representing the parties. During this conference, the parties try to narrow the legal and factual issues and possibly work out a settlement. If the parties cannot reach a settlement, the attorneys and the judge discuss the administrative details of the trial: its length, witnesses, and any pretrial stipulations of fact or law to which the parties agree.

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request to produce documents

If a plaintiff seeks at least $20 in monetary damages, the Seventh Amendment to the U.S. Constitution entitles the parties to a jury trial. The plaintiff must, however, demand a jury trial in her or his complaint. Some types of trials require 12-person juries, but 6-person juries hear most civil cases. If the plaintiff seeks an equitable remedy (an injunction or other court order) or if the parties have waived their right to a jury, a judge serves as the fact finder in the case. Trials have six stages: jury selection, opening statements, examination of witnesses, closing arguments, conference on jury instructions, and posttrial motions. The following sections describe these stages.

In a lawsuit, the right of a party to examine and copy papers of the opposing party that are relevant to the case. A legal request may be made, and the categories of the documents must be stated to allow the other party to know what documents he or she must produce.

Jury Selection The jury selection process begins when the clerk of the courts randomly selects a number of potential jurors from the citizens within the court’s jurisdiction. Once the potential jurors have reported for jury duty, the voir dire, or jury selection, process begins. The voir dire process selects the jurors who will decide the case as well as two or three alternate jurors who will watch the trial and be available to replace any juror who, for some legitimate reason, must leave jury duty before the trial ends. During voir dire, the judge and/or attorneys question potential jurors to determine whether they are able to render an unbiased opinion in the case. If a potential juror’s response to a question indicates that she or he may be biased, either attorney may challenge, or ask the court to remove, that potential juror “for cause.” For example, a lawyer could challenge for cause a potential juror who was a college roommate of the defendant. In most states, each party has a certain number of peremptory challenges. These peremptory challenges allow a party to challenge a certain number of potential jurors without giving a reason. Peremptory challenges, however, may lead to abuse. For example, in the past, attorneys have used peremptory challenges to eliminate a certain class, ethnic group, or gender from the jury. In the 1986 case, Batson v. Kentucky,5 the U.S. Supreme Court ruled that race-based peremptory challenges in criminal cases violate the equal protection clause of the Fourteenth Amendment to the U.S. Constitution. (Chapter 4 discusses the amendments to the Constitution in more detail.) The Supreme Court later extended the ban on race-based challenges to civil cases. In Case 3-3, the U.S. Supreme Court addressed the issue of whether the equal protection clause covers gender-based challenges.



476 U.S. 79 (1986).

CASE 3-3

A pretrial sworn and recorded testimony of a witness that is acquired out of court with no judge present.

pretrial conference An informal meeting of the judge with the attorneys representing the parties before the actual trial begins.

voir dire The process of questioning potential jurors to ensure that the jury will be made up of unbiased individuals.

peremptory challenge In a jury trial, the right of the plaintiff and the defendant in jury selection to reject, without stating a reason, a certain number of potential jurors who appear to have an unfavorable bias.


FACTS: The State of Alabama filed a complaint for paternity and child support against J.E.B. on behalf of T.B., the unwed mother of a minor child. The court called a panel of 12 males and 24 females as potential jurors. Only 10 males remained after three individuals were removed for cause. The state used its peremptory challenges to remove nine male jurors, and J.E.B. removed the tenth, resulting in an all-female jury. The trial court rejected J.E.B.’s objection to the gender-based challenges, and the jury found J.E.B.

to be the father. J.E.B. appealed, and the court of appeals affirmed the trial court’s ruling that the equal protection clause of the Fourteenth Amendment does not prohibit gender-based challenges. The Alabama Supreme Court declined to hear the appeal, and J.E.B. appealed to the U.S. Supreme Court. ISSUE: Does the equal protection clause prohibit removing possible jurors during voir dire on the basis of their gender?

(continued) REASONING: Justice Blackmun delivered the opinion of the Court: Discrimination in jury selection, whether based on race or on gender, causes harm to the litigants, the community, and the individual jurors who are wrongfully excluded from participation in the judicial process. The litigants are harmed by the risk that the prejudice which motivated the discriminatory selection of the jury will infect the entire proceedings. The community is harmed by the State’s participation in the perpetuation of invidious group stereotypes and the inevitable loss of confidence in our judicial system that state-sanctioned discrimination in the courtroom engenders.

As with race-based Batson claims, a party alleging gender discrimination must make a prima facie showing of intentional discrimination before the party exercising the challenge is required to explain the basis for the strike. When an explanation is required, it need not rise to the level of a for cause challenge; rather, it merely must be based on a juror characteristic other than gender, and the proffered explanation may not be pretextual. Equal opportunity to participate in the fair administration of justice is fundamental to our democratic system.

It reaffirms the promise of equality under the law—that all citizens, regardless of race, ethnicity, or gender, have the chance to take part directly in our democracy. When persons are excluded from participation in our democratic processes solely because of race or gender, this promise of equality dims, and the integrity of our judicial system is jeopardized. DECISION AND REMEDY: Yes, to remove a potential juror based solely on gender is a violation of the equal protection clause. The court of appeals decision was reversed, and the case was remanded in favor of J.E.B. SIGNIFICANCE OF THE CASE: This case extended protection against being peremptorily removed from a jury on the basis of gender alone, thus putting gender protections on par with the protections for race and ethnicity. Although historically the extension of the Fourteenth Amendment’s equal protection clause to gender has been used to protect women’s equal rights, the court found that the clause was equally applicable when a man’s equal rights were being violated.

CRITICAL THINKING The defendant was contesting the removal of males from the jury. Does this fact affect your assessment of the quality of the Court’s reasoning? Explain.

ETHICAL DECISION MAKING Which ethical norm does the case decision serve?

mock trial A contrived or imitation trial, with a jury recruited by a jury selection firm, that attorneys sometimes use in preparing for an actual trial to test theories, experiment with arguments, and try to predict the outcome of the real trial.

shadow jury An unofficial jury, provided by a jury selection firm, that sits in during the actual trial and deliberates at the end of each day to evaluate for the attorneys how each side is doing.


Despite Batson and J.E.B., it is still not easy to challenge a dismissal as being based on race or gender. And in a 2006 case, the U.S. Supreme Court said that to find a dismissal unconstitutional, there must be no alternative to a gender- or race-based reason for dismissing a juror.6 The voir dire process has become more sophisticated over time. In cases involving significant amounts of money, rather than relying on their instinct or experience during jury selection, attorneys use professional jury selection services to identify demographic data to help select ideal jurors. Jury selection firms also provide additional services, including mock trials, in which mock jurors who are demographically similar to the real jurors hear the arguments and give feedback prior to the case, and shadow juries, in which shadow jurors sit in during the actual trial and deliberate at the end of each day to evaluate for the attorneys how each side is doing. Critics argue that jury selection services give an unfair advantage to one side when only one party can afford these services. Opening Statements Once the attorneys have impaneled, or selected, a jury, the case begins with opening statements. Each party’s attorney explains to the judge and jury what facts he or she 6

Rice, Warden et al. v. Collins, 126 S. Ct. 969 (2006).

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intends to prove, the legal conclusions to which these facts lead, and how the fact finder should decide the case based on those facts. The Examination of Witnesses and Presentation of Evidence Following opening statements, the plaintiff and defendant, in turn, present their cases-in-chief by examining witnesses and presenting evidence. The plaintiff has the burden of proving the case, meaning that if neither side presents a convincing case, the fact finder must rule in favor of the defendant. Thus, the plaintiff presents her case first. The procedure for each witness is the same. First, the plaintiff’s attorney questions the witness in direct examination. The plaintiff’s attorney asks the witness questions to elicit facts that support the plaintiff’s case-in-chief. Questions must relate to matters about which the witness has direct knowledge. Attorneys cannot elicit hearsay from the witnesses. Hearsay is testimony about what a witness heard another person say. Hearsay is impermissible because the opposing attorney cannot question the person who made the original statement to determine the statement’s veracity. The federal rules of evidence also prohibit attorneys from asking leading questions. Leading questions are questions that imply a specific answer. For example, an attorney cannot ask a witness, “Did the defendant come to your office and ask you to purchase stock from him?” Instead, attorneys must ask questions such as, “When did you first encounter the defendant?” After direct examination, opposing counsel may cross-examine the witness. Opposing counsel, however, may ask only questions related to the witness’s direct examination. On crossexamination, attorneys can ask leading questions. Attorneys try to show inconsistencies in the witness’s testimony, cast doubt on the claims of the plaintiff’s case, and elicit information to support the defendant’s case. After cross-examination, the plaintiff’s attorney may conduct a redirect examination, a series of questions aimed at repairing damage done by the cross-examination. At the judge’s discretion, opposing counsel has an opportunity to re-cross the witness to question her testimony on redirect examination. The parties follow this procedure for each of the plaintiff’s witnesses. Immediately following the plaintiff’s presentation of her case, the defendant may move for a directed verdict. This motion is a request for the court to direct a verdict for the defendant because even if the jury accepted all the evidence and testimony presented by the plaintiff as true, the jury would still have no legal basis for a decision in favor of the plaintiff. The federal court system refers to a motion for a directed verdict as a motion for a judgment as a matter of law. Courts rarely grant motions for a directed verdict because plaintiffs almost always present at least some evidence to support each element of the cause of action. If the court denies the defendant’s motion for a directed verdict, the defendant then presents his case. The parties question the defendant’s witnesses in the same manner as they questioned the plaintiff’s witnesses, except that the defendant’s attorney conducts direct and redirect examination and the plaintiff’s attorney conducts cross-examination and recross-examination. Closing Arguments After the defendant’s case, the attorneys present closing arguments. In closing arguments, each attorney summarizes evidence from the trial in a manner consistent with his or her client’s case. The plaintiff’s attorney presents her closing argument first, followed by the defendant’s attorney, and the plaintiff has the option to present a rebuttal of the defendant’s closing argument. Jury Instructions In a jury trial, the judge “charges the jury” by instructing the jurors on how the law applies to the facts of the case. Both sides’ attorneys submit statements to the judge explaining how they believe she should charge the jury. The judge’s instructions are usually a combination of both sides’ suggestions. After the judge charges the jury, the jurors retire to the jury room to deliberate. Once they reach a decision, they return to the courtroom, where the judge reads their verdict and discharges them from their duty. Trial procedures in the United States are quite different from trial procedures in other countries, as the Global Context box illustrates.

directed verdict A ruling by the judge, after the plaintiff has put forward his or her case but before any evidence is put forward by the defendant, in favor of the defendant because the plaintiff has failed to present the minimum amount of evidence necessary to establish his or her claim.

GLOBAL Context Trials in Japan Civil procedure in Japan differs significantly from American civil procedure. The Japanese legal system has no juries and no distinct pretrial stage. Instead, a trial is a series of discrete meetings between the parties and the judge. At the first meeting, the parties identify the most critical and contested issues. They choose one and recess to gather evidence and marshal arguments on the issue. At the next meeting, the judge rules on the chosen issue. If the judge decides against the plaintiff, the case is over. If the plaintiff wins, the process continues with the next

issue. The process continues until the plaintiff loses an issue or until the judge decides all issues in the plaintiff’s favor, resulting in a verdict for the plaintiff. In addition, the discovery process in the Japanese court system is not as simple as it is in the United States. To obtain evidence, parties must convince the judge to order others to testify or produce documents. The judge can fine or jail parties who refuse to comply with such orders. Additionally, if a party does not comply with the judge’s requests for discovery, the judge may admit the facts the other party sought to discover.

POSTTRIAL MOTIONS Once the trial ends, the party who received the favorable verdict files a motion for a judgment in accordance with the verdict. Until the judge enters the judgment, the court has not issued a legally binding decision for the case. The party who loses at trial has a number of available options. One option is to file a motion for a judgment notwithstanding the verdict, or judgment non obstante verdicto, asking the judge to issue a judgment contrary to the jury’s verdict. To grant the motion, the judge must find that, when viewing the evidence in the light most favorable to the nonmoving party, a reasonable jury could not have found in favor of that party. In other words, as a matter of law, the judge must determine that the trial did not produce sufficient evidence to support the jury’s verdict. This motion is similar to a motion for a directed verdict, except the parties cannot make this motion until after the jury issues a verdict. The federal court system refers to this motion as a motion for judgment as a matter of law. The losing party can also file a motion for a new trial. Judges grant motions for a new trial only if they believe the jury’s decision was clearly erroneous but they are not sure that the other side should necessarily have won the case. A judge often grants a motion for a new trial when the parties discover new evidence, when the judge made an erroneous ruling, or when misconduct during the trial may have prevented the jury from reaching a fair decision.


prejudicial error An error of law that is so significant that it affects the outcome of the case.

brief A written legal argument, which a party presents to a court, that explains why that party to the case should prevail.


Either party may appeal the judge’s decision on posttrial motions or on her or his final judgment. Sometimes, both parties appeal the same decision. For example, if a jury awarded the plaintiff $10,000 in damages, the plaintiff and the defendant may both appeal the amount of the judgment. Appellate courts, however, reverse only about 1 out of every 10 trial court decisions on appeal. To be eligible for appeal, the losing party must argue that a prejudicial error of law occurred during the trial. A prejudicial error is a mistake so significant that it likely affected the outcome of the case. For example, a prejudicial error could occur if the judge improperly allowed hearsay evidence that enabled the plaintiff to prove an element of her case. To appeal a case, the attorney for the appealing party (the appellant) files a notice of appeal with the clerk of the trial court within a prescribed time. The clerk then forwards the record of appeal to the appeals court. The record of appeal typically contains a number of items: the pleadings, a trial transcript, copies of the trial exhibits, copies of the judge’s rulings on the parties’ motions, the attorneys’ arguments, jury instructions, the jury’s verdict, posttrial motions, and the judgment order. The appellant then files a brief, or written argument, with the court. Appellants file briefs to explain why the judgment in the lower court was erroneous and why the appeals court should reverse it. The attorney for the party who won in the lower court (the appellee) files an answering brief. The appellant may then file a reply brief in response to the appellee’s brief. Generally, however, appellants do not file reply briefs.

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The appeals court then usually allows the attorneys to present oral arguments before the court. The court considers these arguments, reviews the record of the case, and renders a decision. There are four possible decisions an appellate court can render. The court can accept the lower court’s judgment by affirming its decision. Alternatively, the appellate court may conclude that the lower court’s decision was correct but the remedy was inappropriate, in which case it modifies the remedy. If the appellate court decides that the lower court was incorrect, it reverses the lower court’s decision. Finally, if the appeals court thinks the lower court committed an error but does not know how that error affected the outcome of the case, it remands the case to the lower court for a new trial. An appellate court usually has a bench with at least three judges. Appellate courts do not have juries; rather, the judges decide the case by majority vote. One of the judges who votes with the majority records the court’s decision and its reasons in the majority opinion. These decisions have precedential value—that is, judges use these prior appellate court decisions to make decisions in future cases. Also, these decisions establish new guidelines in the law that all citizens must follow. If a judge agrees with the majority’s decision but for different reasons, she may write a concurring opinion, stating the reasons she used to reach the majority’s conclusion. Finally, judges disagreeing with the majority may write a dissenting opinion, giving their reasons for reaching a contrary conclusion. Attorneys arguing that a court should change the law frequently cite dissenting opinions from previous cases in their briefs. Likewise, appellate judges who change the law often cite dissenting opinions from past cases. For most cases, only one appeal is available. In states with both an intermediate and a final court of appeals, a losing party may appeal from the intermediate appellate court to the state supreme court. In a limited number of cases, the losing party can appeal the decision of a state supreme court or a federal circuit court of appeals to the U.S. Supreme Court. Appeal to the U.S. Supreme Court Every year thousands of individuals file appeals with the U.S. Supreme Court, but the Court hears, on average, only 80 to 90 cases each year. To file an appeal to the U.S. Supreme Court, a party files a petition asking the Court to issue a writ of certiorari, an order to the lower court to send to the Supreme Court the record of the case. The Court issues very few writs. The justices review petitions and issue a writ only when at least four justices vote to hear the case (the rule of four). The court is most likely to issue a writ in four instances: (1) The case presents a substantial federal question that the Supreme Court has not yet addressed; (2) multiple circuit courts of appeal have decided the issue of the case in different ways; (3) a state court of last resort has ruled that a federal law is invalid or has upheld a state law that may violate federal law; or (4) a federal court has ruled that an act of Congress is unconstitutional. If the Supreme Court does not issue a writ of certiorari, the lower court’s decision stands.

affirm An appellate court decision that accepts a lower court’s judgment in a case that has been appealed.

modify An appellate court decision that grants an alternative remedy in a case; rendered when the court finds that the decision of the lower court was correct but the remedy was not.

reverse An appellate court decision that overturns the judgment of a lower court, concluding that the lower court was incorrect and its verdict cannot be allowed to stand.

remand An appellate court decision that returns a case to the trial court for a new trial or for limited hearing on a specified subject matter; rendered when the court decides that an error was committed that may have affected the outcome of a case.

writ of certiorari A Supreme Court order, issued after the Court decides to hear an appeal, mandating that the lower court send to the Supreme Court the record of the appealed case.

Alternative Dispute Resolution Many firms find that using alternative dispute resolution (ADR) methods to resolve their legal problems offers many benefits. The term ADR refers to the resolution of legal disputes through methods other than litigation, such as negotiation, mediation, arbitration, summary jury trials, minitrials, neutral case evaluations, and private trials. Why might a business prefer ADR to litigation? First, ADR methods are generally faster and cheaper. According to the National Arbitration Forum, the average time from filing a complaint to judgment through litigation is 25 months.7 Because ADR is faster, it is usually cheaper. According to the American Intellectual Property Law Association, for cases valued in the $1 million to $25 million range, the average total cost of patent litigation for each party through the close of discovery is $1.9 million.8 Through the end of trial, the average cost to each party is $3.5 million. 7

National Arbitration Forum, Business-to-Business Mediation/Arbitration vs. Litigation: What Courts, Statistics, & Public Perceptions Show about How Commercial Mediation and Commercial Arbitration Compare to the Litigation System, January 2005, p. 3. 8 AIPLA, Report of the Economic Survey, pp. 1-109–1-110.

alternative dispute resolution (ADR) The resolution of legal problems through methods other than litigation.


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Thus, if a party can resolve a dispute through alternative dispute resolution, this can save a significant amount of money. Second, a business may want to avoid the uncertainty associated with a jury decision; many forms of ADR give the participants more control over the resolution of the dispute. Specifically, the parties can select a neutral third party, frequently a person with expertise in the area of the dispute, to help facilitate resolution of the case. Third, a business may want to avoid setting a precedent through a court decision. Fourth, a business may prefer ADR because it is confidential. Fifth, because many forms of ADR are less adversarial than litigation, ADR allows the parties to preserve a business relationship. Courts also generally support the use of ADR, which alleviates some of the pressure on the overwhelming court dockets. Congress has recognized the benefits of ADR methods through its enactment of the Alternative Dispute Resolution Act of 1998. This act requires federal district courts to have an ADR program along with a set of rules regarding the program. Additional evidence of congressional support for ADR comes from the passage of the Administrative Dispute Resolution Act, which mandates that federal agencies must create internal ADR programs.

LO 3-5

Primary Forms of ADR NEGOTIATION

negotiation A bargaining process in which disputing parties interact informally to attempt to resolve their dispute.

Many business managers make frequent use of negotiation, a bargaining process in which disputing parties interact informally, either with or without lawyers, to attempt to resolve their dispute. No neutral third party is involved. Thus, negotiation differs from other methods of dispute resolution because the parties maintain high levels of autonomy. Some courts require parties to negotiate before they bring their dispute to trial. Before negotiation begins, each side must determine its goals for the negotiation. Moreover, each side must identify the information it is willing to give the other party. Because negotiation generally occurs in every case before a more formal dispute resolution method is chosen, negotiation is not necessarily considered an alternative to litigation.

MEDIATION mediation A type of intensive negotiation in which disputing parties select a neutral party to help facilitate communication and suggest ways for the parties to solve their dispute.

An extension of negotiation is mediation. In mediation, the disputing parties select a neutral party to help facilitate communication and suggest ways for the parties to solve their dispute. Therefore, the distinguishing feature of mediation is that the parties voluntarily select a neutral third party to help them work together to resolve the dispute. The neutral third party frequently has expertise in the area of the dispute. Mediation begins when parties select a mediator. Each party then typically writes a mediation brief to explain why it should win. An important feature of mediation is that it allows multiple parties to participate in a dispute. The parties take turns explaining the dispute. One of the mediator’s main goals is to help each party listen carefully to the opposing party’s concerns. The mediator asks the parties to identify any additional concerns. The parties begin generating alternatives or solutions for the disputed points. The mediator helps the parties evaluate the alternatives by comparing the alternatives with the disputed points and interests identified earlier. Finally, the mediator assists the parties in agreeing on a solution. The mediation concludes when the agreement between the parties is reached. The agreement is then usually put into the form of a contract and signed by the parties. The mediator may participate in the drafting of the contract. If one of the parties does not follow the agreement, that party can be sued for breach of contract. However, parties typically abide by the agreement because they helped to create it. If mediation is not successful, the parties can turn to litigation or arbitration to resolve their dispute. However, nothing said during the mediation can be used in another dispute resolution method; the mediation process is confidential.

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Advantages and Disadvantages of Mediation The primary advantage of mediation is that it helps the disputing parties preserve their relationships; this is especially attractive for businesses with a working relationship they would like to continue. A second advantage is the possibility of finding creative solutions. The goal of mediation is to find a compromise between the needs of various parties rather than to find one party right and all the others wrong. A third advantage is the high level of autonomy mediation gives the participants. Instead of a neutral third party pronouncing a solution, the interested parties work together to create a solution, and this can make them more committed to following the agreement afterward. These benefits can obviously be very worthwhile. However, we need to pay attention to the critics of the mediation process. One criticism of mediation is that it creates an image of equal parties working toward an equitable solution and thereby hides power imbalances that can lead to the party with greater power getting an agreement of greater benefit. A second criticism is that some people who enter mediation have no intention of finding a solution but, instead, use mediation as a tactic to draw out the dispute. Uses of Mediation Mediation is most commonly used in collective bargaining disputes because it allows the workers to maintain a relationship with their employer while still having their needs addressed. Under the National Labor Relations Act (NLRA), a union must contact the Federal Mediation and Conciliation Services to attempt to mediate its demands before beginning a strike to achieve higher wages or better working hours. Similarly, the Equal Employment Opportunity Commission (EEOC) encourages the mediation of employment discrimination claims. The EEOC has a mediation program that uses mediators employed by the EEOC as well as external mediators trained in mediation and discrimination law. Mediation is also used extensively in environmental law because environmental disputes are often best served by finding a compromise between the frequently multiple parties.

ARBITRATION One of the most frequently used methods of dispute resolution is arbitration, the resolution of a dispute by a neutral third party outside the judicial setting. Arbitration is frequently used in disagreements between employees and employers, and it is increasingly being used between consumers and businesses. Arbitration is often a voluntary process in that parties have a contractual agreement to arbitrate any disputes. This agreement may stipulate how the arbitrator will be selected and how the hearing will be administered. Lawyers, professors, and other professionals typically serve as arbitrators. The general qualifications for being an arbitrator are honesty, impartiality, and subject-matter competence. Additionally, arbitrators are expected to follow the Arbitrator’s Code of Ethics. Typically, parties choose arbitrators from the Federal Mediation and Conciliation Services (FMCS), a government agency, or the American Arbitration Association (AAA), a private, nonprofit organization. The Arbitration Hearing The arbitration hearing is similar to a trial. Both parties present their cases to a neutral third party; parties may represent themselves or use legal counsel. During this presentation, the parties may introduce witnesses and documentation, cross-examine the witnesses, and offer closing statements. The fact finder offers a legally binding decision. However, arbitration is also different from a trial in several ways. First, the arbitrator often takes a much more active role in an arbitration hearing than a judge takes in a trial, and the arbitrator can question witnesses. Second, no official written record of the hearing is kept in most arbitrations. Third, the rules of evidence applicable in a trial are typically relaxed in arbitration. The Arbitrator’s Award The arbitrator typically provides a decision within 30 days of the arbitration hearing. The arbitrator’s decision is called an award, even if no monetary compensation is awarded. The arbitrator’s decision differs from a judge’s decision in several ways. The arbitrator does not have to state any findings of fact, conclusions of law, or reasons to support the award, and he or she is not as bound by precedent as a judge is. Also, because the arbitrator was hired to

arbitration A type of alternative dispute resolution in which disputes are submitted for resolution to private nonofficial persons selected in a manner provided by law or the agreement of the parties.


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resolve a dispute between two parties, the arbitrator is more likely to make a compromise ruling instead of a win-lose ruling. Unlike the case in most other forms of ADR, the arbitrator’s decision is legally binding. In certain cases, a decision may be appealed to the district court. However, few of these cases are appealed. The courts give extreme deference to arbitrators’ decisions. The Federal Arbitration Act (FAA), the federal law enacted to encourage the use of arbitration, explicitly lists four grounds on which an arbitrator’s award may be set aside: (1) The award was the result of corruption, fraud, or other undue means; (2) the arbitrator displayed bias or corruption; (3) the arbitrator refused to postpone the hearing despite sufficient cause, refused to hear relevant evidence, or otherwise misbehaved to prejudice the rights of one of the parties; (4) the arbitrator exceeded his or her authority or failed to use that authority to make a mutual, final, and definite award. In a 2008 decision, the U.S. Supreme Court held that these grounds are the only grounds for appeal and that the parties in an arbitration proceeding do not have the ability to give the courts additional grounds to set aside a decision.9 Consequently, in the United States, arbitration decisions are generally upheld. In fact, the Fifth Circuit recently held that “manifest disregard of the law and contrary to public policy are the only nonstatutory bases recognized by this circuit for the vacatur of an arbitration award.”10 Advantages and Disadvantages of Arbitration Arbitration may be preferable to litigation for several reasons. First, arbitration is more efficient and less expensive. Second, parties have more control over the process of dispute resolution through arbitration. They choose the arbitrator and determine how formal the process will be. Third, the parties can choose someone to serve as the arbitrator who has expertise in the specific subject matter. Fourth, the arbitrator has greater flexibility in decision making than a judge has. Unlike judges, who are bound by precedent, arbitrators generally do not have to offer reasons for their decisions. However, arbitration is not without its critics. First, arbitration panels are being used more frequently, resulting in a loss of some of the prior advantages of arbitration, such as efficiency and lower cost. Second, because appealing an arbitration award is so difficult, some scholars argue that injustice is more likely to occur. Third, some individuals are concerned that by agreeing to give up one’s right to litigate, one may be losing important civil rights or giving up important potential remedies without really understanding which rights are being given up. Fourth, some scholars are afraid that if more and more employers and institutions turn to mandatory arbitration, it will become more like litigation. Fifth, some scholars are concerned about the privacy associated with arbitration. Companies and employers are able to hide their disputes through arbitration.

binding arbitration clause A contract provision mandating that all disputes arising under the contract must be settled by arbitration.

Binding Arbitration Clause Given the benefits associated with arbitration, parties may voluntarily submit their cases to arbitration. The primary method of securing arbitration is through a binding arbitration clause, a provision in a contract that mandates that all disputes arising under the contract must be settled by arbitration. The clause also typically states how the arbitrator will be selected. If parties have a binding arbitration agreement, the parties must resolve the dispute through arbitration. Both federal and state courts must uphold agreements to arbitrate. The Case Nugget illustrates the courts’ willingness to enforce binding arbitration agreements. A constraint on binding arbitration clauses is that they must be drafted in a way that ensures that the courts do not see them as unconscionable. An unconscionable contract provision has been defined as one in which the terms are “manifestly unfair or oppressive and are dictated by a dominant party.”11 The doctrine has been used most often to strike down binding arbitration clauses in consumer and employment contracts. Exhibit 3-3 offers tips on creating a binding arbitration clause.


Hall Street Associates v. Mattell, 2008 U.S. LEXIS 2911. Kergosien et al. v. Ocean Energy, Inc., 390 F.3d 346 (5th Cir. 2004). 11 Farris v. County of Camden, 61 F. Supp. 2d 307, 341 (D. N.J. 1999). 10

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Exhibit 3-3 Overall, make sure the clause treats both parties fairly.

1. Be clear and unmistakable about what you wish to arbitrate. 2. The arbitration clause must be bilateral. 3. State explicitly which party will pay the arbitrator’s fees, and make sure that it will not cost the non-drafting party more to arbitrate than it would have cost to litigate. Specify how the arbitrator will be selected. 4. Spell out the costs associated with the arbitration. 5. Avoid limitations on the remedies available to the parties. 6. Consider potential parties when determining where to hold the arbitration.

Tips for Creating a Binding Arbitration Clause

CASE Nugget The Validity of Binding Arbitration Agreements Preston v. Ferrer United States Supreme Court 128 S. Ct. 978 (2008) Under the FAA, is an administrative proceeding the same as a trial? It has long been held that under the FAA, even if state statutes refer a state law controversy initially to a judicial forum, if the parties have agreed to submit that dispute to arbitration, the dispute must be arbitrated. Until 2008, however, the question existed of whether the same rule would apply when the state law directed that the first mode of resolution must be an administrative proceeding rather than a court hearing. In this case, the U.S. Supreme Court ruled that for purposes of the FAA, an administrative proceeding was the equivalent of a judicial proceeding. In Preston v. Ferrer, the two had included a binding arbitration agreement in a contract for Preston to represent Ferrer. When Preston attempted to collect his fees, a question arose about whether the matter had to be resolved by the California Labor Commission, which had jurisdiction over issues arising under the California Talent Agencies Act. The high court agreed with Ferrer that the dispute must be resolved through arbitration because the FAA preempted the state law. Even if a state law provides that an administrative forum has jurisdiction over a specific type of dispute, a binding arbitration agreement will supersede the forum declared by the state law.

Other ADR Methods MED-ARB Med-arb is a dispute resolution process in which the parties agree to start out in mediation and, if the mediation is unsuccessful on one or more points, to move on to arbitration. In some cases, the same neutral third party may participate in both the mediation and the arbitration. Some critics argue that if parties know that the mediator may become the ultimate decision maker, they will be less likely to disclose information during the mediation stage. Others argue that having the same neutral mediator-arbitrator offers faster resolution because the third party is familiar with the facts of the case.12 12

See Gerald F. Phillips, “Same Neutral Med-Arb: What Does the Future Hold?” Dispute Resolution Journal 60 (May–July 2005), p. 24.

med-arb A type of dispute resolution process in which both parties agree to start out in mediation and, if unsuccessful, to move on to arbitration.


Part I

The Legal Environment of Business

SUMMARY JURY TRIAL summary jury trial An abbreviated trial that leads to a nonbinding jury verdict.

A summary jury trial is an abbreviated trial that leads to a nonbinding jury verdict. Two advantages are inherent in this method of dispute resolution. First, it is quick; a summary jury trial lasts only a day. Second, because a jury offers a verdict, both parties get a chance to see how their case would fare before a jury of their peers. Each judge can set his or her own rules. The judge advises the jury on the law, and each party’s lawyer presents an opening statement and a limited amount of evidence before the jury. The lawyers have limited time for their presentations, and witnesses do not usually testify. The jury reaches an advisory verdict, although the jury does not know that its verdict is nonbinding. The parties then enter into a settlement conference, where they decide to accept the jury verdict, reject the verdict, or settle on some compromise. Approximately 95 percent of cases are settled at this time. However, if the case is not settled, it will go to a regular trial. At that trial, nothing from the summary jury trial is admissible as evidence.

MINITRIAL minitrial A type of conflict resolution in which lawyers for each side present their arguments to a neutral adviser, who then offers an opinion as to what the verdict would be if the case went to trial. This decision is not binding.

A minitrial is similar to arbitration and mediation because it involves a neutral third party. However, despite the presence of a neutral third party, business representatives of the disputing corporations participate and have settlement authority. Lawyers for each side present their arguments before these executives and the neutral adviser, who then offers an opinion as to what the verdict would be if the case went to trial. The neutral adviser’s opinion, like the jury’s verdict in a summary jury trial, is not binding. Next, the corporate executives discuss settlement options. If they reach an agreement, they enter into a contract that reflects the terms of the settlement.

EARLY NEUTRAL CASE EVALUATION With early neutral case evaluation, the parties select a neutral third party and explain their respective positions to this neutral, who then evaluates the strengths and weaknesses of the case. The parties use this evaluation to reach a settlement. Eighteen federal district courts currently use early neutral case evaluation.13

PRIVATE TRIALS private trial An ADR method in which a referee is selected and paid by the disputing parties to offer a legally binding judgment in a dispute.

Several states allow private trials, an ADR method in which a referee is selected and paid by the disputing parties to offer a legally binding judgment in a dispute. The referees do not have to have any specific training; however, because retired judges often serve as referees, this method is often referred to as “rent-a-judge.” The cases are often heard privately to ensure confidentiality. The referee writes a report and files it with the trial judge, but a dissatisfied party reserves the right to request a new trial before a trial court judge. Private jury trials with experienced jury members are becoming more popular today as well. Private trials have been criticized because they seem to provide faster and cheaper justice for those who can afford the initial fee and because they hide the trial from the public eye. 13

Michael H. Diamant et al., Strategies for Mediation, Arbitration, and Other Forms of Alternative Dispute Resolution, SK074 ALI-ABA 205 (2005) [citing the CPR Institute for Dispute Resolution, www.cprador.org].

SUMMARY Jurisdiction

In personam jurisdiction is the power of a court to render a decision affecting a person’s legal rights. Subject-matter jurisdiction is the power of a court to render a decision in a particular type of case. The three forms of subject matter jurisdiction are state, exclusive federal, and concurrent.


Venue is the geographic location of the trial.

The Structure of the Court System

The United States has two parallel court structures: the state and federal systems. The federal structure has district courts (trial courts), circuit courts of appeal, and the U.S. Supreme Court. The state court structure varies by state but generally includes courts of common pleas (trial courts), state courts of appeal, and a state supreme court.

Chapter 3

Threshold Requirements

The U.S. Legal System and Alternative Dispute Resolution


Standing: For a party to have the legal right to file a case, the outcome of the case must personally affect that party. Case or controversy: There must be an issue before the court that a judicial decision is capable of resolving. Parties cannot ask the judge for an advisory opinion. Ripeness: The case cannot be moot; it must be ready for a decision to be made.

Steps in Civil Litigation

The stages of a civil trial include the pretrial, trial, posttrial, and appellate stages. Pretrial includes consultation with attorneys, pleadings, the discovery process, and the pretrial conference. The trial begins with jury selection, followed by opening statements, the plaintiff’s case, the defendant’s case, closing arguments, jury instructions, jury deliberations, the jury’s verdict, and the judgment. After the trial, parties may file posttrial motions. The parties may then file appeals to the appropriate appellate court and, in some cases, to the U.S. Supreme Court.

Alternative Dispute Resolution

Alternative dispute resolution is a way to settle problems without having to go to a costly and time-consuming trial.

Primary Forms of ADR

The primary forms of ADR are negotiation, mediation, and arbitration.

Other ADR Methods

Other methods of ADR include med-arb, summary jury trials, minitrials, early neutral case evaluation, and private trials.

Point/Counterpoint Should Companies Be Allowed to Include Binding Arbitration Clauses in Consumer Contracts?




Arbitration is a much faster way to resolve a likely small dispute. Through the discovery process, a defendant could draw out a case for two to three years before the case would actually go to trial. Thus, the consumer benefits from the binding arbitration clause by forcing the defendant to resolve the dispute quickly. According to a recent study by Ernst & Young, 55 percent of consumer arbitrations were resolved in the consumer’s favor.* Another study suggested that 93 percent of people who participated in arbitration thought that they were treated fairly.† Consumers receive fair and fast treatment through mandatory arbitration. Consumers have a choice as to whether to purchase a good or service, and in some cases the purchase may include a requirement on how disputes will be resolved. If a consumer is opposed to a mandatory arbitration clause, the consumer can purchase the good or service from another provider. In conclusion, companies should be permitted to include binding arbitration clauses in their consumer contracts.

Arbitration may require the consumer to pay more upfront costs to begin the dispute resolution process. For example, the consumer may have to pay for the costs of the arbitrator. To file a complaint, a consumer has to pay filing fees only, which cost around $150. To file a claim through the American Arbitration Association, a consumer has to pay between $500 and $1,000, and the consumer is required to advance the arbitrator’s fees. Many consumers are not likely to read all the fine print when applying for a credit card or purchasing a service. A consumer has no bargaining power to remove a mandatory arbitration clause from the contract; consequently, the consumer has no choice. It is unfair to force a consumer to submit a dispute to arbitration when she or he has no power to bargain regarding that aspect of the sales or service contract. Finally, because arbitration is secret, a company can hide its disputes from the general public. The public exposure associated with lawsuits encourages companies to respond to and resolve disputes better. In conclusion, consumers are harmed more than helped by binding arbitration clauses in consumer contracts.

Ernst & Young, “Outcomes of Arbitration: An Empirical Study of Consumer Lending Cases,” www.adrforum.com/rcontrol/documents/ResearchStudiesAndStatistics/200 5ErnstAndYoung.pdf † “Report to the Securities and Exchange Commission Regarding Arbitrator Conflict Disclosure Requirements in NASD and NYSE Securities Arbitrations,” www.nyse.com /pdfs/arbconflict.pdf


Part I

The Legal Environment of Business

Questions & Problems 1. Explain the two types of jurisdiction that a court must have to hear a case and render a binding decision over the parties. 2. Explain the differences between trial courts and appellate courts. 3. Identify and define the alternative tools of discovery. 4. Explain the three threshold requirements a plaintiff must meet before he or she can file a lawsuit. 5. The citizens of each state elect state court judges. The president, on the other hand, appoints federal court judges for lifetime positions. Why might this difference lead to different rulings on similar cases? Which method—election or appointment—do you like better? Why? What are the advantages and disadvantages of each method? 6. Missouri was International Shoe Corporation’s principal place of business, but the company employed between 11 and 13 salespersons in the state of Washington, who exhibited samples and solicited orders for shoes from prospective buyers in Washington. The state of Washington assessed the company for contributions to a state unemployment fund. The state served the assessment on one of International Shoe Corporation’s sales representatives in Washington and sent a copy by registered mail to the company’s Missouri headquarters. International Shoe’s representative challenged the assessment on numerous grounds, arguing that the state had not properly served the corporation. Is the corporation’s defense valid? Why or why not? [International Shoe Co. v. Washington, 326 U.S. 310 (1945).] 7. The Robinsons, residents of New York, bought a new Audi car from Seaway Volkswagen Corp., a retailer that was incorporated in New York and had its principal place of business there. World-Wide Volkswagen, a company incorporated in New York and doing business in New York, New Jersey, and Connecticut, distributed the car to Seaway. Neither Seaway nor World-Wide did business in Oklahoma, and neither company shipped cars there. The Robinsons were driving through Oklahoma when another vehicle struck their Audi in the rear. The gas tank of the Audi exploded, injuring several members of the family. The Robinsons brought a product liability suit against the manufacturer, distributor, and retailer of the car in an Oklahoma state court. Seaway and World-Wide argued that the Oklahoma state court did not have in personam jurisdiction over them. After the state’s trial court and supreme court held that the state did have in personam jurisdiction over Seaway and World-Wide,

they appealed to the U.S. Supreme Court. How do you think the Court decided in this case? Why? [World-Wide Volkswagen Corp. v. Woodson, 444 U.S. 286 (1980).] 8. Nicastro, the plaintiff, was using a metal-shearing machine in New Jersey when he hurt his hand. The machine was produced by J. McIntyre Machinery, Ltd., which manufactured the machine in England, where the company is based. However, Nicastro brought the company to court in New Jersey because that is where the injury occurred. The company argued that it could not be brought to court in New Jersey because the court did not have personal jurisdiction over it due to the company’s lack of minimum contacts in the state. Nicastro also said that the company’s distributor for the United States sold the equipment in the country; company officials attended trade shows in the country, even if they were not in New Jersey; and the record shows that one machine was in New Jersey. Ultimately, the company knew that its United States distributor could sell its products in any state, and any product could somehow end up in any other state. On the other hand, the company did not travel to, advertise, or contact any residents of New Jersey. Do you think the company is subject to personal jurisdiction in the state of New Jersey? How do you believe the Supreme Court ruled in this case? Why? [ J. McIntyre Machinery Ltd. v. Nicastro, 131 S. Ct. 2780 (2011).] 9. Central West Virginia Energy Company, a West Virginia coal sales company, along with Massy Coal Company, a Virginia corporation, filed a lawsuit in federal district court against Mountain State Carbon and its member companies, one of which, Severstal Wheeling, was located in Wheeling, West Virginia. The plaintiffs alleged that the defendants, all of which were in the steel business, refused to accept shipments of coal in breach of their supply agreement with Central Energy. The defendants filed a motion to dismiss for lack of diversity, claiming that both Severstal and Central Energy had their principal places of business in West Virginia. The district court dismissed the complaint for lack of diversity, citing that Severstal’s self-described day-to-day operations, such as “purchasing, sales, transportation, engineering, human resources, and accounting/financial functions,” are all handled in Wheeling and noting Severstal’s “visibility in and involvement with the Wheeling community.” The plaintiffs appealed, arguing that the court misinterpreted Hertz and that the district court failed to consider the importance of the

Chapter 3

The U.S. Legal System and Alternative Dispute Resolution

fact that Severstal’s officers control the company’s policies and high-level decisions from the corporate offices in Dearborn, where seven of the company’s eight corporate officers maintain their offices. The plaintiffs also noted that in Severstal’s corporate filings with the states of Ohio, Michigan, and West Virginia, the company listed a Dearborn, Michigan, address as its principal place of business. How do you think the court ruled on the appeal? Why? [Central West Virginia Energy Company, Inc. v. Mountain State Carbon LLC, Case No. 10-1486, 4th Cir. Ct. of Appeals, 2011 U.S. App. LEXIS 7557.] 10. Attorneys, journalists, media, and legal and human rights organizations brought action against the Central Intelligence Agency, challenging the constitutionality of Section 702 of the Foreign Intelligence Surveillance Act (FISA). In particular, they objected to a recent change to FISA, through the FISA Amendments Act, that shifted the party-monitoring compliance with the act’s limitations from the judiciary to the executive branch, eliminating the power of the judiciary to review the surveillance procedures. The government argued that the plaintiffs lacked standing to bring the case to court. The plaintiffs argued that the recent change to FISA created a reasonable fear of future injury and that they had incurred costs to avoid that future injury. How do you think the court ruled in this case? Why? [Amnesty International United States et al. v. Clapper, Alexander, and Holder, 2011 U.S. App. LEXIS 5699.] 11. Dakota Foundry was purchasing some equipment from Tromley Industries. According to the practice of the firm, the operations manager was supposed prepare a quote on Kloster stationery, and the back of the stationery contained its standard terms and conditions of sale, including a binding arbitration agreement. The salesman would make several copies and pass them to everyone involved for negotiations. The salesman made copies but did not include the back


page, which contained the standard terms, including the binding arbitration clause. After further negotiations, Tromley issued another quotation, which stated that it was a revised quotation and had combined the December 2009 quotes “and all subsequent changes made during our meetings into one, cohesive system quote.” This quote also contained the same note as the original quote, advising Dakota to “[p]lease pay particular attention to the attached copy of our Standard Terms and Conditions of Sale which are an integral part of this quotation.” However, no standard terms were attached to the quote. This second quote did have a document entitled “standard payment terms” attached, but it did not include any arbitration terms. Dakota Foundry accepted the second quote. When problems arose with the equipment, Dakota filed suit, and Tromley filed a motion to compel arbitration on grounds that the contract incorporated Tromley’s Standard Terms and Conditions, which included the binding arbitration clause. Do you think the court compelled arbitration? Why or why not? [Dakota Foundry, Inc. v. Tromley Indus. Holdings, Inc., 737 F. 3d 492 (2013).] 12. Cleveland Construction Co, Inc., (CCI) was a general contractor building a grocery store in Houston, Texas. The company subcontracted the exaction and grading to Levco in a contract that contained a binding arbitration clause that mandated arbitration in Ohio of any disputes arising under the contract. When a dispute arose between the two, Levco filed suit in a Texas state court. CCI sought to compel arbitration in Ohio in accordance with the binding arbitration clause, but Levco argued that a Texas statute allowed any binding arbitration clause to be voided if it required arbitration outside the state of Texas, so the case could be litigated. Where should the case ultimately be resolved and why? [Cleveland Construction, Inc. v. Levco Construction, Inc., 359 SW 3d 843 (2012).]


1 4

The Legal Environment of Business


Administrative Law

CASE OPENER Does the EPA Have an Obligation to Regulate Automobile Emissions? On October 20, 1999, a group of 19 private organizations filed a rule-making petition asking the Environmental Protection Agency (EPA) to regulate “greenhouse gas emissions from new motor vehicles” under the Clean Air Act.1 The petitioners cited the fact that 1998 was the “warmest year on record,” that greenhouse gas emissions have significantly accelerated climate change, and that carbon dioxide is the most important man-made contribution to climate change. Fifteen months after the petition was filed, the EPA requested public comment on the issues. Then, on September 8, 2003, the EPA entered an order denying the rule-making petition, citing two reasons: (1) The Clean Air Act does not authorize the EPA to issue mandatory regulations to address global climate change; and (2) even if the agency had authority, it would be unwise to do so at this time. The case, Massachusetts v. EPA, eventually worked its way up to the U.S. Supreme Court, which had to decide whether the EPA was improperly failing to regulate carbon dioxide gas in automobile exhaust as a climate-changing pollutant. 1. 2. 1

What government entity is the final determiner of whether a particular type of rule will be issued by an agency? Did the EPA err in not regulating greenhouse gases under the Clean Air Act?

Massachusetts v. EPA, 549 U.S. 497 (2007).

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


LO 4-1

What is administrative law?

LO 4-2

What is an administrative agency?

LO 4-3

How and why are administrative agencies created?

LO 4-4

What types of powers do administrative agencies have?

LO 4-5

What is the difference between an executive agency and an independent agency?

LO 4-6

What is the Administrative Procedures Act?

LO 4-7

How do formal, informal, and hybrid rule making differ from one another?

LO 4-8

What are the limits on agency power?

Introduction to Administrative Law WHAT IS ADMINISTRATIVE LAW? As a business owner or manager, you will need to be aware of regulations that affect your business. In addition to learning about laws passed by Congress, you will also need to know about rules passed by administrative agencies. Administrative law consists of the substantive and procedural rules created by administrative agencies (bodies of the city, county, state, or federal government), involving applications, licenses, permits, available information, hearings, appeals, and decision making. An administrative agency is generally defined as any body created by the legislative branch (e.g., Congress, a state legislature, or a city council) to carry out specific duties. Agencies have three types of power: legislative, judicial, and executive. They may make rules for an entire industry, adjudicate individual cases, and investigate corporate misconduct. Because legislative, judicial, and executive powers have traditionally been placed in separate branches of government by the Constitution, the role of administrative agencies has led some to refer to agencies as the unofficial fourth branch of government. Although there is a semblance of truth to that characterization, administrative agencies are not in fact another branch, primarily because all their authority is simply delegated to them, and they remain under the control of the three traditional branches of government. The first federal administrative agency, the Interstate Commerce Commission (ICC), was created by Congress near the end of the nineteenth century. Congress felt that the anticompetitive conduct of railroads could best be controlled by a regulatory body. The ICC no longer exists as a separate agency,2 but for more than 100 years, the ICC regulated passenger and freight transportation. Following the crash of the stock market and the Great Depression of the 1930s, Congress saw a need for additional agencies to regulate business in the public interest. Since then, numerous agencies have been created whenever Congress believed an area required more intense regulation than Congress could provide. In fact, after the Enron scandal, there was talk that Congress might create a new agency to regulate the accounting industry. To date, no such agency has materialized.

WHY AND HOW ARE AGENCIES CREATED? When Congress sees a problem that it believes needs regulation, it may create an administrative agency to deal with that problem. The idea is that the agency can be staffed with people who have special expertise in the area the agency is regulating and therefore know what types of regulations are necessary to protect the citizens in that area. Agencies typically act more swiftly than Congress in creating and enacting new laws. Today, administrative agencies actually create more rules than Congress and the courts combined. Congress creates administrative agencies through passage of enabling legislation, which is a statute that specifies the name, functions, and specific powers of the administrative agency. 2

LO 4-1 administrative law The collection of rules and decisions made by administrative agencies to fill in particular details missing from constitutions and statutes.

LO 4-2 administrative agency Any government body created by the legislative branch (e.g., Congress, a state legislature, or a city council) to carry out specific duties.

Interstate Commerce Commission (ICC) The first federal administrative agency; created to regulate the anticompetitive conduct of railroads.

LO 4-3 enabling legislation A statute that specifies the name, functions, and specific powers of an administrative agency and grants the agency broad powers for the purpose of serving the public interest, convenience, and necessity.

The functions of the ICC were transferred to the Transportation Department by Congress as part of a cost-saving measure.



Part I

The Legal Environment of Business

Enabling statutes grant agencies broad powers for the purpose of serving the “public interest, convenience, and necessity.” These broad powers include rule making, investigation, and adjudication.

B UT W H AT I F .   .   .  WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? In the opening case, the EPA believed it did not have enough power to make rules regarding global climate change. Let’s say that a member of the EPA argued that only Congress has the power to make this type of regulation, which would directly affect the way many businesses operate. Would the EPA member be correct?

LO 4-4

subpoena An order to appear at a particular time and place and provide testimony.

subpoena duces tecum An order to appear and bring specified documents.

administrative law judge (ALJ) A judge who presides over an administrative hearing; may attempt to get the parties to settle but has the power to issue a binding decision.

consent order A statement in which a company agrees to stop disputed behavior but does not admit that it broke the law.

order A binding decision rendered by a judge.

executive agency An agency that is typically located within the executive branch, under one of the cabinetlevel departments. The agency head is appointed by the president with the advice and consent of the Senate.

Rule Making Enabling statutes permit administrative agencies to issues rules that control individual and business behavior. These rules have the same effect as laws. If an individual or business fails to comply with agency rules, there are often civil, as well as criminal, penalties. Agencies may enact three types of rules: procedural, interpretive, and legislative. Procedural rules are rules regarding the internal operations of an agency. Interpretive rules are rules that explain how the agency views the meaning of the statutes for which the agency has administrative responsibility. Finally, legislative rules are policy expressions that have the effect of law. The various rule-making processes are discussed later in this chapter. Investigation Enabling statutes grant executive power to agencies to investigate potential violations of rules or statutes. Many times, companies cooperate with agencies and voluntarily furnish information. Other times, however, agencies must use their investigative powers, defined in their enabling legislation, to gather information. Such powers typically include the power to issue a subpoena (i.e., an order to appear at a particular time and place and provide testimony) and a subpoena duces tecum (i.e., an order to appear and bring specified documents). Adjudication Enabling statutes delegate judicial power to agencies to settle or adjudicate individual disputes that an agency may have with businesses or individuals. After investigation, the agency holds an administrative hearing before an administrative law judge (ALJ). The ALJ will try to convince the parties to reach a settlement via a consent order, but the judge also has the authority to render a binding decision (an order) after a hearing (administrative law matters are heard only by an ALJ because there is no right to a jury trial in administrative agencies). An appeal to the full commission or the head of an agency may then be filed. That decision may be appealed to the circuit court of appeals. If there are no appeals, the ALJ’s initial order becomes the final order. Decisions of ALJs are typically upheld. Example of an Administrative Problem. The EPA administrator, using the congressional mandate under the Clean Air Act, sets forth rules governing the amount of certain hazardous air pollutants that may be emitted into the atmosphere. Using these standards, another branch of the EPA sends investigators to inspect a plant suspected of violating the act. If the inspector finds a violation and the EPA imposes a penalty, the plant operator will most likely contest the imposition of the fine, and a hearing will be held before an ALJ employed in another division of the EPA. If the matter is not settled at the hearing, the ALJ will preside over another hearing and render a binding order. That order may be appealed within the agency and finally to the federal court. The courts, however, typically defer to the expertise of the agency and the associated ALJ. In other words, most orders by an ALJ are upheld.

Types of Administrative Agencies Agencies are classified as either executive or independent. The administrative head of an executive agency is appointed by the president with the advice and consent of the U.S. Senate. Executive-agency heads may be discharged by the president at any time, for any reason. When


Chapter 4 Administrative Law



Commodity Futures Trading Commission (CFTC) Consumer Product Safety Commission (CPSC) Equal Employment Opportunity Commission (EEOC) Federal Communications Commission (FCC) Federal Trade Commission (FTC) National Labor Relations Board (NLRB) Nuclear Regulatory Commission (NRC) Securities and Exchange Commission (SEC)

Federal Deposit Insurance Corporation (FDIC) General Services Administration (GSA) International Development Corporation Agency (IDCA) National Aeronautics and Space Administration (NASA) National Science Foundation (NSF) Occupational Safety and Health Administration (OSHA) Office of Personnel Management (OPM) Small Business Administration (SBA) Veterans Administration (VA)

a new president is elected, he will typically place his appointees in charge of executive agencies. These agencies are generally located within the executive branch, under one of the cabinetlevel departments. Hence, executive agencies are referred to as cabinet-level agencies. Examples of traditional executive agencies are the Federal Aviation Agency (FAA), located within the Department of Transportation, and the Food and Drug Administration (FDA), located within the Department of Health and Human Services. Independent agencies are governed by a board of commissioners, one of whom is the chair. The president appoints the commissioners of independent agencies with the advice and consent of the Senate, but these commissioners serve fixed terms and cannot be removed except for cause. No more than a simple majority of an independent agency can be members of any single political party (e.g., if the board consists of seven members, no more than four may be from the same political party). Serving fixed terms is said to make the commissioners less accountable to the will of the executive (thus the term independent agency). These agencies are generally not located within any department. Examples of independent agencies are the Federal Trade Commission (FTC), the Securities and Exchange Commission (SEC), and the Federal Communications Commission (FCC). Another difference between these two types of agencies is the scope of their regulatory authority. Executive agencies tend to have responsibility for making rules covering a broad spectrum of industries and activities. Independent agencies, often called commissions, tend to have more narrow authority over many facets of a particular industry, focusing on such activities as rate making and licensing. Executive agencies have a tendency to focus more on social regulation, whereas independent agencies are more often focused on what we refer to as economic regulation. Exhibit 4-1 lists the major administrative agencies. Some agencies do not fall clearly into one classification or the other. These agencies are typically referred to as hybrid agencies. Created as one type of agency, the body may share characteristics of the other. The EPA, for example, was created as an independent agency, not located within any department of the executive branch. Yet it is headed by a single administrator who serves at the whim of the president. During the early 1990s, in fact, there were discussions of the need to transform the EPA into a cabinet-level executive agency. (These initiatives did not get beyond the discussion stage.) Another example is the “independent” Federal Energy Regulation Commission (FERC), which has the typical structure of an independent agency yet is located within the Department of Energy.

How Are Agencies Run? In 1946, Congress passed the Administrative Procedures Act (APA) as a major limitation on how agencies are run. Prior to passage of APA, agencies could decide on their own how to make rules, conduct investigations, and hold hearings and trials. Under APA, there are very specific guidelines on rule making by agencies. The two most common types of rule making are informal and formal; a third type is known as hybrid. Each is discussed below, along with a few exemptions.

Exhibit 4-1 Major Administrative Agencies

independent agency An agency that is typically not located within a government department. It is governed by a board of commissioners, who are appointed by the president with the advice and consent of the Senate.

LO 4-5

hybrid agency An agency that has characteristics of both executive and independent agencies.

LO 4-6

Administrative Procedures Act (APA) Federal legislation that places limitations on how agencies are run and contains very specific guidelines on rule making by agencies.


Part I

LO 4-7 informal rule making A type of rule making in which an agency publishes a proposed rule in the Federal Register, considers public comments, and then publishes the final rule. Also called notice-andcomment rule making.

Federal Register The government publication in which an agency publishes each proposed rule, along with an explanation of the legal authority for issuing the rule and a description of how the public can participate in the rule-making process, and later publishes the final rule.

The Legal Environment of Business

INFORMAL RULE MAKING The primary type of rule making administrative agencies use is informal rule making, or notice-and-comment rule making. Informal rule making applies in all situations in which the agency’s enabling legislation or other congressional directives do not require another form. An agency initiates informal rule making by publishing the proposed rule in the Federal Register along with an explanation of the legal authority for issuing the rule and a description of how the public can participate in the rule-making process. The Federal Register is the official daily publication for rules, proposed rules, and notices of federal agencies and organizations as well as executive orders and other presidential documents.3 After publication, opportunity is provided for all interested parties to submit written comments. The comments may contain data, arguments, or other information a person believes might influence the agency in its decision making. Although the agency is not required to hold hearings, it has the discretion to receive oral testimony if it wishes to do so. Although the agency is not required to respond to all comments it receives, it is required to respond to comments that significantly concern the proposed rule. After considering the comments, the agency may alter the rule. It publishes the final rule, with a statement of its basis and purpose, in the Federal Register. This publication also includes the date on which the rule becomes effective, which must be at least 30 days after publication. Informal rule making is most often used because it is more efficient for the agency in terms of time and cost. No formal public hearing is required, and no formal record need be established. Some people believe that informal rule making is unfair because parties who are interested in the proposed rule have no idea what types of evidence the agency has received from other sources with respect to that rule. Thus, if the agency is relying on what one party might perceive as flawed or biased data, that party has no way to challenge that data.

B UT W H AT I F .   .   .  WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Let’s say, in the Case Opener, that the EPA decides it would like to make a rule governing the carbon dioxide emissions of new vehicles. The EPA publishes the rule in the Federal Register along with an explanation of the legal authority of the rule. Is this enough information for the Federal Register? What is the missing third prong?

LO 4-7 formal rule making A type of rule making that is used when legislation requires a formal hearing process with a complete transcript; consists of publication of the proposed rule in the Federal Register, a public hearing, publication of formal findings, and publication of the final rule if adopted.

FORMAL RULE MAKING The APA requires formal rule making when an enabling statute or other legislation mandates all regulations or rules to be enacted by an agency as part of a formal hearing process that includes a complete transcript. The first step in formal rule making is publication in the Federal Register of a notice of proposed rule making by the agency. The second step is a public hearing at which witnesses give testimony on the pros and cons of the proposed rule and are subject to cross-examination. An official transcript of the hearing is kept. On the basis of information received at the hearing, the agency makes and publishes formal findings. On the basis of these findings, an agency may or may not promulgate a regulation. If a regulation is adopted, the final rule is published in the Federal Register. Because of the expense and time involved in obtaining a formal transcript and record, most enabling statutes do not require a formal rule-making procedure when promulgating regulations. If a statute is drafted in a manner that is at all ambiguous with respect to the type of rule making required, the court will not interpret the law as requiring formal rule making. In the following case, the court had to decide whether to require formal rule making for substantive rules adopted by an agency. 3

Federal Register, www.gpoaccess.gov/fr/


Chapter 4 Administrative Law

CASE Nugget Do Substantive Rules Require Formal Procedure? Alexis Perez v. John Ashcroft U.S. District Court for the Northern District of Illinois, Eastern Division 236 F. Supp. 2d 899 (2002) Perez, a native and citizen of Venezuela, had been a member of the Good Shepherd Church since November 1996. Beginning in December 1996, he worked as that congregation’s music director, a full-time paid position. Under the law, a limited number of visas are available to an immigrant who, among other things, seeks to enter the United States to work for an organization in a professional capacity in a religious vocation or occupation. The Immigration and Naturalization Service (INS) denied Perez’s visa application on the basis of his lack of religious training. Perez argued that the INS adopted the requirement of religious training in violation of the Administrative Procedures Act (APA), because it is a substantive rule adopted without the use of notice and comment or other formal rulemaking procedures. Perez argued that he met all the requirements specified by the APA and INS regulations and, further, that the regulations contained no mention of a formalreligious-training requirement. INS countered that its imposition of the formal-training requirement—and its denial of Perez’s visa request because he lacked that training—simply represented a reasonable interpretation of the regulations and that Perez’s visa application was properly denied because he had no such training. There is no dispute that INS did not engage in any sort of formal rule-making process before adopting the requirement of formal religious training. The INS argued that the formal-training requirement was simply an interpretation of the regulations—more specifically, of the definition of “religious occupation”—and that therefore no formal rule making was necessary. The court disagreed. All substantive rules adopted by an agency, that is, rules that create law, must be implemented through formal rule-making procedures.

HYBRID RULE MAKING After agencies began regularly making rules in accordance with the appropriate procedures, the flaws of each type of rule making became increasingly apparent. In response to these problems, a form of hybrid rule making became acceptable to the courts and legislature. Hybrid rule making is an attempt to combine the best features of both formal and informal rule making. The starting point, publication in the Federal Register, is the same. Publication is followed by the opportunity for submission of written comments, and then there is an informal public hearing with a more restricted opportunity for cross-examination than that in formal rule making. The publication of the final rule is done in the same manner as it is for other forms of rule making. Exhibit 4-2 compares formal, informal, and hybrid rule-making procedures.

EXEMPTED RULE MAKING The APA contains an exemption from rule making that allows an agency to decide whether public participation will be allowed. Exemptions include rule-making proceedings with regard to “military or foreign affairs” and “agency management or personnel.” Exemptions are also granted for rule-making proceedings relating to “public property, loans, grants, benefits, or contracts” of an agency. Military and foreign affairs often need speed and secrecy, which are incompatible with public notice and hearings. Other exemptions are becoming more difficult to justify in the eyes of the courts unless they meet one of the exemptions of the Freedom of Information Act (discussed later in this chapter).

LO 4-7

hybrid rule making A type of rule making that combines features of formal and informal rule making; consists of publication in the Federal Register, a written-comment period, and an informal public hearing with restricted cross-examination.


Part I

The Legal Environment of Business

Exhibit 4-2 Rule-Making Procedures

interpretive rule A rule that does not create any new rights or duties but is merely a detailed statement of an agency’s interpretation of an existing law, including the actions a party is to take to be in compliance with the law.

Type of Rule Making PROCEDURE




Public hearing




Formal record




Publication of proposed rule in Federal Register




Written comments from the public and interested parties




Oral testimony and cross-examination


No (agency discretion)

Yes (limited)

Publication of final rule in Federal Register




Also exempted from the rule-making procedures are interpretive rules and general policy statements. An interpretive rule is a rule that does not create any new rights or duties but is merely a detailed statement of the agency’s interpretation of an existing law. Interpretive rules are generally very detailed, step-by-step statements of what actions a party is to take to be considered in compliance with an existing law. The following case demonstrates the deference federal courts give to agency interpretation of ambiguous statutes.

CASE Nugget What Is the Authority of Agency Interpretation of Statutes? Warner-Lambert Company v. United States U.S. Court of Appeals for the Federal Circuit 425 F.3d 1381 (2005) Warner-Lambert imports and sells lozenges in packages under the name Halls Defense™ Vitamin C Supplement Drops. The drops are composed primarily of sugar and glucose syrup, which together constitute more than 95 percent of each drop. Vitamin C constitutes just under 2 percent of each drop, with the remaining small percentage consisting of citric acid, flavors, and color. The Customs Service reclassified imported vitamin C supplement drops from their previous duty-free status as medicaments to dutiable status as sugar confectionery. As a result, the drops were subject to a duty of 6.1 percent. Warner-Lambert sued in the Court of International Trade. On appeal, the Customs Service reclassification was upheld. In a sixpage detailed letter ruling, Customs explained the reasons for its action, including that its prior classification of the drops was “based upon the belief that Vitamin C imparted therapeutic or prophylactic character to the merchandise” but that “additional research indicates that Vitamin C has not been shown in the U.S. to have substances which imbue it with therapeutic or prophylactic properties or uses.” The Court of International Trade held that Customs justifiably concluded that although the merchandise “may possess medical properties, it is being marketed as much for its flavor as for its medicinal value. Thus, it cannot be said that this merchandise is suitable only for medical purposes.” The drops are marketed to provide users with their requirement of vitamin C, not to prevent or cure disease. If a statute is ambiguous and if the implementing agency’s construction is reasonable, the federal courts must accept the agency’s construction of the statute, even if the agency’s reading differs from what the court believes is the best statutory interpretation.


Chapter 4 Administrative Law

Policy statements are general statements about the directions in which an agency intends to proceed with respect to its rule-making or enforcement activities. Again, these statements have no binding impact on anyone; they do not directly affect anyone’s legal rights or responsibilities. A final exemption applies when public notice and comment procedures are “impracticable, unnecessary, or contrary to the public interest.” This exemption is used most commonly either when the issue is so trivial that there would probably be very little, if any, public input or when the nature of the rule necessitates immediate action. Whenever an agency chooses to use this exception, it must make a good-cause finding and include in its publication of the final rule a statement explaining why there was no public participation in the process.

policy statement A general statement about the directions in which an agency intends to proceed with respect to its rule-making or enforcement activities; has no binding impact on anyone.

REGULATED NEGOTIATION The exceedingly high number of challenges to regulations, as well as a growing belief that structured bargaining among competing interest groups might be the most efficient way to develop rules, has stimulated interest among a number of agencies in a relatively new form of rule making, often referred to as reg-neg. Each concerned interest group and the agency itself sends a representative to bargaining sessions led by a mediator. After the parties achieve a consensus, that agreement is forwarded to the agency. The agency is then expected to publish the compromise as a proposed rule in the Federal Register and follow through with the appropriate rule-making procedures. The agency, however, is not bound to do so. If it does not agree with the proposal the group negotiated, the agency is free to try to promulgate a completely different rule or a modification of the one obtained through the negotiation. The reasoning behind reg-neg is similar to that supporting the increased use of mediation. If the parties can sit down and try to work out a compromise solution together, that solution is much more likely to be accepted than one handed down by some authority. The parties who hammered out the agreement now have a stake in making it work because they helped to create it. Admittedly, reg-neg is not possible in all situations. If there is an unmanageably large group of interests that would have to be represented, if any possible compromise would have to result from one group’s backing away from a fundamental principle, or if two groups feel so antagonistic toward each other that they would be unable to sit down and talk rationally, reg-neg would probably not even be worth trying.

PROBLEMS ASSOCIATED WITH RULE MAKING Agency employees are not subject to the same political pressures as legislators, but they are also not unbiased. Often the people with the necessary expertise to regulate specific areas come from the industry they will now be regulating. There is some concern that it will be difficult for regulators to ignore their past ties to industry and pass regulations that are in the public interest, especially when the regulations would increase costs to the industry or are opposed by the industry for other reasons. When people are discussing an agency in which they perceive this problem as existing, they often refer to the agency as being a captured agency. The counterargument is that those who have been deeply involved in an industry know it best. To prevent such actions during his administration, President Obama issued the Executive Order on Ethics Commitments by Executive Branch Personnel. The order prohibits executivebranch employees from accepting gifts from lobbyists; closes the revolving door that allowed government officials to move to and from private-sector jobs in ways that gave that sector undue influence over government; and requires government hiring to be based on qualifications, competence, and experience, not political connections.4 Regulators must be sensitive to the role the economy plays in the public’s willingness to accept or support certain regulations. When the economy is flourishing and unemployment is low, there is much greater acceptance of regulations. When unemployment is high, people are much more reluctant to accept regulations that they believe might cause some workers to lose their jobs and/or cause the prices of products to rise. 4

For a full text of the executive order, see www.whitehouse.gov/the_press_office/ExecutiveOrder-EthicsCommitments/

reg-neg A type of rule making in which representatives of concerned interest groups and of the involved government agency participate in mediated bargaining sessions to reach an agreement, which is forwarded to the agency.


Part I

The Legal Environment of Business

OTHER ADMINISTRATIVE ACTIVITIES Agencies perform a variety of less well known but equally important tasks. These include advising, conducting research, issuing permits, and managing property. One of the most common situations in which individuals come into contact with agencies occurs when an agency advises businesses and individuals on whether the agency considers an activity legal or illegal. Agencies also conduct studies of industries and markets. For example, the FTC, OSHA, and FDA conduct studies to determine, respectively, the level of economic concentration, safety in the workplace, and safety of drugs. Also, agencies provide information to the general public on various matters through hotlines, publications, and seminars. Agencies also devote much of their time to issuing licenses or permits. The EPA, for example, helps protect the environment by requiring certain environmentally sound activities before granting permits. Local agencies are responsible for issuing liquor licenses and cabaret (dancing) permits to local bars and restaurants. Finally, agencies often are responsible for managing government property. Case 4-1 illustrates limitations on an agency’s use of its powers to issue and, in this case, revoke a driver’s license.

CASE 4-1


FACTS: The trial court granted plaintiff Wang’s petition for a writ of administrative mandate compelling the defendant, Department of Motor Vehicles (DMV), to set aside its revocation of Wang’s class C driver’s license. On appeal, the DMV argued that, as a matter of law, it had the authority to revoke Wang’s class C license because it allegedly caught her cheating on an examination for a class B license. Wang, the holder of a valid class C (noncommercial) driver’s license, applied for a class B (commercial) driver’s license. She was given a written examination to determine whether she was qualified for a class B license, but she was not permitted to complete that examination because she was allegedly cheating while taking the examination by using crib notes. Wang was never criminally prosecuted for using crib notes, under Vehicle Code section 14610.5, because the DMV determined that there was insufficient evidence to support criminal action. The only administrative action taken against Wang by the DMV was to order the revocation of her class C (noncommercial) driver’s license. ISSUE: Does the Vehicle Code empower the state to revoke a driver’s license if the driver cheated on the test for a different driver’s license? REASONING: The DMV appealed the Appeals Court’s concurring opinion that “[n]o such action is authorized by the Vehicle Code.” The DMV argues that, as a matter

of law, the DMV does have authority to revoke Wang’s class C license because it allegedly caught her cheating on the examination for a class B license. The DMV purports to derive that authority from the Vehicle Code as follows: (1) Section 13359 provides that the DMV “may suspend or revoke the privilege of any person to operate a motor vehicle upon any of the grounds which authorize the refusal to issue a license”; (2) section 12809, subdivision (d), provides that the DMV may refuse to issue a license to any person who has “committed any fraud in any application”; (3) an examination is part of an application; (4) the use of a crib sheet in taking an examination is a fraudulent act; so (5) by using the crib sheet, Wang committed a fraud in an application, which therefore authorized refusal to issue a class B license, which therefore authorized revocation of her class C license, because any ground for refusal to issue a license is also a ground for revocation of a license. The DMV’s argument thus depends upon the DMV’s contention that under section 13359, any ground for refusal to issue one license is also sufficient to justify revocation of a different license. The DMV cites no authority for its construction of section 13359. We have found no case on point, but we conclude that the DMV’s interpretation cannot be correct because it would lead to untenable results. In general, the DMV’s interpretation of the statute would authorize revocation of a class C license held by any

(continued) unsuccessful applicant for a class B license. The statutory requirements for a class B license, however, are more demanding than the statutory requirements for a class C license, so statutory ineligibility for a class B license has no tendency, in itself, to show lack of statutory entitlement to a class C license.  .  .  . Because the DMV’s interpretation of section 13359 turns every unsuccessful application for a class B license into an authorization to revoke the

applicant’s class C license, it effectively negates the lower statutory threshold for entitlement to a class C license. DECISION AND REMEDY: Affirmed, and respondent recovered the costs of her appeal. SIGNIFICANCE OF THE CASE: The administrative agency is limited to the powers provided in the statute governing its operations.

CRITICAL THINKING What facts, had they existed, would have altered this decision?

ETHICAL DECISION MAKING Who besides the parties directly involved have interests in the results of this decision?

Limitations on Agency Powers

LO 4-8

There are four basic limits on agency power: political, statutory, judicial, and informational (see Exhibit 4-3). The hope is that these limitations will keep the agencies and their thousands of employees from abusing their discretion.

POLITICAL LIMITATIONS As discussed earlier in this chapter, the president appoints the administrative heads of all executive agencies with the advice and consent of the Senate. If the president is unhappy with the head of such an agency, that person may be fired at any time for any (or no) reason. As such, executive agencies are particularly accountable to the executive branch. Moreover, the political slant (liberal or conservative) of the agency is significantly influenced by the president. Congress also has significant control over agencies because the Senate must approve presidential nominees for them to become the administrative heads of agencies. Moreover, Congress has control over the budgets of all agencies. If Congress decides that a particular agency is not performing as it wishes, that agency’s budget may be cut or even defunded. Just before the Enron crisis, Congress, after being heavily lobbied by the accounting industry, threatened to defund the Securities and Exchange Commission (SEC). In effect, Congress did not like the SEC’s proposal that stock options should be charged as earnings. Arthur Levitt, then head of the SEC, heard the warning loud and clear and decided to walk away from his firmly held position. In later interviews, Levitt said it was his biggest regret as head of the SEC.5

STATUTORY LIMITATIONS Congress has the power to create or dissolve an agency. If Congress is unhappy with an agency, it may amend the agency’s enabling legislation and limit the agency’s power. Moreover, in 1996, legislation was signed into law that gives Congress 60 days to review proposed agency rules. 5

PBS video, Bigger than Enron—How Greed and Politics Undercut America’s Watchdogs, 1999.



Part I

The Legal Environment of Business

Congress may override those rules before they become effective. In addition, the APA (passed by Congress in 1946) sets forth guidelines that all agencies must follow when engaged in rule making.

JUDICIAL LIMITATIONS An individual or business that believes itself harmed by an administrative rule may challenge that rule in federal court after all administrative procedures have been exhausted.6 This is probably the biggest constraint on agency power. If a rule is subjected to judicial review, the court will consider the following: substantial evidence Refers to evidence that a reasonable mind could accept as adequate to support a conclusion. It is defined as “more than a scintilla but less than preponderance” and consists of “such relevant evidence as a reasonable person would accept as adequate to support a conclusion.”7

1. The facts of the case: Courts typically defer to an agency’s fact finding. The facts must be supported by substantial evidence. 2. The agency’s interpretation of the rule: Once again, the courts typically defer to the expertise of the agency and uphold the agency’s interpretation of the rule. 3. The scope of the agency’s authority: Has the agency exceeded the authority granted it by its enabling legislation? Although we typically think of judicial limitations as reining in overly zealous administrative regulators, the Case Opener illustrates that sometimes the judiciary is called on to restrict inaction by an agency. In Massachusetts v. EPA, the agency had resisted regulating greenhouse gases, arguing that carbon dioxide and similar gases are not pollutants under the Clean Air Act and, therefore, that the agency had no power to regulate them. When the high court reviewed the legislative mandate, however, it held that U.S. motor-vehicle emissions make a “meaningful contribution to greenhouse gas concentrations” and hence to global warming—and therefore the agency did have the authority to regulate such gases as air pollutants under the Clean Air Act. In June 2009, the EPA granted a Clean Air Act waiver of preemption to California, allowing California to implement its own, more stringent greenhouse gas emission standards for motor vehicles beginning with model year 2009. By mid-2010, with the agreement of the auto industry, the California standard became the federal standard.8 The National Labor Relations Board (NLRB) is an independent administrative agency (see Exhibit 4-1). As you read the following case, Northwestern University and College Athletes Players Association, are you convinced there is substantial evidence that student athletes should be treated as employees under the law? Moreover, when this administrative decision is appealed to the courts, should the courts defer to the NLRB’s interpretation of what it means to be an “employee?” 6 In a few situations, a court may not review an agency action. These include situations involving politically sensitive issues and those in which the agency’s enabling legislation prohibits judicial review. 7 Mareno v. Apfel, 1999 U.S. Dist. LEXIS 8575 (S.D. Ala., Apr. 8, 1999). 8 Tony McAdams, Nancy Neslund, and Kiren Zucker, Law, Business, & Society, 10th ed. (New York: McGraw-Hill, 2012), p. 745.

CASE 4-2


FACTS: Upon a petition duly filed under Section 9(c) of the National Labor Relations Act, as amended (“the Act”), a hearing was held before a hearing officer of the National Labor Relations Board (“the Board”). Pursuant to the provisions of Section 3(b) of the Act, the Board has delegated to the undersigned its authority in this proceeding.

The Employer [Northwestern University] is a private, nonprofit, nonsectarian, coeducational teaching university chartered by the State of Illinois, with three campuses, including one located in Evanston, Illinois. It currently has an undergraduate enrollment of about 8,400 students. . . .  The Employer maintains an intercollegiate athletic program

(continued) and is a member of the National Collegiate Athletic Association (NCAA). The NCAA is responsible for formulating and enforcing rules governing intercollegiate sports for participating colleges. The Employer is also a member of the Big Ten Conference, and its students compete against the other 11 member schools (as well as nonconference opponents) in various sports. There are currently 19 varsity sports, which the Employer’s students can participate in at the Division I level, including 83 varsity sports for men and 11 varsity sports for women. In total, there are about 500 students who compete in one of these sports each year for the Employer. . . . As part of its athletic program, the Employer has a varsity football team that competes in games against other universities. The team is considered a Football Bowl Subdivision (FBS) Division I program. Since 2006, the head football coach has been Patrick Fitzgerald, Jr., and he has been successful in taking his team to five bowl games. His football staff comprises a Director of Football Operations, Director of Player Personnel, Director of Player Development, nine full-time assistant coaches, and four graduate assistant coaches who assist him with his various duties. There are also five full-time strength coaches, two full-time video staff employees, two administrative assistants, and various interns who report to him. In turn, Head Coach Fitzgerald reports to Athletic Director James J. Phillips and President Dr. Morton Shapiro. The Employer’s football team is composed of about 112 players of which there are 85 players who receive football grant-inaid scholarships that pay for their tuition, fees, room, board, and books. The players on a scholarship typically receive grant-in-aid totaling $61,000 each academic year . . .  ISSUE: Under the Act, should student athletes who play football be deemed employees and given the legal right to bargain collectively? REASONING: A party seeking to exclude an otherwise eligible employee from the coverage of the Act bears the burden of establishing a justification for the exclusion. Accordingly, it was the Employer’s burden to justify denying its scholarship football players employee status. I find that the Employer failed to carry its burden. Section 2(3) of the Act provides in relevant part that the “term ‘employee’ shall include any employee. . . .” The U.S. Supreme Court has held that in applying this broad definition of “employee,” it is necessary to consider the common law definition of “employee.” NLRB v. Town & Country Electric, 516 U.S. 85, 94 (1995). Under the common law definition, an employee is a person who performs services for another under a contract of hire, subject to the other’s control or right of control, and in return for payment. As a result, the Board has subsequently applied the common law test to determine whether individuals are indeed statutory employees. As the record demonstrates, players receiving scholarships to perform football-related services for the Employer under a contract for hire in return for compensation are subject to the Employer’s control and are therefore employees within the meaning of the Act.

Clearly, the Employer’s players perform valuable services for their Employer. Monetarily, the Employer’s football program generated revenues of approximately $235 million during the nine-year period from 2003 to 2012 through its participation in the NCAA Division I and Big Ten Conference that were generated through ticket sales, television contracts, merchandise sales, and licensing agreements. The Employer was able to use this economic benefit provided by the services of its football team in any manner it chose. Less quantifiable but also of great benefit to the Employer is the immeasurable positive impact to Northwestern’s reputation a winning football team may have on alumni giving and increase in number of applicants for enrollment at the University. . . . Equally important, the type of compensation that is provided to the players is set forth in a tender that they are required to sign before the beginning of each period of the scholarship. This tender serves as an employment contract and gives the players detailed information concerning the duration and conditions under which the compensation will be provided to them. Because NCAA rules do not permit the players to receive any additional compensation or otherwise profit from their athletic ability and/or reputation, the scholarship players are truly dependent on their scholarships to pay for basic necessities, including food and shelter. . . . In the instant case, the record establishes that the players who receive scholarships are under strict and exacting control by their Employer throughout the entire year.  .  .  . The coaches have control over nearly every aspect of the players’ private lives because they must follow many rules under threat of discipline and/or the loss of a scholarship. The players have restrictions placed on them and/or have to obtain permission from the coaches before they can (1) make their living arrangements, (2) apply for outside employment, (3) drive personal vehicles, (4) travel off campus, (5) post items on the Internet, (6) speak to the media, (7) use alcohol and drugs, and (8) engage in gambling. The fact that some of these rules are put in place to protect the players and the Employer from running afoul of NCAA rules does not detract from the amount of control the coaches exert over the players’ daily lives. . . . In sum, based on the entire record in this case, I find that the Employer’s football players who receive scholarships fall squarely within the Act’s broad definition of “employee” when one considers the common law definition of “employee.” DECISION AND REMEDY: For the reasons discussed in detail below, I find that players receiving scholarships from the Employer are “employees” under Section 2(3) of the Act. Accordingly, IT IS HEREBY ORDERED that an election be conducted under the direction of the Regional Director for Region 13 in the following appropriate bargaining unit: Eligible to vote are all football players receiving football grant-in-aid scholarship and not having exhausted their playing 65

(continued) eligibility employed by the Employer located at 1501 Central Street, Evanston, Illinois, but excluding office clerical employees and guards, professional employees and supervisors as defined in the Act. Peter Sung Ohr, Regional Director National Labor Relations Board, Region 13

SIGNIFICANCE OF THE CASE: The preceding case will be appealed, potentially all the way to the U.S. Supreme Court. If the courts uphold this administrative ruling of the NLRB, colleges and universities will be required to treat students who are athletes as employees under the law, changing forever the definition of what it means to be a student athlete.9

CRITICAL THINKING There is extensive listing in this decision of the various aspects of the student athlete’s life that are controlled by the coaching staff. What is the purpose of that listing as justification for the eventual decision?

ETHICAL DECISION MAKING One of the groups of stakeholders who are often ignored in an ethical decision are future generations. Those of us alive now do not know the names of future generations, have by definition never met them, and consequently have a difficult time considering them relevant when we make a decision even when these people are going to be affected in major ways by the decision. What groups of people in future generations will be affected by this decision? How will they be affected?

INFORMATIONAL LIMITATIONS Agency power is limited by the Freedom of Information Act (FOIA), the Government in Sunshine Act, and the Privacy Act of 1974. Freedom of Information Act (FOIA) Federal legislation that mandates and facilitates public access to government information and records, including records about oneself. Sensitive information (e.g., on national security) is excluded.

Freedom of Information Act The Freedom of Information Act (FOIA), passed in 1966, requires federal agencies to publish in the Federal Register places where the public can get information from the agencies. The act requires similar publication of proposed rules and policy statements. It requires agencies to make such items as staff manuals and interpretations of policies available for copying to individuals, on request. Finally, all federal government agencies must publish records electronically. Any individual or business may make a FOIA request to a federal government agency. Information may be obtained regarding how the agency gets and spends its money. Statistics and/or information collected by the agency on a given topic is also available. Perhaps most important, citizens are entitled to any records that the government has about them. For example, you could contact the Internal Revenue Service (IRS) and request all information that it has collected about you. FOIA does not apply to Congress, the federal courts, the executive staff of the White House, state or local governments, and private businesses. Exemptions to FOIA include, but are not limited to, national security, internal agency matters (e.g., personnel issues), criminal investigations, financial institutions, and an individual’s private life. Immediately after taking office, President Obama issued a Memorandum for the Heads of Executive Departments and Agencies, indicating that FOIA should be administered with a clear presumption: In the face of doubt, openness prevails.10 The memorandum directs that information should not be withheld simply because it is legal to do so and that if an agency cannot make full disclosure of information, it should consider making a partial disclosure. Case 4-3 demonstrates the limits of an FOIA request. 9

For a full transcript of the NLRB’s 24-page decision, go to http://www.chicagotribune.com/sports/chi-nlrb-northwestern-football-unionruling-20140326,0,2025939.htmlpage 10 U.S. Department of Justice, www.usdoj.gov/ag/foia-memo-march2009.pdf


CASE 4-3


FACTS: On June 25, 2009, Plaintiff Electronic Privacy Information Center (EPIC) submitted a FOIA request to the National Security Administration (NSA), seeking documents related to the Comprehensive National Cybersecurity Initiative (CNCI), an initiative established by former President George W. Bush that outlines federal cybersecurity goals. The plaintiff is a not-for-profit public interest research organization that reviews federal activities and policies to determine their possible impact on civil liberties and privacy interests. The NSA is an agency within the Department of Defense that is responsible for shielding our nation’s coded communications from interception by foreign governments and for secretly intercepting intelligence communications from foreign nations. President Bush established the CNCI on January 8, 2008, by issuing National Security Presidential Directive 54 (NSPD 54), also known as Homeland Security Presidential Directive 23. The contents of NSPD 54 have not been released to the public. The CNCI, as described by the Senate Committee on Homeland Security and Governmental Affairs, is a “multi-agency, multi-year plan that lays out 12 steps to securing the federal government’s cyber networks.” The CNCI was formed “to improve how the federal government protects sensitive information from hackers and nation states trying to break into agency networks.” On June 25, 2009, the plaintiff submitted a written FOIA request to the NSA that, in its entirety, sought the following documents: the text of the National Security Presidential Directive 54 otherwise referred to as Homeland Security Presidential Directive 23; the full text, including previously unreported sections, of the Comprehensive National Cybersecurity Initiative as well as any executing protocols distributed to the agencies in charge of its implementation; and any privacy policies related to either the Directive or the Initiative, including but not limited to contracts or other documents describing privacy policies for information shared with private contractors to facilitate the Comprehensive National Cybersecurity Initiative. The NSA responded to the plaintiff ’s request on August 14, 2009, and produced two redacted documents that had been previously released under FOIA. The NSA referred part of the plaintiff ’s FOIA request to the National Security Council (NSC) because a responsive document in the NSA’s possession had originated with the NSC. The plaintiff brought this lawsuit against both the NSA and NSC to compel the production of documents responsive to its FOIA request. ISSUE: Are the NSA and NSC subject to a FOIA request?

REASONING: Congress enacted FOIA to promote transparency across the government. The Supreme Court has explained that FOIA is a means for citizens to know what their government is upto. The strong interest in transparency must be tempered, however, by the legitimate governmental and private interests that could be harmed by release of certain types of information. Accordingly, Congress included nine exemptions permitting agencies to withhold information from FOIA disclosure. The text of FOIA makes clear that the statute applies to agencies only. The statutory definition of an “agency” explicitly includes any executive department, military department, government corporation, government-controlled corporation, or other establishment in the executive branch of the government (including the Executive Office of the President). Using legislative history as its guide, however, the Supreme Court has held that “the President’s immediate personal staff or units in the Executive Office whose sole function is to advise and assist the President are not included within the term ‘agency’ under the FOIA.” The National Security Act of 1947 established the NSC to “advise the President with respect to the integration of domestic, foreign, and military policies relating to national security.” This circuit has unambiguously held that the NSC is not an agency subject to FOIA. Organizations that are not an agency under FOIA are neither required to respond to a FOIA request nor subject to a FOIA lawsuit. The plaintiff attempts to distinguish prior case law because the FOIA request in that case was made directly to the NSC, whereas in this case, the NSA referred the request to the NSC. The plaintiff contends that, by referring the FOIA request to the NSC, the NSA “treat[ed] the NSC as if it were an agency subject to the FOIA,” and therefore this Court should find the NSC subject to FOIA in this case. The plaintiff’s argument is unpersuasive. It is true that agencies that receive FOIA requests and discover responsive documents that were created by another agency may forward, or refer, those requests to the agency that originated the document. Here, however, the question is whether an entity that is not an agency subject to FOIA must respond to a FOIA request referred from an agency that is subject to FOIA. This question appears to be one of first impression in this circuit because neither the parties nor the court has located authority that directly addresses the issue. The Court finds the answer to this question to be clear-cut: The answer is no. An entity that is not subject to FOIA cannot unilaterally be made subject to the statute by any action of an agency, including referral of a FOIA request. It would defy logic and well-settled legal norms if an agency could unilaterally expand the scope of FOIA by referring requests to entities beyond FOIA’s ambit. 67

(continued) DECISION AND REMEDY: For the reasons previously stated, the court concludes that counts III and IV of the plaintiff’s complaint should be dismissed and that the NSC should be dismissed from this action. Accordingly, the defendants’ partial motion to dismiss is granted.

Beryl A. Howell United States District Judge SIGNIFICANCE OF THE CASE: This case demonstrates that a party may not obtain documents indirectly under the FOIA that it could not obtain directly.

CRITICAL THINKING What facts would have had to be changed for this decision to have granted the FOIA request? In other words, what facts are especially crucial to the reasoning here?

ETHICAL DECISION MAKING Ethics requires an initial consideration of the values that are in play in this particular decision. What values would have needed to be uppermost in the judge’s mind for him to have decided that with these facts, the FOIA request should have been granted?

Government in Sunshine Act The Government in Sunshine Act requires agency business meetings to be open to the public if the agency is headed by a collegiate body. A collegiate body consists of two or more persons, the majority of whom are appointed by the president with the advice and consent of the Senate. This open-meeting requirement applies only when a quorum is present. The law also requires agencies to keep records of closed meetings. Privacy Act Under the Privacy Act of 1974, a federal agency may not disclose information about an individual to other agencies or organizations without that individual’s written consent. This law guarantees three primary rights: 1. The right to see records about oneself, subject to the Privacy Act’s exemptions. 2. The right to amend a nonexempt record if it is inaccurate, irrelevant, untimely, or incomplete. 3. The right to sue the government for violations of the statute, such as permitting unauthorized individuals to read your records.11

Exhibit 4-3 Limits on Agency Power






The Senate must approve agency heads; Congress has power over agency budgets.


Congress may create or eliminate agencies and amend enabling legislation (i.e., powers of agencies); Congress reviews and may override agency rules.


Interested parties may challenge administrative rules in the courts, which may review the agency’s finding of facts, its interpretation of the rule, and the scope of the agency’s power in making the rule.


The Freedom of Information Act, Government in Sunshine Act, and Privacy Act of 1974 specify agencies’ responsibilities regarding public access to information.

FCIC, “Your Right to Federal Records,” www.pueblo.gsa.gov/cic_text/fed_prog/foia/foia.htm

E-COMMERCE and the Law E-Government: Changing the Relationship between the Government and Citizens According to the United Nations, e-government, which is defined as the delivery of government services through digital information technologies, including the Internet, is important because it reduces the cost of government while significantly improving the quality of services and citizen access. According to the latest UN report about this topic, e-government makes public administration more proactive, efficient, transparent, and service-oriented. Annual surveys by the UN indicate that nations throughout the world have made significant progress in e-government development, with the United States and Europe being among the leaders in this development. The UN has characterized the development of e-government into the following stages: Stage I—Emerging: A government’s online presence mainly consists of a web page and/or an official website; links to ministries or departments of education, health, social welfare, labor, and finance may or may not exist. Much of the information is static, and there is little interaction with citizens. Stage II—Enhanced: Governments provide more information on public policy and governance. They have created links that enable citizens to access archived information such as documents, forms, reports, laws and regulations, and newsletters easily. Stage III—Interactive: Governments deliver online services such as downloadable forms for tax payments and applications for license renewals. In addition, the beginnings of an interactive portal or website with services to enhance the convenience of citizens are evident. Stage IV—Transactional: Governments begin to transform themselves by introducing two-way interactions between citizen and government (C to G). This includes options for paying taxes and applying for ID cards, birth certificates, passports, and license renewals

as well as similar C-to-G interactions, and it allows the citizen to access these services online 24/7. Stage V—Connected: Governments transform themselves into a connected entity that responds to the needs of its citizens by developing an integrated backoffice infrastructure. This is the most sophisticated level of online e-government initiatives, and it is characterized by: 1. Horizontal connections (among government agencies). 2. Vertical connections (central and local government agencies). 3. Infrastructure connections (interoperability issues). 4. Connections between governments and citizens. 5. Connections among stakeholders (government, private sector, academic institutions, NGOs, and civil society). In addition, governments support and encourage e-participation and citizen engagement in the decisionmaking process.* The most recent ranking of nations in terms of their progress toward development of effective e-government was as follows: (1) Sweden, (2) Denmark, (3) Norway, (4) United States, (5) Netherlands, (6) Republic of Korea, (7) Canada, (8) Australia, (9) France, and (10) United Kingdom.† Sadly, the United States was at the top of the list in 2001, but because the Bush administration failed to make a serious commitment to transforming the federal government through information technology and failed to develop an overall e-government plan detailing where the government wants to go and how it wants to get there, other nations have made much more rapid progress in this area than has the United States.‡ *United Nations, “E-Government Survey 2008,” http://unpan1.un.org/intradoc/ groups/public/documents/UN/UNPAN028607.pdf † Ibid., p. 20. ‡ Robert D. Atkinson (Progressive Policy Institute), “Unsatisfactory Progress: The Bush Administration’s Performance on E-Government Initiatives,” October 14, 2004, www.ppionline.org/ppi_ci.cfm?knlgAreaID5140&subsecID5290&content. ID54252960

The Privacy Act applies only to records about individuals maintained by agencies in the executive branch of the federal government. There are 10 exemptions to the Privacy Act under which an agency can withhold certain kinds of information from you. Examples of exempt records are those containing classified information on national security and those concerning criminal investigations.12





Part I

The Legal Environment of Business

Federal and State Administrative Agencies Currently, more than 100 federal agencies are in operation as well as countless state agencies. Often, when there is a federal agency, there are also comparable state agencies to which the federal agency delegates much of its work. For example, the most important federal agency affecting environmental matters is the Environmental Protection Agency. Every state has a state environmental protection agency to which the federal EPA delegates primary authority for enforcing environmental protection laws. However, if at any time the state agency fails to enforce these laws, the federal EPA will step in to enforce them.

SUMMARY Introduction to Administrative Law

Administrative law consists of the substantive and procedural rules created by administrative agencies (government bodies of the city, county, state, or federal government) involving applications, licenses, permits, available information, hearings, appeals, and decision making. An administrative agency is generally defined as any body created by the legislative branch (e.g., Congress, a state legislature, or a city council) to carry out specific duties. Administrative agencies are created by Congress through passage of enabling legislation, which is a statute that specifies the name, functions, and specific powers of the administrative agency. Enabling statutes grant agencies broad powers for the purpose of serving the “public interest, convenience, and necessity.” An agency holds an administrative hearing before an administrative law judge (ALJ). The ALJ may attempt to get the parties to settle but has the power to issue a binding decision.

Types of Administrative Agencies

Executive agency: The administrative head of an executive agency is appointed by the president with the advice and consent of the U.S. Senate. Executive-agency heads may be discharged by the president at any time, for any reason. Executive agencies are generally located within the executive branch, under one of the cabinet-level departments (and thus are referred to as cabinet-level agencies). Examples are the Federal Aviation Agency (FAA) and the Food and Drug Administration (FDA). Independent agency: Independent agencies are governed by a board of commissioners. The president appoints the commissioners with the advice and consent of the Senate. Commissioners serve fixed terms and cannot be removed except for cause. No more than a simple majority of an independent agency can be members of any single political party. Hybrid agency: Hybrid agencies do not fall clearly into classification as an independent or an executive agency. Created as one type of agency, the body may share characteristics of the other type. The EPA, for example, was created as an independent agency, not located within any department of the executive branch, yet the head of the EPA serves at the whim of the president.

How Are Agencies Run?

In 1946, Congress passed the Administrative Procedures Act (APA) as a major limitation on how agencies are run. APA provides very specific guidelines on rule making by agencies. • •

Informal rule making: Under APA, the proposed rule is published in the Federal Register, and there is opportunity for public comment. Formal rule making: All rules must be enacted by an agency as part of a formal hearing process that includes a complete transcript. The process begins with publication in the Federal Register of a notice of proposed rule making by the agency. Next, there is a public hearing at which witnesses give testimony on the pros and cons of the proposed rule and are subject to cross-examination. The agency makes and publishes formal findings. If a regulation is adopted, the final rule is published in the Federal Register. Hybrid rule making: Hybrid rule making is an attempt to combine the best features of formal and informal rule making. The starting point is publication in the Federal Register,

Chapter 4 Administrative Law


followed by the opportunity for submission of written comments and then an informal public hearing with a more restricted opportunity for cross-examination than that in formal rule making. Exempted rule making: APA contains an exemption from rule making that allows an agency to decide whether public participation will be allowed. Exemptions include rule-making proceedings with regard to military or foreign affairs, agency management or personnel, and public property, loans, grants, benefits, or contracts of an agency.

Interpretive rules are rules that do not create any new rights or duties but merely state the agency’s interpretation of an existing law. They are generally very detailed, step-by-step statements of what actions a party is to take to be considered in compliance with an existing law. In reg-neg, each concerned interest group and the agency itself sends a representative to bargaining sessions led by a mediator. If the parties achieve a consensus, that agreement is forwarded to the agency. The agency is then expected to publish the compromise as a proposed rule in the Federal Register and follow through with the appropriate rule-making procedures. If the agency does not agree with the proposal the group negotiated, the agency is free to try to modify or replace it. Limitations on Agency Powers

There are four basic limits on agency power: political, statutory, judicial, and informational. Freedom of Information Act: Passed in 1966, FOIA requires federal agencies to publish in the Federal Register places where the public can get information from the agencies. Any individual or business may make a FOIA request to a federal agency for information on how the agency gets and spends its money, statistics and/or information collected by the agency on a given topic, and any records the government has about the individual seeking the information. Exemptions to FOIA include, but are not limited to, national security, internal agency matters (e.g., personnel issues), criminal investigations, financial institutions, and an individual’s private life. Government in Sunshine Act: This act requires agency business meetings to be open to the public if the agency is headed by a collegiate body (i.e., two or more persons, the majority of whom are appointed by the president with the advice and consent of the Senate). The law also requires agencies to keep records of closed meetings.

Federal and State Administrative Agencies

Privacy Act: Under the Privacy Act, a federal agency may not disclose information about an individual to other agencies or organizations without that individual’s written consent. Administrative agencies exist at the federal and state levels.

Point/Counterpoint Do Agencies Have Too Much Power? YES


The U.S. government is founded on separation of powers. That is why we have three branches of government: executive, legislative, and judicial. Giving administrative agencies all three powers—executive, legislative, and judicial—gives the agencies power to do anything they want with virtually no oversight. Agencies hire people who formerly worked in industry. Thus, these people often view regulation skeptically, yet they are the same people who run the agencies.

Administrative agencies came into existence because Congress, as well as state and local governments, did not have the expertise, time, or resources to deal with specialized problems such as air pollution, securities regulation, and banking administration. Without administrative agencies, these problems would not be addressed. An agency employs professionals with expertise and experience in the area the agency regulates. These people understand the industry and the ways in which it needs to be regulated.


Part I

The Legal Environment of Business

Questions & Problems 1. 2. 3. 4. 5.

What is enabling legislation? What are the limits on agency power? What are the three main powers given to agencies? List the three categories of agencies. Describe the various types of rule making.

6. John and Jacqueline Stowers are the sole owners of Manna, a limited liability company registered to do business in the state of Ohio. Manna is a family-run enterprise that sells food and other products to its members. Manna operates from the family’s home, specifically from the western section of the home, where its operations occupy one main room and one overflow room (the Manna rooms). Manna has approximately 100 members. To become a member, one must pay a 10-dollar initial fee, fill out an application, and complete an interview with Jacqueline Stowers. Members may order products through Manna by mail, e-mail, or phone. The products are primarily food products, although Jacqueline Stowers testified that members may also order some cleaning or personal hygiene products. The food products available to Manna members include raw chicken, turkey, beef, and eggs. The meat is typically frozen. After receiving orders from members, Manna obtains the ordered products from various suppliers. Testimony from Jacqueline and Kathryn Stowers indicated that the primary supplier from which Manna obtains products is United Natural Foods, which delivers the products to Manna from Indiana. When ordering from other suppliers, however, the Stowers will transport the products back to the Manna rooms themselves in their own unrefrigerated personal vehicles. The products are stored in refrigerators in the Manna rooms, which contain refrigerators and shelving, until members take the products from Manna. Manna has regular hours posted on the outside of the building and on its website, indicating when members may come to pick up their ordered products. Members pay Manna when they pick up their products, although the pricing is determined at the time of the order. Manna’s pricelist is posted on its website. A search warrant was executed on the Manna rooms and the rest of the Stowers’ home in December 2008. Manna’s food products and other items were seized as part of an investigation of Manna as an unlicensed retail food establishment. Ohio law authorizes regulation of retail food establishments and requires all retail food establishments to be licensed. Appellants did not have a retail food establishment license. Should defendants be forced

to obtain a food license? Why or why not? [Stowers v. Ohio Dep’t of Agric., (2011 Ohio 2710).] 7. Greenwood, an OSHA inspector, was driving by a construction site and thought that perhaps the site was unsafe. He got out of his car and videotaped the site, causing the foreman to ask him to leave. Greenwood also took measurements at the site and ultimately filed a report on OSHA violations of construction rules. The company running the construction site was assessed $49,000 in fines for OSHA violations. The company petitioned the court for review of the decision, arguing that an inspection by OSHA without a warrant was a violation of the right to privacy under the Fourth Amendment. How do you think the court decided? Explain your reasoning. [Lakeland Enterprises of Rhinelander, Inc. v. Chao, 402 F.3d 739 (7th Cir. 2005).] 8. Morales, a native and citizen of Mexico, was arrested in 1994 for entering the United States without inspection. He was released and served with a mail-out order to show cause why he should not be sent back to Mexico. Eventually, a removal hearing was scheduled, and Morales was notified by certified mail of the time and place of the hearing. When Morales failed to attend the hearing, he was ordered removed in absentia. The Immigration and Naturalization Service (INS) apprehended and removed Morales from the United States in 1998. He attempted to reenter illegally in January 2001— this time using a false border-crossing card. He was apprehended at the port of entry and was expeditiously removed. Undaunted, Morales reentered the United States undetected the following day. Sometime between his 1998 and 2001 removals, Morales married a U.S. citizen. In March 2001, Morales’s wife filed an I-130 alien relative petition based on his marriage to a U.S. citizen. When Morales and his wife met with the INS in January 2003, an immigration officer served them with a denial of the I-130 petition and a notice of intent to reinstate Morales’s removal order. The case came before a three-judge panel, which held that the regulation authorizing immigration officers to issue reinstatement orders is invalid, and Morales’s removal order could be reinstated only by an immigration judge. Until 1997, removal orders could be reinstated only by immigration judges (i.e., not immigration officers). In 1997, the attorney general changed the applicable regulation to delegate this authority, in most cases, to immigration officers. Does the attorney general have the authority to change an INS regulation? Why

Chapter 4 Administrative Law

or why not? [Raul Morales-Izuierdo v. Alberto R. Gonzales, Attorney General, 2007 U.S. App. LEXIS 10865 (9th Cir. 2007).] 9. Six conservation organizations filed a petition in Thurston County Superior Court, asking that court to hold, pursuant to a provision in the Administrative Procedures Act (APA), that the Washington Forest Practices Board, the Washington Department of Ecology, and the Washington Department of Natural Resources (agencies) “failed to promulgate forest practice rules that advanced the environmental protection purposes and policies of the Forest Practices Act of 1974.” The agencies countered by arguing that a formal petition for rule making must precede any petition for judicial review. Must an interest group exhaust administrative remedies before suing in a state or federal court? Why or why not? [Northwest Ecosystem Alliance v. Washington Forest Practices Board, 66 P.3d 614 (2003).] 10. Plaintiff pro se Wilfredo A. Golez (Golez) filed a motion to compel the work attendance records of two former coworkers who are not parties to the instant litigation. Golez states that he requires the employment records of his former coworkers to show that other employees who were late were not terminated as he was and, therefore, rebut defendants’ contention that his own attendance irregularities led to termination. Plaintiff argues that he was improperly terminated during FMLA-protected absences. In addition to the rule set forth in the Privacy Act of 1974, federal courts generally recognize a privacy right that can be raised in response to discovery requests. The party whose privacy is affected may object, as defendants have done here, or seek a protective order. Resolution of a privacy objection or request for protective order requires a balancing of the need for the particular information against the privacy right asserted. Should Golez be permitted to compel production of records of his coworkers over their objections? Explain your reasoning. [Golez v. Potter, 18 Wage & Hour Cas. 2d (BNA) 923 (2011).] 11. On January 21, 2003, Robbins filed an application for site plan approval to construct an asphalt plant within the town limits of Hillsborough. Robbins had entered into a contract to purchase the property prior to submitting his application for site plan review, and subsequently, he purchased the property. At the time he filed his application, an asphalt plant was a permitted use in a general industrial (GI) district, subject to a site plan review. The property on which the asphalt plant was to be constructed was zoned GI. In reliance on the zoning ordinance in effect at the time of his application, Robbins spent approximately $100,000 to engineer and submit a site plan to comply with the conditional-use requirements set forth in


the ordinance and to prepare for the required public hearings before the Town of Hillsborough Board of Commissioners. Three public hearings were held. The board received evidence but reached no decision. At the close of the third hearing, the board scheduled a fourth hearing. Before the fourth hearing, the board amended the zoning ordinance to temporarily suspend review, consideration, and issuance of permits for manufacturing processes. Robbins’s fourth hearing was canceled. Eventually, the suspension became a moratorium on permits until the end of the year. Robbins filed a complaint in Orange County Superior Court, alleging that he was entitled to rely on the language of the zoning ordinance in effect at the time he applied for the permit; that the board violated the law by failing to give notice of a public hearing or hold a public hearing prior to its decision to extend the moratorium; and that the defendant’s decision to prohibit asphalt plants permanently was arbitrary and capricious. How should the court decide? Explain your answer. [Robbins v. Town of Hillsborough, 625 S.E.2d 813 (N.C. Ct. App. 2006).] 12. The county board of commissioners (the Board) entered into a memorandum of understanding (MOU) with a professional baseball team. The MOU obligated the team, among other things, to relocate to the city for spring training. The MOU called for the renovation of a stadium complex. In addition, the MOU called for renovations at the team’s minor league spring training facilities. Several informational briefings for individual members of the Board were conducted privately, and e-mails were circulated among Board members, regarding the negotiations and agreement with the team. Sarasota Citizens for Responsible Government sued, alleging that the privately conducted meetings and e-mails by Board members were a violation of the Government in Sunshine Law requiring that: All meetings of any board or commission of any state agency or authority or of any agency or authority of any county, municipal corporation, or political subdivision, except as otherwise provided in the Constitution, at which official acts are to be taken are declared to be public meetings open to the public at all times, and no resolution, rule, or formal action shall be considered binding except as taken or made at such meeting. The board or commission must provide reasonable notice of all such meetings.

How should the court rule? Why? [Sarasota Citizens for Responsible Gov’t v. City of Sarasota, 48 So. 3d 755 (2010).] 13. The respondent, the Public Company Accounting Oversight Board, was created as part of a series of accounting reforms in the Sarbanes-Oxley Act


Part I

The Legal Environment of Business

of 2002. The board is composed of five members appointed by the Securities and Exchange Commission (SEC). It was modeled on private self-regulatory organizations in the securities industry—such as the New York Stock Exchange—that investigate and discipline their own members subject to SEC oversight. Unlike these organizations, however, the board is a government-created entity with expansive powers to govern an entire industry. Every accounting firm that audits public companies under the securities laws must register with the board, pay it an annual fee, and comply with its rules and oversight. The board may inspect registered firms, initiate formal investigations, and issue severe sanctions in its disciplinary proceedings. The parties agree that the board is “part of the Government” for constitutional purposes. Although the SEC has oversight of the board, it cannot remove board members at will but can do so only “for good cause shown,” “in accordance with” specified

procedures. The parties also agree that the commissioners, in turn, cannot themselves be removed by the president except for “inefficiency, neglect of duty, or malfeasance in office.” The board inspected the petitioner accounting firm, released a report critical of its auditing procedures, and began a formal investigation. The firm and the petitioner, Free Enterprise Fund, a nonprofit organization of which the firm is a member, sued the board and its members, seeking, inter alia, a declaratory judgment that the board is unconstitutional and an injunction preventing the board from exercising its powers. The petitioners argued that the Sarbanes-Oxley Act contravened the separation of powers by conferring executive power on board members without subjecting them to presidential control. Is the Public Company Accounting Oversight Board constitutional? Why or why not? [Free Enter. Fund v. Pub. Co. Accounting Oversight Bd., 130 S. Ct. 3138 (2010).]


The Legal Environment of Business

1 5


Constitutional Law

CASE OPENER The Constitutionality of the Affordable Care Act In 2010, in an attempt to increase the number of Americans covered by health insurance and reduce the cost of health care, Congress passed the Patient Protection and Affordable Care Act. A key provision of the act was the “individual mandate,” a provision requiring most Americans to obtain “minimum essential” health insurance. By 2014, those not exempt or covered by insurance provided by their employer or a government program would have to buy insurance from a private insurer, or they would be assessed a shared responsibility payment by the Internal Revenue Service. This penalty would be assessed and collected in the same manner as any other tax penalty. Twenty-six states, several individuals, and the National Federation of Independent Business brought an action challenging the constitutionality of the individual mandate, among other provisions of the act. The 11th Circuit Court of Appeals upheld the other challenged provisions of the act but found that Congress lacked the authority to pass the individual mandate. The appellate court went on to hold that the individual mandate was severable from the rest of the act, despite the argument that the framework of the act depended on the individual mandate, and so upheld the rest of the act. 1. Did Congress have the authority to pass the act under the commerce clause? 2. Did Congress have the authority to pass the act under its power to lay and collect taxes?


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

LO 5-1

What is federalism?

LO 5-2

What is the function of each branch of government, and how does each branch serve to check the others?

LO 5-3

What is the relationship between the supremacy clause and preemption?

LO 5-4

How does the commerce clause affect the power of both the state and federal governments to regulate?

LO 5-5

What is the difference between commercial and political speech, and why is that difference important?

LO 5-6

How do the rights guaranteed by the Bill of Rights affect business managers?

The U.S. Constitution sets forth the framework of our nation’s government; it establishes a system of government that divides power between the federal government and the states. This system of government provides the focus for this chapter. In this chapter, we examine the constitutional provisions that affect business. Then we turn our focus to the primary source of the federal government’s authority to regulate business: the commerce clause. We next examine the federal government’s authority to tax and spend. Finally, in the last part of the chapter, we focus on how several amendments to the Constitution affect business.

LO 5-1 federalism A system of government in which power is divided between a central authority and constituent political units.


The U.S. Constitution The U.S. Constitution establishes a system of government based on the principle of federalism, according to which the authority to govern is divided between federal and state governments. According to the Tenth Amendment to the Constitution, all powers that the Constitution neither gives exclusively to the federal government nor takes from the states are reserved for the states. Because the federal government has only those powers granted to it by the Constitution, federal legislation that affects business must be based on an expressed constitutional grant of authority. In addition to allocating authority between state and federal governments, the Constitution allocates the power of the federal government among the three branches of government. The first three articles of the Constitution establish three independent branches of the federal government: the legislative, executive, and judicial branches. The Constitution ensures that each branch maintains a separate sphere of power to prevent any one branch from obtaining undue power and monopolizing control of government. The Constitution also establishes a system of checks and balances. Each branch’s powers keep the other branches from dominating the government. For example, Congress, the legislative or lawmaking branch, has the power to enact legislation, but the president can veto a law that Congress passes. The legislature, however, can overturn a presidential veto with a two-thirds vote of the members of Congress. And if Congress passes a bill and the president signs it, the judiciary can strike it down as unconstitutional. Figure 5-1 illustrates the system of checks and balances in more detail.


Chapter 5 Constitutional Law

Figure 5-1 The System of Checks and Balances

—Can pass amendments to overrule judicial rulings —Can impeach judges —Establishes lower courts and sets number of judges

Legislative Branch

—Can declare laws passed by Congress unconstitutional

—Can refuse to approve president's budget —Can overrule presidential vetoes —Can refuse to approve presidential appointments —Can refuse to ratify treaties —Can impeach and remove president

—Can veto laws passed by legislative branch —Can call special sessions of Congress

—Can declare acts of the executive branch unconstitutional

Judicial Branch

—Appoints federal judges —Can pardon federal offenders

Executive Branch

(© Brand X Pictures/PunchStock, Hisham F. Ibrahim/Getty Images, PhotoLink/Getty Images)

JUDICIAL REVIEW Although the Constitution does not explicitly allow courts to review legislative and executive actions to determine whether they are constitutional, early common law established this process, known as judicial review. In the landmark 1803 U.S. Supreme Court case Marbury v. Madison, Chief Justice John Marshall wrote for the majority: [I]f a law be in opposition to the constitution; if both the law and the constitution apply to a particular case, so that the court must either decide that case [conforms] to the law, disregarding the constitution; or [conforms] to the constitution, disregarding the law; the court must determine which of these conflicting rules governs the case. This is of the very essence of judicial duty.

Judicial review also allows courts to review the constitutionality of lower courts’ decisions.

The Supremacy Clause and Federal Preemption The supremacy clause, located in Article VI of the Constitution, provides that the Constitution, laws, and treaties of the United States constitute the supreme law of the land, “any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.” Any state or local law that directly conflicts with the Constitution, federal laws, or treaties is void. Federal laws include rules passed by federal administrative agencies. For example, the Federal Aviation Administration has banned the use of cell phones on airplanes. If a Missouri law permitted cell phone usage on airplanes, it would be unconstitutional according to the supremacy clause. In some areas, the state and federal governments have concurrent authority; that is, both governments have the power to regulate the same subject matter. In such cases, the states

LO 5-2

judicial review The power of a court to review legislative and executive actions, such as a law or an official act of a government employee or agent, to determine whether they are constitutional.

LO 5-3 supremacy clause Article VI, Paragraph 2, of the U.S. Constitution, which states that the Constitution and all laws and treaties of the United States constitute the supreme law of the land. Thus, any state or local law that directly conflicts with the U.S. Constitution or federal laws or treaties is void.


Part I

federal preemption

may regulate in the area as long as a person’s compliance with the state regulation would not cause her or him to be in violation of a federal regulation. For example, Congress has established a number of environmental standards, but some states have passed even more protective standards. Sometimes, however, when the state and federal governments have concurrent authority, the federal government can decide to regulate that area exclusively. In such a situation, according to the doctrine of federal preemption, the state law is unconstitutional. To determine whether Congress intended to provide exclusive regulation, courts look to the language of the statute and transcripts of congressional hearings.

A principle asserting the supremacy of federal legislation over state legislation when both pertain to the same matter.

commerce clause Clause 3 of Article I, Section 8, of the U.S. Constitution, which authorizes Congress to “regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.”

LO 5-4

The Legal Environment of Business

The Commerce Clause The primary source of authority for federal regulation of business is the commerce clause, located in Article I, Section 8, of the Constitution. This clause states that the U.S. Congress has the power to “regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” This allocation of authority simultaneously empowers the federal government and restricts the power of state governments.

THE COMMERCE CLAUSE AS A SOURCE OF AUTHORITY FOR THE FEDERAL GOVERNMENT Today, most federal regulations are exercises of congressional authority according to the commerce clause. As long as a law affects commerce among the states, or interstate commerce, in some way, the regulation is generally constitutional. Congress, however, has not always enjoyed such extensive power. In many cases, legislatures change the law by replacing statutes with different ones. In many other cases, however, the law changes even when statutes do not change because courts often interpret statutes differently over time. For example, although the text of the commerce clause has not changed since 1787, courts’ interpretations of the meaning of the commerce clause have morphed over time. In particular, the phrase “among the several States” has been subject to changing interpretations throughout U.S. history. Prior to the 1930s, courts interpreted the clause very strictly, requiring the regulated activity actually to involve trade between states. This interpretation limited federal regulation of business. In the 1930s, however, the Supreme Court began to interpret the commerce clause more broadly. The 1937 case NLRB v. Jones & Laughlin Steel Corp. was a turning point in the Supreme Court’s interpretation of the commerce clause. In that case, the Court ruled that Congress could regulate labor relations at a manufacturing plant because a work stoppage at the plant would seriously affect interstate commerce. The Court stated that “[a]lthough activities may be intrastate in character when separately considered, if they have such a close and substantial relationship to interstate commerce that their control is essential or appropriate to protect that commerce from burdens or obstructions, Congress cannot be denied the power to exercise that control.” Since that case, Congress has regulated a broad range of business activities according to the commerce clause, through legislation such as the Federal Mine Safety and Health Act, which sets standards for safety in coal mines; the Americans with Disabilities Act, which prohibits firms from discriminating against employees and potential employees who have disabilities; and the Consumer Protection Act, which criminalizes certain loan-sharking activities. Although businesses have challenged these statutes as being beyond the scope of congressional power, courts have upheld the statutes as valid exercises of congressional authority according to the commerce clause. When the law changes, however, its movement is not always unidirectional. In fact, sometimes courts revert to standards and methods of interpretation that they rejected in the past. For example, the 1995 case United States v. Lopez marked a significant change in the nearly 60-year trend in the Supreme Court’s interpretation of the commerce clause. In Lopez, the Court ruled that Congress had exceeded its commerce clause authority when it passed the Gun-Free School

Chapter 5 Constitutional Law


Zone Act, a law banning the possession of guns within 1,000 feet of any school. In its ruling, the Court said that Congress could not regulate in an area that had “nothing to do with commerce, or any sort of enterprise.” Case 5-1 illustrates how the Supreme Court applies the commerce clause to determine the constitutionality of statutes Congress passes.

CASE 5-1


FACTS: Petitioner Christy Brzonkala and respondents Antonio Morrison and James Crawford were students at Virginia Polytechnic Institute (Virginia Tech). Brzonkala met the respondents at a campus party, where they allegedly assaulted and raped her; according to Brzonkala, Morrison subsequently made boasting, debasing, and vulgar remarks on campus about what he would do to women. Brzonkala claimed to be emotionally disturbed and depressed as a result. She was treated by a university psychiatrist, and soon after the rape she withdrew from the university. Brzonkala filed a complaint against the respondents under Virginia Tech’s Sexual Assault Policy. Morrison was initially found guilty and suspended for two semesters, but his punishment was ultimately set aside. Brzonkala then sued Morrison, Crawford, and Virginia Tech in federal court, alleging, among other claims, that Morrison’s and Crawford’s attack violated the Violence against Women Act. Morrison and Crawford moved to dismiss this complaint on the grounds that it failed to state a claim and that the act’s (§  13981) civil remedy was unconstitutional. The district court dismissed the complaint on grounds that Congress lacked authority to enact the section. The U.S. court of appeals affirmed the district court’s conclusion. ISSUE: Did Congress have the power under the commerce clause to enact the Violence against Women Act? REASONING: Congress can regulate three broad categories of activities under its commerce powers. It can regulate the use of the channels of interstate commerce. It can regulate and protect the instrumentalities of interstate commerce, or persons or things in interstate commerce, even though the threat may come only from intrastate activities. It can regulate those activities that substantially affect interstate commerce. The act is properly analyzed

as a potential regulation of an activity that substantially affects commerce. The most relevant precedent is Lopez, in which the Supreme Court held that the Gun-Free School Zones Act of 1990, which made it a federal crime to knowingly possess a firearm in a school zone, exceeded Congress’s authority under the commerce clause. That statute was struck down because, first, by its terms it was unrelated to commerce, and whenever the courts have sustained federal regulation of intrastate activity based on the activity’s substantial effects on interstate commerce, the activity in question has been some sort of economic endeavor. Second, the statute had no express jurisdictional element to limit its reach to a discrete set of firearm possessions that additionally have an explicit connection with or effect on interstate commerce. Third, Congress had no findings about the effect of gun possession at school on interstate commerce. Fourth, the link between gun possession and a substantial effect on interstate commerce was attenuated. To uphold the law would have meant that there were no limits on what Congress could regulate. Likewise, gender-motivated crimes of violence are not economic activity, and there was no jurisdictional element showing that the federal cause of action is in pursuance of Congress’s power to regulate interstate commerce. There were some statistics showing the impact of genderrelated crime on victims and their families, but the Court had to decide whether these statistics demonstrate a substantial impact on interstate commerce, and the Court did not believe they do. The Court found that the congressional finding relied on a method of reasoning the Court had already rejected as unworkable if any limit on congressional powers is to be maintained. It is not sufficient to find that gender-motivated violence affects interstate commerce “by deterring potential victims from traveling interstate, from engaging in employment in interstate business, and from transacting with business, and in places involved

(continued) in interstate commerce; . . . by diminishing national productivity, increasing medical and other costs, and decreasing the supply of and the demand for interstate products.” Allowing such reasoning would give Congress the power dormant commerce toclause regulate almost any crime. A restriction on states’

DECISION authority that isAND impliedREMEDY: The Court affirmed the in the commerce clause lower courts’ decisions, holding that Congress may not of the U.S. Constituregulate noneconomic, violent criminal conduct solely on tion: The power given to Congress to enact legislation that affects interstate commerce in effect prohibits a state from passing legislation that improperly burdens interstate commerce.

the basis of that conduct’s aggregate effect on interstate commerce. SIGNIFICANCE OF THE CASE: The case clearly demonstrates an increasing willingness of the Court to limit congressional authority under the commerce clause. Note that the Court is not passing judgment on the quality of the law but is just saying that such a law would need to be passed by the state, not the federal, legislature.

CRITICAL THINKING This case was a 5-4 decision. What reasoning do you think supported the dissent’s opinion?

ETHICAL DECISION MAKING Recall the WH framework. What values led the majority to rule that Congress lacks authority to enact § 13981 of the Violence against Women Act? Do you think the values you listed are appropriate in this situation in spite of the individuals who are harmed by the decision?

The issue of whether the commerce clause has authorized Congress to act still arises today. One such recent illustration is in the individual mandate provision of the Affordable Care Act (ACA), described in the opening scenario. Despite cases such as Lopez and Brzonkala, many commentators had thought that the ACA individual mandate would be seen as a regulation affecting interstate commerce. The implementation of the act would certainly lead to an increase in purchases of health care insurance, thereby significantly affecting the market for it and for health care; more people would be able to obtain additional health care once they had insurance. However, Justice Roberts disagreed, making a new distinction between regulating existing activity and creating new activity, with the former being seen as affecting interstate commerce and the latter not doing so. Thus, the individual mandate provision contained in the ACA could not be justified as authorized by the commerce clause.

B UT W H AT I F ?   .   .   . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall that in the Case Opener, Obama’s mandate required people to purchase health insurance who did not currently have. What if Obama’s act had imposed certain rules on only those who currently had health insurance, simply mandating that their insurers could not drop them from coverage and requiring that individuals who currently had coverage could not drop that coverage?

THE COMMERCE CLAUSE AS A RESTRICTION ON STATE AUTHORITY The federal government’s authority to regulate interstate commerce sometimes conflicts with the states’ authority to regulate intrastate commerce. Courts have attempted to resolve this conflict by distinguishing between regulations of commerce and regulations under states’ police power. 80


Chapter 5 Constitutional Law

Police power consists of the residual powers retained by each state to safeguard the health and welfare of its citizenry. Typical exercises of a state’s police power include state criminal laws, building codes, zoning laws, sanitation standards for restaurants, and regulations for the practice of medicine. Sometimes a state’s use of its police power affects interstate commerce. If the purpose of a state law is to regulate interstate commerce or to discriminate against interstate commerce, the law is usually unconstitutional. Likewise, if a law substantially interferes with interstate commerce, it is generally unconstitutional. This restriction on states’ authority to pass laws that substantially affect interstate commerce is called the dormant commerce clause. Most cases are not so simple, however, and courts must balance the states’ interest in protecting their citizens against the impact on interstate commerce. In balancing these competing interests, a court generally asks whether the state regulation is rationally related to a legitimate state end. If it is, the court then asks whether the regulatory burden imposed on interstate commerce is outweighed by the state’s interest in enforcing the legislation. The court may also inquire whether there is a less drastic alternative available to attain the legitimate state purpose. Although the supremacy clause establishes the sovereignty of federal law, courts generally presume that laws passed in accordance with states’ police power are valid. For example, the city of Chicago passed an ordinance banning spray paint in the city as a means of reducing graffiti. Paint manufacturers challenged the legislation as a violation of the dormant commerce clause, but the U.S. court of appeals upheld the legislation. Case 5-2 illustrates an attempt to challenge a state regulation on the grounds that it places an undue burden on interstate commerce.

CASE 5-2

police power Power retained by each state to pass laws that protect the health, safety, and welfare of its citizens.

dormant commerce clause A restriction on states’ authority that is implied in the commerce clause of the U.S. Constitution: The power given to Congress to enact legislation that affects interstate commerce in effect prohibits a state from passing legislation that improperly burdens interstate commerce.


FACTS: Arizona generally requires all alcoholic beverages sold to consumers in the state to pass through a three-tier distribution system comprising producers, wholesalers, and retailers. However, Arizona has carved out two exceptions to its system that allow wineries under specified circumstances to bypass the three-tier distribution system. First, all wineries that produce fewer than 20,000 gallons of wine per year—whether located in state or out of state—are allowed to ship an unlimited amount of wine directly to consumers, regardless of how the order is placed, and to sell directly to retailers. Second, all wineries—whether located in state or out of state—are allowed to ship two cases of wine per year directly to consumers who purchase wine while they are physically present at the winery. Black Star Farms, a Michigan winery, produced approximately 35,000 gallons of wine in 2006. Thus, the small-winery exception was not available to Black Star

Farms, and wholesalers would not handle its wine in a costeffective manner because it did not sell enough in the state. Nevertheless, the in-person exception did allow Black Star Farms to ship up to two cases per year to a consumer who purchased the wine while he or she was physically present at the winery in Michigan. Black Star Farms contended that these challenged exceptions to the three-tier system violated the dormant commerce clause, and sued the State Liquor Control Board because the winery could not ship directly to consumers who do not physically go to Michigan to purchase the wine. They were joined in their action by a couple who wished to purchase Black Star Farms wine in Arizona without going to the Michigan winery. These consumer plaintiffs contended that it was economically and practically impossible for them to visit wineries located far from Arizona, including those in Michigan, Napa, and Oregon, to purchase wine in person and have it shipped home.

(continued) Black Star Farms and defendants each filed motions for summary judgment, and the district court denied Black Farms’ motion but granted defendants’ cross-motions for summary judgment, concluding that Black Star Farms failed to carry its burden of showing that the challenged statutory scheme discriminates against out-of-state wineries in practical effect. Black Farms appealed. ISSUE: Do the exceptions to the state of Arizona’s threetier distribution system violate the dormant commerce clause? REASONING: For the purposes of the dormant commerce clause, discrimination means differential treatment of in-state and out-of-state economic interests that benefits the former and burdens the latter. If such discrimination is found, the court will apply strict scrutiny. The party challenging the statute must prove discrimination. This act at issue is intended to provide for a separate method of regulating only the sale and delivery of wine produced by small wineries and allowing small wineries to bypass the wholesalers. Before the changes to the law, the small-wineries exception applied only to small wineries at which 75 percent of the grapes used were grown within the state of Arizona, making that exception facially unconstitutional because it treated in-state and out-of-state wineries differently. The exception now applies to all small wineries regardless of where their grapes are grown, so the law is facially neutral. The in-person exception likewise applies

to in- and out-of-state wineries and is also facially neutral; it thus appears facially constitutional. Although Black Star Farms Winery contends that the law is discriminatory in its effect, (1) there was no indication that the exception creates a system under which local goods constitute a larger share, and goods with an out-ofstate source constitute a smaller share, of the total sales in the market, and (2) more than half of all U.S. wineries can take advantage of the exception, and as of the time the case was heard, more out-of-state than in-state wineries had taken advantage of it. Further, there is no indication whatsoever that the in-person exception has any effect on the flow of interstate commerce. Thus, the law does not discriminate on its face or practically against interstate commerce. DECISION AND REMEDY: The court of appeals concluded that Arizona’s statutory exceptions to its three-tier distribution system, which treat similarly situated in-state and out-of-state wineries the same and impose no new impermissible burdens on out-of-state wineries, do not have the practical effect of favoring in-state economic interests over out-of-state interests. Therefore, the appellate court affirmed the district court’s decision. SIGNIFICANCE OF THE CASE: The case illustrates how the court responds to a challenge to a state statute based on grounds that the law violates the dormant commerce clause.

CRITICAL THINKING What different facts might have led the court to a different conclusion?

ETHICAL DECISION MAKING Identify the primary stakeholders helped and hurt by the outcome of this case.

Taxing and Spending Powers of the Federal Government No government can function without a source of revenue. Article I, Section 8, of the Constitution gives the federal government the “Power to lay and collect Taxes, Duties, Imports, and Excises.” The taxes laid by Congress, however, must be uniform across the states. In other words, the government cannot impose higher taxes on residents of one state than it imposes on those of another. 82


Chapter 5 Constitutional Law

Although tax collection allows the government to provide essential services, the government can also use taxes for other purposes. For example, to encourage the development of certain industries and discourage the development of others, the government can provide tax credits for firms entering favored industries. As long as the “motive of Congress and the effect of its legislative action are to secure revenue for the benefit of the general government,” the credit is constitutional. The fact that it also has a regulatory impact does not affect the constitutionality of the credit. Although we may all think we know what a tax is, we may be surprised by what the courts call a tax. For example, many were surprised by the Supreme Court’s determination that the penalty imposed under the Affordable Care Act on those who do not obtain health care insurance is a tax. In explaining that finding, Chief Justice Roberts explained that although the payment was intended to encourage the purchase of insurance, nothing in the mandate made the failure to purchase the insurance unlawful; the law could be read as simply imposing a tax, collected by the IRS like other taxes, on those choosing not to purchase health insurance. The chief justice found no problem with the fact that the statute referred to the payment as a penalty and not as a tax.

B UT W HAT IF ?  . .   . What if the facts had been different and the language of the ACA had clearly stated that although the payment was to be made through the IRS, the payment for failure to purchase health care insurance was a penalty and not a tax? Would that language have necessarily affected the Supreme Court’s interpretation of the constitutionality of the statute?

Article I, Section 8, also grants Congress spending power by authorizing it to “pay the Debts and provide for the common Defense and general Welfare of the United States.” As with its power to tax, Congress can use its spending power to achieve social welfare objectives. For example, in South Dakota v. Dole, the Supreme Court upheld a federal statute that grants federal funds for state highways to only those states in which 21 is the legal drinking age.

Other Constitutional Restrictions on Government THE PRIVILEGES AND IMMUNITIES CLAUSE Article IV, Section 2, of the Constitution states that “Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States.” This provision, called the privileges and immunities clause, prohibits states from discriminating against citizens of other states when those nonresidents engage in ordinary and essential activities. These activities include buying and selling property, seeking employment, and using the court system. States may treat residents and nonresidents differently only when they have substantial reason for doing so. For example, according to the privileges and immunities clause, a state cannot prohibit nonresidents from opening restaurants in the state. States can, however, allow state universities to charge higher tuition to out-of-state students because residents pay taxes that fund state universities, whereas out-of-state students do not.

THE FULL FAITH AND CREDIT CLAUSE Article IV, Section 1, of the Constitution contains the full faith and credit clause. This clause states, “Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State.” This provision requires courts in all states to uphold contracts

privileges and immunities clause Clause in the U.S. Constitution requiring a state to grant citizens of other states the same legal benefits that it grants its own citizens.

full faith and credit clause The clause of the U.S. Constitution (Article IV, Section 1) mandating that each state must recognize, respect, and enforce the public records, legislative acts, and judicial decisions of the other states.


Part I

The Legal Environment of Business

and public acts established in other states. For example, this clause protects wills, marriage and divorce decrees, and judgments in civil courts. Courts have held, however, that states do not have to give full faith and credit to laws that violate their public policy. Thus, for example, although Massachusetts permits same-sex marriage, the full faith and credit clause does not require other states to recognize such marriages.

THE CONTRACT CLAUSE contract clause The clause in the U.S. Constitution that prohibits the government from unreasonably interfering with an existing contract.

Article I, Section 9, contains the contract clause, which states that government may not pass any “Law impairing the Obligation of Contract.” In application, courts interpret this clause to mean that no law can be passed that will unreasonably interfere with existing contracts. For example, in the 1934 U.S. Supreme Court case Home Building & Loan Association v. Blaisdell, the Home Building & Loan Association challenged Minnesota’s Mortgage Moratorium Act as a violation of the contract clause. The act, implemented temporarily during the Great Depression, authorized courts to extend the redemption periods of mortgages to delay foreclosures of mortgages on real estate. The Court ruled that the act’s provisions were within the state’s police power to protect its citizens and did not violate the contract clause. Although the act impaired contractual obligations between lenders and borrowers, the Court held that courts must balance even substantial contractual impairments against states’ interest in protecting the welfare of their citizens.

The Amendments to the Constitution The first 10 amendments to the U.S. Constitution, known as the Bill of Rights, substantially affect government regulation of business. These amendments prohibit the federal government from infringing on individual freedoms. Moreover, the Fourteenth Amendment extends most of the provisions in the Bill of Rights to the states, prohibiting state interference in citizens’ exercise of their rights. Thus, the federal and state governments cannot deprive individuals of the freedoms protected by the Bill of Rights. Remember, however, that the amendments are a limit only on actions of the government—they do not limit the behavior of private employers. This distinction is commonly misunderstood by many citizens. Many other countries do not have constitutional provisions to protect citizens from the government. The Australian constitution, for example, only creates the framework for government in Australia. In many of the countries that do have individual protections in their constitutions, these protections have emerged recently. Some other countries’ constitutions provide rights that American citizens do not have, as the Global Context box on Belarus’s constitution illustrates. Courts apply many amendments to corporations because corporations are treated, in most cases, as artificial persons. The remainder of this chapter describes the amendments that most significantly affect the regulatory environment of business. Exhibit 5-1 summarizes the first 10 amendments.

THE FIRST AMENDMENT Freedom of Speech and Assembly The First Amendment guarantees freedom of speech, including gestures and other forms of expression, and of the press. It prohibits abridgment of the right to assemble peacefully and to petition the government for redress of grievances. Finally, it prohibits the government from aiding the establishment of religion and from interfering with the free exercise of religion. Like other rights, First Amendment rights are not absolute. For example, a person does not have the right to yell “Fire!” in a crowded theater. Nor does the First Amendment protect false statements about another that are injurious to that person’s reputation. Due to the difficulty of determining the boundaries of individual rights, courts hear a large number of First Amendment cases.

GLOBAL Context Constitution of Belarus We think of the Constitution as establishing our system of government and guaranteeing certain rights to us, but some nations’ constitutions actually impose duties on their citizens. For example, the constitution of Belarus requires everyone to protect the environment, preserve the nation’s historical and cultural heritage and other cultural treasures, and respect the dignity, rights, liberties, and legitimate interests of others.

In addition, although the U.S. Constitution’s Bill of Rights primarily restricts the government from interfering with our freedoms, some constitutions go much further in terms of giving people rights. For example, under the Belarus constitution, everyone has the right to an education, housing, and health care. Working people are entitled to work no more than 40 hours per week.




• Protects freedom of religion, press, speech, and peaceable assembly. • Ensures that citizens have the right to ask the government to redress grievances.


• Finds that a well-regulated militia is necessary for security. • States that government cannot infringe on citizens’ right to bear arms.


• States that government cannot house soldiers in private residences during peacetime or during war except for provisions in the law.


• Protects citizens from unreasonable search and seizure. • Ensures that government issues warrants only with probable cause.


• Ensures that government does not put citizens on trial except by the indictment of a grand jury. • Gives citizens the right not to testify against themselves. • Prevents government from trying citizens twice for the same crime. • Creates due process rights. • States that government cannot take private property for public use without just compensation.


• Provides the right to a speedy public trial with an impartial jury, the right to know what criminal accusations a citizen faces, the right to have witnesses both against and for the accused, and the right to have an attorney.


• States that in common lawsuits in which the monetary value exceeds $20, citizens have the right to a trial by jury.


• States that government will not set bail at excessive levels. • Prohibits government imposition of excessive fines. • Prohibits cruel and unusual punishment.


• States that although the Bill of Rights names certain rights, this does not remove other rights retained by citizens.


• States that powers that the Constitution does not give to the federal government are reserved for the states.

Exhibit 5-1 Summary of the Bill of Rights



Part I

LO 5-5 political speech Speech that is used to support political candidates or referenda. It is given a high level of protection by the First Amendment as compared to other types of speech.

LO 5-6 commercial speech Speech made by businesses about commercial matters, such as the sale of goods and services. It is protected by the First Amendment.

The Legal Environment of Business

Political Speech. The First Amendment protections also apply to corporations. Courts do not, however, treat all corporate speech the same. Sometimes corporations engage in political speech; that is, they support political candidates or referenda. At one time, states restricted firms’ political advertising because they feared that corporations, with their large assets, would drown out other voices. In the 1978 case First National Bank of Boston v. Bellotti, however, the U.S. Supreme Court considered the constitutionality of a Massachusetts law that prohibited certain corporations from spending money to influence voters on issues that did not materially affect the corporation. The Court held that the law was unconstitutional, stating, “The concept that the government may restrict speech of some elements of our society in order to enhance the relative voice of others is wholly foreign to the First Amendment.” The Court ruled that the First Amendment protects corporate political speech to the same extent as ordinary citizens’ political speech. Commercial Speech. Not all corporate speech is political speech. Commercial speech is speech that conveys information related to the sale of goods and services. Courts analyze government restrictions on commercial speech according to a four-part test established in Central Hudson Gas & Electric Corp. v. Public Service Commission of New York. The Central Hudson test is illustrated in Figure 5-2. In Case 5-3, the Supreme Court applied this test to several New York regulations. Unprotected Speech. The First Amendment right to free speech is not absolute. In the 1942 case Chaplinsky v. New Hampshire, the U.S. Supreme Court held: There are certain well-defined and narrowly limited classes of speech, the prevention and punishment of which have never been thought to raise any Constitutional problem. These include the lewd and obscene, the profane, the libelous, and the insulting or fighting words—those which by their very utterance inflict injury or tend to incite an immediate breach of the peace.

Figure 5-2 The Central Hudson Test for Commercial Speech


Does the speech concern an illegal activity? is it misleading? NO Is the government interest served by the restriction on commercial speech substantial?


YES Does the regulation directly advance the government interest asserted?


YES Is the regulation more extensive than necessary to serve the government interest? NO Speech is NOT PROTECTED by the First Amendment


Speech is PROTECTED by the First Amendment

CASE 5-3


FACTS: Bad Frog, a Michigan corporation, manufactures and markets alcoholic beverages under its Bad Frog trademark. Each label prominently features an artist’s rendering of a frog holding up its middle finger. Versions of the label feature slogans such as “He just don’t care,” “An amphibian with an attitude,” “Turning bad into good,” and “The beer so good . . . it’s bad.” In May 1996, Bad Frog’s New York distributor applied to the New York State Liquor Authority for brand-label approval and registration pursuant to Section 107-a(4)(a) of New York’s Alcoholic Beverage Control Law. NYSLA denied the application in July. Explaining its rationale for the rejection, the authority found that the label “encourages combative behavior” and that the gesture and the slogan, “He just don’t care,” placed close to and in larger type than a warning concerning potential health problems, foster a defiance of the health warning on the label, entice underage drinkers, and invite the public to disregard conventional wisdom and to disobey standards of decorum. In addition, the authority said it considered that approval of this label meant that the label could appear in grocery and convenience stores, with obvious exposure on the shelf to children of tender age, and that it is sensitive to the label’s adverse effects on a youthful audience. Bad Frog filed suit against the NYSLA in October 1996 and sought a preliminary injunction barring NYSLA from taking any steps to prohibit the sale of beer by Bad Frog under the controversial labels. ISSUE: Is the picture of a frog behaving badly on a product label entitled to protection as commercial speech? REASONING: In the words of the court: Bad Frog’s label attempts to function, like a trademark, to identify the source of the product. Though the label communicates no information beyond the source of the product, the minimal information suffices to invoke the protections for commercial speech, articulated in the Central Hudson Case.

Central Hudson sets forth the analytical framework for assessing government restrictions on commercial speech: [I]t at least must concern lawful activity and not be misleading. Next, we ask whether the asserted government interest is substantial. If both inquiries yield positive answers, we must determine whether the regulation directly advances the government interest asserted, and whether it is not more extensive than is necessary to serve that interest. The last two steps in the analysis have been considered, somewhat in tandem, to determine if there is a sufficient “‘fit’ between the [regulator’s] ends and the means chosen to accomplish those ends.” The burden

to establish that “reasonable fit” is on the governmental agency defending its regulation, though the fit need not satisfy a leastrestrictive-means standard. Applying the test, the labels concern lawful activity and not be misleading. The state claims two interests to support its asserted power to ban Bad Frog’s labels: (i) the State’s interest in “protecting children from vulgar and profane advertising” and (ii) the State’s interest “in acting consistently to promote temperance, that is, the moderate and responsible use of alcohol among those above the legal drinking age and abstention among those below the legal drinking age.”

Both of the asserted interests are “substantial” because states have a compelling interest in protecting the physical and psychological well-being of minors, which includes shielding minors from the influence of literature that is not obscene by adult standards. The state also has a substantial interest in regulating alcohol consumption. To meet the direct-advancement requirement, a state must demonstrate that the law will directly restrict harms to that interest. In terms of protecting children from vulgarity, the restriction fails. Because of the wide range of vulgar displays throughout contemporary society, including comic books targeted directly at children, barring such displays from labels for alcoholic beverages cannot realistically be expected to reduce children’s exposure to such displays to any significant degree. Attacking an almost insignificant part of a substantial problem is not sufficient. As to the state interest in temperance, there was no evidence that viewing that gesture on a beer label will encourage disregard of health warnings or encourage underage drinking. Thus the law fails the third prong. Finally, the law is more extensive than necessary to serve the asserted interest in insulating children from vulgarity. Less restrictive alternatives include restrictions on specific locations where children are more likely to view it, such as on billboards or on television advertising; restrictions on over-the-air advertising; and segregation of the product in the store. DECISION AND REMEDY: The court concluded that “the State’s prohibition of the labels from use in all circumstances does not materially advance its asserted interests in insulating children from vulgarity or promoting temperance, and is not narrowly tailored to the interest concerning children.” The court therefore reversed the lower court’s denial of Bad Frog’s request for injunctive relief with respect to the disapproval of its labels. SIGNIFICANCE OF THE CASE: The case illustrates the application of the Central Hudson test. 87


CRITICAL THINKING What law do you think would advance the state’s articulated interests without running afoul of the First Amendment?

ETHICAL DECISION MAKING Which stakeholders’ interests are advanced by this ruling? Which ones are harmed?

Thus, for example, the First Amendment does not protect defamation, or speech that harms the reputation of another. Moreover, as you will learn in Chapter 6, courts may require an individual who uses such speech to compensate the person whose reputation was harmed by the speech. The First Amendment does not protect obscenity, either, although in many cases courts find it difficult to determine whether particular speech constitutes obscenity. In the 1973 case Miller v. California, the U.S. Supreme Court established a three-part standard to determine whether speech is obscene: 1. Would the average person, applying contemporary community standards, find that the speech, taken as a whole, appeals to the prurient (marked by or arousing an immoderate or unwholesome interest or desire) interest? 2. Does the speech depict or describe, in a patently offensive way, sexual conduct specifically defined by law? 3. Does the speech, taken as a whole, lack serious literary, artistic, political, or scientific value?

establishment clause One of two provisions in the First Amendment of the U.S. Constitution that protect citizens’ freedom of religion. It prohibits (i) the establishment of a national religion by Congress and (ii) the preference of one religion over another or of religion over nonreligious philosophies in general.


If the answer to all three questions is yes, the First Amendment does not protect the speech in question. Can you identify any significant ambiguities in the Miller standard? Fighting words are a third class of unprotected speech. In Chaplinsky v. New Hampshire, a man protesting the government called the city marshal a “damned racketeer” and a “damned Fascist.” The city arrested him for violating a statute prohibiting the use of offensive, derisive, or annoying words toward another in a public place. The U.S. Supreme Court held: “The English language has a number of words and expressions which by general consent are ‘fighting words’ when said without a disarming smile. . . . Such words, as ordinary men know, are likely to cause a fight.” The Court further held that “‘damned racketeer’ and ‘damned Fascist’ are epithets likely to provoke the average person to retaliation, and thereby cause a breach of the peace.” Thus, the Court determined that the First Amendment did not protect the man’s speech. Many universities believe that hate speech, or derogatory speech directed at members of another group, such as another race, satisfies the definition of fighting words. Thus, 60 percent of universities have banned verbal abuse and verbal harassment, and 28 percent have banned advocacy of an offensive viewpoint. State and federal appellate courts have struck down many of these hate-speech codes, but no cases have reached the Supreme Court yet. The international community, however, is less protective of hate speech. For example, a United Nations declaration and a number of foreign laws state that hate speech is not a protected form of expression. Freedom of Religion The First Amendment contains two provisions that protect citizens’ freedom of religion. The establishment clause maintains that government “shall make no law

GLOBAL Context Free Speech in China The Chinese constitution does not guarantee freedom of speech or assembly, nor does it recognize any form of natural rights or human rights. Instead, it recognizes citizens’ rights, which are specifically enumerated in the Chinese constitution or laws. Not only does the Chinese constitution not provide protections for expressive activity, but numerous Chinese laws prohibit citizens from

engaging in political acts directed against the regime— acts that are protected in the United States. For example, Article 25 of China’s Publishing Control Act prohibits the publication of any material that opposes the basic rules of the constitution. Articles 7 and 12 of the Law on Assemblies, Processions, and Demonstrations prohibit assemblies, processions, and demonstrations that oppose these basic rules.

respecting an establishment of religion.” In the 1971 case Lemon v. Kurtzman, the U.S. Supreme Court codified the following three tests to determine whether a particular government statute violates the establishment clause: 1. Does the statute have a secular legislative purpose? 2. Does the statute’s principal or primary effect either advance or inhibit religion? 3. Does the statute foster an excessive government entanglement with religion? To determine whether the statute fosters an excessive government entanglement with religion, courts examine the character and purposes of the institutions benefited, the nature of the aid that the government provides, and the resulting relationship between the government and the religious authority. The free-exercise clause states that government cannot make a law “prohibiting the free exercise” of religion. Although government must remain neutral in matters of religion, determining whether a government action advances religion or merely allows free exercise of religion is often difficult. Likewise, determining whether a government action establishes religion or simply avoids interference with free exercise of religion is also difficult. Issues concerning the establishment clause and the free-exercise clause often arise in workplace settings. In government workplaces, this conflict sometimes raises difficult issues. For example, in 1966, Tucker, an employee of the California Department of Education, insisted on signing office memos with his name and the letters “SOTLJC,” an abbreviation for “Servant of the Lord Jesus Christ.” In an attempt to avoid workplace disruptions and the appearance of government support for religion, Tucker’s supervisor prohibited all displays of religious symbols in the workplace. The supervisor suspended Tucker for refusing to comply with the restrictions. When Tucker challenged the suspension on grounds that the rules interfered with his free exercise of religion, the appellate court agreed. In private workplaces, issues related to free exercise of religion most often arise under Title VII, the federal law prohibiting employment discrimination. We discuss this important legislation in detail in Chapter 24.

free-exercise clause A clause in the First Amendment of the U.S. Constitution that states that government (state and federal) cannot make a law “prohibiting the free exercise” of religion. This clause is interpreted to include absolute freedom to believe and freedom to act that may face state restriction.

THE FOURTH AMENDMENT Freedom from Unreasonable Searches and Seizures The Fourth Amendment guarantees citizens the right to be “secure in their persons, their homes, and their personal property.” Thus, it prohibits government from conducting unreasonable searches of individuals and seizing their property to use as evidence against them. A search is unreasonable if the government official conducting the search does not first obtain a search warrant from a court. A search warrant is a court order that authorizes law enforcement agents to search for or seize items specifically described in the warrant. Government officials can obtain search warrants only if they can show probable cause to believe that the search will uncover specific evidence of criminal activity. In other words, the government officials must have a sufficient reason based on known facts to obtain a warrant.

search warrant A court order that authorizes law enforcement agents to search for or seize items specifically described in the warrant.



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The Supreme Court has ruled, however, that in certain circumstances, government officials do not need a search warrant. For example, when law enforcement officials believe it is likely that the items sought will be removed before they can obtain a warrant, they may conduct a search without a warrant. Law enforcement officials frequently conduct automobile searches without a warrant according to this rule. In most other cases, though, law enforcement officials must obtain a warrant before conducting a search. For example, an Ohio law required buyers of five or more beer kegs to provide the beer distributor with the address of the party where the kegs would be consumed. Additionally, the law required the buyers to sign a form allowing police and liquor agents to enter their property without a warrant to search the premises to enforce state liquor laws. In 2001, a college professor challenged the law on grounds that it infringed on citizens’ Fourth Amendment rights. Before the court decided the case, Ohio repealed the law. Technological changes have raised interesting issues in the application of the Fourth Amendment. For example, because growing marijuana indoors requires heat lamps that use large amounts of electricity, when police found that a suspected marijuana grower had unusually high electric bills, they used an instrument that detects heat emissions to provide them with the evidence necessary to obtain a warrant to search his house physically. In determining whether using a thermal-imaging instrument on private property constituted an unlawful search, the Court asked whether using a thermal-imaging instruments is more like going through someone’s garbage, which had been previously held not to violate the Fourth Amendment, or more like using a high-powered telescope to look through someone’s window, which had been previously found to be a violation. In finding the use of this new technology more analogous to the latter type of search, the U.S. Supreme Court ruled that police use of thermal-imaging devices to detect heat patterns emanating from private homes constitutes a search that requires a warrant and further held that the warrant requirement applies also to any “more sophisticated systems” that give the police knowledge that in the past would have required physical entry of the home. Somewhat more recently, drug-sniffing dogs have had a surprisingly prominent role in the Supreme Court’s holdings related to the Fourth Amendment. In the 2013 case of Florida v. Jardines,1 the high court held that bringing a drug-sniffing dog onto someone’s front porch without a warrant violates the Fourth Amendment’s protection against warrantless searches. Justice Scalia wrote that a person’s minimal expectation of privacy extends not only to his house but to its immediate surroundings such as the porch. The outcome is somewhat different, however, if the drug-sniffing dog is accompanying an officer to a person’s vehicle for a routine traffic stop. In Florida v. Harris,2 an officer made a routine traffic stop of a truck, and when he walked up to the vehicle with the drug-sniffing dog, the dog, through its behavior, indicated the presence of illegal drugs in the door of the truck. The officer treated the dog’s behavior as giving him probable cause to search the interior of the door of the truck, where he subsequently found 200 pseudoephedrine pills and other methamphetamine precursors. In this case, the high court upheld the search. In addition to protecting individuals and their homes, the Fourth Amendment also protects corporations and places of business. This protection generally applies in criminal cases, but Fourth Amendment issues also arise when government regulations authorize administrative agencies to conduct warrantless searches. Although administrative searches usually require search warrants, courts have established an exception to this rule: If an industry has a long history of pervasive regulation, a warrantless search is not unreasonable. In such industries, administrative agencies can use warrantless searches to ensure that firms uphold regulations. This pervasive-regulation exception, however, is not always easy to interpret. Courts have ruled that warrantless searches authorized by the Federal Mine Safety and Health Act are legal because the federal regulatory presence is comprehensive and well defined. Thus, reasonable commercial-property owners ought to know that their property is subject to periodic inspections. 1 2

133 S. Ct. 1409 (2013). 133 S. Ct. 1050 (2013).


Chapter 5 Constitutional Law

A warrantless search based on the Occupational Safety and Health Act, however, may violate the Fourth Amendment because no significant legislation of working conditions existed before Congress passed that act in 1970. Hence, businesspeople covered by the law cannot reasonably anticipate warrantless searches.

CASE Nugget When Is the Consent of a Co-owner Sufficient Consent? Walter Fernandez v. California United States Supreme Court 134 S. Ct. 1126 (2014) Police officers saw Fernandez, a suspect in a violent robbery, run into an apartment building and heard screams coming from one of the apartments. When they knocked on the apartment door, Roxanne Rojas, who appeared to be battered and bleeding, answered. As soon as the officers asked her to step out of the apartment so that they could conduct a protective sweep, Fernandez came to the door and objected. Suspecting that Fernandez had assaulted Rojas, the officers removed him from the apartment and placed him under arrest. He was then identified as the perpetrator in the earlier robbery and taken to the police station. An officer later returned to the apartment and, after obtaining Rojas’ oral and written consent, searched the premises, where he found several items linking Fernandez to the robbery. The trial court denied Fernandez’s motion to suppress that evidence, and he was convicted. In determining that the Fourth Amendment rights of Fernandez had been not been violated by the search, the U.S. Supreme Court reviewed the firmly established law that police officers may search jointly occupied premises if one of the occupants consents and reaffirmed the narrow exception to this rule, that the consent of one occupant is insufficient when another occupant is present and objects to the search. However, it held that this exception does not extend to a case like that of Fernandez, in which consent was provided by an abused woman well after her male partner had been removed from the apartment they shared. A past objection to a search by an absent party does not invalidate consent by a present party with whom authority is shared. due process clause

THE FIFTH AMENDMENT The Fifth Amendment protects individuals in several important ways. First, it protects against self-incrimination, meaning that in a criminal case, the defendant does not have to testify in court as a witness against himself or herself. The Fifth Amendment also protects against double jeopardy. Thus, government cannot try a person more than once for the same crime. Due Process For businesspeople and corporations, the Fifth Amendment’s due process clause provides extensive protection. This clause states that government cannot deprive a person of life, liberty, or property without due process of law. The due process clause guarantees two types of due process: procedural and substantive. Procedural due process requires the government to use fair procedures when taking the life, liberty, or property of an individual or corporation. At a minimum, procedural due process

A clause in the Fifth Amendment of the U.S. Constitution providing that the government cannot deprive an individual of life, liberty, or property without a fair and just hearing.

procedural due process The requirement that a government must use fair procedures before depriving a person of his or her life, liberty, or property.


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entitles a person to notice of any legal action against her and to a hearing before an impartial tribunal. Originally, courts interpreted the due process clause as protecting an individual’s right of procedural due process only in federal criminal proceedings. The subsequent passage of the Fourteenth Amendment extended the requirement of due process to criminal proceedings by state governments. Today, courts apply the due process clause to diverse situations, including the termination of welfare benefits, food stamps, or Social Security benefits; the suspension of a driver’s license; the discharge of a public employee from his job; and the suspension of a student from school. The procedures that government must follow when taking an individual’s life, liberty, or property vary according to the nature of the taking. Generally, more procedures are necessary as the magnitude of potential deprivation increases.

CASE Nugget Can the United States Government Define Marriage as Between Only a Man and a Woman? United States v. Windsor United States Supreme Court 132 S. Ct. 2675 (2013) One of the most awaited Supreme Court decisions in 2013 was the case of United States v. Windsor, in which the high court ultimately struck down the Defense of Marriage Act (DOMA), an act that said that for purposes of all federal laws, a marriage must be between opposite sex partners. Even if a state recognized a marriage for same-sex partners, those partners were not considered married under federal laws. Obviously, this imposed a tremendous burden on same-sex couples, but it also made things more complicated for business because both state and federal laws impose certain obligations on employers to married employees, so in terms of their treatment of married employees, firms had to ensure that they treated some employees one way under state law and another way under federal law. As the constitutionality of DOMA was being debated, many thought that it would be struck down on grounds of federalism, that the state always has been and should be the one to define marriage. However, the court instead found that DOMA denies same-sex couples the dignity that the states intended them to have and sets them apart in a way that violates the due process and equal protection principles guaranteed under the Constitution. As Justice Kennedy explained in his majority opinion, “DOMA singles out a class of persons deemed by a State entitled to recognition and protection to enhance their own liberty. It imposes a disability on the class by refusing to acknowledge a status the State finds to be dignified and proper. DOMA instructs all federal officials, and indeed all persons with whom same-sex couples interact, including their own children, that their marriage is less worthy than the marriages of others. The federal statute is invalid, for no legitimate purpose overcomes the purpose and effect to disparage and to injure those whom the State, by its marriage laws, sought to protect in personhood and dignity. By seeking to displace this protection and treating those persons as living in marriages less respected than others, the federal statute is in violation of the Fifth Amendment.” This ruling will have a significant impact on how businesses must now treat a significant number of employees, bringing them under the umbrella of several federal statutes. substantive due process The requirement for laws depriving an individual of life, liberty, or property to be fair and not arbitrary.

Substantive due process refers to the basic fairness of laws that may deprive an individual of her life, liberty, or property. To satisfy the substantive due process requirement, government must have a proper purpose for enacting laws that restrict individuals’ liberty or the use of their property. The standard for determining whether a law violates substantive due process depends


Chapter 5 Constitutional Law

on the nature of the potential deprivation. Laws affecting fundamental rights must bear a substantial relationship to a compelling government purpose. These fundamental rights generally include the rights protected in the Constitution: the right to vote, the right to travel freely from state to state, the right to privacy, and so on. Compelling state interests include, for example, public safety and national security. Not all laws, however, affect fundamental rights. To show that a law that does not affect fundamental rights satisfies the substantive due process requirement, government must prove only that the law bears a rational relationship to a legitimate state interest. Courts uphold most government regulations according to this rational-basis test. For example, courts have upheld minimum-wage laws, rent control laws, banking regulations, environmental laws, and regulations prohibiting unfair trade practices according to the rational-basis test. The Prohibition against Uncompensated Takings The Fifth Amendment provides that when government takes private property for public use, it must pay the owner just compensation, or fair market value, for her property. This provision is called the takings clause, and it applies to corporations. Several significant issues have arisen with respect to the takings clause. For example, what constitutes a public use for which government can take private property? This issue is explored in depth in Chapter 6. The takings clause has prompted other issues as well. What happens, for instance, when a government regulation interferes so substantially with an individual’s use of her property that it effectively takes her property? For example, environmental regulations often affect the way landowners can use their property. Under the case of Lucas v. South Carolina Coastal Commission, the Supreme Court held that if a regulation is so extensive that it leaves the property owner with no economically viable use of his land, the regulation constitutes a taking, and the owner is entitled to compensation for the value of his property, even though the state did not seek to take title to his land. The Privilege against Self-Incrimination Although most provisions of the Fifth Amendment apply to corporations, corporations do not enjoy the Fifth Amendment’s protection against selfincrimination. Sole proprietors, however, are entitled to this protection. Thus, different businesses have different constitutional rights depending on their form of business organization. For example, in the 1988 U.S. Supreme Court case Braswell v. United States, the Court distinguished between the rights of corporate-record custodians and sole proprietors. Braswell was both the operator and the sole shareholder of his business. When a grand jury issued a subpoena requiring him to produce corporate books and records, Braswell argued that the subpoena violated his Fifth Amendment privilege against self-incrimination. The Court denied Braswell’s claim, writing that “subpoenaed business records are not privileged, and as a custodian for the records, the act of producing the records is in a representative capacity, not a personal one, so the records must be produced.” The Court held that the subpoena would have violated Braswell’s privilege against self-incrimination if his business had been a sole proprietorship.

THE NINTH AMENDMENT The Right to Privacy The Ninth Amendment states, “The enumeration in the Constitution, of certain rights, shall not be construed to deny or disparage others retained by the people.” Although this amendment does not expressly guarantee the right to privacy, courts have interpreted the Ninth Amendment, together with the First, Third, Fourth, and Fifth Amendments, as providing individuals with a right to privacy. In the 1965 case Griswold v. Connecticut, the Supreme Court ruled that a Connecticut law prohibiting the use of contraceptives was unconstitutional because it violated individuals’ right to privacy. Justice Douglas wrote: Specific guarantees in the Bill of Rights have penumbras [fringes]. . . . Various guarantees create zones of privacy. The right of association contained in the penumbra of the First Amendment is one.  .  . . The Third Amendment in its prohibition against the quartering of soldiers “in any house” in time of peace without the consent of the owner is another facet of that privacy. The

takings clause A clause in the Fifth Amendment of the U.S. Constitution requiring that when government uses its power to take private property for public use, it must pay the owner just compensation, or fair market value, for the property.


equal protection clause A clause in the Fourteenth Amendment of the U.S. Constitution that prevents states from denying “the equal protection of the laws” to any citizen. This clause implies that all citizens are created equal.

strict scrutiny The most exacting standard of review used by the courts in determining the constitutionality of a statute; requires a compelling government interest and the least restrictive means of attaining that objective.

intermediate scrutiny A standard of review under which a law must be necessary to achieve a substantial, or important, government interest and it must be narrowly tailored to that interest.

rational-basis test The lowest standard of review; requires a law to be designed to protect a legitimate state interest and be rationally related to that interest.

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Fourth Amendment explicitly affirms the “right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures.” The Fifth Amendment in its SelfIncrimination Clause enables the citizen to create a zone of privacy, which government may not force him to surrender to his detriment.

THE FOURTEENTH AMENDMENT Equal Protection The Fourteenth Amendment contains the equal protection clause, which prevents states from denying “the equal protection of the laws” to any citizen. This clause combats discrimination because it applies whenever government treats certain individuals differently than other similarly situated individuals, usually through a classification scheme. As with the due process clause, to determine whether a law violates the equal protection clause, courts use different standards based on the nature of the rights the classification affects. Three standards of scrutiny apply: strict scrutiny, intermediate scrutiny, and the rational-basis test. If a law prevents individuals from exercising a fundamental right, or if the law’s classification scheme involves suspect classifications, the action will be subject to strict scrutiny. Suspect classifications include classifications based on race, national origin, and citizenship. Courts uphold suspect classifications only if they are necessary to promote a compelling state interest. In cases involving suspect classifications, courts do not begin their analysis with a presumption that the classification is constitutional, so few laws pass the strict-scrutiny standard. For example, in the 1954 case Brown v. Board of Education, the U.S. Supreme Court ruled that the classification scheme used to segregate public schools racially violated the equal protection clause. Several courts have held, however, that in some cases, remedying past discrimination against a group is a compelling state interest. Chapter 24 discusses this issue in detail. If the law’s classification scheme is based on gender or on the legitimacy of children, courts use intermediate scrutiny. According to this standard, the law is constitutional only if it is substantially related to an important government objective. When a classification scheme involves other matters, courts apply a rational-basis test. According to this test, courts ask whether there is any justifiable reason to believe that the classification scheme advances a legitimate government interest. Because courts begin their analysis with a strong presumption that the government action is constitutional, almost all laws pass this test.

SUMMARY The U.S. Constitution

Federalism: The authority to govern is divided between two sovereigns, or supreme lawmakers: the federal government and the states. Separation of powers: The Constitution divides power among the legislative, executive, and judicial branches of government. The system of checks and balances allocates specific powers to each branch to keep the other branches from dominating government.

The Supremacy Clause and Federal Preemption

Federal supremacy: Any state or local law that directly conflicts with the U.S. Constitution or federal laws or treaties is void. Concurrent authority: Both state and federal governments have the power to regulate certain matters; generally, the federal government defers to the state. Federal preemption: The federal government uses this doctrine to strike down laws that do not directly conflict with a federal law but attempt to regulate an area within federal legislative jurisdiction.

The Commerce Clause

The commerce clause grants the federal government the authority to pass regulations that significantly affect interstate commerce. Today, this clause provides the basis for most federal government regulations.

Chapter 5 Constitutional Law


Police powers are the residual powers retained by states to pass laws to safeguard the health and welfare of their citizens. The dormant commerce clause prohibits states from passing laws that significantly interfere with interstate commerce. Taxing and Spending Powers of the Federal Government

Congressional taxes must be uniform across all states. Congress can use taxes and spending for purposes other than generating revenue; for example, it can use them to indirectly promote social goals.

Other Constitutional Restrictions on Government

The privileges and immunities clause prohibits states from discriminating against citizens of other states. The full faith and credit clause states that in civil matters, courts in all states must uphold rights established by legal documents. The contract clause states that Congress cannot pass laws that unreasonably interfere with existing contracts.

The Amendments to the Constitution

First Amendment: •

Protects corporate speech in certain circumstances. It protects corporate political speech to the same extent that it protects individuals’ political speech. The Central Hudson test determines whether the First Amendment protects particular corporate commercial speech. Contains the establishment clause, which states that Congress may not make laws respecting an establishment of religion, and the free-exercise clause, which states that Congress may not make laws prohibiting the free exercise of religion.

Fourth Amendment: •

Protects both corporations and individuals from unreasonable government searches and seizures. Although administrative searches generally require a warrant, administrative agencies may inspect some industries without a warrant to ensure compliance with industry regulations.

Fifth Amendment: •

States that government cannot take an individual’s life, liberty, or property without due process of law. There are two types of due process: procedural due process, which focuses on rules for enforcing laws and entitles individuals to notice of legal action against them, and substantive due process, which requires government to have a proper purpose for enacting laws that restrict individuals’ liberty or the use of their property. States that if government takes private property for public use, it must compensate the owner. The extent to which some government regulations constitute takings, however, generates much litigation. Includes a privilege against self-incrimination, although the provision does not apply to corporations. Only individual citizens and sole proprietorships may exercise this right. Guarantees individuals equal protection under the law. Courts use three standards of scrutiny in equal protection cases: (i) strict scrutiny, to analyze government actions that abridge fundamental rights or that include suspect classifications; (ii) intermediate scrutiny, to analyze classifications based on gender or on legitimacy of children; and (iii) the rationalbasis test, to analyze classifications involving other matters.

Ninth Amendment: •

Along with the First, Third, Fourth, and Fifth Amendments, this amendment provides individuals with a right to privacy.

Fourteenth Amendment: •

Applies the due-process clause to state governments and contains the equal protection clause, which prohibits states from denying the equal protection of the laws to any citizens.


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The Legal Environment of Business

Point/Counterpoint Is Judicial Review Consistent with Our System of Democracy? NO


Our system of government is one of popular sovereignty: Voters have the liberty to make the laws under which they will live. As established in Marbury v. Madison, judicial review permits the Supreme Court to strike down laws passed by Congress—laws that ostensibly represent the will of a majority of Americans. The Supreme Court, however, is not politically accountable. By declaring a law unconstitutional, the Supreme Court makes it enormously difficult for voters to overturn that decision; only an amendment to the Constitution (requiring approval of two-thirds of Congress and three-quarters of the state legislatures) can override it. Judicial review stymies voters’ liberty to govern themselves. Proponents of judicial review argue that it is necessary to protect the ideals in the Constitution. But the Constitution represents the values a majority of Americans held more than two centuries ago. The acts of the political branches of government, on the other hand, are more likely to reflect the values accurately of a majority of Americans today. Thus, to promote the values of a majority of Americans, the Supreme Court should refrain from judicial review. Judicial review is especially problematic because the nine unelected justices of the Supreme Court are not likely to reflect the views of the nation as a whole. A vast majority of the justices throughout American history have been white, male, and wealthy. Thus, the values they promote when they strike down legislative acts are likely to differ from the values of a majority of Americans.

Judicial review has an important role to play in ensuring that our democracy functions. Without the possibility of judicial review, elected representatives could pass laws to insulate themselves from political pressure. For example, Congress could pass a law making it a crime to criticize members of Congress. Such laws inhibit democracy from functioning well. The Supreme Court, insulated from political pressure, should exercise its power of judicial review to ensure participation and reinforce representation in the political process. Judicial review also allows the Supreme Court to transcend legislative preoccupation with immediate results and protect values at the center of our political system (e.g., protection of minority rights). Our system, moreover, has many countermajoritarian features. The Constitution established the Senate, in which Wyoming and California are on equal footing; and the electoral college, not a popular majority, elects the president. Senate rules permit filibustering, allowing one senator to obstruct a proposed piece of legislation unless a supermajority of senators override the filibuster. In short, our system is republican, not majority rule. Judicial review is not inconsistent with this form of government. Additionally, the Supreme Court has a high turnover rate. On average, a Supreme Court vacancy opens up every 22 months, so a one-term president can expect to fill two Supreme Court seats. This high turnover rate tends to ensure that the Court stays in step with the national pulse. And the political branches of government are not exactly the paradigms of deliberative democracy that high school textbooks make them out to be.

Questions & Problems 1. Explain how each branch of the government checks the power of the other branches. 2. How can both Sue and Sam be correct when Sue claims the commerce clause increases government’s power and Sam claims the commerce clause reduces government’s power? 3. What is the purpose of the contract clause? 4. How does the contract clause affect state regulation?

5. How does the First Amendment protection of corporate political speech differ from the protection of corporate commercial speech? 6. Taxpayers in the state of Kentucky alleged that a tax on out-of-state municipal bonds that excluded interest from in-state bonds was a violation of the commerce clause. Representatives of the state argued that the tax reflected a traditional government function that could persist without any differential treatment

Chapter 5 Constitutional Law

of local interests against the similar interests of outof-state entities. Additionally, because Kentucky itself participates in the bond market, its potential discrimination should be found allowable. How would you have ruled in this case? Why? [Department of Revenue of Kentucky v. George W. Davis, 553 U.S. 328 (2008).] 7. A group of winemakers from California and several Massachusetts residents challenged a Massachusetts law that distinguishes how large wineries and small wineries may distribute their wines in the state of Massachusetts. The Massachusetts law defined wineries that produced over 30,000 gallons of wine as “large” and allowed these wineries either to sell directly to consumers or to sell through wholesalers, but not both. On the other hand, “small” wineries could use both distribution methods. Conveniently, all wineries in Massachusetts were below the 30,000 gallon cap. Thus, the only wineries being blocked from certain forms of distribution were wineries from outside of the state. These out-of-state winemakers decided to sue the state of Massachusetts, claiming that the state’s laws on this matter violated the commerce clause by giving in-state businesses an unfair advantage over out-of-state businesses. The district court concluded that this Massachusetts law unconstitutionally discriminated against interstate commerce and ruled in favor of the plaintiffs, granting injunctive relief. The defendant representatives of the state of Massachusetts appealed this decision. How do you think the court ruled in the appeal? Why? [Family Winemakers of California v. Jenkins, United States Court of Appeals for the First Circuit 592 F. 3d 1 (2010).] 8. Delaware enacted an apprentice regulatory scheme to “develop and conduct employee training and registered apprenticeship programs” and to provide “for the establishment and furtherance of standards of apprenticeship and training to safeguard the welfare of apprentices and trainees.” Under the state’s prevailing wage regulations, contractors who participated in the program could pay their apprentices significantly lower wages on certain public works projects. One of the requirements for having a registered apprenticeship training program that would qualify a contractor to pay these lower wages was to be a Delaware Resident Contractor or hold and maintain a Delaware Resident Business License. “The Registrant must hold and maintain a permanent place of business, not to include site trailers or other facilities serving only one contract or related set of contracts.” Thus, out-of-state contractors were basically excluded from participating in the program and qualifying for paying the lower wages. Tri-M, an out-of-state contractor


who could not participate in the apprenticeship program and thus take advantage of paying lower wages to apprentices unless he established a permanent facility in the state of Delaware, sought a declaratory judgment and injunctive relief against enforcement of the Delaware prevailing wage law and the Delaware apprenticeship and training law. On what constitutional grounds do you think Tri-M sought this injunction? Why do you believe Tri-M should have won or lost its case? [Tri-M Group v. Sharp, 638 F. 3d 406 (2011).] 9. The Entertainment Software Association (ESA), representing video game developers such as Sony Computer Entertainment and Nintendo, filed a motion for a permanent injunction in Illinois, claiming that the Illinois Sexually Explicit Video Game Law (SEVGL) was a content-based restriction on speech. The ESA argued that the law requiring the marking “18” on games containing sexually explicit images was subjective and failed to meet the Central Hudson test. The district court agreed. Representatives of the state, including then-governor Rod Blagojevich, appealed the decision, arguing that the law was narrowly tailored to promote a legitimate state interest. Using the four steps of the Central Hudson test, how do you think the court of appeals decided the case? [Entertainment Software Association v. Blagojevich et al., 469 F.3d 641 (2006).] 10. Members of the Old Order Groffdale Conference Mennonite Church have traditionally used horses and buggies for transportation. They began using tractors about 40 years ago, especially for hauling their agricultural products to market. To ensure that the tractors are not used to displace horses and buggies, the Order requires steel cleats that slow the speed of the tractors to be attached to the wheels of all tractors driven by church members. To minimize damage to the road from these cleats, the Order made them larger and mounted them on rubber belts, but in 2009, after determining that the cleats were damaging newly resurfaced roads, Mitchell County passed an ordinance providing that, “No tire on a vehicle moved on a highway is allowed to have any block, stud, flange, cleat or spike or any other protuberances of any material other than rubber.” Zimmerman, a Mennonite, continued to operate his tractor on the road with the steel cleats attached to the tires and was cited for violating the ordinance. Zimmerman filed a motion to dismiss the charges on grounds that the law violated his First Amendment right to free exercise of religion, and the trial court denied his motion. How do you think the state’s supreme court should have decided the appeal, and why? [Mitchell County v. Zimmerman, 810 NW 2d 1 (2012).]


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11. For more than a century, a memorial, 43-foot, Latin Cross had been present at Mount Soledad, but in 1989, the city of San Diego was sued on grounds that the presence of the cross violated the First Amendment. In response to a court ruling that the cross had to be removed and sold to the highest bidder, the city simply sold the land to a nonprofit association, which then spent around $1 million making the cross the centerpiece of a Korean War memorial. A decade of litigation followed. Finally, in 2006, a federal judge ordered the city to remove the cross. However, Congress obtained the land through eminent domain to preserve it in its original state. In response, the Jewish War Veterans of the United States of America and others represented by the American Civil Liberties Union brought a lawsuit challenging Congress’s taking of the memorial and the presence of the cross on federal property under the establishment clause. The parties alleged that congressional preservation of the cross denoted an unfair advancement of a religion and an excessive entanglement with a religion. The district court ruled the cross constitutional because, instead of promoting a religion, it was there to promote the service of veterans. However, the Ninth Circuit Court of Appeals, after conducting an inquiry into the purpose and history of the memorial, learned that “the Memorial has a long history of religious use and symbolism that is inextricably intertwined with its commemorative message. This history, combined with . . . the prominence of the Cross in the Memorial, leads us to conclude that a reasonable observer would perceive the Memorial as projecting a message of religious endorsement, not simply secular memorialization” and therefore violates the establishment clause. What test did the Court of Appeals use to come to its conclusion? [Trunk v. City of San Diego, 629 F.3d 1099 (2011).] 12. In 2007, the Prescription Confidentiality Law was passed in the state of Vermont. One of the key measures of the law stipulated that without a doctor’s consent, any documents containing information about prescribing practices could not be sold or used for marketing. The law was in response to the practice of companies using doctors’ personal prescribing histories without the doctor’s knowledge. Subsequently, pharmaceutical and data companies argued that the law violated their First Amendment rights by restricting their speech without good reason. Are the

companies right? How did the court decide? [Sorrell v. IMS Health Inc., 131 S. Ct. 2653 (2011).] 13. The city of Toledo, Ohio, passed the Clean Indoor Air Ordinance, which, among other provisions, required smoking to be prohibited in bars and restaurants except in separate smoking lounges that met very specific criteria. The lounge could not constitute more than 50 percent of the establishment’s square footage into which the public is invited, must have a separate ventilation system, and cannot be located in an area where employees are required to work or that the public must walk through to go to the restroom. An association of bar and restaurant owners challenged the law as a regulatory taking. The district court denied the claim, and the association appealed. How do you think the appellate court ruled and why? [D.A.R.E. Inc. v. City of Toledo, 393 F.3d 692 (2005).] 14. In April 1986, the FBI arrested Larry Dean Dusenbery in his home. After the FBI removed Dusenbery from the premises and placed him in custody, it obtained and executed a search warrant for his property. During the search, FBI agents seized drugs, drug paraphernalia, weapons, an automobile, and $21,939 in currency. Dusenbery pleaded guilty to a charge of possession with intent to distribute. The trial court sentenced him to 12 years in prison and a 6-year special parole. Two years later, the FBI began administratively to forfeit the seized possessions. This process required the FBI to send written notice of the forfeiture procedures to Dusenbery. The FBI, in accordance with this policy, sent letters to Dusenbery by certified mail to the federal corrections institution where he was incarcerated. The FBI sent identical letters to his home address and his mother’s address. The FBI received no response but nevertheless proceeded with the forfeiture of his assets. Five years later, Dusenbery filed a motion requesting the FBI to return his property to him. He received a response from the U.S. government informing him that the FBI had returned all property not used in the drug business and had forfeited the rest of it. Dusenbery filed a civil suit claiming that the FBI denied his right of due process when it forfeited his property because he had never received the letter from the FBI. The district court ruled that the FBI had not violated his due process rights; the FBI satisfied his rights when it sent the notice. How do you think the appellate court ruled in this case? Why? [Dusenbery v. United States, 534 U.S. 161 (2002).]


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CASE OPENER Untenable Trading Mathew Martoma, a portfolio manager for Steven Cohen’s SAC Capital Advisors LP, was accused of illegal insider trading by the U.S. Securities and Exchange Commission (SEC) in July 2008. The SEC subsequently sued Martoma, his former hedge fund, and the doctor accused of giving Martoma insider information. Allegedly, Wyeth LLC (PFE) and Elan Corp. (ELN) were two companies developing an Alzheimer’s drug that performed poorly. When one of the doctors involved in the drug trials called Martoma, he was informed of such information. He then told Cohen to sell his company’s shares of the drug companies to avoid losses. The results of the drug tests and trials had not been released to the public before Martoma was informed of them and passed them on. Ultimately, the SEC could not prove that Cohen knew the advice Martoma received was illegal; thus, he was exluded from the lawsuit. However, Martoma’s tips netted the company a record-breaking $276 million. Thus, the SEC charged Martoma with two counts of securities fraud and conspiracy. 1. 2.

Do you believe Martoma did anything illegal? Anything unethical? If a person has inside information and does not trade on it himself but passes it on another who uses it to trade, is the person who passed on the information guilty of insider trading?

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

LO 6-1

What are the basic elements of a crime?

LO 6-2

How are crimes classified?

LO 6-3

Who can be held responsible when a corporate crime is committed?

LO 6-4

What are the basic steps of a criminal proceeding?

LO 6-5

What laws attempt to prevent white-collar crime? 99


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This chapter helps the future business manager recognize when conduct has become criminal. The discussion begins by introducing the elements of a crime and explaining some common crimes that occur in the business context. After discussing how liability can be imposed on corporations and corporate executives, the chapter sets forth the steps of criminal procedure. The chapter concludes by discussing some of the laws used to fight business crime. As the Case Opener illustrates, criminal behavior can come in many forms and affect large numbers of people. Also, crimes can quickly expand in terms of the number of people involved. It is important to note that Martoma and Cohen and everyone Cohen told made large sums of money at the expense of other investors. Although some crimes in commercial settings might seem like victimless ones at first, crimes always have victims, even if they are not readily identifiable.

LO 6-1

The Nature and Elements of a Crime The purpose of criminal law is to punish an offender for causing harm to public health, safety, or morals. In a criminal proceeding, the government files the charges against the defendant. Thus, the government is always a party to a criminal action. Government involvement distinguishes criminal trials from civil proceedings. As you may recall from Chapter 3, an individual person or corporation can file a civil lawsuit. This difference exists because in a criminal trial, society is seen as the victim, whereas a civil trial involves an individual victim or victims. In many situations, a particular course of conduct may lead a defendant to be prosecuted for committing a crime and to be sued in civil court for compensation by the victims of the crime. The outcome of the two cases may not be the same, however, for a number of reasons. As you will learn, the precise elements needed to prove the resulting criminal and civil cases will be different, and whereas many of the steps of civil and criminal procedure are the same, the defendant has additional protections in the criminal case. For example, the burden of proof in the criminal case is beyond a reasonable doubt, which is a much higher standard than that of a civil case, which, as you learned in Chapter 3, is a preponderance of the evidence. You will learn about many of the additional protections afforded criminal defendants later in this chapter.

ELEMENTS OF A CRIME Criminal laws usually define criminal behavior and set guidelines for punishment. To punish an individual for criminal behavior, the government must demonstrate the two elements of a crime: actus reus Latin for “guilty act”; a wrongful behavior that is associated with the physical act of a declared crime.

mens rea Latin for “guilty mind”; the mental state accompanying a wrongful behavior.

1. Wrongful behavior, that is, actus reus (guilty act). 2. Wrongful state of mind, also known as mens rea (guilty mind). The government thus must show that a defendant committed a prohibited act with a wrongful intent. To prove the first element, actus reus (guilty act), the government must establish the nonmental elements of the crime. That is, the government must demonstrate that a prohibited act or a prohibited consequence resulted because of the behavior of the defendant. To prove the second element, mens rea (guilty state of mind), the government must prove that the defendant acted with the state of mind required by the law defining the relevant offense. The state of mind required by an offense may be purposeful, knowing, reckless, or negligent. The defendant’s type of wrongful state of mind helps determine the seriousness of the punishment for the crime. A defendant can purposefully commit a crime by engaging in a specific wrongful behavior to bring about a specific wrongful result. A defendant can knowingly commit a wrongful act if the person knows the act is wrongful or believes that the act is wrongful yet does nothing to confirm or disconfirm this belief. A defendant is reckless if a criminal act occurs when the individual consciously ignores substantial risk. Finally, a defendant is negligent if he or she does not meet a standard of care that the reasonable person would use in the context that led to the criminal act.

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In certain cases, liability may be assessed even without establishing the guilty-mind criterion just mentioned. Only certain crimes, typically violations of regulatory statutes, allow punishment to be assessed without having to prove a guilty mind. When liability is assessed without the guilty-mind criterion, it is known as liability without fault or strict liability. Liability without fault involves actions that, regardless of the care taken, are deemed illegal to engage in; such acts are specifically prohibited regardless of state of mind. Liability without fault would apply, for example, if a business were to sell cigarettes or alcohol to a minor. Although the business might not have intended to sell cigarettes or alcohol to a minor (thus lacking a guilty mind), the statutory violation still allows liability to be imposed.

liability without fault A legal term that imposes responsibility for damages regardless of the existence of negligence. Also called strict liability.

B UT W HAT IF . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall that in the Case Opener, Martoma advised Cohen to buy and sell securities on the basis of his tip. Instead, what if Martoma believed he was discussing the poor performance of the new drugs with a close friend and did not believe this friend would ever financially benefit from such information? How would such a change affect mens rea?

LO 6-2

CLASSIFICATION OF CRIMES Crimes are divided into categories based on the seriousness of the offense. Today, the categories used are felonies, misdemeanors, and petty crimes. Felonies include serious crimes, such as murder, that are punishable by imprisonment for more than one year in a penitentiary or by death. Misdemeanors are less serious crimes punishable by fines and/or imprisonment for less than one year. Petty offenses, such as violating a building code, are minor misdemeanors and are usually punishable by a jail sentence of less than six months or a small fine. The statute defining the crime usually establishes whether the crime is a felony, misdemeanor, or petty offense. Crimes may also be federal or state, depending on whether they are created by the state or federal legislature.

felony A serious crime, such as murder, rape, or robbery, that is punishable by imprisonment for more than one year or by death.

misdemeanor A crime that is less serious than a felony and is punishable by a fine and/or imprisonment for less than one year.

petty offense

White-Collar Crime Originally, white-collar crimes were distinguished from other crimes because of the social status of the offender. The more modern approach is to define white-collar crime as a variety of nonviolent illegal acts against society that occur most frequently in the business context. Clearly, the crimes described in the Case Opener fall under this broad definition of white-collar crime. Mail fraud, bribery, embezzlement, and computer crimes are examples of offenses typically classified as white-collar crimes. These crimes occur more frequently than you might think. According to some estimates, one in three American households is the victim of white-collar crime every year. The consequences of white-collar crimes are far-reaching. First, the cost of white-collar crimes can be tremendous. According to some estimates, fraud in the health care industry alone costs society over $100 billion each year. Second, when company employees commit the crime, many companies fail to report the crime to avoid publicity. Third, white-collar crimes can be costly to the environment. For example, improper disposal of chemicals, such as dumping chemicals in a stream, has long-term repercussions for marine life, the surrounding ecosystem, and any humans who may come in contact with the contaminated water source. Of course, the amount of money collected in fines from corporate executives engaged in criminal activity has not been insignificant either. For example, in 2010, the federal government

A minor crime that is punishable by a small fine and/or imprisonment for less than six months in a jail.

LO 6-3 white-collar crime A variety of nonviolent illegal acts against society that occur most frequently in the business context.


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collected $2.8 billion in restitution, criminal fines, and felony assessments in criminal cases.1 Fines, however, are only one way that those found guilty of fraud and other white-collar crimes might be punished. There are at least four other ways to punish white-collar criminals. First, incarceration has been mandated for certain types of white-collar crimes. As the prevalence of white-collar crime has increased, so too has the number of white-collar offenders who are in jail. Second, whitecollar criminals may be ordered to do community service, such as giving speeches about business crime. For instance, junk-bond king Michael Milliken was compelled to give speeches about corporate crime after he was convicted of insider trading. Third, judges may disqualify the individual from employment. For instance, the judge may prohibit the offender from engaging in an occupation in which the same or a similar criminal act could occur again. Fourth, the offender can be placed under house arrest. Individuals must wear a sensor so that the government can monitor whether they have left their houses. With changes in technology, and governments that are increasingly pressed financially, governments are increasingly looking for sentences other than imprisonment for nonviolent offenders. People in the criminal justice field are also starting to recognize that there is something wrong with a system that results in a higher incarceration rate in the United States than in other industrialized nations. According to the most recent statistics, the United States was incarcerating 770 persons per 100,000, whereas the rate in Europe was around 110 per 100,000.

SPECIFIC WHITE-COLLAR CRIMES bribery A corrupt and illegal activity in which a person offers, gives, solicits, or receives money, services, or anything of value to gain an illicit advantage.

Bribery One of the better-known white-collar crimes is bribery. Bribery is the offering, giving, soliciting, or receiving of money or any object of value for the purpose of influencing the judgment or conduct of a person in a position of trust. Bribery of a public official is a statutory offense under federal law. The purpose of this law against bribery is to maintain the integrity of the government. This statute also covers bribes offered to witnesses in exchange for testimony. Perhaps one of the most publicized examples of bribery was the 2002 Winter Olympics bribery scandal in Salt Lake City, Utah. The Salt Lake City Olympics Bid Committee allegedly gave International Olympic Committee members between $4 million and $7 million in cash and other benefits. These benefits included college tuition assistance payments, shopping trips for bathroom fixtures and doorknobs, and trips to the Super Bowl. More common, however, is the simple cash bribe to obtain a government contract. For example, in 2008, the CEO of a multimedia communications company was convicted of paying over $200,000 in bribes to the technology director of Atlanta Public Schools to secure contracts to help connect schools in poor and rural areas to the Internet. He was sentenced to a five-year prison term and payment of restitution. The government official who had accepted the bribe, and ultimately testified against the man who bribed him, was sentenced to three years in prison.2 To demonstrate bribery under this statute, the government must show three elements: (1) something of value was offered, given, or promised to; (2) a federal public official with; and (3) intent to influence that person’s judgment or conduct. The “thing of value” element has been construed very liberally; actual commercial value is not necessary. For instance, had the Salt Lake City Olympics Bid Committee given a member of the International Olympic Committee shares of stock in a new Silicon Valley start-up called BellyUp.com but the shares turned out to be worthless because the start-up was never established, this act may constitute bribery even though the stock is commercially worthless. Ultimately, the Department of Justice was unable to prove any of the 15 charges of bribery that it had filed against two members of the Salt Lake City Olympics Bid Committee. Several members of the committee resigned, however. As a result of investigations into the matter, 10 members of the International Olympics Committee were fired and another 10 were sanctioned. 1

Department of Justice, “U.S. Attorneys Contributed to $6.68 Billion in Civil & Criminal Collections in Fiscal Year 2010,” December 16, 2010, www.justice.gov/usao/cae/news/docs/2010/12-16-10CollectionsPressreleaseFY2010.pdf 2 “Georgia Man Sentenced for E-Rate Bribery,” AsianFanaticsForum, December 28, 2008, asianfanatics.net/forum/topic/612815-georgiaman-sentenced-for-e-rate-bribery/

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Additionally, the definition of “public official” is also expansive. The statute defines public officials as members of Congress, government officers and employees, and anyone “acting for or on behalf of” the federal government “in any official function, under or by authority of” a federal government department or agency. For example, individuals who work for private corporations that have some degree of responsibility for carrying out federal programs or policies are considered public officials. Another type of bribery is commercial bribery, which includes a bribe in exchange for new information or payoffs. For example, suppose Comdac Computers is looking for a company that manufactures a certain type of computer part. Jane Devlon owns such a company and realizes that if Comdac gets the computer parts from her, she will potentially make a lot of money. When Comdac sends its contractor to the Devlon factory, Devlon offers the contractor $500,000 in exchange for the contractor’s promise that Comdac will buy all such parts from only her factory for the next year. Alternatively, she might offer the contractor $5,000 to disclose the dollar amounts of the competing bids so that she can offer a better bid to earn the contract. One final type of bribery is the bribery of foreign officials. The purpose of the Foreign Corrupt Practices Act (FCPA) is to combat such bribery. The FCPA prohibits payments to foreign officials to influence an official act or decision corruptly or to influence a foreign government. You might think of the FCPA as an extension of the law to prevent bribery of a public official. The FCPA allows the government to prosecute those who bribe foreign officials. But Congress does not pass laws affecting foreign affairs in a vacuum. Laws governing whitecollar crime, like all laws, are dynamic, and one source of change in these laws is international law. Multinational organizations in which the United States is a member often pressure the United States to alter American law so that it conforms to certain international standards. Thus, for example, Congress amended the FCPA in 1998 to conform to the antibribery convention adopted by the Organization for Economic Cooperation and Development (OECD). The amendments broaden the scope of actions the FCPA and the definition of a public official cover. As of this writing, 30 OECD countries—such as Japan, South Korea, and Brazil—are expected to adopt similar antibribery statutes. Extortion Often confused with bribery, but completely different, is the crime of extortion. Extortion, otherwise known as blackmail, is the making of threats for the purpose of obtaining money or property. Whereas bribery is offering someone something to obtain a desired result, extortion involves the threat of doing something if the target of the extortion does not relinquish money or a specific piece of property. For example, if Cohen in the Case Opener threatened to tell the SEC government about Martoma’s actions if he did not pay Cohen $500,000, then Cohen would have committed extortion. Cohen’s actions would have been extortion because he would have issued a threat (to tell the SEC about Martoma’s insider trading) for the purpose of obtaining money. Fraud Criminal fraud encompasses a variety of means by which an individual intentionally uses some sort of misrepresentation to gain an advantage over another person. Fraud generally requires the following three elements: (1) a material false representation made with intent to deceive (scienter), (2) a victim’s reasonable reliance on the false representation, and (3) damages. Both the federal and the state governments have passed a number of statutes codifying specific types of fraudulent schemes. These schemes to defraud include a multitude of frauds, such as credit card fraud, insurance fraud, and securities fraud. Exhibit 6-1 summarizes the fraudulent acts that might occur in the corporate setting, many of which are discussed in this chapter. One of the FBI’s largest securities fraud crackdowns occurred in June 2000, when it arrested a group of Mafia leaders for a series of scams that cost investors an estimated $25 million. Government officials claimed that the Mob bought large stakes in small companies and then bribed and coerced brokers to promote the stocks to other investors at inflated prices. The Enron scandal also involved securities fraud, with Enron’s top executives allegedly overstating its earnings to maintain high stock prices. Complex accounting methods were used to

extortion A criminal offense in which a person obtains money, property, and/or services from another by wrongfully threatening or inflicting harm on the other’s person, property, or reputation. Also called blackmail.

fraud An intentional deception that causes harm to another.


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Exhibit 6-1 1. Forgery: The fraudulent making or altering of any writing in a way that changes the legal rights and liabilities of another. 2. Defalcation: The misappropriation of trust funds or money held in a fiduciary capacity. 3. False entries: The making of an entry into the books of a bank or corporation that is designed to represent the existence of funds that do not exist. 4. False token: A false document or sign of existence used to perpetrate a fraud, such as making counterfeit money. 5. False pretense: A designed misrepresentation of existing facts or conditions by which a person obtains another’s money or goods, such as the writing of a worthless check. 6. Fraudulent concealment: The suppression of a material fact that a person is legally bound to disclose. 7. Mail fraud: The use of mails to defraud the public. 8. Health care fraud: Any fraudulent act committed in the provision of health care products or services. 9. Telemarketing fraud: Any scheme, including cramming and slamming, using the telephone to commit a fraudulent act. 10. Ponzi scheme: An investment swindle in which high profits are promised from fictitious sources and early investors are paid off with funds raised from later ones. 11. Check kiting: Drawing checks on an account in one bank and depositing them in an account in a second bank when neither account has sufficient funds to cover the amounts drawn. Just before the checks are returned for payment to the first bank, the kiter covers them by depositing checks drawn on the account in the second bank. Due to the delay created by the collection of funds by one bank from the other, known as the float time, an artificial balance is created. 12. Pretexting: Using fraudulent means to obtain information about someone’s phone use.

Selected Fraudulent Crimes

insider trading The illegal buying or selling of a corporation’s stock or other securities by corporate insiders, such as officers and directors, in breach of a fiduciary duty or some other relationship of trust and confidence, while in possession of material, nonpublic information about the security.

hide the corporation’s debt. Enron’s top executives and big investors sold their stocks while encouraging employees to continue buying company stocks. With the drastic decline in the company’s stock value, many Enron employees lost much of their 401(k) investments. Another specific type of securities fraud involved in the Enron case, as well as in this chapter’s Case Opener, is insider trading. Illegal insider trading is generally a person’s buying or selling of a security, in breach of a fiduciary duty or some other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider-trading violations also include tipping such information, securities trading by the person tipped, and securities trading by those who misappropriate such information.3 Enron’s big investors and top executives knew the stock prices were inflated due to the overstated earnings. They then used their knowledge, which was not public knowledge, to decide to sell off their stock before the price lowered drastically, thus engaging in insider trading. Consider how insider trading might violate each of the ethical norms we have previously discussed. In March 2011, another apparent insider-trading scheme came to light when it was alleged that a corporate lawyer and a trader operated an insider-trading scheme that lasted decades and earned the two $32 million. The lawyer worked for a mergers and acquisitions firm, and he gave nonpublic information about deals the firm was working on to his partner, the trader, so that he could make appropriate stock trades using this information. One of their alleged profitable inside trades occurred when information that the lawyer acquired in April 2009 about Oracle’s proposed bid for Sun Microsystems led the trader to purchase more than 4 million shares of the target company, which he was then able to make a handsome profit on when the deal closed in 2010.4 3 4

U.S. Securities and Exchange Commission, www.sec.gov/answers/insider.htm Ben Protess, “Two Charged in Insider Trading Scheme Linked to Law Firms,” The New York Times, April 6, 2011.


Chapter 6 Criminal Law and Business

Another example of insider trading involves Qwest Communications, a Denver-based local phone provider in 14 western and midwestern states. Qwest has been under investigation over the past few years for various white-collar crimes, including insider training. Robin Szeliga, Qwest’s former chief financial officer, is the highest-ranking official at Qwest to admit wrongdoing in the scandal. She admits to selling 10,000 shares of Qwest stock in 2001 for a net profit of $125,000. Szeliga knew some of Qwest’s business units would not meet their targets. She also knew Qwest had illegally used nonrecurring revenue to try to meet its goals. Because the information Robin acted on was not public, and because she gained substantially by acting on the private information, Szeliga pleaded guilty to a single count of insider trading. Stock-option backdating is yet another type of securities fraud that the SEC has been increasingly cracking down on. Backdating occurs when an employee falsifies documents to make it appear as though the company had granted options on certain dates, but the dates are selected after the fact by looking backward for dates on which the stock price was low, thereby falsely inflating the net profits of the company. In 2007, Myron F. Olesnyckyj, the former general counsel of Monster Worldwide, Inc., pleaded guilty to securities fraud for participating in a multiyear scheme with other Monster executives to secretly backdate stock options granted to thousands of Monster officers, directors, and employees, including himself. By backdating and improperly accounting for options, Monster granted undisclosed compensation to its employees, failed to recognize compensation expenses, and overstated its net income by $340 million from 1997 through 2005. Olesnyckyj personally made $381,000 from the scheme, which he agreed to forfeit. An additional type of fraud is false pretense. False pretense is the illegal obtaining of property belonging to another through materially false representation of an existing fact, with knowledge of the falsity of the representation and with the intent to defraud. For example, Jim goes door-to-door selling vacuum cleaners at an amazing discount. To obtain the discount, the customers must pay immediately, and the vacuum cleaner will be delivered in three to five business days. However, Jim possesses no vacuum cleaners and does not plan to deliver any. Jim has committed the crime of false pretense because he illegally obtained another’s property (the money he received as payment) by making a false representation (telling the customers they would be receiving a vacuum) with the knowledge of the falsity (he knew there were no vacuum cleaners) and the intent to defraud (he did not plan to deliver any vacuum cleaners). Forgery, the fraudulent making or altering of any writing in a way that changes the legal rights and liabilities of another, is another type of fraud. If you sign your colleague’s name to the back of a check made out to your colleague, you have committed forgery. One of the most frequently prosecuted frauds is mail fraud, which is the use of mails to defraud the public. The Mail Fraud Act of 1990 makes mail fraud a federal crime. To prove mail fraud, the government must demonstrate two elements: (1) an intent to defraud and (2) the use of or causing the use of mails to further the fraudulent scheme. Case 6-1 demonstrates the consideration of these two elements.

CASE 6-1

false pretense The illegal obtaining of another’s property by making a materially false representation of an existing fact, with knowledge of the falsity of the representation and with the intent to defraud.

forgery A criminal falsification by imitating, impersonating, or altering a real document with the intent to deceive or defraud.


FACTS: Svete, Girardot, and their agents were in the business of selling financial products based on agreements with viators, or persons who have terminal illnesses and sell their life insurance policies to third parties for

less than the mature value of the policies. Investors who purchased these financial interests from agents of Svete and Girardot testified at trial that the sales agents made fraudulent statements and provided them with mail that

(continued) contained false statements regarding the life expectancies of viators, the status of the contracts, and risks associated with investments. The invested plaintiffs claimed that the defendants included statements by “medical specialists who had access to the viators’ medical records,” but that these statements were false. The plaintiffs commented that, in fact, these viators were not terminally ill, and the information provided by so-called medical professionals was incomplete. Companies controlled by Svete obtained more than $100 million from more than 3,000 investors. Several of the investors that signed contracts with the defendants testified that they did not read or understand the contracts. Nanette Zima, who served as the president of the brokerage company Svete formed, LifeTime Capital, Inc., testified that Svete and Girardot instructed her to alter contracts that had been signed by investors without the knowledge or consent of the investors who had signed them. In defense, Svete and Girardot argued that a person of “ordinary prudence and sophistication” would have read the contracts and disregarded the false statements. The defendants requested a jury instruction based on this argument. Instead of providing the requested jury instruction, the district court gave the pattern jury instruction of mail fraud. ISSUE: Does the crime of mail fraud require proof that the scheme was capable of deceiving a reasonably prudent person?

REASONING: The district court gave a mail fraud pattern jury instruction that defined a scheme to defraud as including any plan or course of action intended to deceive or cheat someone out of money or property by means of false or fraudulent pretenses, representations, or promises. This jury instruction relied on the precedent of United States v. Brown. The Court of Appeals overruled the precedent of United States v. Brown that the district court relied on to give a mail fraud pattern jury instruction, instead of the jury instruction requested by the defendants. The Eleventh Circuit held that the precedent of Brown was inconsistent with the mail fraud statute’s plain language and Supreme Court precedent, which instructed courts to reject common law elements that clearly were inconsistent with statutes Congress enacted. DECISION AND REMEDY: The defendants’ appeal to exclude the jury instruction about mail fraud was affirmed. The Eleventh Circuit overruled the precedent of United States v. Brown and ordered a new trial. SIGNIFICANCE OF THE CASE: This case shows what prosecutors must prove in a mail fraud case. This theory is important to prosecutors because they must know how to use the theory effectively. In addition, this case highlights the importance of relying on precedent that is consistent with a statute’s plain language.

CRITICAL THINKING Are you persuaded that Svete and Girardot were using the mails to perpetuate a fraudulent scheme? Why or why not? In other words, which reasons are responsible for your conclusion?

ETHICAL DECISION MAKING Return to the WH process of ethical decision making. Whom does this decision affect? In other words, who are the stakeholders in this decision?

Congress amended the mail fraud statute in 1994 to include commercial carriers and courier services as substitutes for the U.S. mail. Thus, using FedEx or UPS to further a fraudulent scheme can be prosecuted as mail fraud. Similarly, the wire fraud statute attempts to prevent the use of wire, radio, or television transmissions to defraud the public. Other types of fraud include health care fraud, telemarketing fraud, and bankruptcy fraud. The Department of Justice recently named health care fraud its top priority after violent crime. An example of health care fraud is the submission of false claims to insurance plans such as Medicare or Medicaid. Additionally, some doctors prescribe unneeded equipment to patients and then receive kickbacks from the manufacturers of the equipment. 106

Chapter 6

Criminal Law and Business

Telemarketing fraud has also gained much attention recently. The National Fraud Information Center reported that telephone cramming was the top telemarketing fraud of 1998. Cramming is a scheme in which companies bill consumers for optional services that the consumers did not order. Another frequent telemarketing scheme is slamming, in which consumers are tricked into changing their phone service to another carrier without their consent. The elderly, who have been more susceptible to telemarketing fraud, are often the specific targets of telemarketing schemes. Thus, the Department of Justice and the FBI have been collaborating on various undercover operations, such as Operation Senior Sentinel, to investigate and prosecute fraudulent telemarketers. Another type of fraud involves bankruptcies. In 2014, 1,107,699 bankruptcy claims were filed. An individual can file for bankruptcy to be relieved of oppressive debt. Yet claims need to be reviewed carefully to prevent bankruptcy fraud. For example, an individual might hide some assets so that she will not be considered during the proceedings. Or, as one of the stars of the Real Housewives of New Jersey show did, a person might hide part of her income. In the Real Housewives case, the housewife claimed to be unemployed, even though she had allegedly just signed a contract for a second season of Real Housewives, and she did not reveal her income from website sales and personal and magazine appearances. Conversely, a creditor (a party to whom another owes money) might file a false claim against a debtor (the party who owes money to a creditor). Thus, bankruptcy fraud can occur on the part of the debtor or the creditor, although 70 percent of bankruptcy fraud claims involve concealment of assets by the debtor. The U.S. Department of Justice estimates that 10 percent of all bankruptcy petitions contain some elements of fraud. Yet, according to a report by the U.S. Department of Justice, in fiscal year 2012, the United States Trustee Program (USTP) filed 2,120 criminal referrals, a 7.7  percent increase over the 1,968 criminal referrals made during fiscal year 2011. In October 2006, the Justice Department created an Internet hotline for the public to report suspected bankruptcy fraud to the USTP. This hotline is just one aspect of the Department of Justice’s revitalized commitment to combating bankruptcy fraud and protecting the integrity of the bankruptcy system. Bankruptcy fraud is punishable by a fine of up to $250,000 and/or up to five years in prison, but often the person who engages in bankruptcy fraud is also engaging in another crime, such as tax evasion, which can result in greater penalties. For example, in 2013, Larry Lake was sentenced to 168 months in prison and ordered to pay $550,000 in fines and approximately $25 million in taxes, interest, and penalties for bankruptcy fraud and tax evasion. The day before he filed for bankruptcy, he had knowingly and fraudulently transferred and concealed more than $3 million held in an online trading account and a bank account. He had transferred the funds through a series of bank deposits, wire transfers, and cashier’s checks and used a shell company to help hide assets. Sometimes fraud cases can be very complex and involve multiple types of fraud. For example, in one recent case, a Beverly Hills lawyer was convicted of three counts of mail fraud, seven counts of wire fraud, and five counts of lying in a court hearing. In an elaborate fraudulent scheme, the lawyer had purchased a yacht for $1.9 million, sold it to two partners to drive up its insurance value, and then had a company he owned repurchase the yacht and insure it for $3.5 million. Finally, he and his partners sank the yacht and tried to collect the insurance. A fraudulent crime that has recently come into the public eye is pretexting. Pretexting can be defined as using or causing others to use false pretenses, fraudulent statements, fraudulent or stolen documents, or other misrepresentations, including posing as an account holder or employee of a telecommunications carrier, to obtain the telephone records of another. Pretexting entered the national lexicon in 2006 when news broke that the investigators hired by Hewlett-Packard’s board of directors to locate the source of several leaks to the media were engaging in this practice. Under the federal Telephone Records and Privacy Protection Act of 2006, anyone convicted of employing fraudulent tactics to persuade phone companies to hand over confidential data about a customer’s calling habits can be sent to prison for up to 10 years. Some states also have statutes outlawing pretexting. Both individuals and businesses can be victims of fraud. To minimize the chances that your firm will be a victim of fraud, review the fraud prevention tips in Exhibit 6-2 very carefully.



Part I

The Legal Environment of Business

Exhibit 6-2 Fraud Prevention Tips

Red Flags Suggesting Possible Fraud When you are looking at a brochure offering an investment opportunity that seems almost too good to be true, it may indeed not be as good as it seems, especially if it contains these red flags of fraud:

• No independent proof of profitability: The brochure provides the investment strategy but includes no details that can be verified, such as names and addresses of specific companies in which it invests. • Control by a single person. • No audited financial statements and no evidence of internal controls. • Unusually high rates of return: The rates of return are significantly higher than those for other funds with a similar investment strategy. • New investors’ reliance primarily on existing investors in deciding to invest. False Assurances That an Investment Opportunity Is Not Fraudulent

• Long-time existence of investment opportunity: A Ponzi scheme can operate for a long time. As long as the company keeps getting new investors, it can continue to use the new investors to pay off the few who insist on collecting their returns. Many investors may be content to accumulate paper profits, especially if there is a financial incentive for reinvestment of profits. For example, the Financial Advisory Fund had been in business for almost 20 years before its fraudulent foundation was uncovered. • A list of names and addresses of satisfied investors you can contact: All such schemes will have some satisfied investors who have received payments from the new investment money. • Membership in the Better Business Bureau: Any company can pay to join. If most of the investors have not attempted to withdraw their funds and the company is still getting new investments, there will be no disgruntled investors to complain to the BBB. • A report of profitability from Dun & Bradstreet: Dun & Bradstreet does not do an independent financial audit of a company’s profits. As stated on its website, Dun & Bradstreet simply provides the information regarding profits that it receives from companies. • Acceptance of money rolled over from IRAs: There is no government check on the soundness of firms that roll over IRAs. • Bank references: If a firm simply has a large amount of money in a checking account in a bank and has never sought a loan from the bank, the bank would have no reason to do any due diligence on the firm. Also, if the owner of the firm is personable and the account has never been overdrawn, the bank personnel may well give the firm a good reference. • Glossy brochures and television ads: All you need for both is some money and the knowledge that many people may be overly impressed by a fancy brochure or ad campaign. These tips come from Barry Minkow, who went from starting his own carpet cleaning business at the age of 16, to taking this multimillion-dollar company public at the age of 20, to facing a 23-year prison sentence and $26 million victim restitution payment at the age of 21 for massive fraud and theft perpetuated on behalf of his company, to now being a pastor and the cofounder of the Fraud Discovery Institute. The fascinating story of how Barry Minkow, through fraudulent Ponzi schemes, check kiting, and theft, managed to build the multimillion-dollar ZZZZ Best Carpet Cleaning Company by the age of 20 is contained in his book, Cleaning Up. The book also provides insights into why some people may commit white-collar crimes, and it describes many of the long-running frauds Minkow has helped to uncover since deciding to use his understanding of the perpetuation of fraud to help uncover and prevent it.

GLOBAL Context Embezzlement and Bribery in China On March 8, 1982, in response to a concern about a rise in white-collar crimes, Chinese officials added a resolution entitled “Severely Punishing Criminals Who Do Great Damage to the Economy” to the Chinese Criminal Code. The provision targeted top-ranking officials by providing that any state functionaries who extort, accept bribes, or exploit their office will no longer receive the fixed-term punishment (usually 10 years) allocated for bribery and extortion. Instead, those officials found guilty of extortion and accepting bribes would be sentenced to life imprisonment or possibly put to death. Bank fraud is another white-collar crime that may be punishable by death. In 2004, China executed four people, including employees of two of its Big Four state banks, for fraud totaling $15 million. Three of the cases involved China Construction Bank.

A former accounting officer at this bank worked with others to steal 20 million yuan ($2.4 million) from the bank by using fake papers. He and an accomplice were executed, along with another Construction Bank employee who was found to have taken 20 million yuan from the bank in an unrelated case. Additionally, an official employed by the Bank of China was executed for cheating. The precise number of people executed in China is not made available to the public. Estimates range from 5,000 to 10,000 a year for crimes including murder, corruption, and, on occasion, even bottom-pinching. Most are executed by a single shot in the back of the head. Such punishments may seem extreme, but the reaction of the Chinese to the increase in white-collar crime reflects the culture’s unusually great concern for social harmony.

Ponzi schemes are another form of fraud that Americans are increasingly seeing discussed in the news. A Ponzi scheme is a fraudulent operation in which the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors rather than from profit earned by the operator. In early 2009, Bernie Madoff, the perpetrator of one of the largest Ponzi schemes to date, was charged with 11 felony charges, including securities fraud, investment adviser fraud, mail fraud, wire fraud, three counts of money laundering, false statements, perjury, false filings with the United States Securities and Exchange Commission, and theft from an employee benefit plan. Madoff ultimately pled guilty to all 11 counts and was subsequently sentenced to a term of imprisonment of 150 years for this crime, which was estimated to have cost investors losses of $18 billion. As of April 2014, the government had seized $2.35 billion in corporate and personal assets from Madoff that were to be distributed to victims of the fraud. Even though Madoff was prosecuted in 2009, it wasn’t until 2014 that five of his former aides were convicted on grounds that they had helped him conceal his massive fraud for years. In a trial that lasted five months, back-office director Daniel Bonventre, portfolio managers Annette Bongiorno and Joann Crupi, and computer programmers Jerome O’Hara and George Perez pled guilty on all counts, including securities fraud and conspiracy to defraud clients. Prior to this trial, nine other people have pled guilty in connection with Madoff’s fraud. Embezzlement Joe is Kathleen’s attorney. Kathleen gave Joe $5,000 to put in escrow, an account to which Joe will have access, although the money is not his to use as he pleases. Suppose Joe takes some of that money out of the account and uses it to gamble, and he fixes the records to cover up the fact that he has used some of the money for his personal use. He has committed the crime of embezzlement, the wrongful conversion of another’s property by one who is lawfully in possession of that property. Embezzlement is distinguished from larceny because the individual did not take the property from another; he was already in possession of the property. Embezzlement usually occurs when an employee steals money. Thus, it is often employees in banks who commit the crime. However, as the recent embezzlement of $6.9 million from the American Cancer Society demonstrates, even nonprofit organizations are vulnerable to the crime of embezzlement. White-collar crimes such as embezzlement are a problem in many countries. For example, the Chinese government, which has been focusing on economic crimes, caught employees in two major Chinese banks altering deposit slips and bank orders to direct the money to personal accounts throughout China. Those employees received death sentences for embezzlement, as discussed in the Global Context box.

embezzlement A wrongful conversion of another’s funds or property by one who is lawfully in possession of those funds or that property.



Part I

computer crime

Computer Crimes The term computer crime refers broadly to any wrongful act that (1) is directed against computers, (2) uses computers to commit a crime, or (3) involves computers. Computer crime is not necessarily a new kind of crime but is, instead, a new way of committing traditional crimes. Consider fraud, a crime that has existed for centuries. Today, online auctions, such as eBay, are a common source of fraud in the United States. Indeed, some statistics suggest that, compared with nonelectronic methods, using computers is a more profitable method of committing crimes. According to federal officials, the average loss in a nonelectronic embezzlement is $23,500; in contrast, in a computer fraud case, the average loss is almost $500,000.5 Computer crimes are often difficult to prosecute, in large part because they are difficult to detect. A computer crime could be committed by an insider, such as an employee, or by an outsider, such as a hacker—a person who illegally accesses or enters another person’s or a company’s computer system to obtain information or to steal money. In addition, computer systems are quite open to attack. The American Society for Industrial Security has reported that the losses from computer crimes in a single year were more than $250 billion for U.S. companies. Furthermore, the attacks are frequent. The IRS alone detects 800 to 1,200 cases of computer system misuse annually. A cyber terrorist is a hacker whose intention is the exploitation of a target computer or network to create a serious impact, such as the crippling of a communications network or the sabotage of a business or organization. The activity of a cyber terrorist can have an impact on millions of citizens if the terrorist’s attack is successful, particularly if it involves the computer systems of a major stock exchange, any bank, or any federal agency or government. In an attempt to aid prosecutions of computer crimes, Congress passed the Counterfeit Access Device and Computer Fraud and Abuse Act of 1984 (also know as the Computer Fraud and Abuse Act, or CFAA). The act prohibits six broad categories of computer crimes:

Crime committed using a computer.

hacker A person who illegally accesses or enters another person’s or a company’s computer system to obtain information or to steal money.

cyber terrorist A hacker whose intention is the exploitation of a target computer or network to create a serious impact, such as the crippling of a communications network or the sabotage of a business or organization, which may have an impact on millions of citizens if the terrorist’s attack is successful.

virus A computer program that rearranges, damages, destroys, or replaces computer data.

The Legal Environment of Business

1. Unauthorized use of or access to a computer to obtain classified military or foreign policy information with the intent to harm the United States or to benefit a foreign country. 2. Unauthorized use of a computer to collect financial or credit information protected under federal privacy law. 3. Unauthorized access to a federal computer and the use, modification, destruction, or disclosure of data it contains or the prevention of an authorized person’s use of such data. 4. Alteration or modification of data in financial computers, causing a loss of $1,000 or more. 5. Modification of data that impedes medical treatment to individuals. 6. Fraudulent transfer of computer passwords or similar data that could aid unauthorized access that either (a) affects interstate commerce or (b) permits access to a government computer. Computer crimes falling into the first category are felonies, whereas the others are misdemeanors. The National Information Infrastructure Protection Act of 1996 amended the Computer Fraud and Abuse Act. One of the major changes to the CFAA is the substitution of the term protected computers for federal interest computers so that the statute now protects any computer attached to the Internet. In a further attempt to aid prosecution of computer crimes, the U.S. Department of Justice formed the Computer Crime and Intellectual Property Section (CCIPS) in its Criminal Division. Attorneys in this division prosecute only federal computer crimes. They also coordinate their activities with numerous government entities, the private sector, scholars, and foreign representatives in an attempt to develop a global response to computer crime. Destruction of data is one of the most serious problems facing companies today. A virus is a computer program that rearranges, damages, destroys, or replaces computer data. Thus, if an employee or a hacker creates and releases a virus, a company can easily lose vital information. The most economically destructive computer crime to date was the creation of the Love Bug virus. In May 2000, the virus spread rapidly throughout the world by e-mail. Once the e-mail was opened, it destroyed files on the user’s computer, and then the virus sent itself to every address 5

Charles Alexander, “The Wells Fargo Stick-Up,” Time.com, www.time.com/time/magazine/article/0,9171,954673-3,00.html

E-COMMERCE and the Law Computer Use and Ethics The use of computers to store and transfer important business information has resulted in a new set of ethical concerns. How private is the computer screen? Are companies allowed to collect information about their customers? Who owns the information customers give to e-businesses? E-commerce law is gradually adjusting to such questions. But, as the beginning of Chapter 1 pointed out, knowing the law is just the first step in discovering the ethical business decision. One case that considered questions related to e-commerce and privacy involved Toysmart.com and its privacy policy. In 2000, the Federal Trade Commission (FTC) filed a complaint against Toysmart.com, charging the online retailer with selling customer lists despite its earlier

privacy statements that claimed its customers’ personal data would never be shared with a third party. The customer lists were included as assets to be sold as part of the company’s bankruptcy proceedings. The FTC issued a settlement with Toysmart.com allowing the lists to be sold as long as (1) the sale occurred before July 2001, (2) the lists would be sold to a family-oriented company, and (3) the buyer would agree to abide by the original Toysmart. com privacy policy. After the FTC imposed these restrictions, the result was that customers’ personal information was not sold. The Toysmart.com case makes it clear that, for both ethical and legal reasons, companies that adopt a privacy policy need to think that policy through before announcing it to customers.

in that computer’s e-mail address book. In the end, the virus caused more than $10 billion in damages and halted computers in major companies and government agencies worldwide. Companies can try to prevent the destruction of data by installing virus detection programs on their computers. However, the detection programs recognize only previously existing harmful files. As a result, if someone creates a new virus, the detection program is useless. When an employee uses his or her computer in a manner not authorized by the employer, the employee has committed a crime. Employers, then, must clearly communicate with employees about authorized versus unauthorized behavior. For example, if an employee uses her work computer to run her own personal business on the side, her employer may argue that she is engaging in theft because she is not using her computer in an authorized manner. Thus, when you become a business manager, you will want to make sure that you explicitly list acceptable computer uses, along with the penalties associated with unauthorized use.

Corporate Criminal Liability An individual or a corporation can be charged with and convicted of a crime. However, there has been much debate over whether corporations should be held criminally responsible. Under the common law, a corporation could not be considered a criminal because it was not an actual person and thus did not have a mind. Consequently, it could not meet the mens rea (guilty-mind) requirement for a crime. Slowly, however, courts began to impose liability on corporations for strict-liability offenses, those offenses that do not require state of mind. Next, courts imposed liability on corporations by imputing the state of mind of the employee to the corporation. Currently, corporations can be held criminally accountable for almost any crime. However, they cannot be held liable for crimes that are punishable only by a prison sentence. For a corporation to be held criminally liable for the acts of an employee, the prosecutor must show that (1) the employee was acting within the scope of her or his employment; (2) the employee was acting with the purpose of benefiting the corporation; and (3) the act was imputed to the corporation. In addition to corporations having criminal liability, corporate executives may also be personally liable for a business crime. The beneficiary of the crime is irrelevant because corporate executives and officers can be found to be personally liable regardless of whether the crimes were committed for their personal benefit or for the benefit of the corporation. Also, under the “responsible corporate officer” doctrine, a court may assess criminal liability on a corporate executive or officer even if he or she did not engage in, direct, or even know about

LO 6-3

strict-liability offense Offense for which no mens rea is required.



Part I

The Legal Environment of Business

a specific criminal violation. As Case 6-2 demonstrates, corporate executives sometimes have the responsibility and power to ensure the company’s compliance with the law. If the executive fails to meet this responsibility, the executive can be held criminally liable.

CASE 6-2


FACTS: Defendant Park, the president of a national foodchain corporation, was charged, along with the corporation, with violating the Federal Food, Drug, and Cosmetic Act by allowing food in the warehouse to be exposed to rodent contamination. Park had conceded that his responsibility for the “entire operation” included warehouse sanitation, but he claimed that he had delegated the responsibility for sanitation to dependable subordinates. He admitted at trial that he had received a warning letter from the Food and Drug Administration regarding the unsanitary conditions at one of the company’s warehouses. The trial court found the defendant guilty. The court of appeals reversed. The case was appealed to the U.S. Supreme Court. ISSUE: Can corporate executives be criminally liable for failing to ensure a company’s compliance with the law? REASONING: The Supreme Court has noted that the only way corporations can act is through their individual employees. The act in question, the Federal Food, Drug, and Cosmetic Act, requires stringent, affirmative actions on the part of corporate executives, but these standards are justified by the public interest in food safety. We expect executives such as Park to exercise appropriate authority

and demonstrate supervisory responsibility. There is considerable evidence that Park had a duty to ensure sanitary conditions and that he violated that duty by failing to ensure that those to whom he delegated responsibility did their jobs. The Court said: “[T]he requirements of foresight and vigilance imposed on responsible corporate agents are beyond question, demanding, and perhaps onerous, but they are not more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and well-being of the public that supports them.” DECISION AND REMEDY: The U.S. Supreme Court reversed the appellate court’s reversal of the trial court’s conviction, finding that corporate executives can be criminally liable for failing to ensure a company’s compliance with the law. SIGNIFICANCE OF THE CASE: This case signaled to corporate officials that they could no longer use ignorance as a defense, because a court will hold high-level corporate actors responsible for their company’s failure to comply with the law, even if they were unaware of what was going on within their company.

CRITICAL THINKING Given the rule laid down in this case, could the defendant have presented any evidence that would have led to a different decision?

ETHICAL DECISION MAKING Suppose you were in Park’s position in this case. You allegedly allowed food in your warehouse to be exposed to rodent contamination. If you were guided by the public disclosure test, what would you decide to do?

Chapter 6


Criminal Law and Business

Since United States v. Park, the general rule that corporate executives may be held accountable for the crimes arising from their failure to meet their responsibility has remained intact. The rule has, in fact, broadened so that now executives can be held criminally liable for offenses that we generally do not think of as crimes. For example, in United States v. Iverson,6 a corporate officer of a waste treatment facility was convicted and sentenced for violating the Clean Water Act after he ordered employees to dispose of wastewater illegally. This case demonstrates that corporate executives can be sentenced not only for committing the common law crimes that we have traditionally understood to be criminal offenses but also for violating provisions of regulatory statutes that permit criminal sanctions. In such cases, vicarious liability, or liability imposed on one person for the acts of another, is assessed to the corporate executive. In fact, courts have held that employers are vicariously liable for the wrongful acts of their employees if the employer directed, partook in, or authorized the wrongful act.

Criminal Procedure

vicarious liability The liability or responsibility imposed on a person, a party, or an organization for damages caused by another; most commonly used in relation to employment, with the employer held vicariously liable for damages caused by its employees.

LO 6-4

Criminal procedure differs from civil procedure in several key ways. First, the government, referred to as the prosecutor, always brings the criminal case, whereas in a civil case, the party filing the case, the plaintiff, can be an individual, business, or government entity. Second, the outcome of each is different. In a criminal case, the objective is punishment, so the defendant may be fined or imprisoned; in a civil case, the objective is to remedy a wrong done to the plaintiff, so the defendant either will have to provide compensation to the plaintiff or may be subject to an equitable remedy such as an injunction or order for specific performance. Third, because the potential impact of losing a criminal case is so much more serious than the impact of losing a civil case, the Constitution provides a number of safeguards for the criminal defendant. These safeguards are set forth in Exhibit 6-3.





• Protection from unreasonable search and seizure. • Restrictions on warrants.


• Prohibition of double jeopardy. • Right not to incriminate oneself. • Right to due process.


• • • • • •


• Freedom from excessive bail. • Freedom from excessive fines. • Freedom from cruel and unusual punishment.


• Extension of the right to due process in all state matters. • Extension of most constitutional rights to defendants at the state level.

162 F.3d 1015 (1998).

Right to a speedy and public trial. Right to a trial by an impartial jury of one’s peers. Right to be informed of the accusations against oneself. Right to confront witnesses. Right to have witnesses on one’s side. Right to counsel at various stages of the proceedings.

Exhibit 6-3 Constitutional Provisions That Safeguard Criminal Defendants’ Rights


Part I

The Legal Environment of Business

PRETRIAL PROCEDURE arrest The action in which a police officer or a person acting under the law takes a person into custody.

probable cause Any essential element and/or standard by which a lawful officer may make a valid arrest, conduct a personal or property search, or obtain a warrant.

Miranda rights The rights that are read to an arrested individual by a law enforcement agent before the individual is questioned about the commission of a crime.

booking After an individual is arrested, the procedure during which the name of the defendant and the alleged crime are recorded in the investigating agency’s or police department’s records.

first appearance The initial appearance of an arrested individual before a judge who determines whether there was probable cause for the arrest. If the judge ascertains that probable cause did not exist, the individual is freed.

bail A thing of value, such as a money bail bond or any other form of property, that is given to the court to allow a person’s temporary release from jail and to ensure his or her appearance in court.

Prior to an arrest, grand juries may conduct criminal investigatory proceedings or issue a grand jury subpoena for company records. Criminal proceedings generally begin when an individual is arrested for a crime. A law enforcement officer must perform the arrest. This officer is often a police officer but may also be an agent of another government agency, such as the Bureau of Alcohol, Tobacco and Firearms; the Federal Bureau of Investigation; or the Immigration and Naturalization Service. A law enforcement officer should obtain an arrest warrant before an individual is taken into custody. Ordinarily, to obtain an arrest warrant, the law enforcement agent must demonstrate that there is probable cause, or a likelihood, that a suspect committed or is planning to commit a crime. A magistrate, the lowest-ranking judicial official, issues the arrest warrant. In certain circumstances, however, courts have recognized that law enforcement agents can arrest a suspect without a warrant if the officer believes there is probable cause but not enough time to obtain the warrant. When law enforcement agents arrest individuals, the officers must inform the individuals of their Miranda rights. If they fail to do so, any information a defendant offers at the time of the arrest is not admissible at trial. To comply with the Supreme Court’s requirements for protecting a citizen’s rights, a law enforcement officer must inform the defendant of the following facts before questioning: 1. “You have the right to remain silent and refuse to answer any questions.” 2. “Anything you say may be used against you in a court of law.” 3. “You have the right to consult an attorney before speaking to the police and have an attorney present during any questioning now or in the future.” 4. “If you cannot afford an attorney, one will be appointed for you before the questioning begins.” 5. “If you do not have an attorney available, you have the right to remain silent until you have had an opportunity to consult with one.” 6. “Now that I have advised you of your rights, are you willing to answer any questions without an attorney present?” The Miranda rights are not absolute. In fact, the Supreme Court has several times created exceptions to the Miranda rights. For example, in New York v. Quarles,7 the Court created a public-safety exception to the Miranda rights. This exception allows statements to be used at trial, even if a person was not informed of his or her Miranda rights, if the need to protect the public is served by the admissibility of the statements in question. After being arrested and read their Miranda rights, defendants are taken to the police station for booking, a procedure during which the name of the defendant and the alleged crime are recorded in the investigating agency’s or police department’s records. After the prosecutor files the complaint, the defendant makes the first appearance, which is the appearance before a magistrate who determines whether there was probable cause for the arrest. If the magistrate ascertains that probable cause did not exist, the individual is freed. If the defendant committed a minor offense and pleads guilty, the magistrate sentences the individual. However, if the defendant claims innocence, the magistrate ensures that the defendant has a lawyer, or appoints one, if necessary, for an indigent defendant, and sets bail. Bail is the amount of money defendants pay to the court on release from custody as security that they will return for trial. Next, the prosecutor has a choice: Should the case be prosecuted? The Principles of Federal Prosecution, established by the U.S. Department of Justice, suggest that at the federal level the decision to prosecute depends on two primary factors: (1) whether the evidence is sufficient to obtain a conviction and (2) whether prosecuting the case serves a federal interest. If the prosecutor decides not to go forward with the case, the defendant may still be liable for his or her actions in civil court.


467 U.S. 649 (1984).

Chapter 6


Criminal Law and Business

If the prosecutor chooses to proceed with a criminal action, the prosecutor must demonstrate the likelihood that the defendant’s actions and intent meet the elements of a crime by charging the defendant with a crime through an information or an indictment. For a misdemeanor, the prosecutor must present to the magistrate evidence sufficient to justify prosecution of the defendant. This is done through a written document called an information, a formal accusation stating the facts and specifying the violation of criminal law. However, for a felony, the prosecutor must present a grand jury with evidence adequate to justify bringing the defendant to trial. If the grand jury agrees that the evidence is adequate, it issues an indictment, a written accusation of the crime allegedly committed by the defendant. Note that the grand jury does not determine guilt. It is simply a group of citizens who consider evidence of criminal conduct presented by the prosecutor and then determine whether there is enough evidence to try the defendant for the crime. In federal cases, a defendant accused of a felony has a constitutional right to a grand jury indictment. However, a felony prosecution may proceed by information if the defendant waives that right. For instance, in a high-profile case in which the defense attorney is trying to work out a deal with the prosecution, the defendant may ask for the case to proceed by information. Federal misdemeanor cases may proceed by indictment or information. If the criminal trial takes place in state court, the defendant may or may not have access to a grand jury. The U.S. Supreme Court has held that indictment by a grand jury is not a fundamental right; thus, states are not required to offer grand juries. About half the states still require felony prosecutions to be initiated by grand jury indictments; most of the rest use information as the method for commencing prosecution. If the grand jury issues an indictment, the defendant appears in court to answer the indictment in a proceeding called the arraignment. At this time, the defendant enters a plea of guilty or not guilty. A defendant may also enter a plea of nolo contendere, whereby the defendant does not admit guilt but agrees not to contest the charges. The advantage of a nolo contendere plea over a guilty plea is that the former cannot be used against the defendant in a civil suit. If the defendant pleads not guilty, his case will be heard before a petit jury, which is a fact-finding jury. At any time, the prosecutor and defendant can make a plea bargain, an agreement in which the prosecutor agrees to reduce charges, drop charges, or recommend a certain sentence if the defendant pleads guilty. Plea bargaining benefits both parties. The defendant gets a lighter sentence, and the prosecution saves time and resources by not trying the case. Businesspeople who commit crimes that affect business often engage in plea bargaining to avoid the publicity associated with a trial and the risk of a severe sentence.

TRIAL PROCEDURE If the case goes to trial and the crime is a felony or a misdemeanor punishable by six months or more in prison, the defendant has a constitutional right to a jury trial. In most states, if the defendant waives the right to a jury trial, the judge will hear the case. When a judge is the fact finder in a case, the trial is called a bench trial. In a criminal trial, the prosecutor has the burden of proof and the defendant does not have to prove anything. The burden of proof has two elements: the burden of production of evidence and the burden of persuasion. To meet the burden of production of evidence, the prosecution must produce any tangible evidence and testimony that prove the elements of the crime that the defendant allegedly committed. Along with producing evidence, the prosecution also has the burden of persuasion: The prosecutor must persuade the jury beyond reasonable doubt that the defendant committed the crime. The burden of proof, then, is higher in a criminal case than in a civil case because, in a civil case, the burden of persuasion requires only that the claim is supported by a preponderance of the evidence. The prosecution presents the government’s case first, introducing evidence and examining witnesses to prove beyond a reasonable doubt that the defendant committed the crime. Once the prosecutions rests its case, it is the defendant’s turn. The defendant either (1) can show, through

information A document, prepared by the prosecutor and presented to the magistrate, which demonstrates that there is enough evidence to charge the defendant and bring him or her to trial.

indictment Finding by the grand jury that there is adequate evidence to charge the defendant and bring him or her to trial.

arraignment The first appearance in court by the defendant, at which the defendant is advised of the pending charges, the right to counsel, and the right to trial by jury and he or she enters a plea to the charge.

nolo contendere A plea in which the defendant does not admit guilt but agrees not to contest the charges.

petit jury A group of 6 or 12 citizens who are summoned to and sworn by the court to hear evidence presented by both sides and render a verdict in a trial.

plea bargain An agreement in which the prosecutor agrees to reduce charges, drop charges, or recommend a certain sentence if the defendant pleads guilty.

bench trial A trial before a judge, with the judgment decided by the judge rather than a jury; occurs when the defendant has waived his or her right to a jury trial.

burden of proof The duty of the plaintiff or prosecution to establish a claim or allegation by admissible evidence and to prove that the defendant committed all the essential elements of the crime to the jury’s or court’s satisfaction beyond any reasonable doubt, in order to convict the defendant.


Part I

The Legal Environment of Business

Exhibit 6-4 Affirmative Defenses to Crimes


A person who is not yet a legal adult may use this defense to defuse the guilty-mind requirement of a crime.

Mistake of Fact

The defendant says his or her honest and reasonable mistake about a fact relevant to the commission of the crime negates the idea of a guilty mind.


The defendant says he or she took an intoxicant without awareness of its likely effect, mistook its identity, or took the intoxicant under force.


The defendant had a severe mental illness that substantially impaired the defendant’s capacity to understand and appreciate the moral wrongfulness of the act.


The defendant says he or she was forced to perform an act against his or her will.


The defendant would not have committed the crime or broken the law if not induced or tricked into doing so by law enforcement officers.


The defendant was acting to prevent imminent harm, and there was no legal alternative to the action he or she took.

Justifiable use of force

Use of force was necessary to prevent imminent death or great bodily harm to the defendant or to another or to prevent the imminent commission of a forcible felony.

examination of witnesses and introduction of evidence, that the prosecution did not meet its burden of proof or (2) can present an affirmative defense. An affirmative defense is a reason the defendant, even though he or she committed the physical acts alleged by the prosecution, should be excused from responsibility for those actions. Exhibit 6-4 lists some common affirmative defenses.

B UT W H AT I F   .   .   . What if in the opening scenario, Cohen thought that the information Martoma gave to him about the Alzheimer’s drugs was public knowledge? What defense could he use to defend himself against an insider trading sentence? Alternatively, is there any way that Martoma could argue that he didn’t know that what he was doing constituted insider trading and was punishable by law?

After the jury hears the case, it deliberates and tries to reach a verdict. A jury that is unable to reach a verdict is known as a hung jury. If the jury finds the defendant not guilty, the accused is acquitted and released. If the jury returns a guilty verdict, the judge sets a date for sentencing.

POSTTRIAL PROCEDURE If the petit jury returns a verdict of not guilty, the government cannot appeal the acquittal. However, if the verdict is guilty, the defendant may appeal the verdict by claiming that a prejudicial error of law occurred at the original trial. If there is no appeal, the defendant will be sentenced after the judge has received additional information relevant to sentencing. Figure 6-1 summarizes the steps of a criminal procedure.


Chapter 6 Criminal Law and Business

Figure 6-1 Steps in a Criminal Procedure



First Appearance

Indictment by a Grand Jury (for felony)

Information (for misdemeanor)


Trial Appeal

Tools for Fighting Business Crime

LO 6-5

Although clearly a significant number of business-related crimes can be committed, certain federal laws help fight such crime. Three federal laws that have been somewhat successful in this battle are RICO, the False Claims Act, and the Sarbanes-Oxley Act of 2002. Although these laws are currently extremely powerful white-collar-crime laws, RICO and the False Claims Act were created with different purposes in mind. Sarbanes-Oxley, however, was created specifically to combat white-collar crime.

RICO One of the most important tools for fighting white-collar crime is Title IX of the Organized Crime Control Act of 1970: the Racketeer Influenced and Corrupt Organizations (RICO) Act. Although the statute was originally enacted to combat organized crime, in effect it prevents legitimate businesses from serving as covers for racketeering. This statute prohibits persons employed by or associated with an enterprise from engaging in a pattern of racketeering activity. Anyone whose business or property has been damaged by this pattern of racketeering activity can sue to recover treble damages and attorney fees in a civil action. Demonstrating a claim under RICO requires proof of a pattern of racketeering. Courts have defined a pattern as more than one action. Thus, a one-time violator could not be prosecuted under RICO because there could be no pattern as yet. Some courts additionally have found that a pattern requires continued criminal activity over a “substantial” period of time. Although pattern is restricted to more than one act, racketeering has been defined broadly to include almost all criminal actions, such as acts of violence, fraud, bribery, securities fraud, and the provision of illegal goods and services. Therefore, RICO is an extremely effective tool in combating white-collar crimes. In addition to being held civilly liable under RICO, a violator may also be subject to RICO’s criminal penalties. A person found to have violated the act may be subject to a fine of up to $25,000 per violation, imprisonment for up to 20 years, or both.

Racketeer Influenced and Corrupt Organizations (RICO) Act A U.S. law that provides extended penalties for criminal acts performed as part of an ongoing criminal organization.


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THE FALSE CLAIMS ACT False Claims Act An act that allows employees to sue employers on behalf of the federal government for fraud against the government. The employee retains a share of the recovery as a reward for his or her efforts.

Sarbanes-Oxley Act An act that criminalizes specific nonaudit services when provided by a registered accounting firm to an audit client; also increases the punishment for a number of white-collar offenses. Also known as the Public Company Accounting Reform and Investor Protection Act of 2002.

Since 1986 private citizens have been using the False Claims Act to sue employers on behalf of the government for fraud against the government. For example, an employee in a health care facility might realize that his employer is submitting fraudulent claims to Medicare. The employee can bring a suit against the employer on behalf of the government for fraud against the government. If an employee realizes that her employer is committing fraud against the government, she must first notify the government of her intent to file the case on behalf of the government. If the government chooses to intervene and prosecute the case itself, with the help of the employee, the citizen would receive 25 percent of the amount recovered. If the government does not opt to get involved, and the citizen continues with the case on behalf of the government, she receives 30 percent. Certainly, an employee who brings a suit against his employer might be worried about retaliation, such as being fired or demoted. Thus, the act provides protection for employees who use the law. If an employer is found guilty of retaliation, the employer may be forced to pay the employee twice the amount of back pay plus special damages. The biggest reward thus far under the act was the approximately $51 million share that four whistle-blowers and their attorneys received for blowing the whistle on a Swiss drug company, Serono, for participating in a marketing scheme that resulted in physicians illegally prescribing over $11.5 million worth of a drug that was paid for by Medicaid. The government settled the case against the company for $704 million. The reward in this case, however, was far above the norm. In 2010, the Justice Department recovered a total of $53.7 billion under the False Claims Act, up from $53.5 billion collected in 2009.8 Although some of these cases might not have been pursued had it not been for the False Claims Act, many people are opposed to the act. Some argue that the whistle-blowers are receiving money that should belong to the taxpayers; others say that the act prompts people to refrain from reporting fraud right away but wait until the value of the case grows. Still others complain that the act results in frivolous lawsuits as employees try to find an easy way to make money. Defenders of the False Claims Act point out that the act has led to revelation of some significant cases of fraud that otherwise might have cost the government millions of dollars. They also point out that when an employee does report a fraudulent employer, it becomes very difficult for that employee to get a job in the same field in the future; thus, a significant incentive needs to be offered to convince employees to report such fraud. A number of False Claims Act cases have been filed against universities, including an interesting case filed in 2006 against Chapman University. In this case, three faculty members alleged that the institution for years encouraged early dismissals, resulting in many students not getting the minimum classroom training required in several subjects. If the college had admitted that it had engaged in this practice, it would never have been accredited and thus never have received millions of dollars in federal grants and student aid, which the lawsuit claimed it took under false pretenses.9 The case was ultimately dismissed by a Summary Judgment in 2007, and in 2011, the plaintiff’s appeal to the U.S. Supreme Court was denied. Other False Claims Act cases against universities have been more successful. For example, in 2009, the University of Phoenix settled an False Claims Act (FCA) suit for $67.5 million for violating federal law that prohibits colleges from paying admissions counselors incentives based on the number of students recruited.

THE SARBANES-OXLEY ACT Unlike RICO and the False Claims Act, the Sarbanes-Oxley (SOX) Act of 2002 was intended to curb white-collar crime. Congress passed Sarbanes-Oxley largely in response to the business scandals of the early 2000s, such as Enron, WorldCom, and Global Crossing, as well as the 8

Fiscal Year 2012 Budget Request, Civil Division, http://www.justice.gov/jmd/2012justification/pdf/fy12-civ-justification.pdf (accessed July 1, 2010). 9 Martin Van Der Werf, “Lawsuit U.: The Growing Reach of the False Claims Act Has Lawyers Fearing Trouble Everywhere,” Chronicle of Higher Education, August 4, 2006, http://chronicle.com/weekly/v52/i48/48a02301.htm

GLOBAL Context Protecting Whistle-Blowers in the United Kingdom One way in which the United Kingdom fights white-collar crime is through the use of a national whistle-blower statute, the Public Interest Disclosure Act of 1998 (PIDA), which protects the whistle-blower from firing or retaliation if he or she makes a good-faith disclosure based on genuine concerns about crime, civil offenses, miscarriage of justice, danger to health and safety or the environment, and the cover-up of any of these. The emphasis of PIDA is on fixing the problem within the company. The most protected, and preferred, disclosure is one that is made to a manager within the company, so the first step is often to disclose the possible violation to a manager in the company. Sometimes such disclosures are not always advisable or possible, so disclosures to the

appropriate ministry are protected, when applicable, as well as disclosures to the appropriate regulatory agency, such as the Health and Safety Executive. Rather than just having a suspicion of wrongdoing, whistle-blowers must believe that their allegations are substantially true before disclosing them to a regulator. If the whistle-blower reasonably believed that he or she would be victimized for disclosure to the company or regulator, reasonably believed that a cover-up was likely and there was no prescribed regulator, or had already raised the issue internally or with a regulator and no action had been taken, he or she would be protected for a wider disclosure. The whistle-blowers do not get monetary rewards, as do whistle-blowers in the United States under the False Claims Act. Instead, they may be protected and compensated if action is taken against them.

accounting firm Arthur Andersen. Although much of the act consists of new rules and regulations for accounting firms, part of the act specifically addresses the issue of white-collar crime. Sarbanes-Oxley makes it illegal for registered public accounting firms to provide nonaudit services to an audit client. Section 201 of the act specifically names as illegal: 1. Bookkeeping or other services related to the accounting records or financial statements of the audit client. 2. Financial information systems design and implementation. 3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports. 4. Actuarial services. 5. Internal audit outsourcing services. 6. Management functions or human resources. 7. Broker or dealer, investment adviser, or investment banking services. 8. Legal services and expert services unrelated to the audit. 9. Any other service that the board determines, by regulation, is impermissible. In addition to criminalizing these activities, Sarbanes-Oxley has amended the penalties associated with other white-collar crimes. Under Sarbanes-Oxley, it is now a felony to fail willfully to maintain proper records of audits and work papers for at least five years, and the punishment for not maintaining these records is up to 10 years’ imprisonment. Also, the destruction of documents received updated punishments. The destruction of documents involved in a federal bankruptcy investigation is now a felony with possible sentences of up to 20 years’ imprisonment. Similarly, the punishment for securities fraud has been increased to 25 years’ imprisonment. In addition, Sarbanes-Oxley has extended the statute of limitations regarding the discovery of fraud. The statute of limitations now extends to two years from the date of discovery of the fraud and five years from the criminal act. The old statute was one year from discovery and three from the act. Also, much like the False Claims Act, Sarbanes-Oxley has taken affirmative steps toward further protecting whistle-blowers.

STATE WHISTLE-BLOWER PROTECTION LAWS Forty-seven states currently have whistle-blower protection laws for either public or private sector employees or both. However, these laws are very different, so it is important for both employers and employees to know the law in their state. The biggest difference among the states is to whom the violation may or must be reported. In many states, employees in the private sector 119


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receive protection from retaliation only if they report the wrongdoing to an external governmental body. Other states take the opposite approach and require the whistle-blower to report his suspicions first internally to his supervisors. Almost no states protect employees who choose to go to the media with their reports of employer wrongdoing.

CASE Nugget Does Whistle-blower Protection under Sarbanes-Oxley Extend to Employees of Private Contractors Serving Public Companies? Lawson v. FMR LLC United States Supreme Court 134 S. Ct. 1158 (2012) Plaintiffs were former employees of FMR, a group of private companies that contracted to advise or manage mutual funds. As is common in the industry, the mutual funds FMR served are public companies with no employees. Both plaintiffs allege that they blew the whistle on putative fraud relating to the mutual funds and, as a consequence, suffered retaliation by FMR. Each filed suit in federal court. Moving to dismiss the suits, FMR argued that the plaintiffs could state no claim under Sarbanes-Oxley’s whistler-blower protection provision because that provision protects only employees of public companies, not employees of private companies that contract with public companies. On appeal from the District Court’s denial of FMR’s motion to dismiss, the First Circuit reversed, concluding that the term “an employee” under SOX refers only to employees of public companies. The U.S. Supreme Court, however, reversed that decision, giving a broader interpretation of the statute and finding that the act’s whistle-blower protection includes employees of a public company’s private contractors and subcontractors. As the court pointed out, to hold otherwise would be to allow the entire mutual fund industry to insulate itself because virtually all mutual funds are structured so that they have no employees of their own; they are managed, instead, by independent investment advisors. The high court also pointed out that this construction was analogous to the whistleblower protection given to employees in the aviation industry, in which the term employees includes protection of employees of contractors and subcontractors of air carriers.

SUMMARY The Nature and Elements of a Crime

The elements of a crime are: • •

Actus reus: Wrongful behavior (guilty act). Mens rea: Wrongful state of mind or intent (guilty mind).

Crimes are classified into three categories: • • •

Felonies: Serious crimes punishable by imprisonment for more than one year or by death. Misdemeanors: Less serious crimes punishable by fines or imprisonment for less than one year. Petty offenses: Minor misdemeanors punishable by small fines or short jail sentences.

Chapter 6 Criminal Law and Business

White-Collar Crime


White-collar crimes include: 1. 2. 3. 4. 5.

Bribery, Extortion, Fraud, Embezzlement, and Computer crimes (destruction of computer data, unlawful appropriation of data or services).

Corporate Criminal Liability

Both corporations, as legal entities, and the corporate officers and managers can be held liable for crimes committed on behalf of the corporation.

Criminal Procedure

Pretrial procedure: The arrest, booking, first appearance, indictment, and arraignment. Trial procedure: Jury selection, trial with burden of proof on prosecution, jury deliberations, jury verdict, and (if guilty) sentencing hearing. Posttrial procedure: Appeal.

Tools for Fighting Business Crime

RICO: Prohibits persons employed by or associated with an enterprise from engaging in a pattern of racketeering activity. Anyone whose business or property has been damaged by this pattern of activity can sue under RICO to recover treble damages and attorney fees in a civil action. False Claims Act: Allows employees to sue employers on behalf of the federal government for fraud against the government. The employee retains a share of the recovery as a reward for his or her efforts. Sarbanes-Oxley Act: Criminalizes specific nonaudit services when provided by a registered accounting firm to an audit client; also increases the punishment for a number of white-collar offenses.

Point/Counterpoint As you are considering this issue, you might want to think about statistics that would help you resolve it.

How Severely Should the Law Punish Individuals Convicted of White-Collar Crime? LESS SEVERELY THAN VIOLENT CRIMINALS


Street crimes are different in kind from white-collar crimes. Whereas white-collar crime affects only individuals’ property, street crime threatens individuals’ lives and health. The law ought to recognize that protecting lives is more important than protecting property. Moreover, white-collar crime tends to affect higherincome individuals, whereas street crime tends to affect lower-income individuals who lack the resources to protect themselves. Street crime disproportionately affects lower-income individuals who cannot afford the private security measures that higher-income individuals use to protect their persons and their property. The law ought to protect those who lack the power to protect themselves.

It is far from clear that white-collar crime has less serious consequences than street crime. For example, individuals who defraud the government in effect steal taxes paid by all members of society, whereas individuals in possession of small amounts of marijuana may never adversely affect other members of society. Indeed, white-collar crime affects all groups in society in both direct and indirect ways. Companies victimized by white-collar crime often must raise the prices of their goods to recoup the costs of the crime. Everyone in society feels the effects of the higher prices. Street crime, although by no means negligible, tends to affect smaller circles of people. Thus, to get the biggest bang for our buck, we should punish white-collar crime more heavily than street crime.


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A third reason to punish white-collar crime less heavily than street crime is that white-collar criminals are more likely to engage in careful cost–benefit analysis when determining whether to commit white-collar crime. If the severity of the punishment, discounted by the chance they will get caught, is less than the expected payoff from the white-collar crime, rational individuals won’t see the crime as a profitable enterprise. We assume that street criminals do not engage in the same kind of careful cost-benefit analysis before deciding, for example, whether to use illegal drugs. The most effective punishment for street crimes is likely to be severe punishment that incapacitates the criminals so that they are unable to commit more street crime. White-collar crime, on the other hand, can effectively be curbed by setting the punishment just high enough to make the crime unprofitable, which would often mean the punishment for white collar crime is less than the stringent punishment necessary for street crime.

Another reason to punish white-collar crime more heavily than street crime focuses on the underlying causes of crime. Much street crime has its roots in other social problems. Often, individuals commit street crime because of the poor environments in which they were raised. Much white-collar crime, however, is committed by well-off individuals out of avarice. The law ought to dole out more severe punishments for crimes caused by individual responsibility, and society ought to use other mechanisms to address crime caused by aleatory factors.

Questions & Problems 1. Name and explain the two elements of a crime. 2. Identify the distinguishing features of white-collar crime. 3. List and define the primary affirmative defenses used in criminal cases. 4. List and describe the main types of fraud committed in the business context. 5. What is meant by reading a defendant his Miranda rights, and why are these rights important? 6. Explain the steps of a criminal prosecution. 7. Explain the federal laws that are currently being used to fight white-collar crime. 8. Chambliss met Chinasa in 2004 through his side business. Chinasa told Chambliss that he lived in Gaithersburg, Maryland, and ran a business called DataNet Communications. When Chambliss began working for Packet 360, Chinasa asked Chambliss to help him by using warranties purchased for Packet 360 clients to replace malfunctioning Cisco products. Chambliss agreed, using a warranty contract held by Medicorps Health, even though Chinasa had no right to make claims under Medicorps’s warranty. Chinasa also eventually purchased his own warranty to use for some returns. For four years, Chinasa and Chambliss initiated hundreds of service requests with Cisco, causing Cisco to ship parts worth millions of dollars. These requests shared many common characteristics. First, each contained a specific complaint that the referenced part

was either not responding or not powering up and that other parts worked on the same chassis. Chambliss had told Chinasa that use of such wording would cause Cisco to send a replacement part instead of trying to resolve the problem through online troubleshooting. Use of that verbiage was important to the scheme because normally only 20–30 percent of service requests Cisco received resulted in shipment of a replacement part. Chinasa and Chambliss had the parts delivered to different addresses to avoid detection. Chinasa instructed Chambliss to have the parts shipped to Chambliss’s house, to Chinasa, and to Chambliss’s friends located in Richmond, Virginia. Chinasa (and others) periodically travelled from Gaithersburg to Chambliss’s house to pick up the parts Cisco had sent and to drop off the parts Chambliss was to send to Cisco. In fall 2009, Cisco became aware of the scheme and started tracking its service requests and intercepting parts Chambliss returned. Initial inspections of intercepted parts revealed that the returned parts in fact were not genuine Cisco products. Indeed, none of the intercepted parts were found to be genuine Cisco products. What crime do you think these two were convicted of? Explain how the facts illustrate the elements of that crime. 9. Chester Jones was the committee chairman of the Perry County Democratic Party and a candidate for the Perry County school board. Jones used money

Chapter 6

given to the Kentucky Democratic Party to hand out 75 $100 checks to Perry County voters in an effort to persuade families to vote for Jones and Neace. In 2009, a grand jury in the Eastern District of Kentucky charged Jones with one count of aiding and abetting mail fraud and one count of conspiring to commit mail fraud and vote buying. Jones signed a plea agreement in which he pleaded guilty to one count of aiding and abetting mail fraud. The district court then sentenced Jones to 12 months’ imprisonment. After Jones’s conviction, a U.S. Supreme Court ruling in Skilling v. United States narrowed the scope of “honest services” fraud. Jones then contested that he wanted to vacate his conviction in the aftermath of the Skilling case. Jones argued that he had pleaded guilty to “conduct that has been determined by the Supreme Court not to be a crime.” The court affirmed the district court’s decision. Do you agree with the court’s affirmation? Why or why not? [United States v. Jones, 2011 U.S. App. LEXIS 2269 (6th Cir. Ky. 2011).] 10. John and Tahir Ramin were indicted on charges of conspiracy to commit mail fraud and conspiracy to commit bribery, among other charges. They were alleged to have bribed Army Major Christopher West to secure a bunkers and barriers contract, which would enable them to provide bunkers and barriers to the airfield that West was responsible for. The defendants were then alleged to have inflated the number of bunkers and barriers that they actually provided to the airfield. In response to the charges, the defendants provided a defense to the bribery charge based on economic duress. The government filed a motion to exclude the evidence related to economic duress, arguing that economic duress was not a valid defense for bribery. Do you think the district court granted the government’s motion to exclude evidence? Why or why not? [United States v. West et al., 2010 U.S. Dist. LEXIS 33294 (N.D. Ill. 2010).] 11. Defendants driver Holland and Kelley, his passenger, were charged with drug possession with the intent to sell. Officers had arrested the driver on a misdemeanor, for changing lanes without signaling, after the officers had been advised by High-Intensity Drug Trafficking Area undercover officers to prevent the defendants from potentially robbing a confidential informant of narcotics. Upon arrest, officers searched the center console of the vehicle, finding evidence that suggested their intent to sell drugs. The officers admitted to having no factual basis for believing that there was evidence of either defendant’s drug possession within the vehicle at the time of arrest. Holland and Kelley argued that the search of the vehicle that ensued after the driver’s arrest was unlawful and that evidence obtained through the arrest should

Criminal Law and Business


be found inadmissible. The government argued that the arrest and search was lawful pursuant to the goodfaith exception and the inevitability exception. Whom do you think the court found in favor of? Why? [United States v. Kelley and Holland, 2011 U.S. Dist. LEXIS 5261 (S.D. Tex. 2011).] 12. The defendant, Raul Pol-Flores, referred two investors to Luis Herrero-Rovira. The two investors were then defrauded of their entire $290,000 investment, and Pol received nearly $20,000 of the funds. When the two investors had deposited the $290,000 in the bank, Pol told the bank that the funds were for investments but that he was not authorized to engage in the activity. Herrero returned the funds to the investors but convinced them to engage in another investment option, CLEIGG. The investors reinvested their $290,000 but saw only $3,622 in interest payments. The CLEIGG account funded numerous wire transfers, totaling $119,072, to banks in Puerto Rico. Herrero withdrew a total of $125,000 from the CLEIGG account. Two of the wire transfers, totaling $20,000, were made to Pol’s company, Polarco. Pol was found guilty on 10 counts of wire fraud. Pol argued that insufficient evidence was presented at trial to convict him as an aider and abettor to wire fraud. The court affirmed the district court’s decision that a reasonable jury could have concluded beyond a reasonable doubt that Pol had participated in Herrero’s wire fraud scheme. Do you agree with the court’s affirmation? Why or why not? [United States v. Pol-Flores, 2011 U.S. App. LEXIS 8885 (2011).] 13. Toby Scammel’s girlfriend was briefly involved in Disney’s acquisition of Marvel in 2009. Scammel bought 659 Marvel options for $5,465 in the days prior to the announcement of the acquisition. Within the nine days following the announcement, Scammel sold all his Marvel shares, amounting to a total of $192,496.61. Although Scammel’s girlfriend would mention general facts about a big project she was working on, the couple claimed that she never gave him details about the acquisition. However, he had access to her electronic documents related to the acquisition and had begun piecing together the companies involved and the timing of the acquisition. Scammell’s girlfriend had confidential information about the deal, including that Disney would pay $50 per share for Marvel and that the deal would be announced by Labor Day. Scammel claimed that his girlfriend had told him nothing and that he had done nothing wrong; he had frequently been involved in the stock market and was simply trading shares normally as he had done before. The sec, in its investigation, also learned just before he purchased many of the Marvel securities, Scammell searched the internet for the terms “insider trading,” “material,


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non-public information,” and “Rule 10b-5.” What crime do you believe Scammel was charged with? Do you think there was enough evidence to warrant his conviction for that crime? [SEC v. Scammel, 2011 WL 3506153 (C.A.C.D. Aug. 11, 2011).] 14. At Boyle’s trial, the state demonstrated that Boyle and others had committed a series of bank robberies in four states during the 1990s. A core group was involved in all the robberies, but sometimes others would also assist them. The group would meet before each crime to plan the robbery, assign everyone’s tasks, and assemble the tools. After each heist, they would divide the proceeds. There was no clear leader and no overall master plan for a series of robberies. At the trial, the judge told jurors that to establish the existence of an enterprise, the government had to prove that “(1) there [was] an ongoing organization with some sort of framework, formal or informal, for carrying out its objectives; and (2) the various members and associates of the association function[ed] as a continuing unit to achieve a common purpose.” The judge also told the jury that it could “find an

enterprise where an association of individuals, without structural hierarchy, [was] form[ed] solely for the purpose of carrying out a pattern of racketeering acts,” and that “[c]ommon sense suggests that the existence of an association-in-fact is oftentimes more readily proven by what it does, rather than by abstract analysis of its structure.” The judge did not give the jury Boyle’s requested instruction that the government was required to prove the enterprise “had an ongoing organization, a core membership that functioned as a continuing unit, and an ascertainable structural hierarchy distinct from the charged predicate acts.” After Boyle was convicted of 11 of 12 counts against him, including the RICO counts, and was sentenced to prison, he appealed on grounds that the instructions about what would constitute proof of an enterprise incorrectly set forth the law. The circuit court affirmed his convictions, and he appealed to the U.S. Supreme Court. How do you think the high court ruled and why? [Boyle v. United States, 129 S. Ct. 2237 (U.S. Sup. Ct. 2009).]


The Legal Environment of Business

1 7


Tort Law

CASE OPENER Plastic Surgeon Defamation Dr. Walter Sullivan was one of several plastic surgeons in Las Vegas whom Julie Jones visited. Jones, an exotic dancer, sought plastic surgery to improve her ability to make money in her profession. After visiting Sullivan for a consultation, she then visited Dr. Joseph Bongiovi, Jr. During her consultation with Bongiovi, Jones mentioned her earlier visit with Sullivan. Bongiovi then told her that a patient of Sullivan’s died the previous week during the same procedure Jones sought. Bongiovi told her the death was the direct result of Sullivan’s negligence. Despite Bongiovi’s allegations, Jones saw Sullivan again and scheduled the surgery with him. Jones did, however, attend a prescheduled appointment with Bongiovi. During the appointment, at Jones’s prompting, Bongiovi confirmed what he had said before—that Sullivan had recently been responsible for a patient’s death during the same procedure Jones sought. On the basis of the confirmation from Bongiovi, Jones called to cancel her surgical appointment with Sullivan. When Sullivan’s office manager asked why she was canceling the appointment, Jones said she had been told that Sullivan was under investigation for a patient’s death. When Sullivan learned of the cancellation, he called Jones to find out who had made the statements; he was unsuccessful in obtaining a name. After speaking with Sullivan, Jones again called Bongiovi’s office to receive confirmation about the allegation. Bongiovi’s assistant confirmed that the statements were true. When Sullivan eventually learned the identity of Bongiovi, he filed suit for defamation. According to Sullivan, Bongiovi’s statements were slanderous per se. At the conclusion of a trial, a jury found in favor of Sullivan and awarded him $250,000 in compensatory damages and $250,000 in punitive damages. Bongiovi appealed, arguing that the jury should have been instructed that actual malice was the standard because Sullivan was a public figure. Furthermore, Bongiovi argued that the compensatory and punitive damages awarded were exorbitant. 1. 2.

What defenses, if any, could Bongiovi have presented to prevent the damage awards? Under which ethical system, if any, should Bongiovi be required to pay damages to Sullivan? Why?


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

LO 7-1

How are torts classified?

LO 7-2

What are some of the most common intentional torts, and what are the elements needed to prove these torts?

LO 7-3

What are the elements that must be proved to win a negligence case?

LO 7-4

What are the doctrines that help a plaintiff win a negligence case?

LO 7-5

What defenses are available in a negligence case?

LO 7-6

How does a party prove a strict-liability case?

LO 7-7

What types of damages are available in tort cases?

tort A violation of another person’s rights or a civil wrongdoing that does not arise out of a contract or statute; primary types are intentional, negligent, and strictliability torts.

As a future business manager, you will likely be involved in a situation in which one party believes he or she has been injured by the actions of another party, in the same way Dr. Sullivan believed he had been injured by Dr. Bongiovi’s allegations about the death of one of Dr. Sullivan’s patients due to the doctor’s negligence. Wrongs such as these are often referred to as torts. A tort is commonly defined as a wrong or injury to another, other than a breach of contract. In fact, tort is a French word meaning “wrong.” This chapter first examines the goals of tort law and the three primary classifications of torts. Next, the chapter examines each of the categories of torts. It concludes by discussing damages that may be available in tort cases.

Introduction to Tort Law Chapter 5 introduced criminal law and explained the punishment individuals may receive for committing crimes. Most of the actions that give rise to criminal prosecutions also provide the basis for a tort claim by the victim of the crime. Although the primary objectives of criminal law are to punish wrongdoers and preserve order in society, the primary objective of tort law is to provide compensation for injured parties. Tort law also contributes to maintaining order in society because it discourages private retaliation by injured persons and their friends. After all, we do not want to live in a community where vigilantes with tempers are roaming about righting some harm they believe has occurred to them. A third objective of tort law is to give citizens a sense that they live in a just society. Our collective sense of right and wrong suggests that someone who creates harm should make things right by compensating those who were harmed. The recognition that one will have to pay for the personal injuries she or he causes may also serve to deter the commission of torts. Although this chapter discusses torts as if they were the same everywhere, tort law is primarily state law, so states may have slightly different definitions of each tort. In describing torts, this chapter uses the definitions common in most states, noting when there seems to be a significant difference in the way certain states define the tort. Despite the public impression of a tort litigation explosion often conveyed by the media, because tort law is state law, no entity regularly compiles and publishes an annual report of the total number of tort cases filed nationwide. Writers for a legal publication, Lawyer’s Weekly USA, however, do keep track of the top 10 jury verdicts every year. What they have found is that after



Chapter 7 Tort Law

years of decline since 2000, the top 10 jury verdicts rose dramatically in 2008 and increased by a smaller number in 2009, with the average of the top 10 jury verdicts increasing from $112 million to nearly $145 million. But the very top award in 2009 was slightly lower, at $370 million, versus $388 million in 2008. In 2010, the average increased less than the prior year, however, rising from nearly $145 million to just under $157 million, but the top award was significantly higher in 2010. A Las Vegas attorney won a judgment of $505 million, with $500 million being punitive damages, against a manufacturer and distributor whose oversized vials of a drug led to an outbreak of hepatitis C at outpatient surgical centers.1 Given what we do know about tort litigation and damages, we know that potential tort liability should concern a competent business manager.

Classification of Torts Torts are most commonly classified as intentional, negligent, or strict-liability torts. Each category differs in terms of the elements needed to prove the tort, the available damages, the available defenses, and the degree of willfulness of the actor. Intentional torts occur when the defendant takes an action intending that certain consequences will result or knowing certain consequences are likely to result. Negligent torts occur when the defendant acts in a way that subjects other people to an unreasonable risk of harm. In other words, the defendant is careless to someone else’s detriment. Finally, strict-liability torts occur when the defendant takes an action that is inherently dangerous and cannot ever be undertaken safely, no matter what precautions the defendant takes. It is important to remember that when we discuss these classifications, we are referring to their use in the United States. The Chinese legal system, for example, narrowly defines the activities actionable under tort law.

LO 7-1 intentional tort A civil wrong resulting from an intentional act committed on the person, property, or economic interest of another. Intentional torts include assault, battery, conversion, false imprisonment, intentional infliction of emotional distress, trespass to land, and trespass to chattels.

negligent tort

Intentional Torts Intentional torts are the most willful of torts. Intentional torts are predicated on the common element of intent. The intent at issue is not intent to harm but, rather, to engage in a specific act, which ultimately results in an injury, physical or economic, to another. In fact, one does not need to establish a motive when proving liability in an intentional tort case. Moreover, in tort law, it is assumed that people intend what could be considered the normal consequences of their actions. For example, if Rob throws a rock toward a group of people, it would be assumed under the law that he intended to hit someone with the rock and that the person hit would be hurt, regardless of Rob’s intention merely to scare the group of people. As a general rule, each specific intentional tort has a set of elements that must be proved to establish the tort, along with specific defenses that can be raised against each tort. However, not all harms intentionally committed will fall neatly into an existing category of torts. Therefore, a general theory of intentional tort liability has been created to aid judges in their decision making. In Section 870 of the Restatement (Second) of Torts, the general theory is explained this way: One who intentionally causes injury to another is subject to liability to the other for that injury, if his conduct is generally culpable and not justifiable under the circumstances. This liability may be imposed although the actor’s conduct does not come within a traditional category of tort liability.

Intentional torts are divided into the following three categories: (1) torts against persons, (2) torts against property, and (3) torts against economic interests. The following sections discuss a number of specific torts that fall into each category, along with the defenses for each.

INTENTIONAL TORTS AGAINST PERSONS Torts against persons are intentional acts that harm an individual’s physical or mental integrity. There are a significant number of these torts. Assault and battery are two of the most common. Imagine that after searching for a parking space for 20 minutes, you finally pull into a spot. 1

Lawyers USA Online, “Top Ten Jury Verdicts of 2010,” http://lawyersusaonline.com/free-white-paper-top-ten-jury-verdicts-of-2010

A civil wrong that occurs when the defendant acts in a way that subjects other people to an unreasonable risk of harm (i.e., the defendant is careless, to someone else’s detriment). Negligence claims are usually used to achieve compensation for accidents and injuries.

strict-liability tort A civil wrong that occurs when the defendant takes an action that is inherently dangerous and cannot ever be undertaken safely, no matter what precautions the defendant takes. In such situations, a defendant is liable for the plaintiff’s damages without any requirement for the plaintiff to prove that the defendant was negligent.

LO 7-2


assault A civil wrong that occurs when one person intentionally and voluntarily places another in fear or apprehension of an immediate, offensive physical harm. Assault does not require actual contact.

battery A civil wrong that occurs when one person intentionally and voluntarily brings about a nonconsented harmful or offensive contact with a person or something closely associated with him or her. Battery requires an actual contact.

Part I

The Legal Environment of Business

However, as soon as you turn off your car, a man who looks like Mike Tyson starts pounding on your car window. He angrily yells, “You took my spot! If you don’t move your car now, I’m going to hit you so hard you won’t remember what your car looks like!” The man has just assaulted you. An assault occurs when one person places another in fear or apprehension of an immediate, offensive bodily contact. Therefore, in the above example, if you think the man is just joking and you start laughing, no assault has taken place because there is no fear or apprehension. Not only must you feel fear or apprehension, but that feeling must be reasonable under the circumstances. An assault is often, but not always, followed by a battery, an intentional, unwanted, offensive bodily contact. Almost any unwanted, intentional contact constitutes a battery. Even contacts that are harmless, if unwanted, are batteries. And even if a touch is intended as a joke, if the reasonable person would be offended, the contact is deemed offensive.2 To return to the example of the parking-space incident, if the man actually hit you, his action would constitute a battery. In contrast, if you both happened to be getting out of your respective cars at the same time and consequently bumped into each other, no battery would have occurred because there was no intentional bodily contact.

B UT W H AT I F   .   .   . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall in the Case Opener that Dr. Sullivan sued Dr. Bongiovi because of the false statement he made. What if, instead, Dr. Sullivan had called Dr. Bongovi and said, “If you ever tell a potential client a lie like that about me again, I will slit your throat!” Would Dr. Sullivan have committed an assault or battery? Why or why not?

defamation A false statement or an action that harms the reputation or character of an individual, business, product, group, government, or nation.

A limited number of defenses are available to an action for a battery. A party charged with a battery may argue that the offended party consented to the contact. Consent, as a defense, mitigates the element of unwanted. A person cannot commit a battery if the contact was consented to and therefore wanted. The most common defense to battery is self-defense, responding to the force of another with comparable force to defend oneself. In our parking-space example, if the man took a swing at you and you shoved him to try to keep him from hitting you, causing him to fall backward and hit his head on the street, he would not succeed in a case against you for battery because you could raise the defense of self-defense. To use this defense, you cannot use a greater level of force than is being used against you. A third defense, defense of others, allows you to defend another by using the same degree of force that you could use to defend yourself. A final defense, defense of property, allows you to use reasonable force to defend your property from an intruder. The use of deadly force in defense of property is rarely, if ever, considered justified. The tort alleged in this chapter’s opening case was defamation, which is the intentional publication (communication to a third party) of a false statement harmful to an individual’s reputation. In addition to the person who publishes a false statement, anyone who republishes, or in any manner repeats, a defamatory statement is also liable for defamation, even if he or she cites the original source of the defamation. If the defamation is published in a permanent form, such as printed in a magazine or newspaper, it is known as libel. Defamation through television and radio broadcasts is also considered libel because the broadcasts are permanently recorded. In the case of libel, general damages are presumed. Thus, the victim would be entitled to compensation for the damages 2

Restatement (Second) of Torts, sec. 19.

Chapter 7 Tort Law

that are presumed to flow from defamation yet are hard to prove, such as the humiliation the victim would feel. If the defamation is made orally, it is slander. To recover damages in a case of slander, the plaintiff must prove special damages; that is, the plaintiff must show specific monetary loss that resulted from the defamatory statements. Although libel is contained in a permanent form, slander, by virtue of being spoken, is not. It is the lack of permanence that gives way to the special damages involved with slander. If the people who heard the slander do not act in a way to cause harm to the slandered person, there is no cause for compensation, which is one of the main goals of tort law. One exception to the requirement of special damages occurs if the false statements constitute slander per se. Slander per se statements are considered so inherently harmful that general damages are presumed. The kinds of statements considered slander per se are claims that an individual (1) has a loathsome, communicable disease (traditionally, venereal disease or leprosy); (2) has committed a crime for which imprisonment is a possibility; (3) is professionally incompetent; or (4) if a woman, has engaged in sexual misconduct. If you say your boss is a tyrant or your roommate is a slob, are you in danger of being sued for defamation? You probably are not because such statements are not really statements of fact; rather, they are opinions, and subjective opinions that cannot be proven are generally not actionable. One of the important elements of defamation is that the defamatory statement must be damaging to someone’s reputation. For example, when a convicted criminal serving three life sentences attempted to sue a journalist for alleged errors in an article detailing his criminal history, the journalist filed a motion to dismiss on grounds that the defendant was libel-proof as a matter of law regarding claims about his criminal background. Upholding the dismissal, the court said the plaintiff’s public reputation at the time the articles were published was so diminished with respect to a specific subject (his kidnapping and murder convictions) that he could not be further injured by allegedly false statements on that subject.3

B UT W HAT IF  . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall in the Case Opener that Dr. Bongiovi knew Jones was contemplating going to Dr. Sullivan for treatment, and he wanted her business, so he told her negative stories about Dr. Sullivan. What if Dr. Bongiovi had no idea Jones had ever heard of Dr. Sullivan and was telling her the story just as a reminder that no surgery is completely risk-free?

The increase in communication over the Internet has presented new questions for the law of defamation to answer. First, does a false statement made over this information network constitute defamation? Second, who can be held liable if defamation does exist? The court first attempted to answer these issues in the case of Cubby v. CompuServ.4 In that case, CompuServ was sued because of defamatory statements published on one of the forums available through its online information service. In holding that CompuServ could not be held liable, the court made an analogy between an online information service provider such as CompuServ and bookstores, saying, “CompuServ’s CIS product is in essence an electronic, for profit library.” The court went on to say that once CompuServ decides to carry a given publication such as a news forum, it has little or no editorial control over that forum. It would therefore be no more feasible for CompuServ to examine every publication it carries for defamatory material than it would be for libraries or booksellers to do so. 3 4

Thomas P. Lamb v. Tony Rizzo, 391 F.3d 1133 (2004). 77b F. Supp. 135 (1991).



absolute privilege A special right, immunity, permission, or benefit given to certain individuals that allows them to make any statements about someone without being held liable for defamation for any false statement made, regardless of intent or knowledge of the falsity of the claim.

conditional privilege A special right, immunity, permission, or benefit given to certain individuals that allows them to make any statements about someone without being held liable for defamation for any false statement made without actual malice.

actual malice In defamation, either a person’s knowledge that his or her statement or published material is false or the person’s reckless disregard for whether it is false.

public figure privilege A special right, immunity, or permission given to people that allows them to make any statements about public figures, typically politicians and entertainers, without being held liable for defamation for any false statement made without malice.

Part I

The Legal Environment of Business

Since Cubby was decided, the Communications Decency Act of 1996 was passed. One section of this act gives immunity to providers of interactive computer services for liability they might otherwise incur because of material they disseminate but others create. A person who is accused of defamation can raise two defenses: truth and privilege. Truth is frequently considered an absolute defense. That is, one cannot be held liable for defamation, regardless of whether damages result, if the statement made was the truth. If I say Bill is a convicted felon, and he is, I have not committed defamation. Under ordinary circumstances, the fact that you thought a statement was true is not a defense. So if I honestly believe Bill is a convicted felon and I tell others he is, but he is not, then I have committed slander. Privilege is an affirmative defense in a defamation action. An affirmative defense occurs when the defendant admits to the accusation but argues that there is a reason he should not be held liable. A privilege is either absolute or conditional. When an absolute privilege exists, one cannot be sued for defamation for any false statements made, regardless of intent or knowledge of the falsity of the claim. Absolute privilege arises in only a limited number of circumstances. The speech and debate clause of the U.S. Constitution gives an absolute privilege to individuals speaking on the House and Senate floors during congressional debate. This privilege exists because Congress wants to get to the truth of matters before it, and if people testifying before Congress had to fear they might be sued, they might be afraid to testify. Absolute privilege also arises during a judicial proceeding. Again, we do not want people to be afraid to testify in court, so we prohibit them from being sued for whatever occurs within the courtroom. As the following Case Nugget illustrates, the concept of a judicial proceeding can extend beyond a traditional courtroom. Conditional privilege is the second type. Under a conditional privilege, a party will not be held liable for defamation unless the false statement was made with actual malice. A statement is made with actual malice if it is made with either knowledge of its falsity or reckless disregard for its truth. Businesspersons should be most concerned about the conditional privilege that arises with respect to job recommendations. To encourage employers to give honest assessments of their former employees, this privilege protects an employer who makes a false statement about a former worker: The employer will not be held liable as long as the statement was made in good faith and was made only to those who had a legitimate interest in the information being communicated. Another conditional privilege is the public figure privilege. Public figures are individuals who are in the public eye, typically politicians and entertainers. Because these individuals have a significant impact on our lives, we want to encourage free discussion about them, so we do not hold people liable for making false statements about them as long as the statements were not made with malice. This privilege does not seem to place an unfair burden on the public figure because such an individual can easily respond publicly to any false claims, given that he or she is already in the public eye and has appropriate outlets available for giving his or her opinion. In the opening scenario, Bongiovi argued on appeal that Sullivan was a public figure by nature of his profession. If Bongiovi could establish that Sullivan was a public figure, Sullivan would have to show that Bongiovi acted with actual malice while making the statements to the patient. There are those who believe a conditional privilege should apply when the defamatory statement is posted somewhere on the Internet. The reasoning behind application of the privilege in this context is that the person who has been defamed over the Internet can respond to the defamatory remarks in the same forum with minimal effort. Thus, there is less need for the stronger legal protection we ordinarily give to private parties who are defamed. In addition, we want to encourage free expression and the exchange of ideas on the Internet. One way to do so is to allow people to respond openly to criticisms on the Internet. When people are overly concerned about making errors, free exchange is hindered. Relaxing defamation standards in regard to the Internet can encourage people to speak their minds freely. Thus far, however, no such privilege has been established. And when a person is found to have committed defamation on an online bulletin board or website, the damages can be significant. For example, a jury awarded $3 million to a university professor who sued a former student who had accused him of being a pedophile on a website she maintained.

Chapter 7 Tort Law

CASE Nugget The Applicability of an Absolute Privilege Hartman and Swinehart v. Keri Supreme Court of Indiana 2008 Ind. LEXIS 265, 883 N.E.2d 774 On May 12, 2003, graduate students Virginia Hartman and Suzanne Swinehart filed formal complaints alleging sexual harassment by Dr. Gabe Keri, an assistant professor at Indiana University–Purdue University Fort Wayne (IPFW) from whom they had taken courses. IPFW charged Dr. Elaine Blakemore with the task of investigating the allegations; Blakemore submitted a report on June 30, 2003, that concluded Hartman and Swinehart’s allegations were credible and commended their willingness to report the behavior. Furthermore, Blakemore suggested Keri be immediately removed from teaching positions. These findings and recommendations were further investigated by a three-person panel and Chancellor Wartell. Blakemore’s report was supported and Keri was given a 100 percent research position with no use of his university office. Keri appealed to the president of Purdue, who upheld the chancellor’s decision. In response, Keri filed suit against Hartman and Swinehart in the Allen Superior Court, claiming libel, slander, and malicious interference. Hartman and Swinehart moved for summary judgment, claiming their statements were protected by absolute privilege. This motion was denied. Hartman and Swinehart appealed. In finding that the students’ statements were entitled to absolute privilege, the state supreme court judges explained that administrative proceedings that are quasi-judicial in nature are entitled to absolute protection. They applied the factors courts use to determine whether a proceeding is quasi-judicial in nature. These factors include whether the body has the power to (1) exercise judgment and discretion; (2) hear and determine or to ascertain facts and make decisions; (3) make binding orders and judgments; (4) affect the personal or property rights of private persons; (5) examine witnesses and hear the litigation of issues on a hearing; or (6) enforce decisions or impose penalties.

One final tort against persons is the tort of intentional infliction of emotional distress. Sometimes called the tort of outrage, intentional infliction of emotional distress occurs when someone engages in outrageous, intentional conduct likely to cause extreme emotional distress to another party. For example, if a person calls his former employer and falsely says her son was just arrested for a double homicide after a botched robbery attempt, most courts would find that behavior outrageous enough to satisfy the first element of the tort. Before damages are awarded in some jurisdictions, the plaintiff must demonstrate injury through physical symptoms directly related to the emotional distress. For instance, in the preceding example, if the employer fainted upon hearing the news, hitting her head on the table and cutting it as she passed out, she would have physical symptoms sufficient to justify a recovery. Other physical symptoms from emotional distress include headaches, a sudden onset of high blood pressure, hives, chills, inability to sleep, and inability to get out of bed. Businesses frequently find themselves sued for this type of tort when they terminate someone’s employment or fail to provide a service that a consumer expected. Many of these actions, like the one in Case 7-2, are unsuccessful, primarily because the bar for what is considered outrageous is high, as are the standards for emotional distress.


CASE 7-1


FACTS: On December 14, 2011, appellant Aaron Olson contracted to receive telephone service from respondent, CenturyLink, and applied for reduced-rate services that CenturyLink provides through Minnesota’s Telephone Assistance Plan (TAP), a statewide program established to reduce telephone rates for low-income households. The respondent did not apply the reduced rate to Olson’s first bill but attached a blank copy of the TAP application. Olson completed the application and mailed it to the respondent, but his next bill also did not reflect a reduced rate. Olson called the respondent and learned that the company had not received his application. Olson then faxed another application to the respondent. A few days later, he contacted the respondent company, but could not confirm whether his application had been received. On January 31, 2012, the respondent company disconnected Olson’s telephone service. When Olson called the respondent to resolve the dispute, the company representatives repeatedly hung up on him. In April 2012, Olson filed suit, claiming that the respondent company violated the Minnesota Human Rights Act (MHRA) and committed intentional infliction of emotional distress. Because he did not have the money for filing fees, Olson also filed a petition to proceed in forma pauperis (IFP). The district court denied the petition, determining that the action was frivolous because the claims had no basis in law. Olson appealed.

REASONING: To prevail on this tort, a plaintiff must establish that the defendant’s conduct (1) was extreme and outrageous, (2) was intentional or reckless, (3) caused emotional distress, and (4) the distress was severe. Extreme and outrageous conduct is behavior that is “so atrocious that it passes the boundaries of decency and is utterly intolerable to the civilized community.” Furthermore, to hold a party liable in tort for intentional infliction of emotional distress, the emotional distress must be so severe “that no reasonable man could be expected to endure it.” In this case, the respondent’s acts of failing to process Olson’s application, disconnecting his telephone service, and hanging up on him during telephone conversations are not so atrocious that they pass the boundaries of decency. For example, previous case law Langeslag v. KYMN Inc. states that “insults, indignities, annoyances, petty oppressions, and other trivialities do not constitute extreme and outrageous conduct.” The evidence provided by the appellant regarding the acts against him by the respondent mirror the acts cited by Langeslag that were previously determined not to constitute extreme and outrageous conduct. DECISION AND REMEDY: The court affirmed the denial of the petition by the district court in favor of the defendant.

SIGNIFICANCE OF THE CASE: This case outlines the standards that must be met for a defendant to be ISSUE: When should a defendant be held liable in tort for held liable in tort for intentional infliction of emotional intentional infliction of emotional distress? distress.

CRITICAL THINKING Notice that case law can, as in this case, serve as a restriction on our emotional response to a case. Many of us have had trouble with our phone carrier. The alleged behavior of CenturyLink is at minimum annoying, but case law lays out standards that determine the availability of remedies in cases like these. Reading the case law, describe behavior that CenturyLink would have had to engaged in for the plaintiff to have prevailed.

ETHICAL DECISION MAKING What value is the court upholding in finding against the plaintiff?



Chapter 7 Tort Law

INTENTIONAL TORTS AGAINST PROPERTY Because businesses own property, anyone who manages a business should be concerned about torts against property. The most common torts a businessperson might be involved with are trespass to realty, nuisance, trespass to personalty, and conversion. Trespass to Realty The tort of trespass to realty, also called trespass to real property, occurs when a person intentionally (1) enters the land of another without permission; (2) causes an object to be placed on the land of another without the landowner’s permission; (3) stays on the land of another when the owner tells him to depart; or (4) refuses to remove something he placed on the property that the landowner asked him to remove. It is no defense for a person to argue that she thought she had a legal right to be on the property or she thought the land belonged to someone else. The intent refers to intentionally being on that particular piece of land. In a recent, unusual case heard in a small claims court in Westchester County, a plaintiff sued the defendant for trespass to realty when the defendant entered the plaintiff’s property to serve the plaintiff with a reply affidavit for another legal action. The defendant had previously been barred from entering the plaintiff’s property. The plaintiff argued that the defendant could not dictate how legal papers are served. The plaintiff sued for $3,000 in compensatory, nominal, and punitive damages. Although the court ruled that the defendant committed trespass to realty, it awarded only nominal damages in the sum of $1. Because guests are welcomed onto one’s property, they are not considered trespassers. However, if a guest is asked to leave and he or she refuses, the person immediately becomes a trespasser and no longer maintains a right to be on the property in question. If charges were brought against such a person, that person could not raise the defense that he or she was a guest. Also, when a trespasser is on someone’s property, the trespasser is liable for damages she or he might cause to the property. Furthermore, under common law, a trespasser cannot hold an owner of property liable for damages the trespasser sustains while on the property. However, as of late, courts have been shifting away from this common law rule. Now, courts typically maintain that owners owe a reasonable duty to anyone who may end up on their property. The specifics of the duty vary by jurisdiction as well as by the status of the parties. In some jurisdictions, it is possible, although rare, for owners to be liable for trespassers who were injured while trying to steal property from the owners.

trespass to realty

Private Nuisance A private nuisance occurs when a person uses her property in an unreasonable manner that harms a neighbor’s use or enjoyment of his property. Using one’s property in a manner that caused the neighbor to be subjected to flooding, vibrations, excessive noise, or smoke could lead to a nuisance claim.

private nuisance

Trespass to Personal Property A person commits trespass to personal property, also called trespass to personalty, by temporarily exerting control over another’s personal property or interfering with the true owner’s right to use the property. Under trespass to personal property, the trespasser is responsible for damages caused to the property as well as for damages caused to the owner related to the trespasser’s wrongful possession of the property. For example, if I take someone’s bike from his garage and use it for a week, I have committed trespass to personalty. If I return the bike after it has a flat tire, I will have to compensate the owner for the cost of repairing the tire and any other expenses that resulted from my having the bike for a week. Also, if the bike was the only means the person had for getting to work, I would be responsible for the person’s lost wages resulting from the missed work, because I took the person’s means of transportation.

trespass to personal property

Conversion Conversion occurs when a person permanently removes personal property from the owner’s possession and control. When conversion occurs, the true owner can no longer regain the property. The owner usually recovers damages for the full value of the converted item plus any additional damages that resulted from the loss. It is not a defense to conversion for a person to argue that she believed she had a legal claim to the goods. For example, if Brittany accidentally takes Melvin’s suitcase believing it to be hers and


A tort that occurs when someone goes on another’s property without permission or places something on another’s property without permission.

A nuisance that affects only a single person or a very limited number of individuals.

Temporary interference with another’s use or enjoyment of his or her personal property.

Permanent interference with another’s use and enjoyment of his or her personal property.


Part I

The Legal Environment of Business

then loses it, she is still liable for conversion. Moreover, the possession of stolen goods also makes a person liable for conversion. Therefore, buying goods in good faith without knowledge of any impropriety also is not a defense to conversion. Even if a person bought the goods believing the purchase was legal, the person with the stolen goods is liable to the legal owner of the goods. An illustration of conversion comes from a recent case heard in the Westchester County Supreme Court. An amateur race-car driver left her race car at a service station. While the car was in the possession of the service station, an employee of the station, with a known drinking problem, apparently drove the car, wrecked it, and totally destroyed it. The car could never be returned in the condition it was in when brought to the station. The owner sued for conversion and recovered the value of the car in damages.


disparagement A business tort that occurs when a statement is intentionally used to defame a business product or service.

slander of quality A business tort that occurs when false spoken statements criticize a business product or service and result in a loss of sales.

trade libel A business tort that occurs when false printed statements criticize a business product or service and result in a loss of sales.

slander of title A business tort that occurs when false published statements are related to the ownership of the business property.

food disparagement A tort that provides ranchers and farmers with a cause of action when someone spreads false information about the safety of a food product.

intentional interference with contract The tort that occurs when someone intentionally takes an action that will cause a person to breach a contract that she or he has with another.

All businesspersons should be familiar with the torts against economic interest. The five most common torts against economic interests, frequently referred to as “business torts,” are disparagement, intentional interference with contract, unfair competition, misappropriation, and fraudulent misrepresentation. The first tort, disparagement, is similar to defamation, but it is a business’s or product’s reputation that has been tarnished. The plaintiff in a disparagement case must prove that the defendant published a false statement of a material fact about the plaintiff’s product or service that resulted in a loss of sales. When such statements are criticisms of the quality, honesty, or reputation of the business or product, the tort is sometimes called slander of quality (if spoken) or trade libel (if in printed form). If the statements relate to the ownership of the business property, the term slander of title is used. Damages for disparaging are ordinarily based on a decrease in profits that can be linked to the publication of the false statement. An alternative, although less common, way to prove damages is to demonstrate that the plaintiff had been negotiating a contract with a third party but the third party lost interest shortly after the publication of the false statement. The profits the plaintiff would have made on the contract would be the damages. Some interesting variations of the tort of disparagement have developed. For example, in 2007, California became the thirteenth state to recognize the tort of food disparagement, which critics call veggie libel. Such laws provide ranchers and farmers with a cause of action when someone knowingly makes false, damaging statements about a food product. The California law was drafted in response to an incident during 2006 in which Taco Bell executives wrongly identified green onions grown at Boskovich Farms in Oxnard as the source of an E. coli outbreak that sickened 70 of the fast-food chain’s customers. A second tort against economic interests is the tort of intentional interference with contract. To bring a claim of intentional interference with contract successfully, the plaintiff must prove that (1) a valid and enforceable contract between the two parties existed; (2) the defendant party knew of the existence of the contract and its terms; (3) the defendant intentionally undertook steps to cause one of the parties to breach the contract; and (4) the plaintiff was injured as a result of the breach.5 When a contract exists, clear liability is placed on third parties for inducing a party to the contract to breach the contract. However, when a prospective contract exists, a third party might be liable for inducing a party to pull out of the contract before it is formed. Because the essence of business involves competition, simply offering a better deal is not enough to create liability when a prospective contract exists. However, if a party uses illegal means to cause another party not to enter into a contract, the party who acted illegally is liable for interfering with contractual relations.6 The most common situation involving intentional interference with a contract in the business context occurs when one employer tries to lure an employee away from another employer. Liability in such a situation, however, is limited to when the employee has a contract for a set period of time and the prospective employer actually knows of the contract. 5 6

Restatement (Second) of Torts, sec. 766. Restatement (Second) of Torts, sec. 766B.


Chapter 7 Tort Law

When a third party interferes with a contract, injured parties may recover damages for what was directly lost through the breached contract. They may also recover any losses suffered related to the breached contract, in addition to damages for emotional distress and harm to reputation.7 A third tort against economic interests, unfair competition, exists because of American views about the purpose of a business. Americans believe a business is intended to make a profit, and the law protects businesses acting on this profit motive. Therefore, when someone enters a business with the sole intent of driving another firm out of business, the law punishes this act as unfair competition. For example, if there is only one jewelry store in town, Mark cannot come in and set up a store that makes no profits, just to drive the other store out of business so that an acquaintance of his can then move in and open up a legitimate jewelry store once the competition has been eliminated. A fourth tort against economic interests is fraudulent misrepresentation, which occurs when one uses intentional deceit to facilitate personal gain. To establish that a fraudulent misrepresentation exists, a party must demonstrate all the following: 1. A party knowingly, or with reckless disregard for the truth, misrepresented material facts and conditions. 2. The party intended to have other parties rely on the misrepresentations. 3. The injured party reasonably relied on the misrepresentations. 4. The injured party suffered damages because of relying on the misrepresentations. 5. A direct link exists between the injuries suffered and a reliance on the misrepresentations.8

unfair competition The act of competing with another not to make a profit but for the sole purpose of driving that other out of business.

fraudulent misrepresentation The tort that occurs when a misrepresentation is made with the intent to facilitate personal gain and with the knowledge that it is false.

As in the criminal act of fraud, in the civil act of fraudulent misrepresentation, a party materially misrepresents something and thereby causes another party to suffer damages. Typically, fraudulent misrepresentation applies only to the misrepresentation of material facts. However, when a party with expert knowledge regarding a specific matter states an opinion, any party reasonably relying on the statement, although it is an opinion and not fact, may recover damages under the tort of fraudulent misrepresentation.

Negligence Negligence is behavior that creates an unreasonable risk of harm to others. Unlike intentional torts, which result from a person willfully taking actions that are likely to cause injury, negligent torts involve the failure to exercise reasonable care to protect another’s person or property. Sometimes, however, harm occurs because an individual suffers an unfortunate accident, an incident that simply could not be avoided, even with reasonable care. For example, suppose Jonathan is driving on the highway when he suffers a stroke. Because of the stroke, he crashes into two other vehicles. He is not, however, liable for damages caused by the accident because he was not negligent. Yet if Jonathan had some type of warning that the stroke was going to occur, he might be liable for the accident. To win a negligence case, the plaintiff must prove four elements: (1) duty, (2) breach of duty, (3) causation, and (4) damages (see Exhibit 7-1). A plaintiff who cannot establish all four of these elements will be denied recovery.

DUTY The plaintiff must first establish that the defendant owes a duty to the plaintiff. In some particular situations, the law specifies the duty of care one individual owes to another. In most cases, however, the courts use the reasonable person standard to determine the defendant’s duty of care. The reasonable person standard is a measurement of the way members of society expect an individual 7 8

Restatement (Second) of Torts, sec. 774A. Restatement (Second) of Torts, sec. 525.

LO 7-3 negligence Behavior that creates an unreasonable risk of harm to others.

reasonable person standard A measurement of the way members of society expect an individual to act in a given situation.


Part I

Exhibit 7-1

The Legal Environment of Business

To prove negligence, a plaintiff must demonstrate:

Elements of Negligence

1. 2. 3. 4.

Duty Breach of duty Causation—actual and proximate Damages

to act in a given situation. To determine the defendant’s duty of care, the judge or jury must determine the degree of care and skill that a reasonable person would exercise under similar circumstances. The judge or jury then uses this standard to evaluate the actions of the individual in the case. When courts attempt to determine whether a reasonable person would have owed a duty to others, they consider four questions: 1. 2. 3. 4.

How likely was it that the harm would occur? How serious was the potential harm? How socially beneficial was the defendant’s conduct that posed the risk of harm? What costs would have been necessary to reduce the risk of harm?

In many situations, it is far from clear what a reasonable person would do. For example, if a reasonable person saw an infant drowning in a shallow swimming pool, what would she do? In most situations like this one, the law holds that individuals have no duty to rescue strangers from perilous situations. In some cases, however, the courts hold that individuals have a duty to aid strangers in certain types of peril. For example, if Sam negligently hits Janice with his car and, as a result, Janice is lying in the street, Sam has a duty to remove her from that dangerous position. Similarly, employers have a special duty to protect their employees from dangerous situations. The courts generally hold that landowners have a duty of care to protect individuals on their property. Similarly, businesses have a duty of care to customers who enter business property. It is important, therefore, for future business managers to be knowledgeable about this duty. Businesses should warn customers about risks they may encounter on business property. Some risks, however, are obvious, and businesses need not warn customers about them. For example, a business need not inform customers that they could get a paper cut from the pages of a book. The courts generally hold that businesses have a duty of care to protect their customers against foreseeable risks about which the owner knew or reasonably should have known. For example, in Haywood v. Baseline Construction Company, a woman who tripped over lumber on the front porch of the House of Blues restaurant in Los Angeles sued for negligence. The business’s attempt to warn customers by marking the lumber with yellow construction tape was insufficient to avoid the determination of negligence; the woman was awarded $91,366 in damages. The liability of businesses grew out of the traditional common law, under which the duty of owners and occupiers of real property depends primarily on the status of the injured party. The injured party may be an invitee, a person who enters another’s premises as a result of an express or implied invitation of the owner for their mutual benefit, with a business invitee being one who is invited onto the property for the purpose of doing business; a licensee, a person who enters another’s premises with the occupier’s consent for his or her benefit alone; or a trespasser, one who is on the property without the owner’s or occupier’s permission, as described earlier in this chapter. Under this approach, the owner owes the greatest duty to the invitee, a duty to inspect the premises to ensure that they are reasonably safe and to warn of any hidden dangers. The owner has a duty to a licensee to warn of any hidden dangers of which he knows but has no affirmative duty to inspect for hidden problems. The owner owes no duty to trespassers except to do them no intentional harm. In 1968, however, the California Supreme Court rejected this rigid division,9 substituting a general duty of reasonable care in its place, under which a duty of reasonable care is owed any 9

Rowland, 443 P.2d 561 (Cal. 1968).

E-COMMERCE and the Law Negligence on the Internet A commonly offered explanation for the increasing occurrence of violence is the increased violence portrayed in the media. Some plaintiffs try to hold owners of certain websites liable under negligence theories for violent acts committed by teenagers. For example, in James v. Meow Media, a 14-year-old boy took six guns to school and shot three of his classmates to death. The parents of the deceased classmates brought suit against several Internet websites and the creators and distributors of various video games. The parents argued that these defendants had a duty of ordinary care to the slain girls. The courts have been consistent, however, in finding that it was not foreseeable that a boy who played certain

video games and viewed certain websites would murder three of his classmates. In similar cases, courts have ruled that defendants (such as website owners, creators and distributors of video games, and directors and producers of movies) do not have a duty to protect a person from the criminal acts of a third party unless there is a special relationship that requires the defendant to act with that duty. Although it appears that website owners, manufacturers, and producers will not be held liable, plaintiffs continue to bring suits against these groups of people. Can you think of an argument for why these groups of people might owe a duty of care to these plaintiffs?

entrant onto the land, regardless of status. More than 25 states have now moved to this standard, with a few using this standard for both the invitees and the licensees, while maintaining the traditional approach to trespassers. The trend is toward the use of this unitary standard, but given the lack of uniformity among the states, it is important to know which approach is being used by the state in which you live and do business. Professionals have more training than ordinary people. Thus, when professionals are serving in their professional capacity, courts generally hold that they have a higher duty of care to clients than does the ordinary person. A professional cannot defend against a negligence suit by claiming ignorance of generally accepted principles in her or his field of expertise. Clients who feel that they have suffered damages as a result of a professional’s breach of her duty of care can bring a negligence case against her. These actions are frequently referred to as malpractice cases.

BREACH OF DUTY Once the plaintiff has established that the defendant owes her a duty of care, she must prove that the defendant’s conduct violated that duty. This violation is called a breach of duty. For example, the driver of an automobile owes the other passengers in his car a duty of care to obey traffic signs. If he fails to stop at a stop sign, he has violated his duty to follow traffic signs and has therefore breached his duty of care.

CAUSATION Causation is the third element of a successful negligence claim, and it has two elements: actual cause and proximate cause. The plaintiff must prove both elements of causation to be able to recover damages. The first element, actual cause (also known as cause in fact), is the determination that the defendant’s breach of duty resulted directly in the plaintiff’s injury. The courts commonly determine whether a breach of duty actually caused the plaintiff’s injury by asking whether the plaintiff would have been injured if the defendant had fulfilled his or her duty. If the answer is no, then the actual cause of the plaintiff’s injury was the defendant’s breach. Actual cause is sometimes referred to as but-for causation because the plaintiff argues that the damages she suffered would not have occurred but for (except because of) the actions of the defendant. Proximate cause, sometimes referred to as legal cause, refers to the extent to which, as a matter of policy, a defendant may be held liable for the consequences of his actions. In most states, proximate cause is determined by foreseeability. Proximate cause is said to exist only when both the plaintiff and the plaintiff’s damages were reasonably foreseeable at the time the defendant breached his duty to the plaintiff. Thus, if the defendant could not reasonably foresee

actual cause The determination that the defendant’s breach of duty resulted directly in the plaintiff’s injury.

proximate cause The extent to which, as a matter of policy, a defendant may be held liable for the consequences of his or her actions. In the majority of states, proximate cause requires the plaintiff and the plaintiff’s damages to have been foreseeable at the time of the accident. In the minority of states, proximate cause exists if the defendant’s actions led to the plaintiff’s harm.


GLOBAL Context Negligence in Germany German law is concerned with the defendant’s ability to foresee, understand, and avoid danger. Both mental and physical capabilities are taken into account. For example, the duty-of-care standard stipulates that “physical and mental disabilities or defects, panic, or confusion” exempt the defendant from being found negligent. Also, although the distinction is not recognized by a statute, the

compensatory damages Money awarded to a plaintiff as reimbursement for her or his losses; based on the amount of actual damage or harm to property, lost wages or profits, pain and suffering, medical expenses, disability, and so on.

punitive damages Compensation awarded to a plaintiff that goes beyond reimbursement for actual losses and is imposed to punish the defendant and deter such conduct in the future.

gross negligence An action committed with extreme reckless disregard for the property or life of another person.

LO 7-4

courts distinguish between conscious and unconscious negligence. Conscious negligence requires knowledge that the offense is about to occur and that it is an actual offense. Unconscious negligence occurs when the defendant is either unaware that the act constitutes an offense or unaware that the act is occurring at all. In such cases, the defendant is found not liable by reason of unconscious negligence.

the damages that the plaintiff suffered as a result of his action, the plaintiff’s negligence claim will not be sustained because it lacks the element of proximate causation. You must be able to foresee that either the plaintiff himself or herself or a person in the plaintiff’s position would be hurt. If you are running a red light, it is foreseeable that a person will be crossing with the light. If you hit a person crossing with the light, we say the person hit was foreseeable. If it makes more sense, we could say “both a person in the plaintiff’s position” and the “plaintiff’s damages,” but most people refer simply to “the plaintiff and the plaintiff’s damages.” For example, if a defective tire on a vehicle blows out, it is foreseeable that the driver may lose control and hit a pedestrian. It is not foreseeable, however, that the pedestrian may be a scientist carrying a briefcase full of chemicals that may explode on impact, causing a third-floor window to shatter, injuring an accountant at his desk. In most states, the accountant would not succeed if he sued the tire manufacturer for negligence. The tire failure is not considered a proximate cause of the accountant’s injury because the contents of the pedestrian’s briefcase were highly unusual. The pedestrian, however, would be eligible to recover damages from the tire manufacturer because hitting a pedestrian is a foreseeable consequence of tire failure. Thus, the defect in the tire is a proximate cause of the pedestrian’s injury. Palsgraf v. Long Island Railroad Company is a well-known case in which the majority opinion set forth the rule of foreseeability in determining proximate cause. The dissent, however, set forth an alternative definition of proximate cause that is accepted today in a small minority of states. Courts following the minority definition do not distinguish actual cause from proximate cause. In these states, if the defendant’s action constitutes an actual cause, it is also considered the proximate cause. Therefore, in these few states, both the pedestrian-scientist and the thirdfloor accountant would be able to recover damages from the tire manufacturer in the previous example.

DAMAGES Damages are the final required element of a negligence action. The plaintiff must have sustained compensable injury as a result of the defendant’s actions. Because the purpose of tort law is to compensate individuals who suffer injuries as a result of another’s action or inaction, a person cannot bring an action in negligence seeking only nominal damages. Rather, a person must seek compensatory damages, or damages intended to reimburse a plaintiff for her or his losses. In typical negligence cases, courts rarely award punitive damages or exemplary damages, which are imposed to punish the offender and deter others from committing similar offenses. Instead, courts usually award punitive damages in cases in which the offender has committed gross negligence, an action committed with extreme reckless disregard for the property or life of another person.

Plaintiff’s Doctrines The plaintiff has the burden of proving all four elements of a negligence case. Direct evidence of negligence by the defendant, however, is not always available. For example, there may have been no witnesses to the negligent conduct, and other evidence may have been destroyed. Therefore,



Chapter 7 Tort Law

two doctrines have been adopted by courts to aid plaintiffs in establishing negligence claims: res ipsa loquitur and negligence per se.

RES IPSA LOQUITUR Res ipsa loquitur literally means “the thing speaks for itself.” The plaintiff uses this doctrine to allow the judge or jury to infer that, more likely than not, the defendant’s negligence was the cause of the plaintiff’s harm, even though there is no direct evidence of the defendant’s lack of due care. To establish res ipsa loquitur in most states, the plaintiff must demonstrate that: 1. The event was a kind that ordinarily does not occur in the absence of negligence. 2. Other responsible causes, including the conduct of third parties and the plaintiff, have been sufficiently eliminated. 3. The indicated negligence is within the scope of the defendant’s duty to the plaintiff.

res ipsa loquitur A doctrine that allows the judge or jury to infer that, more likely than not, the defendant’s negligence was the cause of the plaintiff’s harm, even though there is no direct evidence of the defendant’s lack of due care.

Proof of these three elements does not require a finding of negligence, however; it merely permits it. Once the plaintiff has demonstrated these three elements, the burden of proof shifts to the defendant, who must prove that he was not negligent to avoid liability. One of the earliest uses of res ipsa loquitur was the case of Escola v. Coca Cola.10 In that case, the plaintiff, a waitress, was injured when a bottle of Coca-Cola that she was removing from a case exploded in her hand. From the facts that (1) bottled soft drinks ordinarily do not spontaneously explode and (2) the bottles had been sitting in a case, undisturbed, in the restaurant for approximately 36 hours before the plaintiff simply removed the bottle from the case, the jury reasonably inferred that the defendant’s negligence in the filling of the bottle resulted in its explosion. The plaintiff therefore recovered damages without direct proof of the defendant’s negligence. Plaintiffs in numerous accident cases have subsequently used the doctrine when there has been no direct evidence of negligence. The defendant’s best response to this doctrine is to demonstrate other possible causes of the accident. Case 7-2 illustrates the use of this doctrine. 10

24 Cal. 2d 453, 150 P.2d 436 (1944).

CASE 7-2


FACTS On September 27, 1998, the Plaintiff and her husband, Michael Morris, were shopping in the defendant’s Sam’s Club when the plaintiff slipped and fell on a substance thought to be water next to a small portable freezer known as a spot box. After the fall, some of the defendant’s employees approached to lend the Plaintiff assistance. At this point, the Plaintiff noticed that her clothes were soaked in what she believed to be water from the nearby freezer. When the store manager arrived at the scene, he ordered the water to be cleaned up. He pointed out to the Plaintiff and her husband that the plug in the bottom of the freezer was out. The Plaintiff testified that the store

manager additionally said that the spot box was new and that he feared it might not be functioning properly. As a result of her injury, the Plaintiff was severely bruised and advised to stay in bed and off of her feet for a week. The Plaintiff subsequently filed suit against the defendant in Shelby County, Tennessee. The defendant removed the matter to District Court on the basis of diversity of citizenship. Following the Plaintiff’s case-in-chief, the defendant moved for a judgment as to law, arguing that the Plaintiff failed to provide evidence that the defendant had notice of the water, and that the Plaintiff could not rely upon the doctrine of res ipsa loquitur. The Plaintiff argued

(continued) that she was not attempting to and could not show notice. She claimed instead that she provided evidence that the defendant created a dangerous condition by placing the new spot box out without a plug in it, and that the doctrine of res ipsa loquitur applied. The District Court granted the defendant’s motion. The Plaintiff appealed. ISSUE: Should a plaintiff be allowed to use res ipsa loquitur to recover from injuries suffered by a defendant’s malfunctioning product? REASONING: A plaintiff should be allowed to use res ipsa loquitur to allow the jury to infer negligence when the plaintiff can demonstrate two conditions. First, the plaintiff was injured by an instrumentality that was within the defendant’s exclusive control; second, the injury would not ordinarily have occurred in the absence of negligence. To satisfy the first condition, Tennessee courts require that establishing “exclusive control” involves proving the defendant had a duty of care over the instrument that caused the harm. This standard should not be applied strictly because then the standard would become overly restrictive. Instead, showing that the negligence was more likely than not that of the defendant and not another person will satisfy this condition. The second condition would be satisfied if the plaintiff proves that the injury more likely than not occurred because of some negligent conduct. This standard does not require all possible alternatives to be disproved.

The defendant moved for a judgment as to law, which required the trial court to look at the evidence in the most favorable light possible to the nonmoving party, the plaintiff. If a reasonable jury could find in favor of the plaintiff after evaluating all the evidence, then the trial court’s granting of the motion was in error. In this case, the plaintiff provided evidence that the manager believed that the freezer was malfunctioning and subsequently wanted to remove it from the public space, that the freezer did not have a plug properly installed, and that the substance that she slipped on was likely water emanating from the freezer. The evidence regarding where the liquid was from was corroborated by the plaintiff’s written statement at the scene as well as the testimony of the employee tasked with cleaning the liquid, who said that the water was about 10 inches in diameter and “right there under the drain of the freezer.” This evidence would be sufficient to allow a reasonable jury to find both elements of res ipsa loquitur satisfied and infer negligence on the part of the defendant. DECISION AND REMEDY: The court reversed the trial court’s granting of summary judgment in favor of the defendant and ordered a new trial at which res ipsa loquitur may be used. SIGNIFICANCE OF THE CASE: This case provides an illustration of the type of conditions that can lead a jury to infer negligence.

CRITICAL THINKING Given a negligence action like this one, what evidence could the defendant provide that might convince a jury not to find the defendant negligent?

ETHICAL DECISION MAKING How does the court’s ruling demonstrate that the law is based on the ethical concern for future customers of business firms?

NEGLIGENCE PER SE negligence per se A doctrine that allows a judge or jury to infer duty and breach of duty from the fact that a defendant violated a criminal statute that was designed to prevent the type of harm that the plaintiff incurred.


Negligence per se (literally, “negligence in or of itself ”) is another doctrine that helps plaintiffs succeed in negligence cases. Negligence per se applies to cases in which the defendant has violated a statute enacted to prevent a certain type of harm from befalling a specific group to which the plaintiff belongs. If the defendant’s violation causes the plaintiff to suffer from the type of harm that the statute intends to prevent, the violation is deemed negligence per se. The plaintiff does not have to show that a reasonable person would exercise a certain duty of care toward the plaintiff. Instead, the plaintiff can offer evidence of the defendant’s violation of the statute to establish proof of the negligence.


Chapter 7 Tort Law

For example, if Ohio passes a statute prohibiting the sale of alcohol to minors, and a minor runs a red light and kills two pedestrians while driving under the influence of alcohol sold to him illegally, the liquor store’s violation of the statute prohibiting the sale of alcohol to minors establishes negligence per se on the part of the store. The families of the pedestrians do not need to establish that a reasonable person would have a duty not to sell alcohol to a minor. The Case Nugget provides another illustration of negligence per se.

Defenses to Negligence

LO 7-5

The courts’ doctrines of res ipsa loquitur and negligence per se help the plaintiff in a negligence case, but the courts permit certain defenses that relieve the defendant from liability even when the plaintiff has proved all four elements of negligence. Defendants can successfully rebut negligence claims with contributory negligence, comparative negligence, assumption of the risk, and other special negligence defenses.

CASE Nugget A Clear Illustration of Negligence per se O’Guin v. Bingham County Superior Court of Idaho 122 P.3d 308 (Sup. Ct. Id. 2005) Shaun and Alex O’Guin cut across a field on their way home from school and entered the back of a landfill that was not fenced off, despite a law that required it to be fenced. A portion of a wall of the landfill collapsed, killing the boys. The boys’ parents sued the county that operated the landfill, alleging that failure to have the landfill properly fenced constituted negligence per se. The court agreed, explaining that the following four elements of negligence per se had been met: (1) The statute or regulation clearly defines the required standard of conduct, (2) the statute or regulation must have been intended to prevent the type of harm the defendant’s act or omission caused, (3) the plaintiff must be a member of the class of persons the statute or regulation was designed to protect, and (4) the violation must have been the proximate cause of death.

CONTRIBUTORY NEGLIGENCE Contributory negligence, a defense once available in all states but replaced today in some states by the defense of comparative negligence (discussed in the next section), applies in cases in which both the defendant and the plaintiff were negligent. The defendant must prove that (1) the plaintiff ’s conduct fell below the standard of care needed to prevent unreasonable risk of harm and (2) the plaintiff ’s failure was a contributing cause of the plaintiff ’s injury. How can defendants use contributory negligence in a case? Some defense lawyers argue that if a plaintiff involved in a car accident failed to wear her seat belt, that failure constitutes contributory negligence because her action contributed to her injuries. If the defendant successfully proves contributory negligence, no matter how slight the plaintiff’s negligence, the plaintiff will be denied any recovery of damages. Because this defense seems unfair, many states have adopted the last-clear-chance doctrine. This doctrine allows the plaintiff to recover damages despite proof of contributory negligence as long as the defendant had a final clear opportunity to avoid the action that injured the plaintiff.

contributory negligence A defense to negligence whereby the defendant can escape all liability by proving that the plaintiff failed to act in a way that would protect him or her from an unreasonable risk of harm and that the plaintiff’s negligent behavior contributed in some way to the plaintiff’s accident.

last-clear-chance doctrine A doctrine used by the plaintiff when the defendant establishes contributory negligence. If the plaintiff can establish that the defendant had the last opportunity to avoid the accident, the plaintiff may still recover, despite being contributorily negligent.


Part I

The Legal Environment of Business

For example, suppose that Samantha and Nicole, in their cars, are facing each other while stopped at a red light. The light turns green, and Nicole starts to turn left at the intersection. Samantha sees Nicole start to turn, but she still continues to travel straight through the intersection and crashes into Nicole’s car. Although Samantha had the right-of-way at the intersection, she could have avoided hitting Nicole’s car by braking or swerving. Thus, according to the lastclear-chance doctrine, Nicole could recover damages.


pure comparative negligence A defense accepted in some states whereby the defendant is not liable for the percentage of harm that he or she can prove is due to the plaintiff’s own negligence.

modified comparative negligence A defense accepted in some states whereby the defendant is not liable for the percentage of harm that he or she can prove is due to the plaintiff’s own negligence if the plaintiff’s negligence is responsible for less than 50 percent of the harm; if the defendant establishes that the plaintiff’s negligence caused more than 50 percent of the harm, the defendant has no liability.

assumption of the risk A defense whereby the defendant must prove that the plaintiff voluntarily assumed the risk the defendant caused.

Most states have replaced contributory negligence with comparative negligence because the adoption of the last-clear-chance doctrine still left many situations in which an extremely careless defendant can cause a great deal of harm to a plaintiff who is barred from recovery due to minimal contributory negligence. There are two forms of comparative negligence: pure and modified. According to a pure comparative negligence defense, the court determines the percentage of fault of the defendant. The defendant is then liable for that percentage of the plaintiff’s damages. Courts calculate damages according to modified comparative negligence in the same manner, except that the defendant must be more than 50 percent at fault before the plaintiff can recover. Twenty-eight states have adopted modified comparative negligence, 13 have adopted pure comparative negligence, and 9 have adopted contributory negligence. Every state has adopted one of these three defenses. Thus, the parties to a negligence suit cannot choose among them.

ASSUMPTION OF THE RISK Another defense available to defendants facing negligence claims is called assumption of the risk. To use this defense successfully, a defendant must prove that the plaintiff voluntarily and unreasonably encountered the risk of the actual harm the defendant caused. In other words, the plaintiff willingly assumed as a risk the harm she suffered. There are two types of this defense. Express assumption of the risk occurs when the plaintiff expressly agrees (usually in a written contract) to assume the risk posed by the defendant’s behavior. In contrast, implied assumption of the risk means that the plaintiff implicitly assumed a known risk. The most difficult part of establishing this defense is showing that the plaintiff assumed the risk of the actual harm she suffered. A 1998 case against the Family Fitness Center illustrates an unsuccessful attempt to use assumption of the risk as a defense against a negligence claim.11 In that case, the plaintiff was injured when a sauna bench on which he was lying collapsed beneath him at the defendant’s facility. The trial court granted summary judgment in favor of the defendant on the basis of assumption of the risk. The plaintiff had signed a contract that included the following provision: “Buyer is aware that participation in a sport or physical exercise may result in accidents or injury, and Buyer assumes the risk connected with the participation in a sport or exercise and represents that Member is in good health and suffers from no physical impairment which would limit their use of FFC’s facilities.” The appellate court overturned the trial court’s decision because the type of injury the plaintiff suffered was not the type of risk he had assumed. The court held that anyone signing a membership agreement could be deemed to have waived any hazard known to relate to the use of the health club facilities, such as the risk of a sprained ankle due to improper exercise or overexertion, a broken toe from a dropped weight, injuries due to malfunctioning exercise or sports equipment, or injuries from slipping in the locker room shower. No patron, however, could be charged with realistically appreciating the risk of injury from simply reclining on a sauna bench. Because the collapse of a sauna bench, when properly used, is not a known risk, the court concluded that the plaintiff did not assume the risk of this incident as a matter of law.


Leon v. Family Fitness Center, Inc., 61 Cal. App. 4th 1227 (1998).


Chapter 7 Tort Law

SPECIAL DEFENSES TO NEGLIGENCE Many states have additional ways to defend against a claim of negligence. For example, laws in some states hold that people in peril who receive voluntary aid from others cannot hold those offering aid liable for negligence. These laws, commonly called Good Samaritan statutes, attempt to encourage selfless and courageous behavior by removing the threat of liability. The defendant in a negligence suit can also avoid liability by establishing a superseding cause. A superseding cause is an unforeseeable event that interrupts the causal chain between the defendant’s breach of duty and the damages the plaintiff suffered. For example, suppose Jennifer is improperly storing ammonia in her garage when a meteor strikes her garage, spilling the ammonia into a stream nearby. Will, living downstream, drinks water from the stream and becomes dangerously ill. Because the meteor was unforeseeable, Jennifer is not liable for Will’s injuries, even though she breached her duty of care to Will. Superseding causes allow the defendant to avoid liability because they are evidence that the defendant’s breach of duty was not the proximate cause of the plaintiff’s injuries. In other words, superseding causes disprove the causation element necessary to sustain a negligence claim.

Strict Liability

Good Samaritan statute A statute that exempts from liability a person, such as a physician passerby, who voluntarily renders aid to an injured person but negligently, but not unreasonably negligently, causes injury while rendering the aid.

LO 7-6

Strict liability is liability without fault. The law holds an individual liable without fault when the activity in which she engages satisfies three conditions: (1) it involves a risk of serious harm to people or property; (2) it is so inherently dangerous that it cannot ever be safely undertaken; and (3) it is not usually performed in the immediate community. Instead of banning such activities, the law allows people to engage in these activities but holds them liable for all resulting harm. Inherently dangerous activities include dynamite blasting in a populated area and keeping animals that have not been domesticated. If an animal has shown a vicious propensity, strict liability applies and the owner of the animal is responsible for any injuries suffered in an attack by the animal. If an individual keeps an animal that has shown vicious propensity, he has a duty to warn and protect individuals who come into contact with the animal. Today, the theory of strict liability is used most commonly when the plaintiff is claiming to have been injured by a product that was unreasonably dangerous.

Damages Available in Tort Cases

strict liability Liability in which responsibility for damages is imposed regardless of the existence of negligence. Also called liability without fault.

LO 7-7

There are three types of damages available in tort cases: compensatory, nominal, and punitive (see Exhibit 7-2). You will see this system of classifying damages again when we talk about damages in other contexts, such as in cases involving the breach of a contract.





To make the plaintiff whole again.

An amount equivalent to all losses caused by the tort, including compensation for pain and suffering, but not attorney fees.


To recognize that the defendant committed a tort against the plaintiff.

A trivial amount, typically $1 to $5.


To punish the defendant and deter future wrongdoers.

An amount based on two factors: the severity of the wrongful conduct and the wealth of the defendant.

Exhibit 7-2 Types of Tort Damages


Part I

The Legal Environment of Business

COMPENSATORY DAMAGES tortfeasor A person who commits an intentional or through-negligence tort that causes a harm or loss for which a civil remedy may be sought.

Because the primary objective of tort law is to compensate victims, the primary type of damages are compensatory damages, damages designed to compensate the victim for all the harm caused by the person who committed the tort, often referred to as the tortfeasor. Although we seem to hear a lot about runaway jury awards, there does not seem to be evidence of a trend toward increasingly huge jury awards. The overall median jury award for personal injury cases from 1998 to 2004 was $35,298; that amount actually fell from $37,086 in 2003 to $35,000 in 2004.12 In 2010, the median jury verdict award in personal injury cases was $40,000, which is not a huge jump over a six-year time span.13 Compensatory damages are typically awarded for pain and suffering, costs of repairing damaged property, medical expenses, and lost wages. In the case opener, Dr. Bongiovani argued on appeal that the compensatory damages were excessive, but the appellate court upheld them, noting that when one is defamed in their line of business, they are entitled to general damages for harm to their reputation. In light of the fact that after the allegations, the number of exotic dancers seeking Dr. Sullivan’s services declined, the amount did not seem unreasonable to the court. Surprisingly, attorney fees are not recoverable as compensatory damages, despite the fact that most plaintiffs could not bring an action against the tortfeasor without hiring an attorney. Because the plaintiffs in personal injury cases must usually pay their attorneys anywhere from one-third to one-half of their recovery, some argue that compensatory damages fail to meet the intended goal of properly compensating victims. Others point out that one of the ways plaintiffs can, in essence, recover their attorney fees is by increasing their pain and suffering damages enough to cover these expenses.

NOMINAL DAMAGES nominal damages Monetary damages awarded to a plaintiff in a very small amount, typically $1 to $5, to signify that the plaintiff has been wronged by the defendant even though the plaintiff suffered no compensable harm.

Nominal damages are a small amount of money given to recognize that a defendant did indeed commit a tort in a case in which no compensable damages were suffered by the plaintiff. A plaintiff may receive nominal damages by simply failing to prove actual damages.

PUNITIVE DAMAGES Punitive damages are awarded to punish the defendant. They are given only when the defendant’s conduct is extremely outrageous. The purposes of punitive damages are both to punish the defendant and to deter him and others who are similarly situated from engaging in that kind of activity again. In awarding punitive damages, juries usually consider the egregiousness or willfulness of the tort and the wealth of the defendant. Obviously, the more wrongful the nature of the defendant’s act, the greater the desire to send a message that such behavior will not be tolerated; and the greater the wealth of the defendant, the higher the damages must be to actually punish the defendant. Although the threat of large punitive damages is seen by many groups, including consumer advocates, as a good method for encouraging manufacturers to produce the safest possible products, others disagree. They believe that no threat beyond compensatory damages is required; and they argue that the main effect of punitive damages is to discourage innovation because manufacturers will be afraid of the risk of producing a defective product, which could cost them millions in punitive damages. Since the late 1970s, insurance companies and tort reform groups have been trying to limit the amount of punitive damages that can be assessed, using both the legislative process and the courts. The 1994 case of Honda Motor Company v. Oberg14 provided tort reformers with their first judicial victory. In this case, the U.S. Supreme Court finally struck down a punitive-damage award as being a violation of due process. Oberg, however, was a limited victory because of two unique aspects of the case. First, the punitive damages were over 500 times the amount of the compensatory damages, which is extraordinarily rare. Second, the state law under which the 12

JVR news release, www.juryverdictresearch.com/Press_Room/Press_releases/Verdict_study/verdict_study41.html (accessed October 10, 2006). 13 Indiana Jury Verdicts, Accident and Injury Lawyer Blog, www.accidentinjurylawyerblog.com/2011/08/indiana_jury_verdicts.html, August 8, 2011. 14 114 S. Ct. 2331 (1994).

GLOBAL Context Punitive Damages in Canada and Japan Those who believe the U.S. tort system is in need of reform with respect to its treatment of punitive damages may look to their Canadian neighbors with envy. Punitive-damage awards in Canada are both rare and small. A study in 1990 reported on punitive-damage awards in Ontario. The researchers found that the highest award was $50,000. The majority of punitive-damage awards were less than $25,000; the median award was approximately 20 percent of the compensatory-damage award in the particular case. Following English common law, Canadian courts have traditionally restricted punitive damages to two situations: cases involving oppressive, arbitrary, or unconstitutional actions by government servants and cases in which the defendant’s conduct was calculated to have made a profit in excess of compensatory damages. In 1989, the

Canadian Supreme Court recognized that punitive damages could also be awarded for conduct deserving punishment because of its “harsh, vindictive, reprehensible, and malicious manner.” Two reasons seem to explain the differences in Canadian and American treatment of punitive damages. First, Canadians see something undignified about the flamboyant punitive-damage awards in the United States. Second, civil juries are much less common in Canada, and, in general, judges tend to be much more conservative than juries in making punitive-damage awards. Another country that would be even more heroic to those opposed to punitive damages is Japan. Several times, the Japanese Supreme Court ruled that punitive damages violated Japan’s public policy. Recently, following the lead of the courts, the Japanese legislature forbade the acceptance of punitive damages, even those awarded by foreign courts.

damages were awarded was the only state law in the country that had no provision for judicial review of the amount of punitive-damage awards, and it was the denial of this safeguard that violated the due process clause. Because of its unusual facts, Oberg did not provide much guidance about when punitive damages were so excessive that they violated due process. A few years later, however, in BMW v. Gore,15 the Supreme Court set forth a test that a number of commentators thought would substantially curb punitive-damage awards. The Court said three factors should be considered in determining whether an award was grossly excessive: “the degree of reprehensibility of the nondisclosure; the disparity between the harm or potential harm suffered by [the plaintiff] and his punitive damages award; and the difference between this remedy and the civil penalties authorized or imposed in comparable cases.” However, a 1999 study found that the year after BMW v. Gore, punitive-damage awards across the country were not reduced any more frequently than they had been the year before the decision.16 Since BMW v. Gore, the Supreme Court has continued to encourage the courts to scrutinize punitive-damage awards carefully. In the 2001 case of Cooper Industries, Inc. v. Leatherman Tool Group, Inc.,17 the high court ruled that appellate courts must review the trial court’s decision on the constitutionality of an award de novo, meaning they should no longer give deference to the trial court’s determination that the jury award was not unconstitutionally excessive and uphold it unless there was a clear abuse of discretion on the part of the trial court judge. In the 2003 case State Farm v. Campbell,18 the Supreme Court once again addressed the issue of how to determine punitive damages properly. The Campbells had won a jury verdict for $1 million in compensatory damages and $145 million in punitive damages after State Farm failed to settle what was clearly a valid claim. The high court ruled that punitive-damage awards should bear some relationship to the actual harm caused and should not focus on the wealth of the defendants. Although refusing to draw a firm line about what ratio of compensatories to punitives was acceptable, the Court did say that “in practice, few awards exceeding a single-digit ratio between punitive and compensatory damages, to a significant degree, will satisfy due process.”19 The Court also stated that damages should not focus on deterrence based on wealth or on actions unrelated to the case at hand. Case 7-3 demonstrates how the courts are applying these guidelines today. 15

BMW of North America v. Ira Gore, Jr., 116 S. Ct. 1589 (1995). James Dam, “Large Punitives Mostly Upheld, but $5B Award Overturned,” Lawyer’s Weekly, November 12, 2001, p. A1. 17 532 U.S. 424 (2001). 18 123 S. Ct. 1513 (2003). 19 Ibid., p. 1524. 16


CASE 7-3


FACTS: Charles Clark was fatally injured in an automobile accident when he pulled into an intersection in front of an oncoming vehicle and collided with it. He was not wearing a seat belt and was consequently ejected from his vehicle. His wife sued Chrysler, claiming that its pickup truck was defectively and negligently designed. After a three-day trial, the jury rendered a unanimous verdict in favor of Mrs. Clark on claims of strict liability, negligence, and failure to warn. The jury found Chrysler and Mr. Clark each 50 percent at fault, returning a verdict of $471,258.26 in compensatory damages and $3 million in punitive damages. The court entered a judgment against Chrysler for $3,235,629.13, reflecting 50 percent of the compensatory damages plus the $3 million punitive damages award. After a series of appeals, the last being an appeal of the trial court’s motion to deny the defendant’s motion to send the case back to the district court for a reduction of damages, the case finally landed at the circuit court of appeals on the issue of whether the jury verdict was constitutionally excessive. ISSUE: Should the plaintiff’s $3 million punitive-damage award be struck down as constitutionally excessive when the amount of the compensatory damages is $471,258.26? REASONING: Application of the Gore guideposts to this case renders the punitive-damage award excessive. According to Gore, five criteria are used to determine the reprehensibility of the defendant’s conduct: (1) The harm caused was physical as opposed to economic; (2) the tortious conduct evinced an indifference to or a reckless

disregard for the health or safety of others; (3) the target of the conduct had financial vulnerability; (4) the conduct involved repeated actions or was an isolated incident; and (5) the harm was the result of intentional malice, trickery, or deceit or mere accident. In this case, the physical harm suffered by Mr. Clark weighed strongly in favor of finding Chrysler’s conduct reprehensible, but considering the four other factors leads to the conclusion that the factors as a whole show that Chrysler’s conduct was not sufficiently reprehensible to warrant a $3 million punishment. The second guidepost is the disparity between the actual or potential harm inflicted on the plaintiff and the punitivedamage award. Because the compensatory-damage award here is relatively small, a 1:1 ratio is inappropriate; but because of the lack of reprehensibility, a ratio higher than 2:1 would be unwarranted. The third guidepost is the difference between the punitive-damage award and the civil or criminal penalties that could be imposed for comparable misconduct. Given State Farm’s focus on civil penalties, a $3 million punitivedamage award is excessive in light of comparable civil penalties. DECISION AND REMEDY: The damage award was excessive. Chrysler’s motion was reversed and remanded, with instructions to enter a punitive-damage award in the amount of $471,258.26. SIGNIFICANCE OF THE CASE: This case gives the courts a little more guidance about when punitive damages may be considered excessive.

CRITICAL THINKING Which of the criteria used by the judge seems ambiguous? How might that ambiguity have affected the outcome of the case?

ETHICAL DECISION MAKING What values are guiding the judge’s decision that the punitive-damage award was excessive? Do you think that the values promoted by the decision are appropriate for the situation? Why or why not?


Chapter 7 Tort Law


SUMMARY Introduction to Tort Law

Tort: A civil wrong giving the injured party the right to bring a lawsuit against the wrongdoer to recover compensation for the injuries.

Classification of Torts

Torts are classified as intentional, negligent, and strict liability.

Intentional Torts

Torts against persons include assault, battery, and defamation. Torts against property include trespass to realty, private nuisance, trespass to personal property, and conversion. Torts against economic interest include disparagement, intentional interference with contract, unfair competition, misappropriation, and fraudulent misrepresentation.


The plaintiff must prove four elements: duty, breach of duty, causation (actual and proximate), and damages.

Plaintiff’s Doctrines

Doctrines used to establish negligence: • •

Res ipsa loquitur Negligence per se

Defenses to Negligence

• • • •

Contributory negligence Modified comparative negligence Pure comparative negligence Assumption of the risk

Strict Liability

Persons who engage in activities that are so inherently dangerous that no amount of due care can make them safe are strictly liable, regardless of the degree of care they used when undertaking the activity.

Damages Available in Tort Cases

Compensatory damages to make the plaintiff whole again Punitive damages to punish the defendant and deter future wrongdoers Nominal damages to recognize that the defendant committed a tort against the plaintiff

Point/Counterpoint Should Punitive Damages Be More Strictly Limited? YES Excessive punitive damages are fundamentally unfair. Punitive damages are not a normal part of the tort system. Tort law is supposed to be a way to compensate victims. Punitive damages are almost quasi-criminal in nature; they are designed to punish the defendant, and they reward a plaintiff with, in some cases, riches far beyond what any reasonable person would see as compensation. Tort cases, with the possibility of huge punitive-damage awards, have turned into nothing but litigation lotteries, which have nothing to do with the purposes of our tort system.

NO The BMW standard for excessive punitive damages strikes a fair balance, protecting the interests of both consumers and firms. In the 20 years prior to the BMW case, courts handed down a number of huge punitive-damage awards, some even exceeding $100 million. However, in the years since the BMW case, we have seen that the court’s three-pronged test has resulted in reducing punitive-damage awards, generally staying below a 9:1 ratio of punitive to compensatory damages. They now appear to be much more reasonable and to fulfill their necessary function. If we examine the top


Part I

The Legal Environment of Business

The possibility of a huge punitive-damage award causes people to bring all sorts of loony lawsuits in hopes of striking it rich. If punitive damages were more reasonable, you would not see people, for example, suing the phone company for publishing false information about a physician that led to a botched liposuction or suing NBC for millions because a Fear Factor episode that involved eating rats made a viewer “dizzy and lightheaded and caused him to vomit and run into a doorway.” Besides, unfair punitive-damage awards can ruin a defendant’s good name and, in some cases, run target companies out of business. We must bring fairness back to our tort system by limiting punitive damages. Sure, damage awards have fallen since the BMW and State Farm cases, but they were so exorbitant that they could hardly have gone any higher! Besides, the fact that they have fallen does not mean that they have fallen to reasonable levels. We need more stringent standards for punitive damages to bring predictability, efficiency, and fairness to our civil justice system. We must all work together for these necessary changes.

10 jury verdicts of 2005, the awards are significantly lower than those of 2004 and previous years. There is no longer any need to limit punitive damages further because they are now reasonably related to the harm the defendant has caused, and they are still large enough to deter behavior. Punitive damages, in their current manifestation, fulfill two important functions. First, they represent an important way for a significantly harmed plaintiff to recover costs and attorney fees. Without the possibility of large punitive-damage awards, the plaintiff may not actually be compensated for his or her losses because so much of the recovery goes to the attorneys and costs of litigation. Second, punitive damages perform a necessary deterrence function. If corporations no longer have to fear punitive-damage awards that will hurt them, they will lose some of their motivation to produce safe products and behave as responsible citizens. With the BMW rule, as clarified by State Farm, we now have a system in which punitive damages can serve their intended purpose without posing an unreasonable risk to potential defendants.

Questions & Problems 1. Distinguish the three types of damages available in tort cases. 2. Explain why some people see punitive damages as a necessary aspect of our tort system, whereas others want to restrict their availability. 3. List five intentional torts and explain the elements needed to prove each. 4. List and define the elements that are necessary to prove a case of negligence. 5. Explain the differences between contributory and comparative negligence. 6. Explain the relationship between negligence per se and res ipsa loquitur. 7. Kerns, a home owner, sued defendant contractor Sealy for negligence, breach of contract, wantonness, and res ipsa loquitur in connection with a fire that occurred during the contractor’s application of foam installation in the plaintiff’s attic. The contractor knew that applying the foam at a thickness over 2 inches created a risk of fire, and he applied the foam at a thickness exceeding 4 inches. He then left the scene for lunch. When he returned, Sealy discovered a haze indicative of fire and attempted to remove the foam. At trial, the defendant made a motion of summary judgment to dismiss all charges. Which charges,

if any, do you think survived summary judgment in district court? [Kerns et al. v. Sealy et al., 496 F. Supp. 2d 1306 (2007).] 8. Former Major League Baseball player and radio game announcer Bob Uecker sought an injunction against Ann Ladd, alleging a six- or seven-year pattern of harassment. Ladd, who claimed to be a devoted fan, was charged with felony stalking. An injunction was issued against her bothering Uecker, but the stalking charge was dropped when she agreed to cooperate. Later, Ladd sued Uecker for defamation, claiming that Uecker defamed her in the material he filed in support of his application for the injunction. The trial court dismissed her suit, and she appealed. What do you think the outcome of her appeal was and why? [Ladd vb. Uecker, 780 N.W.2d 216 (Ct. App., Wisc., 2010).] 9. Vernon Hendrickson, an inmate at an Indiana correctional facility, sued correctional officer Scott Cooper for violation of the Eighth Amendment protections against cruel and unusual punishment after Cooper threw Hendrickson against a wall, slammed him onto the concrete floor of his housing unit, and then pressed his knees against Hendrickson’s back while another officer cuffed Hendrickson. The jury found Cooper liable for excessive force and awarded

Chapter 7 Tort Law

Hendrickson $75,000 in compensatory damages and an additional $125,000 in punitive damages. Cooper appealed the decision, arguing that the jury did not have enough evidence to make its finding of excessive force and that the damage awards were excessive. Using the analysis discussed in this chapter, do you think that the punitive damages awarded to Hendrickson were excessive? What other facts might help inform your decision? [Hendrickson v. Cooper, 589 F.3d 887 (2009).] 10. At 2:08 a.m., on Friday, December 29, 2006, the defendant received by e-mail the Lake in the Hills police department Daily Bulletin, and it reported that Carolene Eubanks had been charged with theft and obstruction of justice. As it normally does, the newspaper placed the information from the report in an article and then placed the article in line for publication in the upcoming issue of the newspaper. The article was eventually printed before 6 a.m. on January 2, 2007, and appeared in the defendant’s newspaper on the same date. The Lake in the Hills police department had also sent a second e-mail on December 29, 2006, at 10:25 p.m., that said to remove the name of Carolene Eubanks and replace it with the name of Barbara Bradshaw. Because the employee who posted the article had already gone home, and it was a long holiday weekend, no one was in when the second e-mail arrived, so it wasn’t read until January 2, 2007, at 10:17 a.m. Consequently, the January 2, 2007, edition of the defendant’s newspaper, printed before 6 a.m. on that date, published the article indicating that the plaintiff had been arrested and charged with theft and attempted obstruction of justice. The defendant published a retraction of the article in its January 3, 2007, newspaper, stating that the plaintiff was not the one charged with those crimes. On June 15, 2007, the plaintiff filed her complaint for defamation based on the January 2, 2007, publication. The trial court granted the defendant’s motion for summary judgment based on its exercise of a privilege. Plaintiff appealed. What privilege do you think the court relied on? What do you think the outcome


of the appeal was and why? [Eubanks v. Northwest Herald Newspapers, 397 Ill.App.3d 746, 922 N.E.2d 1196 (2010).] 11. The Bank of New York (BONY) sued the defendant insurance company, Fremont General Corporation, for intentional interference with contract and conversion. BONY sought to recover damages from the defendant’s withdrawal of $14 million from BONY, which BONY alleged interfered with the New York Insurance Company’s ability to pay claims of its policyholders. BONY had a valid contract with Fremont Indemnity, a compensation fund that was managed by the defendant. The defendant was aware of the contract between Fremont Indemnity and BONY. By transferring $14 million to another bank, the defendant breached the custodian agreement. The district court granted Fremont General’s motion for summary judgment on both claims. BONY appealed the decision, arguing that it had met the evidentiary standards required to prove both claims. Do you agree with the district court? What additional information might alter your decision? [Bank of New York v. Fremont General Corporation, 523 F.3d 902 (2008).] 12. In 2008, Wayne Singleton and his eight-year-old son, Jaron, were traveling on a bus for a school field trip to Six Flags. Wayne fell asleep on the way, and while he was asleep, the bus became airborne and drove off the road into a wooded area. The bus eventually collided with a tree. Singleton was asleep when the bus went off the road but woke up for the collision. Jaron was awake the whole time but did not understand the situation. Wayne sued the District of Columbia for the negligence of its employee. At the trial, only Wayne and his son were presented as witnesses. They did not call the bus driver or any other passenger or driver as a witness to provide evidence for why the bus went off the road. Due to this lack of evidence, Wayne invoked res ipsa loquitur to infer evidence for the negligence of the driver. The trial court disagreed and granted the District’s motion for summary judgment. How do you think the case was ultimately decided on appeal? Why? [District of Columbia v. Wayne Singleton et al., No. 77. Court of Appeals of Maryland. (2012).]


1 8

The Legal Environment of Business


Real, Personal, and Intellectual Property CASE OPENER Technology Companies at War In the past five years, there have been significant innovations in technology such as smartphones and tablets. Technology companies rely on intellectual property law (IP), such as patents, trademarks, copyright, and trade secrets, to protect their innovations. For example, Apple and Samsung, the two largest smartphone companies, have filed various patent infringement suits against each other in courts around the world. Apple and Samsung are strong competitors, so if one company were able to obtain an injunction preventing the other company from selling certain phones and tablets, this injunction could be devastating to the losing company. In one of these cases that proceeded to a jury trial, Apple argued that Samsung copied Apple’s design of the iPhone and iPad—specifically, that Samsung copied the rounded rectangle shape of the iPhone in violation of Apple’s design patent and the iPhone’s trade dress. Steve Jobs, the former CEO of Apple, emphasized the importance of neat, clean design for Apple products, and Apple has thus sought and received hundreds of design patents along with trademarks protecting its products. Similarly, Samsung has asserted a number of its own patents against Apple, including a patent covering the ability to photos from a camera phone. Critics argue that these patents and trademarks are too broad (i.e., that something as simple as a rounded rectangle or sending a photo from a phone should not be protected by patents or trademarks). Critics further argue that such broad IP stifles innovation and prevents smaller players from entering the market because they cannot withstand the costs of litigation associated with competing in the smartphone and tablet markets. In response, the patent owners argue that they have expended significant resources in creating their products and deserve to avail themselves of the protection afforded by IP. Critics further argue that technology companies spend millions of dollars on litigation rather than on developing and improving products. Technology companies respond that they have no choice but to seek enforcement of their intellectual property through the legal system. Furthermore, in January 2013, Apple Computer was granted a trademark for its retail store design and layout.1 Specifically, the trademark covers the design, the shelves in the store, and the location of the tables displaying products. One of the main reasons this trademark was important to Apple was that fake Apple stores in China confuses customers. 1. 2. 1


Do you think technology companies should be able to receive protection for allegedly basic ideas (e.g., store design or shape or color of a product) and functionalities? How does intellectual property litigation between competitors (such as Apple and Samsung) affect you?

Erin Geiger Smith, “Apple Trademarks Design of Its Retail Stores,” Reuters, January 29, 2013.

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

LO 8-1

How are the topics of real, personal, and intellectual property related?

LO 8-2

How does real property law balance private and public rights?

LO 8-3

What interests in real property can one hold?

LO 8-4

What are the types of personal property?

LO 8-5

How do you transfer personal property?

LO 8-6

How does intellectual property law balance private and public rights?

LO 8-7

What are the similarities and differences among the methods for protecting various types of intellectual property?

Most Americans cherish the right to own property. For most Americans, this means the right to own real property, such as a house. Increasingly, Americans also cherish the right to own intellectual property, the fruits of the mind, such as a manuscript for a novel. In this chapter, we examine the nature of both real and intellectual property. The chapter starts by exploring how the three areas of law are related. Then, for each of these types of property, the chapter considers what interests individuals can hold and how the laws governing these types of property balance private and public rights. The Case Opener considers a real property issue. By the end of the chapter, you will see that disputes such as the General Motors–Poletown dispute can arise not only when the property in question is land but also when it is personal or intellectual property.

The Nature of Real, Personal, and Intellectual Property Real property, commonly referred to as realty, is land and everything permanently attached to it. The type of ownership interest a person has in a piece of property determines his or her rights to the property. Personal property consists of tangible, movable objects. Intellectual property consists of the fruits of one’s mind. The laws of intellectual property protect property that is primarily the result of mental creativity rather than physical effort. When we are thinking about property rights of any kind, it is important to remember that society, through laws, decides what rights individuals and communities have with regard to property. One metaphor often used with regard to property is that of a bundle of sticks. Each stick represents a distinct right an individual can have with regard to property. The rights to possess property, use it, give it away, or take it away are all sticks. With regard to all types of property, one of the most important rights is the right to exclude others. For example, with regard to real property, an individual can put a fence around the land and ask others to stay off the land. With personal property, you may simply keep it in a place where no one else has access to it. For intellectual property, an individual can accomplish the same thing with a trademark or patent—the holder can put a virtual fence around the idea trademarked or patented and ask others to refrain from using the property.

LO 8-1 real property Land and everything permanently attached to it.

Personal property tangible, movabe objects

intellectual property Intangible property that is the product of one’s mind and not one’s hands.



Part I

The Legal Environment of Business

With regard to real property, some other important sticks are the rights to sell, lease, or mortgage land and the right to allow someone limited access. The public also has important sticks, such as the right to take land, regulate it, and/or tax it. In the next section, the various types of interests a person may have in real property are described in detail. These interests may be conveyed or transferred under legal guidelines for property rights. Most transfers of property are voluntary. However, for the benefit of the public, and to protect public health, safety, and welfare, the government may require involuntary transfers of property.

LO 8-2

Real Property There are a number of types of interests in land, ranging from temporary to permanent to future. The duration of one’s ownership interest and the power one has over using the land depend on the type of estate one is said to hold. The following section on interests in real property describes the various estates in detail. First, though, this chapter explores the landowner’s rights that pertain to areas beyond the surface of the land itself.

EXTENT OF OWNERSHIP When a person owns land, she or he owns more than just the surface. The airspace above the land, extending to the atmosphere, is also part of the legal concept of real property. Rights to airspace generally do not generate much controversy, but occasionally disputes arise that involve aircraft flying too low over individuals’ property. Alternatively, a tree’s branches may hang over into the airspace of the property next door, and the owner of that airspace may want to cut the overhanging branches. In dense, commercial urban areas, airspace may actually be an asset. Owners of two commercial buildings might want to build an overhead walkway joining their buildings across a parking lot that you own. They will have to pay you handsomely for the right to build in your airspace. In addition to having airspace rights, the owner of real property also has water rights, the legal ability to use water flowing across or underneath the property. However, these rights are somewhat restricted; one cannot deprive the landowners downstream from the use of the water by diverting the water elsewhere. Finally, ownership of real property extends to mineral rights; these rights involve the land below the surface. The landowner has the legal ability to dig or mine the materials from the earth, and he may sell or give these rights to another person. Ownership of these subsurface rights includes the right to enter onto the property to remove the underground materials. All these additional rights are illustrated in Figure 8-1. Figure 8-1 Extent of Rights

Airspace Rights Real Property

Water Rights

Mineral Rights/ Subsurface Rights

Chapter 8


Real, Personal, and Intellectual Property


LO 8-3

Various interests in land are discussed in the following sections and summarized in Exhibit 8-1. Fee Simple Absolute With regard to estates in land, a fee simple absolute is the most complete estate a person may have. Exclusive rights to ownership and possession of the land belong to the person who has a fee simple absolute. It is this type of estate to which most people refer when they speak of buying a house or piece of land. A fee-simple-absolute interest is passed to the owner’s heirs when the owner of such an estate dies. Conditional Estate The owner of a conditional estate possesses the same interest as the owner of a fee simple absolute except that this interest is subject to a condition: If a certain required event fails to occur or a specific prohibited event occurs, the interest will be terminated. For example, Todd may be given property rights to a Victorian house on the condition that he is to preserve it in its original form. If he violates this condition by turning the house into a piano showroom or a beer hall, the house will either revert to the original owner or be transferred in accordance with the terms of the deed. (The deed is the instrument used to convey real property.)

fee simple absolute An ownership interest in which the holder has exclusive rights to ownership and possession of the land; the most comprehensive type of estate.

conditional estate An ownership interest in which the holder has the same interest as that in a fee simple absolute except that this interest is subject to a condition.

Life Estate A life estate is granted for the lifetime of an individual; the right to possess the property terminates at the individual’s death. On the death of the holder of the life estate, the property will go to another party as designated by the original grantor. Thus, this future owner has an interest in seeing that the life tenant does not waste the property; in other words, the life holder is not allowed to neglect or abuse the property in a way that diminishes the property value. If the life tenant fails to make necessary repairs or uses the property in ways damaging to its future value, the future holder could bring legal action against the holder of the life estate to recover damages for waste.

life estate

Future Interest A future interest is a person’s present right to property ownership and possession in the future. Such an interest usually exists in conjunction with a life estate or a conditional estate. For example, Joe owns a life estate in Oak Hills Apartments, and on his death the property will pass to Sarah with fee-simple-absolute rights. Sarah, in this case, holds a future interest in Oak Hills Apartments, and if Joe allows the buildings to deteriorate from neglect, Sarah may sue Joe to enjoin him from engaging in waste of the property.

future interest

Leasehold Estate The interest of a leasehold differs from the interests previously described in that the holder of such an estate has a possessory interest but not an ownership interest. This interest is transferred by a contract known as a lease. Both the owner of the property (the lessor, or landlord) and the tenant (the lessee) sign the lease. The contract generally specifies the property to be leased, the amount of the rent payments and when they are due, the duration of the leasehold, and any special rights or duties of either party. A leasehold gives the lessee, or tenant, exclusive rights to the use and possession of the land, including the right to exclude the property owner under most circumstances, for the term specified by the lease. The tenant’s and landlord’s rights and obligations may vary according to the lease, but some states have statutes requiring landlords to keep the property in good condition for the tenant’s use and giving the tenant the right to withhold rent payments if the landlord fails to maintain the




Leasehold estate

Right to possess property for an agreed-on period of time

Life estate

Right to possess property until death, subject to restriction against waste

Conditional estate

Right to possess property until death, subject to restriction against waste

Fee simple absolute

Right to possess property for life and pass it to heirs on death; the most encompassing interest

An ownership interest in which the holder has the right to possess the property until her or his death.

A person’s present right to property ownership and possession in the future.

A possessory interest, but not an ownership interest, transferred by contract.

Exhibit 8-1 Possessory Estates in Land

GLOBAL Context Property Interests in Vietnam In the United States, we take for granted the right to go out and purchase a piece of property if we have the money to do so. Property is not so freely available and transferable in all nations. Vietnam’s new constitution, written in 1992, provides guidelines for the allocation, transfer, and sale of private property. However, the constitution still asserts that the people, or the state, own all the land. Thus, if individuals or private enterprises want to use land, they must pay tax on it as a form of rent. Those who agree to pay the tax on the land are granted a use of right, which entitles them to extended use. The use of right also gives the renter the freedom to transfer the property. Technically, it is not the

property that is being transferred but, rather, the right to use the property. Transference of property can occur only with the approval of a state official. The official ensures that the new owner intends to use the land for the original, state-approved purpose. Moreover, the new owner can never be given a longer term of right or more extensive rights over the land than the original owner had. Finally, the state official determines the price at which the property will be transferred. The government has specified certain prices depending on how the land is used. Considering the involvement of the state in such property transactions, the extent to which the Vietnamese enjoy private property rights is limited.

premises. However, if the tenant fails to make the agreed-on payments without such grounds, the landlord may evict the tenant. The landlord is not allowed to enter the property except when there is an emergency or when the tenant has given permission to enter to make repairs. Near the end of the leasehold, the landlord may enter with notice to the tenant for the purpose of showing the property to a potential tenant. Subleasing of the property by the tenant to another party is permissible unless specifically prohibited by the lease. However, the initial tenant is liable throughout the entire term of the lease for payment of the rent to the landlord.

easement An irrevocable right to use some part of another’s land for a specific purpose without taking anything from it.

profit The right to go onto someone’s land and take part of the land or a product of it away from the land.

license A revocable right to use another’s property temporarily.

Nonpossessory Estates Although most people think of interests in land as being possessory in nature, some estates do not include the right to possess the property. Such interests include easements, profits, and licenses. Easements and profits are similar in that they are neither ownership nor possessory interests, and they are subject to similar rules, but they are not exactly the same. An easement is an irrevocable right to use some part of another’s land for a specific purpose without taking anything from it. A profit is the right to go onto someone’s land and take part of the land or a product of it away from the land. For example, if Bill has the right to drive his car across Jenny’s property to get to his property, he has an easement; but if he has the right to go onto her property and remove the topsoil he needs from it for his landscaping business, he has a profit. Easements and profits can be transferred in multiple ways: by express agreement, inheritance, necessity, implication, or prescription. If the land that benefits from the easement or profit is sold, the nonpossessory interest goes with the property. Thus, if Bill sold his land to Sonny, Sonny would also receive the easement across Jenny’s property. Similarly, if Jenny sold her property, the new owner would have the burden of Bill’s easement as long as it had been properly recorded. Of course, just as easements and profits can be created, they can also be terminated, with the most common method of termination being by agreement. The easement holder may simply deed the easement back to the property owner. If the easement arose by necessity and the necessity no longer exists, the easement would terminate. A license is a right to use another’s property that is both temporary and revocable. For example, when a person purchases a theater ticket, he or she has the right to a specific use of the property for a limited time, subject to good behavior. No property interest goes to the license holder.

PROPERTY TRANSFER The owner’s ability to transfer real property is part of the value of property. Any or all of the owner’s property may generally be transferred to anyone for any price or no price, as the owner desires. However, to effectuate such a transfer, the owner must follow certain legal procedures. These procedures are execution, delivery, acceptance, and recording (see Figure 8-2), the last of which is required to protect the recipient of the property. Such a transfer is presumed to be the conveyance of a fee simple absolute unless the contrary is stated. 154

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Figure 8-2 Execution




County Office




Steps in a Voluntary Transfer

Do Ot cu he m r en ts



The transfer of the owner’s interest in real property is not always voluntary. Transfer of property may also take place without the owner’s knowledge and even, in some cases, against his or her will by either adverse possession or condemnation. In adverse possession, a person takes ownership of property by treating a piece of real property as his or her own, without protest or permission from the owner. Most states have established statutes determining a length of time after which such a possessor receives the ownership interest in the property. The exact lengths of time vary from state to state, but adverse possession must be actual (the person lives on or uses the land as an owner would), open (not secretive), and notorious (without the owner’s permission). In some states, the adverse possessor must have performed certain acts such as the payment of real estate taxes. In other states, such possession must have taken place under color of title; in other words, the adverse possessor was operating under the assumption that he or she actually held the title to the land. Condemnation is the legal process by which a transfer of property is made against the protest of the property owner. As you will remember from Chapter 5’s discussion of the takings clause of the Fifth Amendment, the government has a constitutional right to take private property for the use of the public provided it pays the owner fair compensation. This right may be exercised at any government level, and sometimes it is exercised on behalf of a private company operating to benefit the public. When the government decides to exercise its power of eminent domain, it will first make an offer to purchase the property for what it believes is the fair market value. If the owner either does not want to sell or feels the price is too low, the government will initiate a condemnation proceeding, and the court will determine whether the government body bringing the action has a valid claim that the taking is for a legitimate public purpose. If the court determines that, in fact, the taking of the property will benefit the public interest, the court will then determine the fair market value of the property. This price will be paid to the owner, and the property will be transferred to the government. It is sometimes difficult to determine whether the exercise of eminent domain is actually for the public’s benefit when the property will be conveyed by the government to another private individual. Since the 1980s, businesses increasingly have been appealing to cities to use their power of eminent domain to assist the businesses in acquiring land that the owners have not wanted to sell. Because this transference of property from one private individual to another is for the alleged public use of economic development, an increasing number of state supreme courts began to address the issue of whether economic development was a public use under the constraints of the Fifth Amendment. Some state supreme courts found that job creation and expansion of the tax base did constitute public use, whereas other courts found that they did not constitute public use. The U.S. Supreme Court finally settled the issue—at least for the present time—in the 5-4 decision summarized in Case 8-1.

adverse possession An involuntary property transfer in which a person acquires ownership of property by treating a piece of real property as his or her own, without protest or permission from the owner.

condemnation The legal process by which a transfer of property is made against the protest of the property owner.

CASE 8-1


FACTS: New London, a city in Connecticut, used its eminent domain authority to seize private property to sell to private developers. The city said developing the land would create jobs and increase tax revenues. Kelo Susette and others whose property was seized sued New London in state court. The property owners argued that the city violated the Fifth Amendment’s takings clause, which guarantees that the government will not take private property for public use without just compensation. Specifically, the property owners argued that taking private property to sell to private developers was not public use. The Connecticut Supreme Court ruled for New London. ISSUE: Does a city violate the Fifth Amendment’s takings clause if the city takes private property and sells it for private development, with the hopes the development will help the city’s bad economy? REASONING: •

The city’s taking of private property to sell for private development qualified as a public use within the meaning of the takings clause. The city was not taking the land simply to benefit a certain group of private individuals but was following an economic development plan. Such justifications should be given deference. The takings here qualified as public use even though the public would not use the land.

The Fifth Amendment did not require literal public use, the majority said, but the “broader and more natural interpretation of public use as ‘public purpose.’”

O’Connor’s dissent: •

An unelected (therefore voter-unaccountable) private nonprofit corporation was the primary beneficiary of the government taking.

“Any property may now be taken for the benefit of another private party, but the fallout from this decision will not be random. The beneficiaries are likely to be those citizens with disproportionate influence and power in the political process, including large corporations and development firms.”

The decision eliminates “any distinction between private and public use of property—and thereby effectively delete[s] the words ‘for public use’ from the Takings Clause of the Fifth Amendment.”

DECISION AND REMEDY: The city has not violated the Fifth Amendment. Affirmed, for New London. SIGNIFICANCE OF THE CASE: The U.S. Supreme Court expanded significantly what constitutes public use. Many people believe the Supreme Court went too far— they agree with Justice O’Connor’s opinion.

CRITICAL THINKING When you examine the reasoning in both the majority and dissenting opinions, you can see that a significant conflict between the opinions exists because of the ambiguity of a key term. Identify this term and explain how its interpretation affects the reasoning. How do you think the courts should define the term?

ETHICAL DECISION MAKING Who are the primary stakeholders involved in this case? How are they affected by the ruling? What are the implications of this ruling in terms of the distinction between public and private property? Further, this case highlights an important value conflict. Can you explain how certain values would lead one to support the majority opinion, whereas different values would lead one to support the dissenting opinion? How might holding a different value determine how one predicts the implications of this ruling?


GLOBAL Context Eminent Domain in Germany Germany has both federal and state (Länder) regulations governing eminent domain. The federal system is similar to that in the United States, but one difference is that most of its eminent domain laws are incorporated through statutes, not through cases as in the United States. The German federal government may expropriate land for the public good as long as it provides compensation. Germany’s basic law provides that “Such compensation shall be determined by establishing an equitable balance between the public interest and the interests of those affected.” Compensation in the German system is not based on fair market value alone but must also consider the interests of those affected.

Germans may dispute the amount of compensation in the ordinary courts. A taking requires the government to have the legal authority for the taking. The taking must also be appropriate for accomplishing the government’s purpose and must be done in the least intrusive way possible, meaning that the government cannot take property before it needs it, and it can take only the property it needs. The taking must also pass a balancing test, showing that the public’s interest is greater than the owner’s interest. One other difference in Germany is that if the German government no longer needs the property, it must revert to its former owner. In the United States, once the government has provided just compensation for the property, it belongs to the government.

Whereas the Kelo case involves government attempts to take property from individuals to sell to companies, sometimes governments seek to take the property of one company for use by another company. For instance, in June 2000, Costco, a large retail chain, wanted to expand its warehouse in Lancaster, California. Afraid of losing the large store, which threatened to move if it could not expand, the city considered using its eminent domain powers to acquire an adjacent 99 Cents Only store so that Costco could obtain the property. This example demonstrates that even businesses may be at risk of losing their property to larger, more powerful businesses. The response to the Kelo decision was widespread. President George W. Bush issued an executive order limiting the taking of private property by the federal government to “situations in which the taking is for public use, with just compensation, and for the purpose of benefiting the general public, and not merely for the purpose of advancing the economic interest of private parties to be given ownership or use of the property taken.” During the year and a half after Kelo, 30 state legislatures enacted statutes limiting the use of eminent domain. Additionally, in 2006, nine states passed ballot measures restricting the definition of public use for purposes of eminent domain. Thus, it appears that the ultimate impact of the Kelo decision will be the opposite of what that decision held; by statute, a much more restrictive definition of public use will govern government takings. The case is also important because it shows how constitutional issues directly affect areas of the law, such as property law.

Personal Property

LO 8-4

All property that is not land or not permanently affixed to land is personal property. Personal property may be either tangible or intangible. Tangible property is property that can be identified by the senses. It is property that you can see or touch. Tangible property includes items such as furniture, cars, and other goods. Books are typically thought of as personal property. The owner of a book may write in it and generally do what he or she wants with it, and the law protects the owner against having the book taken by someone else. However, the growing popularity of e-books has raised questions about what rights e-book users have to their e-books. In July 2009, Amazon deleted copies of George Orwell’s 1984 and Animal Farm directly off people’s Kindles (Amazon’s e-book reader) and refunded their money. This action has sparked massive controversy over whether Amazon has the right to remove content that customers had bought from their Kindles. At least one 157


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lawsuit has already been filed as a result of this incident. Much of the outrage has been because people do not see e-books and physical books as different types of property. Businesses that offer digital content should be clear about what rights customers have to the content, and they should make that information well known and visible to avoid problems like the one Amazon is currently facing. Intangible property includes such items as bank accounts, stocks, and insurance policies. Because most intangibles (with the exception of some that are classified as intellectual property and discussed later in this chapter) are evidenced by writings, most of the following discussion applies to both tangible and intangible property. The primary issues that arise in conjunction with personal property involve the means of acquiring ownership of the property, which is discussed in the next section.

LO 8-5

VOLUNTARY TRANSFER OF PROPERTY Voluntary transfer, as a result of either a purchase or a gift, is the most common means by which property is acquired. Ownership of property is referred to as title, and title to property passes when the parties so intend. When transfer of the property is by purchase, the acquiring party gives some consideration to the seller in exchange for title to the property. Such a transfer of ownership usually requires no formalities, but in a few cases, changes of ownership must be registered with a government agency. Sales of motor vehicles, watercraft, and airplanes are among the primary transfers requiring registration. To transfer such property, a certificate of title must be signed by the seller, taken to the appropriate government agency, and then reissued in the name of the new owner. Gifts are another voluntary means of transferring ownership. They differ from purchases in that a promise to make a gift is unenforceable. Once properly made, however, a gift is irrevocable. Three elements are necessary for a valid gift. First, there must be a delivery of the gift. Delivery may be actual, which is the physical presentation of the gift itself, or constructive, which entails the delivery of an item that gives access to the gift or represents it, such as handing over the keys to a car. Second, the delivery must be made with donative intent to make an immediate gift. The donor makes the delivery with the purpose of turning over ownership at the time of delivery. Third, there must be acceptance, a willingness of the donee to take the gift from the donor. Usually, acceptance is not a problem, although a donee may not want to accept a gift because of a desire not to feel obligated to the donor or because of a concern that ownership of the gift may impose some unwanted legal liability. Sometimes, however, it can be difficult to determine whether something is a gift or a loan, especially when proper documentation is not filed at the time of the transaction. This was the scenario faced by Don Whittington when he disputed ownership of a 1979 Kremer Porsche displayed at the Indianapolis Motor Speedway Hall of Fame Museum. Whittington believed that he was the owner of the Porsche and that he had merely loaned it to the museum in 1980. The Indianapolis Motor Speedway Foundation believed that Whittington had given the car as a gift to the museum, and the foundation had even applied for and been granted a title to the car in 2001. In 2004, when Whittington requested the return of the car, he had to prove that he had a possessory interest in the car. Although the museum did not have a record of receiving the car as a gift or a loan, and Whittington had never applied for a tax reduction for giving the car as a gift and was able to produce one document in which he listed the car as an asset, the trial court found in favor of the foundation. The court determined that Whittington’s behavior after the museum took possession of the car was more consistent with giving the car as a gift than as a loan. The gifts we have been discussing so far have been what are called inter vivos gifts, gifts that are made by a person during his or her lifetime. Another type of gift that can be made is a gift causa mortis, a gift that is made in contemplation of one’s immediate death. It can be revoked any time before the death of the donor, and it is automatically revoked if the donor recovers. Litigation over gifts causa mortis often arises because the three elements of delivery, donative intent, and acceptance still have to occur before the gift is complete, and that means before the

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death of the donor. It can sometimes be difficult to determine whether in fact all the elements of a gift causa mortis have been met.

INVOLUNTARY TRANSFER OF PERSONAL PROPERTY Involuntary transfers of ownership occur when property has been abandoned, lost, or mislaid. The finder of such property may acquire ownership rights to such property through possession. Property that the original owner has discarded is abandoned property. Anyone finding such property becomes its owner by possessing it. For example, Karen is on vacation and decides that she doesn’t really need her umbrella and doesn’t want to carry it the rest of the trip, so she leaves the umbrella on a seat in the airport. If Bill then picks it up and takes it with him, he is now the lawful owner of the umbrella. Lost property is property that the true owner has unknowingly or accidentally dropped or left somewhere. He or she has no way of knowing how to retrieve it. In most states, the finder of lost property has title to the lost good against all except the true owner. Mislaid property differs from lost property in that the owner has intentionally placed the property somewhere but has forgotten its location. The person who owns the realty on which the mislaid property was placed has the right to hold the mislaid property. The reason is that the true owner likely will return to the realty looking for the mislaid property. In some states, the law requires that before becoming the owner of lost or mislaid property, a finder must place an ad in the paper that will give the true owner notice that the property has been found and/or must leave the property with the police for a statutorily established reasonable period of time.

OTHER MEANS OF ACQUIRING OWNERSHIP OF PROPERTY There are additional means by which people acquire title to property. One such means is by creation: If a person creates a piece of property, then he or she owns that property. One exception to this rule occurs when a person is paid to create property for someone else, in which case the property is owned by the person who paid for its creation. Another means of acquiring ownership is by court order. In a number of types of cases, the court will determine who is entitled to ownership of property. For example, in a divorce case, the court may award ownership of certain property to different parties, or in a bankruptcy case, the court may award ownership of certain property to a creditor. A far less common means of acquiring ownership is confusion, which involves only fungible goods. Fungible goods are goods for which one unit of the good is essentially the same as every other unit, such as grains of wheat or gallons of oil. If two people accidentally commingle their fungible goods, or if the goods are commingled because of the actions of a third party, each party is entitled to the percentage of the fungible goods that he contributed. However, if one of the parties was responsible for the commingling and that person cannot prove what percentage of the commingled goods she contributed, then the innocent party acquires title to all the goods. For example, if a farmer had stored grain in a rented storage elevator and another farmer wrongfully added his grain to the elevator, the innocent farmer would be entitled to the entire amount in the silo.

Intellectual Property Intellectual property, property that comes from creativity, also carries a bundle of sticks, both for the creator of the property and for the community. The creators of intellectual property often want to keep the property to themselves. For example, creators of copyrighted work (creative work in a fixed form) do not want others to copy that work without permission. At times, intellectual property is more complicated than real property. For example, copyright often has an impact on freedom of speech. If a songwriter creates a song, others may think they have the right to express themselves through this song, but a copyright may prevent this expression.

LO 8-6


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Thus, copyright law and freedom of speech sometimes clash. Legislators and courts play an important role in responding to potential conflicts. They also balance the rights of innovators who create intellectual property with the interests of the community, especially interests in competition and freedom of expression. Courts and legislators decide what sticks to set aside for creators of intellectual property. They also decide what is left for the public, including artists and other businesses. The following sections describe specific types of intellectual property.

LO 8-7 trademark A distinctive mark, word, design, picture, or arrangement that is used by a producer in conjunction with a product and tends to cause consumers to identify the product with the producer.

TRADEMARKS A trademark is a distinctive mark, word, design, picture, or arrangement that a producer uses in conjunction with a product and tends to cause consumers to identify the product with the producer. Even the shape of a product or package may be a trademark if it is nonfunctional. Even though the description of a trademark is very broad, there has still been substantial litigation over precisely what features can and cannot serve as a trademark. In one case, discussed in the Case Nugget, the U.S. Supreme Court grappled with the issue of whether a color can be a trademark.

CASE Nugget Color as a Trademark? Qualitex Co. v. Jacobson Products Co. United States Supreme Court 514 U.S. 159 (1995) For years, the plaintiff, Qualitex Co., had colored the dry-cleaning press pads it manufactured a special shade of green-gold. When Jacobson Products, a competitor, started coloring its pads the same shade of green-gold, Qualitex sued Jacobson Products for trademark infringement. The defendant challenged the legitimacy of the trademark, arguing that color alone should not quality for registration as a trademark. The district court found in favor of the plaintiff, but the Ninth Circuit reversed, holding that color alone could not be registered as a trademark. The plaintiff appealed to the U.S. Supreme Court. In writing for the majority that a color could constitute a trademark, Justice Breyer said that both the language of the Lanham Act and the basic underlying principles of trademark law would seem to include color within the universe of things that could qualify as a trademark. He noted that the broad language used to describe trademarks included “any word, name, symbol, or device, or any combination thereof.” Human beings might use as a symbol or device almost anything at all that is capable of carrying meaning. Justice Breyer noted that a particular shape (of a Coca-Cola bottle), a particular sound (of NBC’s three chimes), and even a particular scent (of plumeria blossoms on sewing thread) could be trademarked, and he reasoned that if a shape, a sound, and a fragrance can act as symbols, it made sense that so could a color. He also noted that a color, if unusual enough in the context, could in fact come to identify goods with their source, just as descriptive words on a product could. The Court concluded that the green-gold color acts as a symbol that has developed secondary meaning (i.e., customers identified the green-gold color as Qualitex’s) and identifies the press pads’ source. The high court therefore reversed the decision in favor of the plaintiff.

Seventeen years later, courts considered whether a color can serve as a trademark in the fashion industry. Christian Louboutin designs and sells high-fashion shoes with red lacquered

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soles, and the red lacquered sole was registered as a trademark in 2008. In 2011, Yves Saint Laurent America, Inc. (YSL), planned to offer a line of monochromatic shoes whose upper part matched the color of the sole, and one of these shoes had a red upper portion along with a red sole. When Louboutin learned of the red YSL shoe, Louboutin sued YSL for trademark infringement. Relying on Qualitex, the district court held that a single color could never serve as a trademark in the fashion industry because single color marks are inherently functional. On appeal, the Second Circuit determined that there was nothing about the fashion industry that should warrant treatment different from other industries. However, the Second Circuit determined that Louboutin had put the color red “in a place that seemed unusual” (Qualitex, 514 U.S. at 162). Based on the evidence in the record, Louboutin’s trademark should be limited to a red lacquer sole that contrasts with the upper portion of the shoe. Thus, YSL was permitted to sell its monochromatic shoe.2 A trademark used intrastate is protected under state common law. To be protected in interstate use, the trademark must be registered with the U.S. Patent Office under the Lanham Act of 1947. If a mark is registered, the holder of the mark may recover damages from an infringer who uses it to pass off goods as being those of the mark owner. The owner may also obtain an injunction prohibiting the infringer from using the mark. (Only the latter remedy is available for an unregistered mark.) Once the mark is registered, the registration must be renewed between the fifth and sixth years. After that initial renewal, the mark holder must renew the registration every 10 years. (If the mark was initially registered before 1990, however, renewal is necessary only every 20 years.) To register a mark with the Patent Office, one must submit a drawing of the mark and indicate when it was first used in interstate commerce and how it is used. The Patent Office conducts an investigation to verify those facts and will register a trademark as long as it is not generic, descriptive, immoral, deceptive, the name of a person whose permission has not been obtained, or substantially similar to another’s trademark. Even though we know the criteria for a trademark, it is not always easy to predict when a trademark will be granted or whether, even if granted, the trademark will stand up to a legal challenge. For example, immediately after actor Charlie Sheen was terminated from his role on the hit television program Two and a Half Men and began receiving a lot of media coverage, he started producing products marked with phrases that were beginning to be identified with his role on the program, namely “Duh, Winning,” “Vatican Assassin,” “Tiger Blood,” and “Rock Star from Mars.” It is uncertain whether these terms will be found by the courts to meet the criteria for trademarks as previously described. Case 8-2 demonstrates a typical analysis used in a trademark infringement suit. 2

Christian Louboutin S.A. et al. v. Yves Saint Laurent America, Inc. (YSL) et al., 696 F.3d 206 (2d Cir. 2012).

CASE 8-2


FACTS: In 1961, plaintiff Toys “R” Us, Inc., obtained a trademark for “Toys ‘R’ Us” and aggressively advertised its products, children’s toys and clothing, in stores across the country. In the late 1970s, defendant Canarsie Kiddie

Shop opened two clothing shops called “Kids ‘r’ Us” within 2 miles of a Toys “R” Us shop. The defendant never tried to register its name. Toys “R” Us sued for trademark infringement in federal district court.

(continued) ISSUE: Does “Kids ‘r’ Us” infringe on the “Toys ‘R’ Us” mark? REASONING: To determine the likelihood of confusion associated with the defendant’s mark, the court considered these factors: •

Strength of the senior user’s mark: A mark can fall into one of four general categories, which, in order of ascending strength, are (1) generic (is entitled to no protection); (2) descriptive (has a secondary meaning and informs public about uses of product); (3) suggestive (suggests qualities of product but requires imagination); and (4) arbitrary or fanciful (does not describe the qualities of the product). The plaintiff’s mark has a strong secondary meaning as a source of children’s products, so the court determines the mark has medium strength. But it falls short of the arbitrary or fanciful protection. Degree of similarity between the two marks: The key question is whether consumers have the impression that purchasing from the junior user is purchasing from the senior user. Both parties use the phrase “R Us.” However, the plaintiff uses an inverted capitalized “R,” whereas the defendant uses a noninverted lowercase “r.” The plaintiff uses “Toys” while the defendant uses “Kids.” The plaintiff’s letter is usually multicolored. Proximity of the products: Both the plaintiff and the defendant sell children’s clothing and are direct competitors. The likelihood that plaintiff will bridge the gap: First, the senior user will expand sales efforts to compete

with the junior user. Second, consumers will assume that both parties are related companies. Evidence of actual confusion: When there is proof that consumers are actually confused by the use of the name, the senior user has a stronger case. Junior user’s good faith: The owner of Kids ‘r’ Us asserted that he did not recall whether he was aware of the plaintiff’s mark. The court does not believe him and concludes that the defendant adopted the “Kids ‘r’ Us” mark with knowledge of the plaintiff’s mark. Quality of the junior user’s product: The court is much more concerned about the possible violation if the quality of the clothing is poor because such clothing would then reflect poorly on the senior user. Sophistication of the purchasers: Because children’s clothing is not a major expenditure, customers will not exercise the same degree of care in evaluating the clothes. Junior user’s goodwill: The junior user did not expend a lot of money advertising and promoting its own name. Thus, the defendant doesn’t have a strong equitable interest in retaining its name.

DECISION AND REMEDY: Judgment for the plaintiff. The defendant’s use of its mark creates the likelihood of confusion and constitutes trademark infringement. SIGNIFICANCE OF THE CASE: This case clarifies the factors to consider in a trademark infringement case.

CRITICAL THINKING How does this case depend to a large extent on the definitions of a few particular terms? How good are the definitions used? What standard are you using to determine whether the definitions are good?

ETHICAL DECISION MAKING If you were the owner of Canarsie Kiddie Shop, Inc., how would your decision to refer to your store as “Kids ‘r’ Us” change if you were to act in accordance with the Golden Rule? What values are in conflict when considering the decisions of the owner of Canarsie Kiddie Shop, Inc., and of one who follows the Golden Rule?

trade dress The overall appearance and image of a product.


The term trade dress refers to the overall appearance and image of a product. Recall that, as described in the Chapter Opener, the shape and design of Apple’s iPhone is an example of trade dress. Trade dress is entitled to the same protection as a trademark. The main focus of a case of

E-COMMERCE and the Law Domain Names and Trade Names If you have a very strong trademark, what better domain name to have than that trademark? Unfortunately, the same trademark may be owned by two companies selling noncompeting goods, yet there can be only one user of any single domain name. For example, “apple” is a trademark owned by both a computer company and the company that produces the Beatles’ records. Both cannot establish a site identified as apple.com Domain names are important because they are the addresses by which people and businesses are located on the web. A domain name is made up of a series of domains separated by periods. Most websites have two domains. The first-level domain, the one that the address ends with, generally identifies the type of site. For example, if it is a government site, the domain name will end in gov; an educational site, in edu; a network site, in net; an organization site, in org; and a business site, in com. These top-level domain names are the same worldwide. The second-level domain is usually the name of whoever maintains the site. For a college, for example, it would be an abbreviation of the college name, such as bgsu. Businesses generally want to use their firm name or some other trademark associated with their product because that name will obviously make it easiest for their customers to find them. So how does a firm go about securing a domain name that reflects its trademark? Network Solutions, Inc. (NSI), which is funded by the National Science Foundation, is responsible for registering domain names. This entity acts on behalf of the Internet Network Information Center, which handles the daily administration of the domain name system in the United States. Initially, a person applied to the NSI to use a specific domain name, and as long as no one else held that name,

registration was granted. Since 1995, however, the NSI has been a little more careful in handing out names. Anyone seeking to register a domain name must now state in the application that the name will not infringe on anyone else’s intellectual property rights and that the registrant intends to use the name on a regular basis on the Internet. A party may lose registration of a name by not using it for more than 90 days. Or the domain name may be canceled if the registrant lied on the registration application. If you have a registered trademark and you find that a party is using your trademark as a domain name and that party does not also have ownership of that mark, you may give written notice to the NSI; under its domain dispute policy, it will most likely put the name on hold, meaning that no one can use the name. Of course, if that party had registered its domain name before you obtained the trademark, there is probably nothing you can do. The party will be entitled to retain the domain name. Some firms have tried to get the domain name they desire by going to another country. That alternative is certainly a possibility. However, many countries require your firm to be incorporated within their borders before you can gain the right to the domain name there. An additional problem is that trademark law relating to domain names is even more unclear abroad. For the new entrepreneur, the best advice is to apply for federal trademark protection and register the domain name simultaneously. And for those not yet on the web, the sooner you get your domain name, the more likely you are to get the name you want. If you feel that your mark is being violated by another’s domain name, you may want to sue the party for infringement because the unauthorized use of another’s trademark in a domain name has been found to be illegal. But you may be in for quite a fight because this is a new area of the law.

trade-dress infringement is usually on whether there is likely to be consumer confusion. For example, in a recent case,3 Tour 18, Ltd., a golf course, copied golf holes from famous golf courses without permission of the course owners. In copying a hole from one of the most famous courses in the country, Harbour Town Hole 19, Tour 18 even copied the Harbour Town lighthouse, which is the distinctive feature of that hole. In its advertising, Tour 18 prominently featured pictures of this hole, including the lighthouse. The operator of the Harbour Town course sued Tour 18 for trade-dress infringement. The court found that there was infringement and made Tour 18 remove the lighthouse and disclaim in its advertising any affiliation with the owner of the Harbour Town course. copyright

COPYRIGHTS Copyrights protect the expression of creative ideas. That is, they do not protect the ideas themselves but protect only the fixed form that expresses the ideas. Copyrights protect a diverse range 3

The protection of the expression of a creative work; that is, protection of the fixed form that expresses the ideas.

Pebble Beach Co. v. Tour 18, Ltd., 942 F. Supp. 1513.



Part I

The Legal Environment of Business

of creative works, such as books, periodicals, musical compositions, plays, motion pictures, sound recordings, lectures, works of art, and computer programs. Titles and short phrases may not be copyrighted. There are three criteria for a work to be copyrightable. First, it must be fixed, which means set out in a tangible medium of expression. Second, it must be original. Third, it must be creative. A copyright automatically arises under common law when the idea is expressed in tangible form. However, if the work is freely distributed without notice of copyright, the work falls into the public domain. A copyrighted work that is reproduced with the appropriate notice affixed is protected for the life of its creator plus 70 years. Under the common law of copyright, an infringer may be enjoined only from reproducing a copyrighted work. For the creator to be able not only to seek an injunction but also recover damages arising from the infringement, the copyrighted work must be registered. One may register a work by filing a form with the Register of Copyrights and providing two copies of the copyrighted material to the Library of Congress. Whenever the work is reproduced, the appropriate notice of copyright should accompany it, although such notice is no longer required by law. Printed works, for example, should be published with the word copyright and the symbol © or the abbreviation copr., followed by the first date of publication and the name of the copyright owner. Once the work is registered, as long as it is always accompanied by the notice of copyright when reproduced, the holder of the copyright has the additional right to sue an infringer for damages caused by the infringer’s use of the copyrighted material and to recover any profits made by the infringer on the copyrighted material. It is not always easy to determine whether a copyright has been infringed, even when two works are similar. After all, if we are talking about creative works, such as photographs of a famous scene, two people might independently take a very similar picture at completely different times and without even knowing of each other’s work. The following Case Nugget illustrates the court’s reasoning in a successful copyright infringement case.

CASE Nugget A Question of Whether There Was Copying Ty, Inc. v. GMA Accessories, Inc. U.S. Court of Appeals, Seventh Circuit 45 U.S.P.Q. 1519 (1998) Ty began selling Beanie Babies, and then GMA started selling bean-bag stuffed animals three years later. Ty sought an injunction under the Copyright Act to stop the sale of GMA’s Preston the Pig and Louie the Cow. Ty argued that these animals violated its copyrights for Squealer (a pig) and Daisy (a cow). Ty was successful in obtaining an injunction for copyright after the court asked the following questions: Did the alleged copier have access to the work he or she potentially copied? Did he or she actually copy the work? The court found that access (and copying) may be inferred when the two works are so similar and unlike anything in the public domain that it is likely the second user copied the first. This inference can be rebutted by disproving access or showing independent creation. Looking at pictures of the two cows compels an inference of copying. If GMA must have had access to Ty’s cow, it must have had access to the pig, too. GMA’s pig is strikingly similar to Ty’s pig but not to anything in the public domain (e.g., a real pig). The only evidence GMA presented was an affidavit by the designer, who swears she never looked at Squealer. However, the actual bean-bag animal looks more like Ty’s design than the designer’s drawing.

Chapter 8

The fair-use doctrine provides that a portion of a copyrighted work may be reproduced for purposes of “criticism, comment, news reporting, teaching (including multiple copies for classroom use), scholarships, and research.” In determining whether the fair-use doctrine provides a valid defense to a claim of copyright infringement, Section 107 of the Copyright Act requires the court to weigh the following four factors: the purpose and character of the use, the nature of the copyrighted work, the amount and substantiality of the portion used in relation to the copyrighted work as a whole, and the effect of the use on the potential market for or value of the copyrighted work. Case 8-3 provides an example of the fair-use doctrine.

CASE 8-3


Real, Personal, and Intellectual Property

fair-use doctrine The lawful use of a limited portion of another’s work for purposes of criticism, comment, news reporting, teaching, scholarship, and research that does not reduce the commercial value of the protected property.


FACTS: Congress enacted legislation to create a memorial for the Korean War. Cooper-Lecky Architects, P.C., was the contractor selected for the creation and construction of the memorial. Cooper-Lecky held a competition to select the sculptor for the memorial, and in 1990, Frank Gaylord, a nationally known sculptor, won the competition and began working on the Korean War Memorial. Specifically, he created a design in which 19 statues represented a platoon of soldiers in formation for war. Gaylord registered copyrights for these soldier sculptures. In 1995, John Alli took photographs of the memorial as a gift for his father, who was a Korean War veteran. When Alli later decided to sell prints of the photo, he approached Cooper-Lecky for permission, and the parties agreed Alli would pay CooperLecky a 10 percent royalty on his sales of the photo. In 2002, the U.S. Postal Service decided to use Alli’s photo as a stamp commemorating the end of the Korean War. Alli told the Postal Service that it would need to get permission from Lecky, who he understood held the copyright on the statues. The Postal Service did not get permission from Lecky or from Gaylord. The Postal Service sold approximately $17 million worth of the stamps, and an estimated $5 million of that $17 million was from collectors who would not use the stamps. Gaylord sued the government in 2006 for copyright infringement in the Court of Federal Claims, where the court determined that the stamp made fair use of the sculptures. Gaylord appealed. ISSUE: Was the Postal Service’s use of Gaylord’s sculpture on a postage stamp fair use? REASONING: The Federal Circuit considered the four factors under Section 107 of the Copyright Act. First, the court considered the purpose and character of the infringing use. Specifically, the court evaluates whether the new

work adds something new, such as a new expression, meaning, or message, and is transformative. The Federal Circuit determined that the stamp did not communicate any further purpose than the memorial. It was not intended to provide commentary or criticism. Furthermore, the stamp had a commercial purpose. Consequently, the court determined this factor weighed against fair use. Second, the Federal Circuit considered the nature of the copyrighted work, the memorial. Under this factor, courts consider (1) whether the work is more creative or more factual, and (2) whether the work is published or unpublished. Works that are more factual and works that are unpublished are more likely to be found as fair use. The memorial was both a creative and published work, so this factor weighed against fair use. Third, the Federal Circuit considered the amount and substantiality of the portion used. The stamp included 14 of the 19 soldier sculptures. Furthermore, the stamp had the same focus as the memorial, so this factor weighed against fair use. Finally, the Federal Circuit considered the effect of the use on the potential market. Here, the court considered the market for the copyrighted work as well as the market for the potentially infringing works. The Court of Federal Claims determined that the stamp did not harm either market and noted that Gaylord agreed that the stamp increased the memorial’s value. The Federal Circuit did not disagree with the Court of Federal Claims’ findings. DECISION: The Federal Circuit determined that the factors led to the conclusion that the stamp’s use was not a fair use. SIGNIFICANCE OF THE CASE: The case clearly sets forth how the elements of the fair-use doctrine are applied.


Critical Thinking Create a series of facts that, had they been true, would have caused the court to have decided that the stamp’s use was a fair use.

Ethical Decision Making What value conflict is responsible for the arguments surrounding the issue of fair use of intellectual property?

In the 1970s, Sony developed a format for videotaping called Betamax. Film studios brought suit against Sony in 1976, arguing that taping a television show was copyright infringement. The district court concluded that recording a show for personal, noncommercial use was fair use, but the appellate court disagreed and found Sony liable. The Supreme Court ultimately ruled on this issue in 1984, agreeing that recording a television program for the noncommercial purpose of time shifting is fair use.4 As technology has continued to develop, copyright enforcement has remained an important concern. For example, Napster was a peer-to-peer file sharing network by which one user could download a file from another user for free. Files that were typically transferred were digital music files. The record industry brought suit against Napster and received a preliminary injunction to stop the exchange of digital music files. Napster appealed to the Ninth Circuit Court of Appeals, which affirmed the preliminary injunction.5 Napster made several arguments regarding fair use. Like the time shifting purpose in the Betamax case, Napster argued that users were engaging in space shifting (i.e., transferring music files from CDs they had purchased to their computers). However, the court found that although the user may have been transferring the format (from CD to computer file) for personal use, the user was necessarily sharing the files with other users, which was not a fair use. In 1994, the Supreme Court decided that commercial parody may be fair use. In that case, 2 Live Crew, a rap group known for its explicit lyrics, recorded and released a song called “Pretty Woman,” which was a parody of Roy Orbison’s “Oh, Pretty Woman.” The Supreme Court considered the four factors listed previously. With respect to the purpose and character of the use, the more transformative the new work is, the less courts will need to focus on the other three factors.

PATENTS patent Protection that grants the holder the exclusive right to produce, sell, and use the object of the patent for 20 years; can be obtained for a product, process, invention, machine, or a plant produced by asexual reproduction.

A patent protects a product, process, invention, machine, or a plant produced by asexual reproduction. For this protection to be granted, three criteria must be satisfied. First, the object of the patent must be novel, or new. No one else must have previously made or published the plans for this object. Second, the object must be useful unless it is a design. It must provide some utility to society. Third, the object must be nonobvious. The invention must not be one that a person of ordinary skill in the trade could have easily discovered. When a patent is issued for an object, it gives its holder the exclusive right to produce, sell, and use the object of the patent for 20 years from the date of application. The holder of the patent may license, or allow others to manufacture 4 5


Sony Corp. of America v. Universal City Studios, Inc., 464 U.S. 417 (1984). A&M Records, Inc. v. Napster, Inc., 239 F.3d 1004 (2001).

Chapter 8


Real, Personal, and Intellectual Property

and sell, the patented object. In most cases, patents are licensed in exchange for the payment of royalties, a sum of money paid for each use of the patented process.

B UT W HAT I F  . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? What if Samsung had presented evidence at the trial that half of the phones on the market at the time of the trial that were made by companies other than Apple or Samsung also shared the iPhone’s design of being rectangular with rounded corners?

The only restriction on the patent holder is that he or she may not use the patent for an illegal purpose. The two most common illegal purposes are tying arrangements and cross-licensing. A tying arrangement occurs when the holder issues a license to use the patented object only if the licensee agrees to buy some nonpatented product from the holder. Cross-licensing occurs when two patent holders license each other to use their patents only on the condition that neither licenses anyone else to use his or her patent without the other’s consent. Both of these activities are unlawful because they tend to reduce competition. To obtain a patent, one generally contacts an attorney licensed to practice before the U.S. Patent Office. The attorney does a patent search to make sure that no similar patent exists. If none exist, the attorney fills out a patent application and files it with the Patent Office. As part of the application process, the inventor has a duty to disclose any prior art he or she is aware of related to the invention, including other patents. The Patent Office evaluates the application, and if the object meets the criteria already described, a patent is issued within approximately two years. Although two years may seem like a long time, it is short compared to the six years it typically takes to secure a patent in Japan. Once the patent is issued, the holder may bring a patent infringement suit in a federal court against anyone who uses, sells, or manufactures the patented invention without the permission of the patent holder. A successful action may result in an injunction prohibiting further use of the patented item by the infringer and an award of damages. Sometimes, however, the result of the case is that the holder loses the patent. This loss would occur if the infringer can prove that the Patent Office should not have issued the patent in the first place. Another way in which a potential patent infringer may attempt to challenge a patent is to ask the United States Patent and Trademark Office (USPTO) to reexamine the patent. Through the reexamination process, a party presents what it argues is invalidating prior art (i.e., patents, articles, or products that disclosed all features of the invention before the patent-at-issue was granted). The USPTO then considers whether the patent should have in fact been issued. Reexamination requests are frequently granted, and it may take several years for the USPTO to consider whether a patent should have been issued. Thus, reexaminations are tools defendants frequently use to slow down or even pause litigation because a court may prefer the USPTO to complete the reexamination before litigation may proceed.

B UT W HAT I F  . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? What if Samsung had been able to bring in evidence that Samsung, in fact, sold a phone with a design similar to the iPhone’s before the iPhone had come out? Would that fact have affected the outcome of the case with respect to Apple’s claim of infringement on its design patent?

tying arrangement An illegal agreement in which the sale of one product is tied to the sale of another.

cross-licensing An illegal contractual arrangement in which two or more parties license each other to use their specified intellectual property only on the condition that neither licenses anyone else to use the property without the other’s consent.


Part I

The Legal Environment of Business

THE AMERICA INVENTS ACT In 2011, Congress passed the America Invents Act, which changed the U.S. patent system in several important ways. First, the first person to file a patent application in the United States for an invention will be deemed to have rights to the invention. This is a change from the previous policy, by which the first person to invent had the rights to the invention. This change is important because in the past, employees could keep diligent records and take their time applying for the patent. The European and Japanese patent systems also have a first-to-file rule. Second, the Act expands the types of prior art that may be considered by the USPTO when granting a patent, which would arguably make it more difficult to obtain a patent. Third, the Act makes changes to the reexamination process, making the process more like litigation by allowing discovery requests during the process. Fourth, the Act prohibits a plaintiff from filing one suit against many unrelated defendants, which has typically increased the number of patent infringement cases filed. Finally, the Act makes it easier and more affordable for small businesses and sole entrepreneurs to apply for patents.

TRADE SECRETS trade secret A process, product, method of operation, or compilation of information that gives a businessperson an advantage over his or her competitors.

A trade secret is a process, product, method of operation, or compilation of information that gives a businessperson an advantage over his or her competitors. Inventions and designs may also be considered trade secrets. Furthermore, a company’s client list (or an employee’s contact list) could be considered a trade secret. A trade secret is protected by the common law from unlawful appropriation by competitors as long as it is kept secret and consists of elements not generally known in the trade. Competitors may discover a secret by any lawful means, such as by doing reverse engineering or by going on public tours of plants and observing the use of trade secrets. Lawful discovery of a secret means there is no longer a trade secret to be protected. When an employee leaves a company to work for a competing company, the original company frequently investigates whether the employee has taken any trade secrets to the competitor. According to one study, 59 percent of departing employees take confidential information from the employer when leaving.6 To ensure that confidential information is protected, companies should consider creating a policy stipulating that any trade secret information must be labeled Confidential or Trade Secret by employees (which would help the employer maintain a trade secret claim) and limit access to this confidential information within the company. If a competitor acquires a trade secret by unlawful means, the originator of the secret can take legal action. To enjoin such a competitor from continuing the use of a trade secret and/or to recover damages caused by the use of the secret, a plaintiff must prove that a trade secret actually existed, that the defendant acquired it through unlawful means, and that the defendant used the trade secret without the plaintiff’s permission. A common dilemma facing an inventor is whether to protect an invention through patent or trade-secret law. If the inventor successfully patents the invention and defends the patent, the inventor has a guaranteed exclusive monopoly on the use of the invention for 20 years, a substantial period of time. The problem is that once this period is over, the patented good goes into the public domain and everyone has access to it. There is also the risk that the patent may be successfully challenged and the protection lost prematurely. Trade-secret law, on the other hand, could protect the invention in perpetuity. The problem is that once someone discovers the secret lawfully, the protection is lost.


“Protecting Trade Secrets When Employees Depart,” LAW 360, September 18, 2009.

Chapter 8

Real, Personal, and Intellectual Property


SUMMARY The Nature of Real and Intellectual Property

Real property is land and anything permanently affixed to the land.

Real Property

Fee simple absolute: Right to possess for life and devise to heirs on death; the most encompassing interest.

Intellectual property is property that is primarily the result of mental creativity rather than physical effort.

Conditional estate: Right that is comparable to a fee simple absolute except that the interest will terminate on the happening or nonhappening of a specified condition. Leasehold estate: Right to possess property for an agreed-on period of time. Easement: Irrevocable right to use a portion of someone else’s land for a specified purpose. License: Right to use another’s property temporarily. Personal Property

Personal property is all property that is not land or permanently affixed to land. Voluntary transfer of personal property: Property can be transferred by purchase or by gift. Involuntary transfer of property: If property is lost, mislaid, or abandoned, a new owner acquires title to the property through possession.

Intellectual Property

A trademark is a distinctive mark, word, design, picture, or arrangement that a producer uses in conjunction with a product and tends to cause the consumer to identify the product with the producer. Trademarks used in interstate commerce can be protected under the Lanham Act. A copyright protects the fixed form of the expression of an original, creative idea. The most common defense to an allegation of copyright infringement is the fair-use doctrine, which provides that a portion of a copyrighted work may be reproduced for purposes of “criticism, comment, news reporting, teaching (including multiple copies for classroom use), scholarships, and research.” A patent protects a product, process, invention, machine, or plant produced by asexual reproduction that meets the criteria of being novel, useful, and nonobvious. Obtaining a patent under the Lanham Act allows the holder to license the use of his or her patented idea for royalties as long as the holder does not enter into a tying arrangement or engage in cross-licensing.

Point/Counterpoint The process of applying for a patent and keeping a patent can be difficult and costly. As you know, an alternative to patenting an invention is to protect it through trade-secret law.

Should Inventors Avoid the Hassles of Patent Protection and Protect Their Inventions through Trade-Secret Law?



Inventors should choose to protect their inventions through trade-secret law. Trade-secret protection

Inventors should not choose to protect their inventions through trade-secret law. Protection through


Part I

The Legal Environment of Business

does not require registration with government agencies. Unlike patent protection, whereby the owner of the patent has exclusive rights to produce, sell, and use the object of the patent only for a limited time, trade-secret protection offers the owner of the trade secret exclusive rights indefinitely. For example, the unique process by which Coca-Cola makes its soft drink has been protected as a trade secret for over 100 years. This approach has prevented competitors from duplicating Coca-Cola’s product. A patent holder also risks the chance of losing the patent if a challenger can show that the patent should not have been issued. Because trade-secret protection is not limited by registration requirements, inventors should use trade-secret law to protect their products.

trade-secret law is risky. It is the responsibility of the owner of the trade secret to take precautionary measures to maintain the privacy of the trade secret. With technological advances, the chance of competitors using legal methods such as reverse engineering to discover the trade secret is likely. An owner of a patent may bring a patent infringement suit if the patent has been used without permission. If a trade secret is discovered through lawful means, it is no longer a secret and the owner cannot bring actions against those using the product or process. Through patent protection, the owner can decide whether to license the patent and can earn a profit from those who choose to use the product. The risks associated with tradesecret protection are too great to make it a desirable choice.

Questions & Problems 1. Explain the bundle-of-sticks idea as it relates to real property. 2. Explain the five possessory interests in land. 3. Explain the bundle-of-sticks idea as it relates to intellectual property. 4. How are trademarks and patents different? 5. Explain copyright infringement. 6. Willard W. Smith had owned a salvage yard since 1980. In 1984, the county enacted a zoning ordinance requiring a permit for salvage yards. Because the operation of Smith’s yard predated the 1984 ordinance, he was not subjected to the permit requirement. A relevant regulation stated, “Any salvage yard which was licensed prior to June 12, 1988, may continue to be operated and maintained in accordance with the statutes and regulations in effect at the time the yard was initially licensed.” In 1992, Smith sold the yard to Poole. Poole continued to use the property as a salvage yard. The use and operation of the property did not change. After Poole failed to apply for a permit, the circuit court found that the previous lawful, nonconforming use of the property was terminated when Smith sold the land to Poole. Poole appealed the court’s decision. Do you think he was successful? Why or why not? [Poole v. Berkeley County Planning Com’n, 488 S.E.2d 349 (1997).] 7. Plaintiff homeowners purchased a parcel of land in the homeowners association’s (HOA’s) subdivision. Their real estate agent requested the attached-garage requirement to be waived, and when the owners did not receive a response from the HOA, they worked

out a plan to construct one. The owners purchased a modular home to which they could attach a garage without first obtaining an architectural review pursuant to a restrictive covenant in the HOA declarations. One member of the HOA unilaterally disapproved of the home. The owners filed suit, and a meeting of the HOA was held regarding the owners’ home. However, the dispute was not resolved. Plaintiff homeowners then filed a request for a permanent injunction to prevent the defendant homeowners association from applying the architectural review covenant that led to the disapproval of the owners’ planned home. The HOA counter-filed, seeking a permanent injunction upholding its application of the architectural review standards and seeking damages. On the basis of the facts presented, to whom do you think the court awarded a permanent injunction and why? [Ronald Bobbie Lawhon v. Winding Ridge Homeowners Association, Inc., 2008 Del. Ch. LEXIS 195.] 8. Thomas A. Carella filed for Chapter 7 bankruptcy. At the time, HSBC Bank USA held the sum of $16,540.94 on deposit in a joint bank account in the names of Carella and his father, Thomas J. Carella. The son sought to protect the money in the bank account, arguing that it was his father’s account. The father had set up the joint account after finding out he needed to undergo heart bypass surgery. The father argues that he set up the joint account for convenience so that his son would have access to the money if the father passed away. The father survived the surgery and continued to manage the joint account. Only the father deposited or withdrew

Chapter 8

Real, Personal, and Intellectual Property

money from the account at any time. The son’s bankruptcy trustee argued that the account was a gift causa mortis and thus is available as part of the bankruptcy. Did the joint account constitute a gift causa mortis? What are the necessary elements for establishing the joint account as a gift causa mortis? [In re Thomas A. Carella, 340 B.R. 710 (Bankr. W.D.N.Y. 2006).] 9. Defendant Tubbs met her fiancé, Church, over the Internet. After several years of correspondence and visits, they became engaged in February 2000. Church and Tubbs planned to be married in Las Vegas in July 2000. Two months before the engagement, Church paid off $4,100 of Tubbs’s credit card debt. He also gave Tubbs an engagement ring that he purchased for $7,274.42. On March 15, 2000, he deposited $194,852.56 in Tubbs’s bank account to fund the purchase of land and a residential home in Michigan. Tubbs purchased the home in both of their names as joint tenants, on Church’s instructions, and in April she moved in. Church moved some personal property to the residence, including a family heirloom diamond ring. On June 5, 2000, Tubbs e-mailed Church stating that their relationship was over because she was horrified after seeing his “bizarre and abnormal behavior” on the Internet and because she had discovered that he led a “risqué lifestyle as a cross-dresser and bi-sexual.” Tubbs rejected Church’s demands to repay the $4,100 and to return the engagement ring, his personal property, and her interest in the Michigan home. On July 24, 2000, Church died in England. Church’s estate subsequently filed suit to recover the property. The court entered a final judgment entitling the estate to the rings or a money judgment for their values; the real property, partitioned as a matter of law to account for its appreciation; complete right, title, interest, and possession of the land and residential home, free and clear of any claim, right, title, or interest of Tubbs; and a money judgment in the amount of $75,000 (the amount of Tubbs’s home equity mortgage), less credits to Tubbs of $13,000 for property taxes she paid from 2000 through 2005, or a modified money judgment in the amount of $62,000. Tubbs appealed. What arguments might she have made on appeal? How do you think the appellate court ruled in this case, and why? [Salens v. Tubbs, 2008 WL 4072342 (C.A. 6 Mich.).] 10. Travis Scheible was riding his bicycle and started to cross the street from behind a mature tree that overhung the sidewalk and obscured his view of oncoming traffic. As he rode into the street, Travis was struck by an oncoming car and was killed. The tree was located on residential property that Jackson had sold to Smith about six months before the accident


under a contract to be paid over the course of two years. Smith began residing on the property. Travis’s mother, Christine Scheible, brought a wrongful-death action against Jackson and Smith. Jackson moved for summary judgment, arguing that he had no duty to Travis because he did not own, possess, or control the property at the time of the accident. Scheible argues that Jackson controlled the property, as proved by the facts that (1) Smith needed Jackson’s permission before changing the property; (2) Smith paid Jackson to continue the liability coverage for the property in Jackson’s name (Smith’s name was never added to the policy); and (3) Smith eventually renounced his rights and returned the property to Jackson. What type of estate did Smith have when he purchased the property from Jackson, and how does this affect who is liable for the tree on the property and thus liable for Travis’s death? What evidence leads to your conclusion? [Jackson v. Scheible, 902 N.E. 2d 807 (Ind. 2009).] 11. The Stop & Shop Supermarket and Big Y Foods are supermarkets offering the same services and competing for the same customers. In an advertisement introducing its new, easy-to-use scan saver cards, Stop & Shop Supermarket used the slogan, “It’s That Simple.” The supermarket used the slogan in radio, television, and print advertisements. The service mark was licensed to the supermarket by plaintiff Fullerton, who owns the right to the service mark. After Stop & Shop started using the slogan, Big Y Foods began to use a similar slogan, “We Make Life Simple.” Both service marks are always accompanied by the name of the store. Fullerton and Stop & Shop Supermarket brought an action alleging infringement of the service mark. Do you think that the court granted the injunction? Why or why not? [The Stop & Shop Supermarket Company and Fullerton Corp. v. Big Y Foods Inc., 943 F. Supp. 120 (1996).] 12. Smith, a satirist and outspoken critic of Walmart, created websites displaying designs and slogans that negatively parodied Walmart’s registered marks. These designs and slogans incorporated the word Walocaust, a word Smith invented by combining the first three letters of Walmart’s name with the last six letters of the word holocaust. Smith also sold novelty items online that were printed with graphics that parodied the retailer’s slogans, with the disclaimer that he was unaffiliated with the retailer. One design depicted a blue stylized bird modeled to resemble a Nazi eagle grasping a yellow smiley face in the same manner that a Nazi eagle is typically depicted grasping a swastika. Above the bird image, the word WAL*OCAUST was printed in a blue font comparable to that commonly used by Walmart.


Part I

The Legal Environment of Business

The lower court found that Walmart had failed to establish that a smiley-face icon it used for advertising was distinctive enough to merit trademark protection and that Smith’s slogans and graphics were scathing parodies and therefore did not violate any Walmart trademarks or cause dilution of its marks. Do you think the court of appeals upheld Smith’s defense that he was engaged in parody and that such parody precluded claims of trademark infringement and dilution? [Smith v. Wal-Mart Stores, Inc., 475 F. Supp. 2d 1318, 2007 U.S. Dist. LEXIS 13335 (N.D. Ga. 2007).] 13. Securities brokerage firm Charles Schwab filed suit against a former employee who left the company and started his own wealth management firm. Charles Schwab claimed that the names of its clients, along with information regarding their accounts and assets, were trade secrets. The employee therefore misappropriated these trade secrets when he contacted the clients to ask them to transfer their accounts to his new firm. Charles Schwab argued that the employee could not have learned of these individuals but for his

work at the Charles Schwab brokerage. Do you think this customer information will be treated as a trade secret? What factors do you think the court will consider when determining whether the customer information is a trade secret? [Charles Schwab & Co. Inc. v. Douglas Castro, Case No. 650053/2013 (E.D.N.Y. January 7, 2013).] 14. Nike and Michael Jordan created the Air Jordan line in the 1980s. Jordan filed suit against a Chinese sportswear company, Qiaodan Sports, in China. Jordan is known in China as Qiaodan, and Qiaodan Sports uses a logo of a silhouette of a tall man holding a basketball, along with the number 23. The company registered “Qiaodan” as a trademark in China. Qiaodan also filed applications for trademarks on Jordan’s sons’ names. According to the complaint, Qiaodan had sales of approximately $450 million per year. Do you think Jordan will be successful in his suit against Qiaodan? [“A Chinese Sportswear Company Has Trademarked Michael Jordan’s Sons’ Names,” Why? http://qz.com/79234/ michael-jordan-versus-qiaodan-sports/]


Contract Law

2 9


Introduction to Contracts and Agreement CASE OPENER The Problematic Promotion Pepsi had a promotion whereby consumers were encouraged to collect Pepsi points by consuming Pepsi products. They could then redeem the points for merchandise. If they did not have quite enough points for the prize they wanted, they could buy the needed additional points for 10 cents each; however, at least 15 original Pepsi points had to accompany each order. At the climax of an early commercial for the promotion, three young boys are sitting in front of a high school building, one reading his Pepsi Stuff catalog while the others drink Pepsi, all gazing in awe at an object rushing overhead as the military march in the background builds to a crescendo. A Harrier jet swings into view and lands by the side of the school building, next to a bicycle rack. Several students run for cover, and the velocity of the wind strips one hapless faculty member down to his underwear. While the faculty member is being deprived of his dignity, the voice-over announces: “Now the more Pepsi you drink, the more great stuff you’re gonna get.” A teenager opens the cockpit of the fighter and can be seen, without a helmet, holding a Pepsi. He exclaims, “Sure beats the bus,” and chortles. The military drumroll sounds a final time, as the following words appear: “Harrier Fighter 7,000,000 Pepsi Points.” A few seconds later, the following appears in more stylized script: “Drink Pepsi—Get Stuff.” John Leonard decided to accept Pepsi’s offer of the Harrier fighter jet for 7 million Pepsi points. He quickly realized that it would be easier to raise the money to buy points than to collect the 7 million points. In early March 1996, he filled out an order form requesting the jet and submitted it to Pepsi, along with 15 Pepsi points and a check for $700,000. In response, Pepsi sent him a letter saying, “The item that you have requested is not part of the Pepsi Stuff collection. It is not included in the catalog or on the order form, and only catalog merchandise can be redeemed under this program.” John then sued for breach of contract. 1. 2. 3.

Did Pepsi offer to sell the Harrier jet for 7 million points? Did Leonard’s submission of the order form constitute an acceptance? Was the alleged contract in this case a bilateral or unilateral contract?


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

LO 9-1

What is a contract?

LO 9-2

What are the sources of contract law?

LO 9-3

How can contracts be classified?

LO 9-4

What are the rules that guide the interpretation of contracts?

LO 9-5

What are the elements of a valid offer and valid acceptance?

LO 9-6

How does an offer terminate?

LO 9-1 contract A promise or set of promises for the breach of which the law gives a remedy or the performance of which the law in some way recognizes a duty.

agreement One of the four elements necessary for a contract; consists of an offer made by one party, the offeror, and the acceptance of the offer by another party, the offeree.

offer A key factor in the agreement element of a contract; consists of the terms and conditions set by one party, the offeror, and presented to another party, the offeree.

acceptance A key factor in the agreement element of a contract; consists of the agreement of one party, the offeree, to the terms of the offer in the contract made by the other party, the offeror.

The Definition of a Contract This part of the text focuses on contracts. A contract, according to the Restatement (Second) of Contracts, is “a promise or set of promises for the breach of which the law gives a remedy or the performance of which the law in some way recognizes a duty.”1 Another, perhaps simpler, way to think of a contract is that it is a set of legally enforceable promises.

ELEMENTS OF A CONTRACT A contract has four elements: the agreement, the consideration, contractual capacity, and a legal object. The agreement consists of an offer by one party, called the offeror, to enter into a contract, and an acceptance of the terms of the offer by the other party, called the offeree. The agreement is discussed in more detail in the latter part of this chapter. The second element of a contract is the consideration, which is defined as the bargained-for exchange. Another way to think of the consideration is that it is what each party gets in exchange for his or her promise under the contract. Consideration is further discussed in Chapter 10. The third element is contractual capacity, the legal ability to enter into a binding agreement. Most adults over the age of majority have the legal ability to enter into binding contracts, but Chapter 10 explains when people have either limited or no capacity to enter into these agreements. Persons who do not have the capacity to enter into legally binding contracts include those who are under the age of majority, intoxicated, or suffering from mental illness. Chapter 10 also discusses the fourth element of a binding, legal contract, legal object. The contract cannot be either illegal or against public policy. The elements of a contract, as well as defenses to its enforcement, are listed in Exhibit 9-1.

DEFENSES TO THE ENFORCEMENT OF A CONTRACT Sometimes the parties may enter into what appears to be a legally binding and enforceable contract because all four elements of a contract are present, but one of the parties may have a defense to the contract’s enforcement. Such defenses fall into two categories. The first, discussed in Chapter 12, is a lack of genuine assent. A contract is supposed to be entered into freely by both parties, but sometimes the offeror secures the acceptance of the agreement through improper means, such as fraud, duress, undue influence, or misrepresentation. In these situations, there 1


Restatement (Second) of Contracts, sec. 1.

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Introduction to Contracts and Agreement




Lack of genuine assent


Lack of proper form

Exhibit 9-1 A Valid Contract Has Four Elements, and No Defenses Can Be Raised against It

Legal purpose Capacity

really is no genuine assent to the contract, and the offeree may be able to raise the lack of genuine assent as a defense to enforcement of the agreement. The second defense, discussed in Chapter 13, is that the contract lacks the proper form, which typically means it lacks a writing. Certain contracts require a writing, and if there is none, the agreement will not be enforced. Chapter 14 discusses the performance and discharge of contracts as well as remedies arising when a contract is breached.

Sources of Contract Law There are two primary sources of contract law: case law and the Uniform Commercial Code (UCC). A third source of law, which has become more important with increasing globalization, is the Convention on Contracts for International Sales of Goods (CISG). Chapters 9 through 14 of this book focus primarily on the law of contracts as established by the common law, and Chapters 15 and 16 focus on the law as established by the UCC and CSIG.

COMMON LAW Today’s law of contracts actually originated in judicial decisions in England, which were followed by the early courts in the United States. Since then, contract law has been modified by our legislatures and by rulings of our courts. The law of contracts is primarily common law, so to find out what the law is, one could go to the Reporters and read the decisions, but an easier way to know the law would be to go to the Restatement (Second) of the Law of Contracts. Prominent legal scholars, recruited by the American Law Institute, organized the principles of the common law of contracts into the original Restatement of the Law, Contracts. The compilation has subsequently been revised and published as Restatement of the Law Second, Contracts. The Restatement (Second) is not actually the law itself, although judges frequently cite it in cases because it is an authoritative statement of what the law is. As the common law of contracts evolved in the various states, not all states interpreted all aspects of the law in the same way, so although we can generalize about the law of contracts, one would of course always want to know exactly what the law at issue is in one’s own state. In the Restatement (Second), the drafters often explain what the law about a particular matter is in the majority of states and then provide alternative approaches that other states have adopted.

UNIFORM COMMERCIAL CODE Having different laws governing contracts in different states did not make interstate commerce flow smoothly. To remedy some of the difficulties created by a patchwork of different laws governing commercial transactions, the National Conference of Commissioners on Uniform State Laws and the American Law Institute drafted a set of commercial laws that could be applicable to all states. This effort was called the Uniform Commercial Code (UCC). The UCC became law in each state that adopted it completely or partially as part of its state code. Thus, for example, if a firm enters into a contract governed by the Uniform Commercial Code in Ohio, it would be operating under the Ohio Uniform Commercial Code.

LO 9-2 consideration The bargained-for exchange; what each party gets in exchange for his or her promise under a contract.

contractual capacity The legal ability to enter into a binding agreement.

legal object A purpose that does not violate a statute or public policy.

lack of genuine assent A defense to the agreement of a contract in which the offeree claims that the offeror secured the agreement through improper means, such as duress, fraud, undue influence, or misrepresentation.

Uniform Commercial Code (UCC) A statutory source of contract law in the United States applicable to transactions involving the sale of goods. The UCC was created in 1952 and adopted by all 50 states, the District of Columbia, and the Virgin Islands; it may be modified by each state to reflect the wishes of the state legislature.

GLOBAL Context Contract Law in the European Union If you are doing business with a member state of the European Union, there is one source to turn to in order to understand how the various member states regulate contracts, and that is the Principles of European Contract Law. The principles were drafted by an independent body of experts from each member state of the European Union under a project

supported by the European Commission. The principles are stated in the form of articles with a detailed commentary explaining the purpose and operation of each article. Comments to each article provide illustrations, short cases that show how the rules are to operate in practice. Each article also has comparative notes surveying the national laws and other international provisions on the topic.

The part of the Uniform Commercial Code that is relevant to contracts is Article 2, which governs contracts for the sale (exchange for a price) of goods (tangible, movable objects). This part of the book will sometimes point out important differences between the UCC and the common law, but the UCC is discussed primarily in Chapters 15 and 16.

LO 9-3

Classification of Contracts Contracts are classified in a number of ways. Different classifications are useful for different purposes, as the following discussion demonstrates.


bilateral contract A promise exchanged for a promise.

CASE 9-1

All contracts can be classified as either bilateral or unilateral. Knowing whether a contract is bilateral or unilateral is important because that classification determines when the offeree is legally bound to perform. Whether a contract is bilateral or unilateral depends on what response the offeror (the party proposing the contract) expects from the offeree (the person agreeing to or accepting the contract). If the offeror wants a promise from the offeree to form a binding contract, the contract is a bilateral contract. A bilateral contract is commonly defined as a promise in exchange for a promise. As soon as the promises are exchanged, a contract is formed and the parties’ legal obligations arise. For example, when Shannon promises to pay Gary $1,000 in exchange for his promise to paint her car on July 1, they have a bilateral contract. If either party fails to perform, the other may sue for breach.


FACTS: The defendant, Zappos.com, is a popular website known mainly for its discounted shoe sales. In 2012, a hacker hacked into the defendant website in an effort to obtain the personal account information of Zappos shoppers. After releasing news of the breach, the defendant faced numerous lawsuits from unhappy customers. Subsequently, the defendant moved to compel arbitration as 176

mandated in its Terms of Use listed on its website. The defendant argued that it and its customers were in a bilateral agreement stating that arbitration must be used in the event of a dispute between the two parties, as supported by its customer terms of use. However, also in the terms of use, the defendant stipulated that it could change its terms of use and all of its agreements anytime at its own discretion.

(continued) Hence, plaintiff customers argued that the agreement was not bilateral and was in fact unfairly unilateral. Specifically, the plaintiff customers argued that the defendant was not actually agreeing to anything and made no promise to its customers regarding dispute resolution. Therefore, the plaintiff customers argued that they should not have to use arbitration and instead should be able to file their class action lawsuit against the defendant. ISSUE: Is an arbitration clause illusory, and therefore unenforceable, when a defendant company can avoid its promise to arbitrate by amending a provision, whereas customers are simultaneously bound to arbitration? REASONING: When the Terms of Use binds consumers to arbitration while leaving the defendant company free to litigate or arbitrate whenever it sees fit, no mutuality of obligation exists. When there is no mutuality of agreement, said arbitration agreement is illusory and therefore unenforceable. In this case, The Terms of Use gave the defendant the right to change the Terms of Use, including the Arbitration Clause, at any time without

notice to the plaintiff customers. On one side, the Terms of Use purportedly bound any user of the defendant website to mandatory arbitration. However, if a customer sought to invoke arbitration pursuant to the Terms of Use, nothing would prevent the defendant from unilaterally changing the Terms and making those changes applicable to that pending dispute if it determined that arbitration was no longer in its interest. In effect, the agreement allowed the defendant to hold its customers and users to the promise to arbitrate while reserving its own escape hatch. By the provisions of the Terms of Use, the defendant company was free at any time to require a consumer to arbitrate and/or litigate anywhere it sees fit, while consumers are required to submit to arbitration in Las Vegas, Nevada. DECISION AND REMEDY: The court denied the defendant’s Motion to Compel Arbitration. SIGNIFICANCE OF THIS CASE: This case provides explanation of when an arbitration clause is illusory and therefore unenforceable.

CRITICAL THINKING Is there enough ambiguity with the word agreement that Zappos could argue that it had an agreement with its customers? If Zappos could change any rule or promise it made to a customer at any time, how could Zappos argue that it was agreement to anything?

ETHICAL DECISION MAKING When a court makes a decision in a contract case, what values are being elevated by the court? In other words, the court is anchoring its reasoning on a preference for a particular value or set of values. What is that value or set of values in a contract case?

In a unilateral contract, the offeror wants a performance to form the contract. The offeror wants the offeree to do something, not promise to do something. The most common unilateral offer is a reward. If Jim loses his dog, he may post a sign stating “$50 reward for the safe return of my poodle, Frenchie.” If Rita calls Jim and says, “Don’t worry, I’ll find your dog,” she is not making a contract because the unilateral offer calls for an action, not a promise. Once she finds Frenchie and takes the dog to Jim, a contract is formed and Jim must pay. Just as the offeree is under no obligation actually to do the act called for by the offeror, the offeror may revoke the offer at any time before performance. However, to prevent injustice, once an offeree begins performance, the offeror must hold the offer open for a reasonable time to allow the offeree to complete the performance. In the Case Opener, the plaintiff would argue that Pepsi appeared to be making an offer for a unilateral contract. In its television commercial, Pepsi promised to provide a prize for a performance, the presentation of a set number of points. By submitting the requisite number of points, the plaintiff believed he was accepting a unilateral offer.

unilateral contract A promise exchanged for an act.



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B UT W H AT I F   .   .   . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall that in the Case Opener, PepsiCo required contestants first to mail in Pepsi points before the company would mail the contestant a prize. But what if the Pepsi points contract required only a promise from contestants to send in Pepsi points on a certain date and PepsiCo would send the prize up front? Would the second scenario be a unilateral or a bilateral contract?

EXPRESS VERSUS IMPLIED CONTRACTS express contract A contract in which all the terms are clearly set forth in either written or spoken words.

implied contract A contract that arises not from words of agreement but from the conduct of the parties.

Contracts are classified as express or implied, depending on how they are created. The terms in express contracts are clearly set forth in either written or spoken words. The contract in the Case Opener was an express contract; the terms were set forth in the ad and the catalog. Implied contracts, in contrast, arise not from words but from the conduct of the parties. For instance, when you have a dental emergency and your dentist pulls your severely infected tooth without prior negotiation about payment, or even any mention of payment, you have an implied contract for payment for his services. As a general rule, three conditions must be met for the courts to find an implied, or as it is sometimes called, an implied-in-fact, contract. First, the plaintiff provided some property or service to the defendant. Second, the plaintiff expected to be paid for such property or service and a reasonable person in the position of the defendant would have expected to pay for such property or services. Third, the defendant had an opportunity to reject the property or services but did not.

QUASI-CONTRACTS quasi-contract A court-imposed contractual obligation to prevent unjust enrichment.

valid A term applied to a contract that includes all four elements of a contract: agreement (offer and acceptance), consideration, contractual capacity, and legal object.

unenforceable A term applied to a contract that, because of a law, cannot be enforced by the courts.

Quasi-contracts are sometimes called implied-in-law contracts, but they are not actually contracts. Rather, to prevent one party from being unjustly enriched at the expense of another, the courts impose contractual obligations on one of the parties as if that party had entered into a contract. For example, assume Jones hears a noise out in his driveway. He looks out and sees a group of workers apparently getting ready to resurface his driveway. The doorbell rings, and he does not answer it. He goes down into his basement office and stays there until the workers have gone and he has a resurfaced driveway. When he receives a bill from the paving company, he refuses to pay on grounds that he did not ask to have the driveway done. In such a case, where Jones knew that the company was getting ready to bestow on him a benefit to which he was not entitled, the court will probably impose a quasi-contract, requiring Jones to pay the paving company the fair market value of the resurfacing. Imposing such a duty prevents Jones from being unjustly enriched at the expense of the paving company. There are limits to the doctrine, however; specifically, the enrichment must be unjust. Sometimes a benefit may simply be conferred on you because of a mistake by the other party, and the courts will not make people pay for others’ mistakes. In our example, if Jones had been out of town when his driveway was repaved, he would have just gotten lucky. The courts would not make him pay for the pavers’ mistake when he could have done nothing to prevent the benefit from being bestowed on him.

VALID, VOID, VOIDABLE, AND UNENFORCEABLE CONTRACTS What everyone hopes to enter into, of course, is a valid contract. A valid contract is one that contains all the legal elements of a contract as set forth in Exhibit 9-1. As a general rule, a valid contract is one that will be enforced. However, sometimes a contract may be valid yet unenforceable. A valid contract may be unenforceable when some law prohibits the courts from enforcing it. For example, the statute of frauds, discussed in Chapter 13, requires certain contracts to be evidenced by a writing before they can be enforced. Similarly, the statute of limitations mandates

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Introduction to Contracts and Agreement

that an action for breach of contract must be brought within a set period of time, thereby limiting the enforceability of the contract. A void contract is, in effect, not a contract at all. Either its object is illegal or it has some defect that is so serious that it is not a contract. If you entered into a contract with an assassin to kill your business law professor, that would be a void contract because it is obviously illegal to carry out the terms of the agreement. A contract is voidable if one or both of the parties can either withdraw from the contract or enforce it. If the parties discover that the contract is voidable after one or both have partially performed, and one party chooses to terminate the contract, both parties must return anything they had already exchanged under the agreement so that they will be returned to the condition they were in at the time they entered into the agreement. Certain types of errors in the formation of a contract lead to it being voidable. Typically, the person who can avoid the contract is the person whom the court is attempting to protect, or the party the court believes might be taken advantage of by the other party. For example, contracts by minors are usually voidable by the minor, as discussed in Chapter 11. Contracts entered into as a result of fraud, duress, or undue influence—a problem with the validity of the acceptance, as described in Chapter 12—may be avoided by the innocent party.

EXECUTED VERSUS EXECUTORY CONTRACTS Once all the terms of the contract have been fully performed, the contract is said to have been executed. As long as some of the duties under the contract have not yet been performed, the contract is considered executory. For example, if Randolph hires Carmine to paint his garage on Saturday for $800, with $200 paid as a down payment and the balance due on completion of the job, the contract becomes executory as soon as the agreement is reached. When the down payment has been made and the painting is halfway completed, the contract is still executory. Once the painting has been finished and the final payment made, the contract is an executed contract.

FORMAL VERSUS INFORMAL CONTRACTS Contracts may also be classified as formal or informal. Formal contracts are those that have a special form or must be created in a specific manner. The Restatement (Second) of Contracts identifies the following four types of formal contracts: (1) contracts under seal, (2) recognizances, (3) letters of credit, and (4) negotiable instruments. When people hear the term formal contract, what often comes to mind is a contract under seal. The term under seal comes from the days when a contract was literally sealed by a piece of soft wax into which an impression was made. Today, sealed contracts may still be literally sealed with wax or some other soft substance, but they are more likely to be simply identified with the word seal or the letters L.S. (an abbreviation for locus sigilli, which means “the place for the seal”) at the end of the document. Preprinted contract forms with a seal printed on them can also be purchased today, and parties using such documents are presumed, without evidence to the contrary, to be adopting the seal for the contract. States today do not require contracts to be under seal. However, 10 states still allow a contract without consideration to be enforced if it is under seal. A recognizance arises when a party acknowledges in court that he or she will perform some specified act and/or pay a price on failure to do so. An example of a recognizance is a bond used as bail in a criminal case. The person agrees to return to court for trial or forfeit the bond. A letter of credit is an agreement by the person or institution that issues the letter to pay a sum of money on receipt of an invoice and other documents (typically documents indicating that the goods were insured against damage in transit). The Uniform Commercial Code governs letters of credit. A negotiable instrument is a written document signed by a person who makes an unconditional promise to pay a specific sum of money on demand or at a certain time to the holder of the instrument. The most common forms of negotiable instruments are checks, notes, drafts, and certificates of deposit. They are governed primarily by the UCC. (Negotiable instruments are discussed in greater detail in Chapters 17 and 18.)

void A term applied to a contract that is not valid because its object is illegal or it has some defect that is so serious that it is not a contract.

voidable A term applied to a contract that one or both parties have the ability either to withdraw from or enforce.

executed A term applied to a contract in which all of the terms have been fully performed.

executory A term applied to a contract in which not all of the terms have been fully performed.

formal contract A contract that must have a special form or must be created in a specific manner.

LO 9-4 contract under seal A contract that has a seal certifying its legality. Such contracts require no consideration for them to be legal.

recognizance An obligation in which a party acknowledges in court that he or she will perform some specified act and/or pay a price on failure to do so.

letter of credit A binding document that a buyer can request from a bank to guarantee that the payment for goods will be made to the seller.

negotiable instrument A written document signed by a person who makes an unconditional promise to pay a specific sum of money on demand or at a certain time to the holder of the instrument; an acceptable medium for exchanging value from one person to another.


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informal contract

Any contract that is not a formal contract is an informal contract, also called a simple contract. Informal contracts may in fact be quite complex, but they are called simple because no formalities are required in making them.

A contract that requires no formalities.

LO 9-5

Contract Law

The Agreement The first element of a contract is the agreement. As noted earlier, this chapter focuses on contracts governed by common law, that is, contracts other than those for the sale of goods. Under the common law, the agreement begins when one party, the offeror, makes an offer to another party, the offeree.

Elements of the Offer An offer has three elements. Under the common law, these elements are intent, definite and certain terms, and communication to the offeree.

INTENT intent The intended purpose or goal of an action, especially in a contract.

CASE 9-2

The first element of the offer is intent. The offeror must manifest an intent to be bound by the offeree’s acceptance. Contracts are interpreted using an objective standard, meaning that the courts are concerned with only the party’s outward manifestations of his or her intent, not what is going on in that party’s mind. The courts interpret the words and actions of the parties the way a reasonable person would interpret them. Thus, if an individual is clearly joking or speaking out in anger, the reasonable person would not think that the individual seriously intended to make an offer, and the courts would consequently not treat the words as an offer. If someone attempts to accept such an offer, the courts will not find that a contract has been made. Sometimes an offeror may try to avoid a contract by later claiming that he was only joking when he made the offer, but the courts are not interested in one’s hidden intent. As Case 9-2 demonstrates, if you joke too well, you may find yourself in an unwanted contract.


FACTS: Plaintiffs W. O. and J. C. Lucy had wanted to purchase Ferguson Farm from the Zehmers for at least eight years. One night, Lucy stopped by the establishment the Zehmers operated and said that he bet Zehmer wouldn’t accept $50,000 for the place. Zehmer replied that he would, but he bet that Lucy would not pay $50,000 for it. Over the course of the evening, the parties drank whiskey and engaged in casual conversation, with the talk repeatedly returning to the sale of Ferguson Farm. Eventually Lucy got Zehmer to draw up a contract for the sale of the farm for $50,000.

When Lucy later attempted to enforce the agreement, Zehmer refused to complete the sale, arguing that he had been drunk and that the agreement to sell the property had been made in jest. Lucy sued to enforce the agreement. ISSUE: Had Lucy and Zehmer entered into a legally binding agreement? REASONING: The mental assent of the parties is not a requirement for the formation of a contract. If the words or other acts of one of the parties have but one reasonable

(continued) meaning, that party’s undisclosed intention is immaterial unless the other party somehow knows that the party does not mean what his words and actions would clearly indicate to any reasonable observer. In this case, not only did Lucy believe that Zehmer was serious when he drew up the contract, but there was no evidence to indicate that any action taken by Zehmer would have indicated that he was not serious. When Zehmer asked his wife to sign the writing that he drew up containing the terms of the sale, he whispered to her that he was joking, but whispered so quietly that Lucy could not and did not hear it. What happened appeared to be a good-faith offer and a good-faith acceptance, followed by the execution and apparent delivery of a written contract. Therefore,

the parties would be held to their outward manifestations of entering into a binding agreement. DECISION AND REMEDY: The parties had entered into a binding agreement, and the court enforced the agreement. SIGNIFICANCE OF THE CASE: This case demonstrates that the courts look at the circumstances surrounding the alleged making of a contract and focus on the outward manifestations of a person’s intent. It clearly sends the message that people need to be careful when joking about entering into a contract because a person who jokes too well might find herself or himself bound to an agreement that she or he did not really want to make.

CRITICAL THINKING Why must a joke be visibly a joke to a reasonable observer for there to be no acceptance?

ETHICAL DECISION MAKING What stakeholders are being protected by the reasoning that supports the rule the court applied in this case?

B UT W HAT I F  . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Recall that in the case opener, the Pepsi commercial shows a fighter jet jokingly dropping a boy off at school. But what if the Pepsi commercial featured a man fully capable of owning and operating a fighter jet who turned in an appropriate and realistic number of number of Pepsi points, and Pepsi Company officials subsequently handed him the keys and deeds to such a prize? What if the commercial announcer also turned to the audience and seriously announced that such a prize was included in their prize catalog and could be theirs? Do both scenarios constitute a realistic offer, neither scenario, or only the second scenario?

Preliminary Negotiations An invitation to negotiate or an expression of possible interest in an exchange is not an offer. For example, if Rachael asked Bill whether he would sell his car for $5,000, she is not making an offer; she is just inquiring about his potential willingness to sell. Likewise, when a firm or government entity requests bids for a construction project, the request is just an invitation for contractors to make offers. Thus the bids would be the offers. Advertisements Another illustration of the invitation to make an offer is the advertisement. If a custom furniture maker places an advertisement in the paper that reads, “Oldfashioned, hand-crafted cedar rocking chairs only $250 the first week in May,” the store is merely inviting potential customers to come to the store and offer $250 for a rocker. Because 181


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Contract Law

no reasonable person would expect the store to be able to sell a rocking chair to every person who might see the ad, the court would interpret the intent of the store as being to invite readers to make an offer. Under limited circumstances, however, an ad can be treated as an offer. If it appears from the wording of the ad that the store did in fact intend to make an offer, the courts will treat it as an offer. In general, when the ad specifies a limited quantity and provides a specific means by which the offer can be accepted, the courts will treat the ad as an offer, as demonstrated by the Case Nugget that follows. The plaintiff in the Case Opener tried to rely on the Lefkowitz case to argue that the Pepsi commercial was an offer because it was “clear, definite, explicit and left nothing to negotiation.” After all, the commercial clearly stated that 7 million points earned a Harrier jet, and the catalog provided an additional means of buying the points for cash. The court in that case, however, found that the commercial could not be regarded as sufficiently definite because it specifically reserved the details of the offer to a separate writing, the catalog. Also, the commercial itself made no mention of the steps a potential offeree would be required to take to accept the alleged offer of a Harrier jet. The court further found that the only offer in this scenario was the plaintiff’s letter of March 27, 1996, along with the order form and the appropriate number of Pepsi points. Because Pepsi rejected this offer with its letter, there was no contract. To prevent possible bait-and-switch advertising, some states have consumer protection laws requiring advertisers to state in their ads either that quantities of the item are limited to the first X number of people or that rain checks will be available if the item sells out.

CASE Nugget When Is an Ad an Offer? Lefkowitz v. Great Minneapolis Surplus Store, Inc. Supreme Court of Minnesota 251 Minn. 188, 86 N.W.2d 689 (1957) In this case, the defendant had published a newspaper announcement stating: “Saturday 9 AM Sharp, 3 Brand New Fur Coats, Worth up to $1,000.00, First Come First Served $1 Each.” Morris Lefkowitz arrived at the store, dollar in hand, but was informed that under the defendant’s house rules the offer was open to ladies but not gentlemen. The court ruled that because the plaintiff had fulfilled all the terms of the advertisement and the advertisement was specific and left nothing open for negotiation, a contract had been formed. From this case came the often-quoted exception to the rule that advertisements do not create any power of acceptance in potential offerees: an advertisement that is “clear, definite, and explicit, and leaves nothing open for negotiation.” In that circumstance, “it constitutes an offer, acceptance of which will complete the contract.”

Auctions Another situation in which what seems to be an offer may not be is the auction. When a person places a good with an auctioneer for sale by auction, is the seller making an offer or is the bidder? The answer depends on what kind of auction is taking place. If nothing is stated to the contrary in the terms of the auction, an auction is presumed to be with reserve. In an auction with reserve, the seller is merely expressing an intent to receive offers. The auctioneer may withdraw the item from auction at any time before the auctioneer’s hammer

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falls, signaling the acceptance of the bid. Similarly, at any time before the hammer falls, the bidder may also revoke the bid. In an auction without reserve, the seller is treated as making an offer to accept the highest bid. Thus, the seller must accept the highest bid. Not surprisingly, very few auctions are without reserve.

DEFINITE AND CERTAIN TERMS Under the common law, the terms of the offer must be definite and certain. In other words, all the material terms must be included. The material terms are those terms that allow a court to determine what the damages are in the event that one of the parties breaches the contract. Sometimes an offer contains not the material term itself but a method for determining the term. For example, Guy’s Sailboats is building Sara a sailboat, and the parties want to make it possible for her to pay one-third of the price of the boat in advance, one-third on delivery, and one-third in 12 monthly payments, with interest, beginning a month after delivery. Rather than stipulating an interest rate to be charged on the monthly payments, the contract might specify an external standard according to which the interest rate would be set through the course of the 12-month payment period. The question of whether the terms of an alleged offer were adequate for the formation of a valid contract often arises in cases when one party believes that a contract had been formed and the other believes that there had been no contract because the terms of the alleged offer were not definite enough. That issue is the focus of Case 9-3.

CASE 9-3


FACTS: Janky originally sued defendant Lake County Conventions & Visitations Bureau (LCCVB), Henry Farag, and Street Gold Records in 2003 over the rightful use and ownership of a song written by Janky titled “Wonders of Indiana.” She alleged primarily that the song had been sold to LCCVB by Farag, her one-time band-mate, without her knowledge. The jury initially awarded Janky $100,000 for LCCVB’s copyright infringement, which LCCVB appealed. The parties litigated through two federal cases, three appeals, one judicial recusal, and several courtimposed sanctions. In 2007, LCCVB and Janky appeared to be on the verge of agreeing on a settlement. On November 20, 2007, Janky’s attorney sent an e-mail to one of LCCVB’s attorneys, providing a list of terms for settling, including the plaintiff’s withdrawal of both complaints and one appeal and LCCVB’s withdrawal of one appeal, as well as stipulating all parties’ responsibility for their own attorney fees. On December 2, 2007, the LCCVB

lawyer responded via e-mail accepting the offer with the inclusion of a stipulated “mutual global release.” In January 2008, attorneys for the defendant sent a draft to Janky of what the mutual global release would entail. This list included that Janky post a $100,000 bond to secure against future claims against the defendants, that Janky admit she was in error in pursuing litigation, that Janky pay all court sanctions, and that she convey ownership of the disputed song to the defendants. Janky filed a motion to enforce the settlement on February 15, 2008, claiming that the December 2 e-mail constituted acceptance of the settlement offer. ISSUE: Did a valid settlement agreement exist between the defendant LCCVB and the plaintiff? REASONING: Taking the December 2 e-mail as a standalone document, the court found that the contract did not provide specific-enough material terms for the court to

(continued) determine damages. The December 2 e-mail explicitly alluded to future documents that would detail the meaning of the term mutual global release rather than defining the term within the e-mail. In the words of the court: Along with needing to state all essential terms, preliminary agreements which incorporate future written agreements are only enforceable if the essential terms they do include are definite. Wolvos, 668 N.E.2d at 675. . . . Without definite terms, the Court is left without anything to enforce. Definiteness is necessary because “the contract must provide a basis for determining

the existence of a breach and for giving an appropriate remedy.” McLinden v. Coco, 765 N.E.2d 606, 613 (Ind. Ct. App. 2002).

DECISION AND REMEDY: A valid contract did not exist because the term mutual global release is not definite enough to be enforceable. SIGNIFICANCE OF THE CASE: This case illustrates the importance of making sure that all the essential terms of a proposed contract are definite and, if necessary, defined in the offer.

CRITICAL THINKING What other reasons might the court have to find the contract invalid?

ETHICAL DECISION MAKING Think about the conduct of the parties in this case. How much blame should the parties receive for their conduct? How might the outcome of this case have been different if the parties had acted in accordance with the Golden Rule?

COMMUNICATION TO THE OFFEREE The offer must be communicated to the offeree or to the offeree’s agent. Only the offeree to whom the offer was directed can accept the offer. If Bill overhears Sam offer to sell his car to Helen for $5,000, he cannot walk over and form a contract by accepting the offer. If he says to Sam, “I’ll give you $5,000 for your car,” he is not accepting the offer but, rather, is making a new offer.

LO 9-6

Termination of the Offer At some point in time, offers terminate; when an offer terminates, it can no longer be accepted to form a binding contract. There are five ways to terminate an offer: revocation by the offeror, rejection by the offeree, death or incapacity of the offeror, destruction or subsequent illegality of the subject matter of the offer, and lapse of time or failure of other conditions stated in the offer.

REVOCATION BY THE OFFEROR option contract An agreement whereby the offeree gives the offeror a piece of consideration in exchange for the offeror’s agreement to hold the offer open for the specified period of time.


The offeror is said to be the master of his offer and, as such, can revoke it at any time, even if he says he will hold the offer open for a stated period of time. If Jim sends Carol a letter offering to mow her yard every week during the summer for the price of $20 a week as long as she responds to his offer within the next month, he can still change his mind and tell her at any time before she responds that he is no longer interested in working for her, thereby revoking his offer. If a person wishes to ensure that an offer will in fact be held open for a set period of time, the person may do so by entering into an option contract with the offeror. An option contract is an agreement whereby the offeree gives the offeror a piece of consideration in exchange for the offeror’s agreement to hold the offer open for the specified period of time.

Chapter 9

Introduction to Contracts and Agreement

There are a number of situations when you might want to enter into an option contract. For example, if the person who made the offer is ill, and you are afraid he or she might die, you would want to enter into an option contract because you would then still have the time of the option to enter into the contract with the estate of the offeror; otherwise, the offer dies with the offeror. You might also want to enter into an option contract if you really want the object of the offer but need time to make sure you can finance it, and you do not want the offeror to sell the item to another party. For example, if the offeror offers to sell you a valuable antique car, but you are not sure you can afford the financing, you might want to get an option contract to give you time to secure financing. There is no requirement as to the value of the consideration. If the consideration is money, the parties may agree that if the offer is eventually accepted and a contract is formed, the consideration for the option contract will become part of the payment for the contract. This situation frequently arises in contracts involving real estate. Jones may be considering opening a restaurant and would like to have the option of purchasing a lot owned by Smith, so he gives Smith $1,000 for a 30-day option to purchase the lot, with the provision that the $1,000 will be deducted from the purchase price if Jones purchases the property. In the event that Jones does not buy the property, Smith will keep the $1,000. The UCC imposes an additional limitation on the offeror’s ability to revoke the offer. A promise to hold an offer for the sale of a good open for a specified period cannot be revoked if it is made in writing and signed by a merchant. As a general rule, the revocation of an offer is effective when it is received by the offeree. Because of this rule, if it is really important to the offeror to know that his offer has been revoked, he should personally deliver the revocation to the offeree.

REJECTION BY THE OFFEREE The second means by which an offer can be terminated is rejection by the offeree. Regardless of how long the offer was stated to be open, once the offeree rejects it, it is terminated. In our earlier example, if Carol calls Jim and says that she is not interested in his working for her this summer or any summer because of the poor quality of the work he has done for her in the past but then calls him back an hour later to say that she has changed her mind and would like to hire him in accordance with his proposed terms, it is too late. There is no offer for her to accept because her rejection terminated the offer.

DEATH OR INCAPACITY OF THE OFFEROR The offer terminates immediately if the offeror dies or loses the legal capacity to enter into the contract. This termination occurs even if the offeree does not know of the terminating event. The exception to this rule occurs when the parties had already entered into an option contract to hold the offer open for a set period of time. If an option contract exists, the administrator of the offeror’s estate or the guardian of the offeror must hold the offer open until it expires in accordance with the option contract.

DESTRUCTION OR SUBSEQUENT ILLEGALITY OF THE SUBJECT MATTER If the subject matter of the offer is destroyed or becomes illegal, the offer immediately terminates. For example, if Jamie offers Bill a job managing the riverboat casino he plans to open on January 1 but, before Bill accepts the offer, the state decides no longer to allow riverboat casinos to operate in the state, the offer of employment terminates.

LAPSE OF TIME OR FAILURE OF ANOTHER CONDITION SPECIFIED IN THE OFFER As noted earlier, the offeror has the power to revoke the offer at any time, even if the offer states that it will be held open a set amount of time. But if the offer states that it will be held open for only a certain time, the offer will terminate when that time expires. In the absence of a time



Part II

Contract Law

condition in the offer, the offer will expire after the lapse of a reasonable amount of time. What constitutes a reasonable amount of time varies, depending on the subject matter of the offer. For example, an offer by a retailer to purchase seasonal goods from a wholesaler would lapse before an offer to purchase goods that could be easily sold all year long.

Elements of the Acceptance Once an offer has been made, the offeree has the power to accept that offer and form a contract. In examining the acceptance under the common law, the basic requirements for a valid acceptance parallel those for a valid offer. There should be a manifestation of intent to be bound by the acceptance to the contract, agreement to the definite and certain terms of the offer, and communication to the offeror.

MANIFESTATION OF INTENT TO BE BOUND TO THE CONTRACT In general, there are two ways an offeree can manifest her or his intent to enter into the contract: by performance or by a return promise. The offeree must either do something or say something to form the contract. Recall the distinction between a bilateral contract and a unilateral contract. If the offer is for a unilateral contract, the offeree can accept only by providing the requested performance. If Bill offered to pay $500 to anyone who returned his lost dog to him, Mary could accept the offer only by returning the dog. Bill did not want her promise, and if she called and promised to return the dog to him, that promise would have no legal effect because the only way to accept a unilateral offer is by performance. With a bilateral contract, what the offeror wants to form the contract is not performance but, rather, a return promise. Sometimes, however, it is not clear whether the offeror wants performance or a return promise. In such a case, the offeree has the option of either performing or making a return promise.

mirror-image rule The principle that holds that the terms of the acceptance must mirror the terms of the offer; if the terms of the acceptance do not mirror the terms of the offer, no contract is formed and the attempted acceptance is a counteroffer.

Silence as a Form of Acceptance Silence, as a general rule, cannot be used to form a contract. For example, Lisa and Marie both work at a local diner where the manager is very flexible and lets the waitresses trade shifts. Marie calls Lisa and leaves her a voice-mail message saying, “I can’t work my three night shifts this week. If you can cover them for me, I’ll pay you an extra $40 on top of the money you’ll receive from the boss for working my shifts. If I don’t hear from you by 7 p.m. tomorrow, I’ll assume we have a deal and you will work for me. Thanks so much!” If Lisa does not call back, no contract has been formed because silence under these circumstances would not constitute an acceptance. The Restatement of Contracts, however, offers three circumstances under which silence can be an acceptance. First, the offeree receives the benefits of the offered services with reasonable opportunity to reject them and knowledge that some form of compensation is expected, yet the offeree remains silent. Second, the offeror tells the offeree that silence or inaction will constitute an acceptance, and the offeree, by remaining silent, intends to accept. Third, the parties, by their previous course of dealing with each other, have established a pattern of behavior whereby it would be reasonable to assume that silence was intended to communicate acceptance. For example, a wholesaler and retailer have a long-standing relationship in which the wholesaler routinely ships a certain type of merchandise to the retailer, who rejects a shipment if it does not meet his needs. After such a pattern of behavior has been established, it is reasonable for the wholesaler to assume that when a shipment is not sent back, the retailer means to accept it.

ACCEPTANCE OF DEFINITE AND CERTAIN TERMS: THE MIRROR-IMAGE RULE When a bilateral contract is being formed under the common law, the mirror-image rule applies to the acceptance. The mirror-image rule says that the terms of the acceptance must mirror the terms of the offer. If the terms of the acceptance do not mirror the terms of the offer, no contract is formed. Instead, the attempted acceptance is a counteroffer.

GLOBAL Context Contracts in Japan The Japanese tend to view contracts as ongoing relationships in which the parties work with each other to smooth out any problems that arise in performance of the contract. The Japanese tend to be suspicious of long, detailed contracts. They have a distinct preference for short, flexible contracts that leave a number of terms to be decided later.

When negotiating a contract with a Japanese businessperson, an American businessperson must recognize how the Japanese will interpret his attempts to include more details in the agreement. The American should think about which details are essential for inclusion.

The mirror-image rule has caused a significant amount of trouble for businesses because often a buyer would make an offer on one form that contained not only the essential terms of the contract but also a number of additional, somewhat minor terms. Generally, the offer was on a standard form that had a place where the essential terms were written in. The seller would often return his standard form with its preprinted terms, along with the essential terms written in to match the terms of the offer. The problem was that because these preprinted forms did not match, there was legally no contract. If both parties performed their contracts, no problems arose; but the fact that there was no contract meant that on occasion one party could decide simply to not perform, leaving the other party with no remedy. Or, if the parties did perform, the buyer might perform according to the terms on the buyer’s form and be sued for breach by the seller, who believed that the terms on the seller’s form were the terms of the agreement. To eliminate this problem of the battle of the forms, UCC Section 2-207 significantly modified the mirror-image rule by providing that, as a general rule, an offeree may include in the acceptance terms that are additional to or different from the terms of the offer as long as (1) the offeror did not explicitly state in the offer that all terms of the offer must be accepted exactly as proposed; (2) the offeror does not promptly reject the new terms on receipt of the acceptance; and (3) the new terms do not materially change the terms of the original offer. In the case of additional terms—terms related to issues not addressed in the original offer—if none of the foregoing conditions occur, a contract is formed and the terms of the agreement are those of the acceptance, as long as the parties are merchants. If the parties are not merchants, the additional terms are merely proposals for additions to the contract and must be accepted by the offeror. If the terms of the acceptance are different from those in the offer, various states treat the terms differently. In most states, the terms are said to cancel each other out, and the courts then look to the UCC for neutral terms to insert into the contract.

COMMUNICATION TO THE OFFEROR An offeror has the power to control the means by which the acceptance is communicated, and if the offeror specifies that only a certain means of communication will be accepted, then only that method of communication forms a valid offer. Suppose, for example, that Jennifer offers to paint Bill’s car for $500 but says that he must accept the offer by telephone before midnight on Thursday. If he sends her an e-mail Thursday morning accepting her offer, there is no valid contract. Even though e-mail might be a valid means of accepting a contract offer if no means is specified, when the offer is limited to a specific means of communicating the acceptance, only that means results in a valid contract. Thus Bill’s attempted acceptance was simply a new offer. If no means of communicating the acceptance is specified, any reasonable means is generally acceptable. Telephone, telegraph, mail, fax, and e-mail are all valid means of accepting an offer. If a person drafting an offer wants acceptance to be only by a particular means, the offer must make it clear that only a certain means is allowed. The Mailbox Rule Because not all acceptances are made in person, a rule needed to be developed to determine the point at which an acceptance made through the mail became effective. The courts settled on the mailbox rule, which provides that an acceptance is valid when it is placed

mailbox rule The principle that holds that an acceptance is valid when it is placed in the mailbox, whereas a revocation is effective only when received by the offeree. In some jurisdictions, the mailbox rule has been expanded to faxes.


E-COMMERCE and the Law Disclosure of Definite and Certain Terms Many people would like to know what sort of terms they will be held to when buying a product. Unfortunately, many people who aren’t aware of the importance of receiving prior disclosures also don’t realize that online businesses commonly refrain from giving full disclosure of terms about a product until the payment information has already been given. If e-businesses do happen to provide these certain terms before a customer agrees to buy a product, the link to the terms themselves may be hard to find. Another aspect of the terms (if given) is that the language in which the contract is written is dense legal language, which may

be hard for the ordinary person to understand fully. These e-business practices in regard to disclosure of terms can be very deceptive. A customer may inadvertently agree to a contract when he or she is only given some information about it. This situation would be as if a student were given a page of text that appeared to be whole and complete, and the student had completed an entire report on the text before being given an additional 50 pages that were also part of the text. Those customers who shop online should be aware of the potential for deception with online sellers and should use caution when making purchases. Source: http://digitalcorpora.org/corp/nps/files/govdocs1/021/021056.pdf

in the mailbox, whereas a revocation is effective only when received by the offeree. Today, the mailbox rule has been expanded to apply to faxes in some jurisdictions, with courts holding that once the fax has been transmitted, the acceptance is effective. It is likewise applied to e-mail transmissions in that once the acceptance is sent, it is considered accepted. The Effect of an Acceptance after a Rejection As previously stated, if an acceptance is received after a rejection is received, the acceptance is not valid because the rejection terminated the offer. However, sometimes a rejection is dispatched, but before it is received, the acceptance is communicated to the offeror. In that case, a valid contract has been formed because the rejection is not effective until it is received. Suppose Brenda e-mails an offer to Harry, and he puts a rejection in the mail. Then, before the rejection is received, Harry calls Brenda and tells her he accepts. A valid contract has been formed, and the rejection will have no effect when it is received. However, if the telephone call had been made after Brenda had received the rejection, there would have been no contract.

SUMMARY The Definition of a Contract

Contracts at their simplest level are legally enforceable agreements. A valid contract is generally viewed as one that has the following elements: agreement, consideration, legal object, and parties with legal capacity.

Sources of Contract Law

There are two sources of contract law: the Uniform Commercial Code and state common law. The Uniform Commercial Code, in Article 2, governs contracts for the sale of goods. All other contracts are also governed by the UCC.

Classification of Contracts

Contracts may be classified in a number of ways. Every contract is either unilateral or bilateral; express or implied; valid, voidable, or void; executed or executory; and formal or informal.

The Agreement

The agreement is the first element of a contract. It begins when one party, the offeror, makes an offer to another party, the offeree.

Elements of the Offer

A valid offer contains the manifestation of the offeror’s intent to be bound to the definite and certain terms that are communicated to the offeree.

Termination of the Offer

An offer can be terminated by revocation by the offeror, rejection by the offeree, death or incapacity of the offeror, destruction or subsequent illegality of the subject matter of the offer, or lapse of time or failure of other conditions stated in the offer.

Elements of the Acceptance

An acceptance is valid when a manifestation of intent to be bound to the terms of the offer is communicated to the offeror by the offeree.


Chapter 9

Introduction to Contracts and Agreement


Point/Counterpoint Recovery based on quasi-contract allows the court to impose liability on a party that did not enter into a contract; three conditions must exist: (1) A benefit was conferred on the defendant; (2) the defendant appreciated the benefit; and (3) because of the circumstances under which the defendant received the benefit, it would be unjust to allow the defendant to retain the benefit without compensating the party that conferred it.

Does the Third Prong of the Test for Imposition of Recovery in a Quasi-Contract Unjustifiably Limit the Court’s Ability to Impose Relief Where It Is Needed? YES


Limiting the application of the doctrine to those circumstances in which the imposition of liability is required to prevent unjust enrichment is unfair. Looking at the case law, the circumstances that justify imposition of liability all focus on what the recipient of the benefit did. If he did not in some way acquiesce to the imposition of the benefit, no liability can be imposed. Such a limitation makes an artificial distinction based on the point in time at which the recipient discovers the conferral of the benefit. If there was some possible way for the recipient to have prevented the conferral, he has to pay; but if he had no way to prevent it, he does not have to pay. This distinction sounds fair enough at first glance, but it overlooks the fact that in either situation the recipient gets something he did not pay for and the other party conferred a benefit for no compensation. What if the benefit is really significant? What if ABC Construction builds a new garage for the Smiths, who were on vacation, instead of for their neighbors, who ordered the garage? Is it really fair for the Smiths to get that garage for free?

The limitation is a necessary one, preventing those knowledgeable about the law from taking unfair advantage of those with less knowledge. Although it may seem unfair for someone to receive a benefit from another party when she did not give any value for that benefit, if she did not ask for the benefit and did not encourage the other party to provide it, there is no justification for making her pay for what is essentially the acting party’s mistake. If we presume that neither party is acting with the intent of getting something undeserved, the recipient is still the most innocent party in the situation and, as such, should not be required to pay for the other party’s mistake. Further, although we say that one party is receiving a benefit, that recipient may be receiving a legal “benefit” that is of no value to her. It seems especially unfair to make someone pay for a benefit that she had no desire to obtain in the first place, even though many others may find that benefit highly desirable.

Questions & Problems 1. Explain why the first question a person should ask when getting ready to analyze a contract problem is, “Is this alleged contract a contract for the sale of a good?” 2. What is the difference between an offer for a unilateral contract and an offer for a bilateral contract? Why might that difference be important to understand? 3. What must a party prove to recover under the theory of quasi-contract? 4. What is the mirror-image rule?

5. What is the mailbox rule? 6. R.J. Reynolds Tobacco Company (RJR) operated a customer rewards program, called Camel Cash, from 1991 to 2007. Under the terms of the program, RJR urged consumers to purchase Camel cigarettes, to save Camel Cash certificates included in packages of Camel cigarettes, to enroll in the program, and, ultimately, to redeem their certificates for merchandise featured in catalogs distributed by RJR. The plaintiffs were 10 individuals who joined the Camel Cash program by purchasing RJR’s products


Part II

Contract Law

and filling out and submitting signed registration forms to RJR. RJR sent each plaintiff a unique enrollment number that was used in communications between the parties. These communications included catalogs RJR distributed to the plaintiffs, containing merchandise that could be obtained by redeeming Camel Cash certificates. From time to time, RJR issued a new catalog of merchandise offered in exchange for Camel Cash, which it either sent on request or mailed to consumers enrolled in the program. The number of Camel Cash certificates needed to obtain merchandise varied from as few as 100 to many thousands, and this encouraged consumers to buy more packages of Camel cigarettes and to save Camel Cash certificates to redeem for more valuable items. RJR honored the program from 1991 to 2006, and during that time, Camel’s share of the cigarette market nearly doubled, from approximately 4 percent to more than 7 percent. In October 2006, however, RJR mailed a notice to program members announcing that the program would terminate on March 31, 2007. The termination notice stated: “As a loyal Camel smoker, we wanted to tell you our Camel Cash program is expiring. C–Notes will no longer be included on packs, which means whatever Camel Cash you have is among the last of its kind. Now this isn’t happening overnight—there will be plenty of time to redeem your C–Notes before the program ends. In fact, you’ll have from OCTOBER ’06 through MARCH ’07 to go to camelsmokes.com to redeem your C–Notes. Supplies will be limited, so it won’t hurt to get there before the rush.” Beginning in October 2006, however, RJR stopped printing and issuing catalogs and told consumers that it did not have any merchandise available for redemption. Several of the plaintiffs attempted, without success, to redeem C–Notes or obtain a catalog during the final six months of the program. The plaintiffs had saved hundreds or thousands of Camel Cash certificates that they were unable to redeem. In November 2009, the plaintiffs filed a class action complaint against RJR. They alleged breach of contract and promissory estoppel, among other claims, because RJR’s actions had made the plaintiffs’unredeemed certificates worthless. The defendant argued that it had no bilateral contract to breach because the plaintiffs had not promised to do anything. The trial court agreed and dismissed the complaint. The plaintiffs appealed. How do you think the appellate court ruled, and why? [Sateriale v. R.J. Reynolds Tobacco Co., 697 F.3d 777, C.A.9 (Cal. 2012).]

7. An oral agreement was made between multiple parties to put together some money and open a bar and restaurant. The men first had to create a joint company. However, one potential owner was not able to provide his share of the funding at the time of the company formation and was subsequently pushed out of the deal by the other owners, who formed the company without him. The man then sued the owners. In response, the defendants argued that the plaintiff had no documentation to support a cause of action. The court had to decide whether the plaintiff’s complaint and statement of fact could support a breach-of-contract claim when no contract seemed to exist. Furthermore, the court considered the idea that a theory of quasi-contract could maintain a cause of action that could consist of the theft of ownership opportunity and/or breach of fiduciary duty. How do you think the court ultimately decided? [Don v. Broger, 2012 Slip Op 51934U, available at http://law.justia.com/cases/new-york/othercourts/2012/2012-ny-slip-op-51934-u.html] 8. Business Systems agreed to provide supplies to IBM as a subcontractor to a deal to update computer systems of the Chicago Transit Authority. The budget for this deal was set at $3.6 million; however, only $2.2 million of services were actually performed under the contract. Business Systems sued IBM, believing that it was entitled to an additional $1.4 million that it had not received in the performance of the project. As evidence of contract, Business Systems produced a spreadsheet detailing the ways in which the $3.6 million would be spent and an e-mail claiming “mutual agreement” to the $3.6 million budget. IBM claimed that it had performed all of its obligations under the contract and that Business Systems was not entitled to the $1.4 million because there was no contract specifying the amount that Business Systems was entitled to. Do you think that Business Systems was entitled to the $1.4 million? What consideration was exchanged between the two parties? [Business Systems v. IBM, 547 F.3d 882 (2008).] 9. Theresa Polk discussed selling her residence and 181 acres of land to BHRGU Avon Properties, LLC. Avon presented an offer for the land. Polk responded by providing two counteroffers, both stipulating that Avon accept before February 7, 2005, at 5 p.m. Avon responded by providing an offer that materially changed terms in the counteroffers and delivered it before the February 7 deadline. Avon also delivered a $25,000 check. Polk’s attorney accepted the check but later wrote “VOID” on it instead of cashing it. Avon filed a suit seeking specific performance. The trial court found in favor of Avon, determining that

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Introduction to Contracts and Agreement

the counteroffers constituted option contracts. Polk appealed, arguing that the counteroffers were not enforceable contracts because they lacked consideration and were therefore offers that required Avon’s acceptance. Avon argued that the $25,000 check constituted consideration for the option contracts, making the contracts enforceable. Do you believe that an option contract was formed? Why or why not? [Polk v. BHRGU Avon Properties, LLC, 2006 Fla. App. LEXIS 20760.] 10. Dr. Griffith allowed his life insurance to lapse after May 15, 2007. According to US Life’s life insurance policy, he was granted a 31-day grace period after which he would be able to reinstate his insurance by paying the balance of the unpaid bill and receiving written approval from US Life of the required evidence of insurability. According to a reminder notice, Griffen had 60 days to make a full payment. On or around June 15, 2007, the insurance provider sent Griffith a lapse notice that included a reinstatement form and a self-addressed envelope and required payment and the reinstatement form to be received by the policy provider within 30 days from the lapsed coverage. On July 23, 2007, Griffith electronically directed payment to American Medical Association Insurance Agency (AMAIA), which acted as a thirdparty administrator for US Life. AMAIA acted on US Life’s behalf to bill and collect premiums. AMAIA


received the check from Griffith on July 30, 2007. On July 28, 2007, Griffith was kneeling beside his bicycle at Bethany Beach, Delaware, when he was struck by a car that had drifted off the road when the driver fell asleep at the wheel. Do you think Griffith was insured at the time of his death? Why or why not? [US Life Insurance Company v. Wilson, 2011 Md. App. LEXIS 52.] 11. In 2008, a lawyer for Mutual Life Insurance e-mailed Dr. Miles regarding the settlement of a lawsuit that he had filed against the insurance company. The e-mail that the attorney sent contained proposed settlement terms. Dr. Miles’ attorney sent an e-mail back explicitly stating that Dr. Miles accepted the terms the company was offering. After the trial was canceled in light of the settlement, the company’s attorney sent Dr. Miles a written settlement that was different from the terms contained in the e-mail. Thus, Dr. Miles rejected the offer, and the company subsequently claimed that there was no settlement. Dr. Miles then took the company to court a second time regarding whether a contract was created through the e-mail that proposed specific settlement terms. If the e-mail seemed to contain all the essential terms of an offer, how do you think the judge decided? [Miles v. Northwestern Mutual Life Insurance Company, 677 F. Supp. 2d 1312. U.S. Dist. LEXIS 123597 (2009).]


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CASE OPENER Upper Deck—Contract Liability or Gift? In 1988, the Upper Deck Company was a baseball card company with an idea for a better baseball card: one that had a hologram on it. By the 1990s, Upper Deck was a major corporation whose value was at least a quarter of a billion dollars. In 1988, however, the outlook wasn’t bright for Upper Deck, which lacked the funds for a $100,000 deposit it needed to buy some special paper by August 1. Without that deposit, its contract with the major-league baseball players’ association would have been jeopardized. Upper Deck’s corporate attorney, Anthony Passante, Jr., loaned the company the money. That evening, the directors of the company accepted the loan and, in gratitude, agreed to give Passante 3 percent of the firm’s stock. Passante never sought to collect the gift of stock, and later the company reneged on its promise. Passante sued for breach of oral contract.1 1.



If you were on the jury, how would you decide the case? (The law of consideration will determine the outcome.) Was the offer of 3 percent of the firm’s stock legal consideration for the loan? Or was it a mere gift? Does Upper Deck have a moral obligation to give Passante the stock? If so, is this legally enforceable?

Passante v. McWilliam, 53 Cal. App. 4th 1240 (1997).

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


LO 10-1

What is consideration?

LO 10-2

When is consideration required?

LO 10-3

What is promissory estoppel and when can it be used?

LO 10-4

What is adequacy of consideration?

LO 10-5

What is an illusory promise?

LO 10-6

What is past consideration?

LO 10-7

What is preexisting duty?

LO 10-8

What is the difference between a liquidated debt and an unliquidated debt?

LO 10-9

What is an accord and satisfaction?

What Is Consideration?

LO 10-1

Rule: Consideration is what a person will receive in return for performing a contract obligation. Suppose, for example, that Dan agrees to purchase Mary’s car for $1,000. Dan’s payment of $1,000 is the consideration Mary will receive for her car. Title to and possession of the car is the consideration Dan will receive in exchange. Consideration can be anything, as long as it is the product of a bargained-for exchange. In a business context, it is often (but not always) money. Other examples of consideration are presented in Exhibit 10-1. Is a promise to refrain from something you are legally entitled to do appropriate consideration for a contract? In Case 10-1, the court considers whether a nephew’s promise to refrain from certain vices is adequate consideration for his uncle’s promise to pay him $5,000.

Rules of Consideration

LO 10-2

The key to understanding consideration is understanding the rules that govern it and their exceptions. We explore these principles in the following sections.

LACK OF CONSIDERATION Rule: For a promise to be enforced by the courts, there must be consideration. A court will enforce one party’s promise only if the other party promised something (an act, money, etc.) in exchange. For example, in a bilateral contract (a promise for a promise), the consideration for each promise is a return promise. Consider this example: Sue promises to pay Mike $2,000 for his car. Mike promises to sell Sue his car for $2,000. The exchange will be done tomorrow.



A benefit to the promisor

A promise to stay in a job until a particular project is complete (This is a benefit to the employer.)

A detriment to the promisee

A promise to your football coach to refrain from riding your motorcycle during football season even though you love riding it

A promise to do something

A promise to cook dinner for your roommate for the next six months

A promise to refrain from doing something

A promise to stop drinking alcohol during exam week

Exhibit 10-1 Examples of Consideration


CASE 10-1


FACTS: William E. Story and his nephew, William E. Story, 2d, agreed that the uncle would pay his nephew $5,000 if the nephew would refrain from drinking, using tobacco, swearing, and playing cards and billiards for money until he turned 21. When the nephew turned 21, his uncle sent him a letter that indicated that the nephew had earned the $5,000 and that he would hold the money with interest until the nephew became capable of taking care of it responsibly. The nephew accepted the terms. The uncle died 12 years later without having transferred the funds to his nephew. The nephew assigned the funds to Louisa Hamer, who brought suit against the executor of the uncle’s estate, Franklin Sidway, to collect the money. Sidway, however, argued that the contract was without consideration to support it and, therefore, invalid. He asserts that the nephew, by refraining from the use of liquor and tobacco, was not harmed but benefited. He further asserts that what the nephew did was best for him to do independently of his uncle’s promise and insists that it follows that unless the uncle was benefited, the contract was without consideration. At trial, judgment was entered in Hamer’s favor but was reversed on appeal in Sidway’s favor. Hamer appealed. ISSUE: The issue before the court is whether a promise of forebearance (e.g., to refrain from particular activities) can be deemed valid and lawful consideration for a contract.

REASONING: Defendant contended that the contract was invalid because it lacked consideration and that there is no consideration unless the promisor is benefited. Such a rule could not be tolerated, and is without foundation in the law. Consideration means not so much that one party is profiting as that the other abandons some legal right in the present or limits his legal freedom of action in the future. Now, applying this rule to the facts before us, the promisee used tobacco, occasionally drank liquor, and he had a legal right to do so. He abandoned that right for a period of years based upon the promise of his uncle that for such forbearance he would give him $5,000. We need not speculate on the effort which may have been required to give up the use of those stimulants. It is sufficient that he restricted his lawful freedom of action within certain prescribed limits upon the faith of his uncle’s agreement. Now, having fully performed the conditions imposed, it makes no difference whether such performance was actually a benefit to the promisor, and the court will not inquire into it. DECISION AND REMEDY: It is deemed established for the purposes of this appeal, that on January 31, 1875, defendant’s testator was indebted to William E. Story, 2d, in the sum of $5,000. All concur. SIGNIFICANCE OF THE CASE: Forbearance is sufficient consideration for a valid and enforceable contract.

CRITICAL THINKING What difference would it have made in this case had the nephew not had the legal right to drink or smoke? Why is this question crucial to the decision?

ETHICAL DECISION MAKING What values is the idea of consideration upholding?

There is an oral contract. Sue’s promise to pay Mike $2,000 for the car is her consideration to Mike. Mike’s promise to sell Sue the car for $2,000 is his consideration to Sue. There has been a mutual exchange of something of value—a promise to pay $2,000 and a promise to sell the car for $2,000. 194


Chapter 10 Consideration





A promise

A promise


A promise

An act

Another example of a bilateral contract, or a promise for a promise, occurred when the U.S. government seized control of insurance giant American International Group (AIG). The U.S. agreed to lend AIG up to $85 billion in exchange for nearly 80 percent of AIG’s stock. The consideration AIG received was the promise of up to $85 billion in U.S. government loans. The consideration the U.S. received was the promise of almost 80 percent of AIG’s stock.2 In a unilateral contract (a promise for an act), one party’s consideration is the promise, and the other party’s consideration is the act. Suppose your professor made the following statement in class: “If any student shows up at my house on Saturday and does the gardening, I will pay that student $100.” You show up and do the gardening. The professor’s consideration to you is the promise of the payment of $100 on completion of the gardening, and your consideration to the professor is the act of completing the gardening. Once again, there has been a mutual exchange of something of value. Exhibit 10-2 summarizes the consideration in bilateral and unilateral contracts. Rule: Promissory estoppel is the legal enforcement of an otherwise unenforceable contract due to a party’s detrimental reliance on the contract. One exception to the rule requiring consideration is promissory estoppel. Promissory estoppel occurs when three conditions are met: • • •

One party makes a promise knowing the other party will rely on it. The other party does rely on the promise. The only way to avoid injustice is to enforce the promise.

How does this work? Suppose that on graduation from college, Amanda receives a job offer across the country. She gives up her apartment, cancels all her other job interviews, and moves all her possessions. After arriving, she rents a new apartment and shows up for work. The only problem is that Amanda is told there is no job! May Amanda sue the employer? The answer in most states is yes, under the theory of promissory estoppel. She spent a lot of money in reliance on the job offer. She also moved across the country. Amanda may be able to recover her reliance damages (i.e., money she spent in reliance on the job offer). Promissory estoppel is not awarded regularly, but in the right case, it can provide a remedy when no other remedy exists. In a recent case, the Ninth Circuit Court of Appeals held that Yahoo’s promise to remove a nude photo from its website was subject to a claim of promissory estoppel. In that case, the plaintiff learned that her ex-boyfriend, pretending to be her, had posted nude photos of her on Yahoo. He also included all her contact information and an invitation for men to contact her for sexual purposes.3 The plaintiff contacted Yahoo (in accordance with its established policies) and requested removal of the photo. Yahoo agreed but, despite repeated requests, did not remove the photo for six months. The court held that Yahoo’s promise to de-post the profile meant that Yahoo had a duty to the plaintiff. As such, the plaintiff’s claim of promissory estoppel could be maintained. If the plaintiff is able to prove that she reasonably relied on Yahoo’s promise to her detriment, she may well prevail on her claim. 2 “U.S. Seizes Control of AIG with $85 Billion Emergency Loan,” Washington Post, September 17, 2008, www.washingtonpost.com/ wp-dyn/content/article/2008/09/16/AR2008091602174 3 “Do Interactive Websites Have a Legal Duty to Remove Malicious Content?” http://writ.news.findlaw.com/scripts/printer_friendly. pl?page=/ramasastry/20090519.html (retrieved May 25, 2009). This article discusses Barnes v. Yahoo, Inc., 2009 U.S. App. LEXIS 10940 (9th Cir. 2009).

Exhibit 10-2 Type of Consideration Based on Type of Contract

LO 10-3 promissory estoppel The legal enforcement of an otherwise unenforceable contract due to a party’s detrimental reliance on the contract.


Part II

LO 10-4

Contract Law

ADEQUACY OF CONSIDERATION Rule: The court seldom considers adequacy of consideration. This rule means that the court does not weigh whether you made a good bargain. Example: Donna purchases a stereo from Celia, a friend in her business law class. Donna pays $500 for the stereo but later realizes that the stereo is not worth $100. May Donna sue Celia? Typically, the answer is no. It is Donna’s responsibility to do her research and determine what price she should pay. The court will not set aside the sale because she made a bad deal. There is an exception to this rule. Suppose that you are on the verge of bankruptcy, and your creditors are threatening legal action. You know that if you default on your mortgage, car payment, bank loans, credit card payments, and other bills, the court may order your assets to be sold to pay the creditors. Instead of risking this result, you decide to sell your assets. You sell your BMW to your best friend for $50 and your vacation house to your sister for $500. Now, asset-free, you declare bankruptcy, knowing that your creditors will be able to collect nothing. Is this permissible? The answer, of course, is no. In such a case, the court will look at adequacy of consideration. If it appears that the sale of the assets was done to avoid payment to creditors, the court may set aside each sale and sell the assets to pay your creditors. In Case 10-2, the court had to consider whether $1 plus love and affection was adequate consideration for the transfer of property.

CASE 10-2


FACTS: Smith and Riley lived together out of wedlock for several years. They opened a joint checking account and, over time, both Smith and Riley deposited money into the account. In addition, Riley entered into a lease with Jerry Strickland and Wanda Strickland with respect to a residence owned by them. The lease was accompanied by an option to purchase. Almost four months later, Smith and Riley asked their attorney to prepare a bill of sale and an assignment. In the bill of sale, Riley transferred to Smith a one-half undivided interest in seven items of personal property. Riley also assigned to Smith a onehalf undivided interest in the lease and option to purchase with the Stricklands; this interest included a right of survivorship in the one-half interest retained by Riley. The property Riley sold and assigned to Smith in the two agreements was stated in each to be “for and in consideration of the sum of One Dollar ($1.00) and other and good and valuable consideration, the sufficiency of which is hereby acknowledged.” When the relationship ended, Smith filed suit against Riley in the trial court, seeking the dissolution of their domestic partnership and seeking to enforce the two written agreements with Riley regarding the sale and assignment of property to her. The trial court

enforced the agreements and divided the parties’ property. The defendant appealed, arguing that the agreements lacked consideration and were void as they were against public policy. ISSUE: Is $1 plus love and affection adequate consideration for the two agreements between Smith and Riley? REASONING: In the court’s own words (abridged and slightly modified): It is a well-settled principle of contract law that in order for a contract to be binding, it must, among other things, be supported by sufficient consideration. In expounding on the adequacy of consideration, the court has stated that it is not necessary that the benefit conferred or the detriment suffered by the promisee shall be equal to the responsibility assumed. Any consideration, however small, will support a promise. In the absence of fraud, the courts will not undertake to regulate the amount of the consideration. The parties are left to contract for themselves, taking for granted that the consideration is one valuable in the eyes of the law.

Quoting the United States Supreme Court, the court went on to state that “[a] stipulation in consideration of $1

(continued) is just as effectual and valuable a consideration as a larger sum stipulated for or paid.” Indeed, the consideration of love and affection has been deemed sufficient to support a conveyance. Both the bill of sale and the assignment recite that they are undertaken “for and in consideration of the sum of One Dollar ($1.00) and other and good and valuable consideration, the sufficiency of which is hereby acknowledged.” Facially, the documents are therefore supported by sufficient consideration, as clearly recognized by the Supreme Court. Moreover, Smith’s “society and consortium”—a concept comparable to the love and

affection—is further evidence of sufficient consideration to support these conveyances. DECISION AND REMEDY: The judgment of the trial court was affirmed. The case was remanded for enforcement of the judgment and for collection of costs. Costs on appeal were taxed to the appellant, Riley. SIGNIFICANCE OF THE CASE: This case demonstrates that courts will generally not consider the adequacy of consideration.

CRITICAL THINKING What is the reasoning of the appellant in terms of why the consideration was not adequate to cause the contracts to be enforceable? What key rule of law did this reasoning overlook?

ETHICAL DECISION MAKING What values are being advanced by the logic of the relevant rule of law in this case? In other words, what values prevent the rule of law from being that consideration must be in an amount similar in value to the item or services being transferred for the contract to be enforceable?

ILLUSORY PROMISE Rule: An illusory promise is not consideration. What is an illusory promise? Suppose Shawn offers to sell Molly his skis for $300. Molly responds, “I’ll look at them in the morning, and if I like them, I’ll pay you.” At this point, Molly has not committed to doing anything. The law considers this an illusory promise—that is, it is not a promise at all. Moreover, an illusory promise is not consideration.


LO 10-5 illusory promise A situation in which a party appears to commit to something but really has not committed to anything. It is not a promise and thus not consideration.

LO 10-6

Rule: Past consideration is no consideration at all. Consideration is an essential element of a contract. For a court to enforce a promise, both sides must offer consideration. Imagine that you have graduated from college and gotten a great job. After you have worked at the company for five years, your boss says to you, “Because you have done such a great job the last five years, I am going to give you 5 percent of the company stock.” Six months later, you still have not received the stock. May you sue your boss to enforce the promise? The answer is no. For a promise to be enforceable, there must be bargaining and an exchange. In this example, there was no exchange. Work done in the past, by definition, has already been performed. As such, you have given nothing in exchange, and the court will not enforce the promise. You are at the mercy of your boss’s goodwill to keep her promise. A promise cannot be based on consideration that was provided before the promise was made. In Case 10-3, the court must consider whether a friend’s marketing idea was the product of a bargained-for exchange (i.e., consideration). As you read the case, consider how you would decide if you were the judge. 197

GLOBAL Context The Importance of Contracts in Other Countries Contracts vary in importance, depending upon the countries using them. In the United States, business people consider contracts to be very important. Contracts are highly detailed. If there is a dispute, the parties refer to the contract terms. If the parties cannot agree, a lawsuit may be filed. The same is not true in many other countries. For example, in China, contracts exist for clarification purposes, not










Low to Medium Low

Medium to High Low to Medium

Low Low

High Low to Medium

U.S. China Russia 4

to enforce the underlying agreement. The Chinese believe that business people should work together to solve their differences. In Russia, business people pay little attention to contracts, documenting only the essentials of the agreement. Parties resolve disputes on their own or attempt to enforce the contract through political and economic pressures. The table following gives an overview of the importance of contracts in these four countries:4

Lothar Katz, Global Contract Practices, http://www.leadershipcrossroads.com/mat/Global%20Contract%20Practices.pdf

CASE 10-3


FACTS: The defendant, Allen Iverson, was a professional basketball player. The plaintiff, Jamil Blackmon, was a family friend. In July 1994, Mr. Blackmon suggested that Mr. Iverson use “The Answer” as a nickname in the summer league basketball tournaments in which Mr. Iverson would be playing. Mr. Blackmon told Mr. Iverson that Mr. Iverson would be “the answer” to all of the National Basketball Association’s (NBA’s) woes. Mr. Blackmon and Mr. Iverson also discussed the fact that the nickname “The Answer” had immediate applications as a label, brand name, or other type of marketing slogan for use in connection with clothing, sports apparel, and sneakers. The parties also discussed using “The Answer” as a logo. Later that evening, Mr. Iverson promised to give Mr. Blackmon 198

25 percent of all proceeds the merchandising of products sold in connection with the term “The Answer.” The parties understood that to “effectuate Mr. Iverson’s agreement to compensate” Mr. Blackmon, Mr. Iverson would have to be drafted by the NBA. Mr. Blackmon thereafter began to invest significant time, money, and effort in the refinement of the concept of “The Answer.” Mr. Blackmon continued to develop and refine the marketing strategy for the sale of merchandise, such as athletic wear and sneakers, in connection with the term “The Answer.” He retained a graphic designer to develop logos bearing “The Answer” as well as conceptual drawings for sleeveless t-shirts, adjustable hats, and letterman jackets for sale in connection with “The

(continued) Answer.” In 1994 and 1995, during Mr. Iverson’s freshman year at Georgetown University and the summer thereafter, there were numerous conversations between Mr. Blackmon and Mr.  Iverson regarding Mr. Blackmon’s progress in refining the marketing concept for “The Answer.” In 1996, just prior to the NBA draft, during which Mr. Iverson was drafted by the Philadelphia 76ers, Mr. Iverson advised Mr. Blackmon that Mr. Iverson intended to use the phrase “The Answer” in connection with a contract with Reebok for merchandising of athletic shoes and sports apparel. Mr. Iverson repeated his promise to pay Mr. Blackmon 25 percent of all proceeds from merchandising goods that incorporated “The Answer” slogan or logo.  .  .  . Despite repeated requests and demands from Mr. Blackmon, Mr. Iverson has never compensated Mr. Blackmon and continues to deny Mr. Blackmon 25 percent of the proceeds from the merchandising of products incorporating “The Answer.” Mr. Blackmon is now suing Mr. Iverson seeking damages for claims alleging [among others] . . . breach of contract . . . arising out of the basketball player’s use of “The Answer,” both as a nickname and as a logo or slogan. ISSUE: Must the defendant, Mr. Iverson, compensate the plaintiff, Mr. Blackmon, for the use of the nickname and slogan/logo “The Answer”? REASONING: The plaintiff claims that he entered into an express contract with the defendant pursuant to which he was to receive 25 percent of the proceeds that the defendant received from marketing products with “The Answer” on them. The defendant argues that there was not a valid

contract because the claim was not timely filed under the Pennsylvania statute of limitations, the terms of the contract were not sufficiently definite, and no consideration was alleged. According to the facts alleged by the plaintiff, he made the suggestion for the defendant to use “The Answer” as a nickname and for product merchandising one evening in 1994. This was before the defendant first promised to pay; according to the plaintiff, the promise to pay was made later that evening. The disclosure of the idea also occurred before the defendant told the plaintiff that he intended to use the idea in connection with the Reebok contract in 1996 and before the sales of goods bearing “The Answer” actually began in 1997. Regardless of whether the contract was formed in 1994, 1996, or 1997, the disclosure of “The Answer” idea had already occurred and was, therefore, past consideration insufficient to create a binding contract. DECISION AND REMEDY: Because the Court has determined that the claim should be dismissed for failure to allege proper consideration, the Court need not address the defendant’s other arguments about the statute of limitations and definiteness of terms. Judge Mary A. Mclaughlin SIGNIFICANCE OF THE CASE: If you expect to be paid for your marketing ideas, make that clear before rolling out your ideas. Moreover, you should seriously consider getting any promise to pay in writing.

CRITICAL THINKING What key fact would have had to be different for Mr. Blackmon to have received a favorable ruling in this case?

ETHICAL DECISION MAKING Most people reading this case probably feel some sympathy for Mr. Blackmon. He put in a lot of time in reliance on a promise that Iverson made. He received nothing for that time even though Iverson benefited from some of it. What stakeholders in a contract are being protected by strict adherence to the need for consideration that the court used to form its conclusion?


LO 10-7

Rule: A promise to do something that you are already obligated to do is not valid consideration. There are actually two parts to this rule. First, performance of a duty you are obligated to do under the law is not good consideration. For example, a police officer is sworn to uphold the law. Part of that public duty involves catching suspected criminals. If someone offers a reward 199


Part II

Contract Law

for the capture of a suspected criminal, the police officer may not collect the reward because he or she was already obligated to apprehend the suspect. Second, performance of an existing contractual duty is not good consideration. Gene decides to have a pool built in his backyard. Under the existing contract, the pool is to be completed by June 1, just in time for summer. The pool contractor comes to Gene and explains that due to a shortage of workers, the completion date cannot be met; however, if Gene were to pay an extra $5,000, additional workers could be hired and the pool would be completed on time. Gene tells the contractor that he will pay the $5,000. On June 1, the pool is completed, and the contractor asks for the additional $5,000 payment. Is Gene legally obligated to pay? The answer is no. The pool contractor had a preexisting contractual duty to complete the pool by June 1. Gene is under no obligation to pay the additional money. Exceptions to the Preexisting-Duty Rule • • • unforeseen circumstances Events that a reasonable person would not be expected to anticipate.

LO 10-8 liquidated debt Debt for which there is no dispute between the parties about the fact that money is owed and the amount of money owed.

LO 10-9 unliquidated debt Debt for which the parties either dispute the fact that any money is owed or agree that some money is owed but dispute the amount.

There are exceptions to the preexisting-duty rule:

Unforeseen circumstances Additional work UCC—sale of goods

If unforeseen circumstances cause a party to make a promise regarding an unfinished project, that promise is valid consideration. Let’s once again consider the pool example. Suppose that Gene’s pool contractor has been building pools in Gene’s neighborhood for the past 20 years. During all that time, the contractor has never had any problem with rocks—until now. While bulldozing the hole for the pool in Gene’s backyard, the pool contractor hits solid rock. He estimates that it will cost an additional $5,000 to clear the rock by using jackhammers and possibly even dynamite. The contractor explains that he is sorry, but unless Gene agrees to pay the additional money, he will not be able to finish the pool. Gene agrees to pay. When the pool is completed, the contractor asks for the additional $5,000. Will a court enforce this promise? The answer is yes. Even though the contractor is completing only what he was obligated to do under the contract, neither party knew of the solid rock. The contractor has given additional consideration (removal of the rock), and Gene will be held to his promise to pay the additional money. If a party to a contract agrees to do additional work (i.e., more than she is obligated to do under the contract), the promise is valid consideration. In the pool example, if the contractor asks Gene for an additional $10,000 but agrees to add a waterfall and a deck to the pool, the promise to do the additional work is consideration. If Gene agrees to pay the $10,000, that is his consideration. Both parties are now bound.

Partial Payment of a Debt Partial payment of a debt may or may not be valid consideration, depending on whether the debt is liquidated or unliquidated. In a liquidated debt, there is no dispute about the fact that money is owed and the amount of money owed. Example: Natalie owes $3,000 on her credit card. She calls the credit card company and explains that she is a poor student and cannot afford to pay the entire $3,000. The credit card company agrees to accept $2,000 as payment in full. The following month, Natalie receives her new credit card statement showing that she owes the remaining $1,000. May the credit card company collect the additional $1,000? Yes! A creditor’s promise to accept less than owed, when the debtor is already obligated to pay the full amount, is not binding. The exception to the rule regarding liquidated debt occurs when the debtor offers different performance. Suppose Natalie offered the credit card company her car in full settlement of the $3,000 debt. If the credit card company accepts, regardless of the value of the car, the debt is paid in full and the credit card company may not sue Natalie for any additional money. In an unliquidated debt, the parties either dispute the fact that any money is owed or agree that some money is owed but dispute the amount. A dispute over an unliquidated debt may be


Chapter 10 Consideration

CASE Nugget Accord and Satisfaction Haynes v. DaimlerChrysler Corp. Supreme Court of Appeals of West Virginia 228 W. Va. 441 (2011) On January 22, 2006, Elgene Phillips was driving his 1998 Dodge Ram 1500 when the vehicle hydroplaned, ran off the left side of the road through a guardrail, and rolled over. Mr. Phillips died as a result of the accident. Gloria Phillips was a passenger in the truck. She testified that Mr. Phillips’s seatbelt was latched prior to the accident but became unlatched during, and as a result of, the accident. An expert witness testified that Mr. Phillips would not have sustained fatal injuries if his seatbelt had remained latched during the accident. Ms. Phillips, whose seatbelt did remain latched during the accident, suffered only minor injuries. As a result of mediation, the parties reached a settlement and entered into a handwritten agreement. Defendant was to pay plaintiff $150,000 for a full and final settlement of all claims, and the agreement was to be confidential. The plaintiff thereafter received two checks, one for $65,000 from Autoliv (the seatbelt manufacturer) and another for $85,000 from Chrysler. The second check, for $85,000, was returned for insufficient funds because Chrysler had just filed for bankruptcy. The handwritten settlement agreement provided that “Defendants” would pay the plaintiff $150,000. No apportionment between defendants was listed in the settlement agreement. Plaintiff asked the court to force Autoliv to pay the remaining $85,000. Autoliv argued that plaintiff’s cashing of the $65,000 check was an accord and satisfaction of Autoliv’s portion of the debt; therefore, Autoliv was not responsible for the remaining $85,000. The plaintiff argued that when the $65,000 check was cashed, plaintiff was not aware that Autoliv meant the check to be the full and final payment of what was owed to plaintiff. The Supreme Court of Appeals of West Virginia agreed with the plaintiff and ordered Autoliv to pay the remaining $85,000.

settled for less than the full amount if the parties enter into an accord and satisfaction. For an accord and satisfaction to be enforceable, three requirements must be met: 1. The debt is unliquidated (i.e., the amount or existence of the debt is in dispute). 2. The creditor agrees to accept as full payment less than the creditor claims is owed. 3. The debtor pays the amount they have agree on. Rule: An accord and satisfaction is an arrangement between contracting parties whereby one of the parties substitutes a different performance for his or her original duty under the contract. The promise to perform the new duty is the accord, and the actual performance of that new duty is the satisfaction. Under such circumstances, the debt is fully discharged. The accord is the new agreement to pay less than the creditor claims. The satisfaction is the payment, by the debtor, of the reduced amount. If the debtor fails to pay the new amount, the creditor may then sue for the full amount of the original debt. It pays to keep your word. One way that people sometimes attempt to create an accord and satisfaction is by sending a check to the creditor and writing “paid in full” on the check. Under common law, in many states, this did create an accord and satisfaction, and if the creditor cashed the check, he or she was bound to accept

accord and satisfaction An arrangement between contracting parties whereby one of the parties substitutes a different performance for his or her original duty under the contract.


Part II

Contract Law

the smaller amount as payment in full. The UCC, however, has changed the scope of this rule. Under UCC Section 3-311, effective in 30 states, the rule remains in place but has two major exceptions. First, in cases of business organizations, thousands of checks may be received each day. To protect themselves, businesses may notify their debtors that any offer to settle a claim for less than the amount owed must be sent to a particular address and/or person. If you check the terms printed on your credit card statement, you will likely find language directing you to send such payments to a different address and person than those to which regular payments are sent. This safeguard protects businesses from inadvertently creating accord-and-satisfaction agreements. Here is an example of the wording you might find on a credit card statement: Conditional Payments: Any payment check or other form of payment that you send us for less than the full balance that is marked “paid in full” or contains a similar notation, or that you otherwise tender in full satisfaction of a disputed amount, must be sent to [address omitted]. We reserve all rights regarding these payments (e.g., if it is determined that there is no valid dispute or if any such check is received at any other address, we may accept the check and you will still owe any remaining balance).5

Second, if a business does inadvertently cash a paid-in-full check, the business has 90 days from the date it cashed that check to offer repayment in the same amount to the debtor. For example, if John owed $3,000 to his credit card company and he sent the company a $2,000 check marked “paid in full” to the correct address and person, the credit card company has 90 days to offer to repay John the $2,000. Once the offer has been made by the business, no accord and satisfaction exists. 5

From Chase Visa statement.

SUMMARY What Is Consideration?

Consideration is something of value given in exchange for something else of value; it must be the product of a mutually bargained-for exchange.

Rules of Consideration

For a promise to be enforced by the courts, there must be consideration. A court will enforce one party’s promise only if the other party promised something (an act, money, etc.) in exchange. Promissory estoppel occurs when one party makes a promise knowing the other party will rely on it, the other party does rely on it, and the only way to avoid injustice is to enforce the promise. The court seldom considers adequacy of consideration. This means that the court does not weigh whether you made a good bargain. An illusory promise is not consideration (i.e., it is not a promise at all). Past consideration is generally no consideration at all. A promise cannot be based on consideration that was provided before the promise was made. The preexisting-duty rule provides that when a party does what it is already legally obligated to do, there is no consideration because there has been no detriment.

Partial Payment of a Debt

In a liquidated debt, there is no dispute about the fact that money is owed and the amount of money owed. In an unliquidated debt, the parties either dispute the fact that any money is owed or agree that some money is owed but dispute the amount. For an accord and satisfaction to be enforceable, three requirements must be met: (1) The debt is unliquidated (i.e., the amount or existence of the debt is in dispute); (2) the creditor agrees to accept as full payment less than the creditor claims is owed; and (3) the debtor pays the amount they have agreed on. The accord is the agreement, and the satisfaction is the payment of the reduced amount.

Chapter 10 Consideration


Point/Counterpoint Should the Courts Evaluate Adequacy of Consideration? YES


Allowing courts to review adequacy of consideration would be a deterrent to those who want to take advantage of parties to a contract. Allowing courts to review adequacy of consideration would give parties an avenue for relief that would be easier to prove than fraud, which is currently the only recourse for parties who believe they were taken advantage of.

When two parties agree to a contract, the court should not intervene to determine whether the parties got a fair deal. The courts have never considered the adequacy of consideration and there is no reason to begin now. Precedent should be followed. The value of the consideration received is subjective, and the court should not substitute its judgment for that of the parties to the contract.

Questions & Problems 1. List the four types of consideration described in the text. 2. What is required to prove promissory estoppel when consideration is missing? 3. Can $1 be adequate consideration? Why or why not? 4. List and describe the three exceptions to the preexisting-duty rule. 5. List the three elements of accord and satisfaction. 6. When Holloman applied for a job at Circuit City, she signed a dispute resolution agreement (DRA) that stated: “This agreement requires you and Circuit City to arbitrate certain legal disputes related to your application for employment or employment with Circuit City.” The job application then added, “Circuit City will consider your application only if this agreement is signed.” Finally, the DRA stated, “I understand that my employment, compensation and terms and conditions of employment can be altered or terminated, with or without cause, and with or without notice, at any time, at the option of either Circuit City or myself.” Holloman was hired, but she later quit and sued Circuit City, claiming she had been discriminated against and constructively discharged. Holloman argued that the arbitration agreement was illusory and not supported by consideration because of Circuit City’s unilateral ability to terminate or modify the agreement. How should the court rule? Explain your reasoning. [Holloman v. Circuit City Stores, 162 Md. App. 332 (Md. Ct. App. 2005).]

7. Cece Hylton and Edward Meztista had a partnership, MMD, which had an advertising account with a grocery store. Pursuant to the partnership agreement, Hylton and Meztista would equally divide the profits MMD earned once expenses were paid. They also agreed to divide the partnership’s liabilities equally. From the record, it appears that the grocery store, which paid MMD $30,000 a month, was the only account the partnership handled. When the grocery store was sold, MMD lost the account. In January 1998, Meztista provided Hylton with a two-page document, which he said was an accounting of MMD’s profits and expenses. The bottom line showed a balance of $35,235.67, of which Hylton was owed $17,617.84. Hylton, however, questioned certain expenses included in the accounting and asked Meztista to let her review the partnership’s books. Hylton was never given the opportunity to see the books. Meztista did not return her telephone calls, nor did he provide her with an explanation regarding the expenses shown on the accounting. In April 1998, Meztista gave Hylton a check for $17,617.84, which was drawn on MMD’s account. The face of the check stated that it was “final payment/payment in full.” Hylton cashed the check, but wrote on it that she was doing so “under protest.” She added: “Cashing this check does not constitute my acceptance of this amount as payment in full.” Did writing “final payment/payment in full” on the check create an accord and satisfaction? What, if any, was the effect of Hylton’s cashing the check after writing “under


Part II

Contract Law

protest” on it? If you were the court, how would you decide and why? [Ex parte Meztista, 845 So. 2d 795 (2001).] 8. The plaintiff in this case is Amir Peleg, a gay Jewish male of Israeli national origin. He worked at the Neiman Marcus store in Beverly Hills from December 28, 2005, to February 21, 2008. The store is owned by defendant Neiman Marcus Group, Inc. (Neiman Marcus). Peleg worked in the fragrances department and performed his duties in an exemplary manner. On February 21, 2008, Peleg alleges he was discharged because of his national origin, religion, and sexual orientation in violation of the California Fair Employment and Housing Act (FEHA). Neiman Marcus responded to the complaint with a motion to compel arbitration of the entire case. The company established that, at the time of hire, Peleg was given a Mandatory Arbitration Agreement (Agreement). Peleg asserted that the Agreement was illusory and unenforceable in light of the following provision: “This Agreement to arbitrate shall survive the termination of the employer-employee relationship between the Company and any Covered Employee, and shall apply to any covered Claim whether it arises or is asserted during or after termination of the Covered Employee’s employment with the Company or the expiration of any benefit plan. This Agreement can be amended, modified, or revoked in writing by the Company at anytime, but only upon thirty (30) days’ advance notice to the Covered Employee of that amendment, modification, or revocation. However, any amendment, modification, or revocation will have no effect on any Claim that was filed for arbitration prior to the effective date of such amendment, modification, or revocation.” Do you agree that the arbitration agreement is illusory? Why or why not? [Peleg v. Neiman Marcus Group, Inc., 204 Cal. App. 4th 1425 (2012).] 9. In 2001, Joseph Toscano, who was employed as the general manager of a Fields Pianos store in Santa Ana, was very unhappy with his job and decided to find other employment. Toscano contacted Michael Greene, the president of San Diego–based Greene Music, because he had heard that Greene was considering buying Fields’s Riverside store. During the course of several conversations in June and July 2001, Michael Greene offered Toscano a sales management position with Greene to start on September 1, 2001. On August 1, 2001, Toscano resigned from Fields in reliance on Michael Greene’s promise of employment. In mid-August, however, Greene withdrew the employment offer. Toscano later found lower-paying jobs, the first at a piano store in Mission Viejo and then at another piano store in Utah. Toscano sued Greene for promissory estoppel. Should Toscano

prevail on his claim for promissory estoppel? Why or why not? [Toscano v. Greene Music, 124 Cal. App. 4th 685 (2004).] 10. Joana Perez began working for Datamark in January 2005. She received two booklets at orientation, “NonStaff Employee Handbook” and “Summary Plan Description.” She did not read either one of them. According to the human resources director, Perez also received a “Problem Resolution Program” booklet (the PRP) that described company dispute resolution policies and procedure. Perez denied receiving it, but she did sign the “Receipt and Arbitration Acknowledgment” form, which was maintained in her personnel file. Her signature acknowledged that she had received and read (or had the opportunity to read) both “Summary Plan Description” and the PRP. She also acknowledged that an arbitration policy required the submission of all employee-related disputes to an arbitrator in accordance with the procedures described in the PRP. Datamark reserved the right to revoke or modify the PRP in writing at any time as long as the writing was signed by an officer of the company and articulated an intent to revoke or modify a policy. Perez learned she was pregnant in August 2005. While employed full-time, she began to miss work due to pregnancy difficulties. She was discharged on October 21, 2005, and filed suit alleging unlawful discrimination because of her gender and/or pregnancy. Perez also alleged that Datamark intentionally or recklessly engaged in extreme and outrageous behavior that caused her severe emotional distress. Datamark filed a motion to compel arbitration. In her response to the motion, Perez alleges that the arbitration agreement is illusory because Datamark could unilaterally change or terminate the agreement without prior notice to the employees. Do you believe the agreement to arbitrate is illusory? Why or why not? (In re Datamark, Inc., Relator, Court of Appeals of Texas, Eighth District, El Paso, 296 S.W.3d 614; 2009 Tex. App. LEXIS 794 (2009).] 11. This appeal arises out of the trial court’s division of property in a divorce case. Vincent Simmons appeals from the trial court’s order awarding to his wife, Dorothy Simmons, a one-half interest in land that he inherited from his parents. Vincent contends that the land is nonmarital property and, consequently, should have remained his separate property. Vincent and Dorothy Simmons were married in 1976. Vincent’s mother executed a trust to convey the land in Florida to her children, Vincent and his sister, upon her death. Louise Simmons died on April 1, 1999, but the land remained in trust for several years after her death. After Louise died, Dorothy became concerned that she would not receive an interest in the Florida land if Vincent died before the trust was distributed, so she

Chapter 10 Consideration

hired an attorney in Monticello, David Chambers, to prepare a document to protect her interest. In the document, Vincent says, in part, “It is my intention, through this affidavit, to convey to my said wife marital interest in said real property. If I should die prior to the above-stated Trust being dissolved, then my said wife shall receive my share of said real property as her own property.” In 2003, Dorothy filed for divorce. Vincent argued that there was a total absence of consideration to support a contract in this case. Dorothy argued that her ongoing marriage to Vincent constituted adequate consideration to support the contract. Who is correct? Why? [Vincent Simmons v. Dorothy Simmons, 98 Ark. App. 12 (Ark. Ct. App. 2007).] 12. Charles Houser began working for appellee, 84 Lumber Company, L.P. (84 Lumber), in 1985. In 1998, Houser became an outside salesman with 84 Lumber, and his compensation changed from a set salary to commission based on his sales. At that time, Houser signed a noncompete agreement, which prohibited him from engaging in sales activities with a competitor of 84 Lumber within a 25-mile radius of 84 Lumber’s Macedonia store for a two-year period following the conclusion of his employment with 84 Lumber. In June 2008, Houser signed a contract providing a set weekly draw and yet another noncompete agreement. In March 2009, Houser left 84 Lumber and, almost immediately thereafter, began working for Carter Lumber, a competitor of 84 Lumber. 84 Lumber filed a lawsuit alleging that Houser had violated the noncompete agreement. The essential question is whether the 2008 noncompete agreement was supported by adequate consideration. “[A] restrictive covenant is enforceable if supported by


new consideration, either in the form of an initial employment contract or a change in the conditions of employment.” 84 Lumber Company argued that Houser’s continued employment was adequate consideration for the new noncompete agreement. Do you agree? Why or why not? [84 Lumber Co., L.P. v. Houser, 2011 Ohio 6852 (2011).] 13. In February 2000, CNS International Ministries, Inc., signed a contract with Eiman Brothers Roofing Systems. Under the contract, Eiman would provide CNS with a clay tile roof for one of its properties. On the basis of the size of the roof provided in CNS’s plans, the total amount of the contract was $52,731. In May 2000, Eiman realized that the plan provided by CNS underestimated the roof’s actual size, which required an additional 20–25 squares. Eiman, demanding a second contract, recalculated and rebid the project. In May 2000, CNS signed a contract modification proposal sent by Eiman, adding $23,000 in costs. With the work substantially complete, CNS noted problems in Eiman’s performance and its alleged failure to deliver on assurances to correct those problems. Consequently, CNS ordered Eiman to stop working on the roof. Eiman then brought a breach-of-contract action. At the time of the alleged breach, CNS had paid a total of $29,000 on the contract. CNS claimed that the contract was unenforceable for lack of consideration, in that Eiman had a preexisting duty to CNS. Specifically, CNS argues that the May 2000 proposal called for Eiman to perform in exactly the same manner as that specified in the original contract. Did Eiman have a preexisting duty to CNS? Why or why not? [Eiman Brothers Roofing Systems, Inc. v. CNS International Ministries, Inc., 158 S.W.3d 920 (2005).]


2 11

Contract Law


Capacity and Legality

CASE OPENER Parents of minors took Apple to court in 2012 for supplying game applications on iPhones that were free but through which users could purchase in-game currencies. Apparently, parents would log on to the games, but within a subsequent 15-minute time frame, the minors using the game would rack up bills ranging from $99.99 to $338.72 at a time. Apple stated that although minors were downloading these applications and in-game currency, the contract in question was actually the Terms of Service between the parents and Apple. According to the Terms of Service, any unauthorized logon on one’s account or unauthorized purchases by anyone on the account was the responsibility of the account holder. On the other hand, the parents argued that all application and in-game purchases made by minors were separate contracts that may be disaffirmed by a parent or guardian. Apple also argued that a contract as the parents were describing it could not legally exist in that as the parents described the scenario, the contractual offer was made to parents in the Terms of Service, yet accepted by the children, and consideration was provided by the parents (the original offerees).1 1. 2. 1

Do the individual purchases made by the minors indeed qualify as separate contracts between Apple and the minors? Even if the purchases were contracts between the minors and Apple, could the parents void these contracts?

In re Apple In-App Purchase Litigation, 5:11-CV-1758 (N.D. Cal.; March 31, 2012).

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


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When would a minor have only limited capacity to enter into a contract?

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How can a contract created when one is a minor be ratified after one is no longer a minor?

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Under what conditions is a contract unenforceable by law?

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When does unfairness affect a contract’s enforceability?

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What is the legal effect of entering into a contract for an illegal purpose?

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Why would anyone care whether a contract was severable?

Capacity This chapter examines the third and fourth elements of a contract. Capacity is the third element of a legally binding contract. A person who has legal capacity to contract is one who has the mental ability to understand his or her rights and obligations under a contract and therefore will presumably be able to understand how to comply with the terms of the agreement. Incapacity, or incompetence, as it is sometimes called, is some sort of mental or physical defect that prevents a natural person from being able to enter into a legally binding contract. Depending on the nature and extent of the defect, a person may have either no capacity, and therefore any attempted contract is void, or limited capacity, resulting in the ability to form only voidable contracts. Historically, people with limited or no capacity included married women, minors, and insane persons. Through statutes, other categories were added for classes of people for whom guardians had been appointed, such as habitual drunkards, narcotic addicts, spendthrifts, the elderly, and convicts. Today, married women have been removed from the category of those lacking contractual capacity, although in a few states their capacity to enter into certain kinds of contracts is still limited. In this section of the chapter, we explain the current law limiting the capacity of some categories of persons to enter into legally binding agreements.


capacity The legal ability to enter into a binding contract.

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One of the oldest limitations on capacity is the ability of minors to enter into only voidable contracts. Today, in all but three states, a minor is someone under the age of 18.2 In most states, however, a person is given full legal capacity to enter into contracts when he or she becomes emancipated before reaching the age of majority. Emancipation occurs when a minor’s parents or legal guardians give up their right to exercise legal control over the minor, typically when the minor moves out of the parents’ house and begins supporting himself or herself. Often the minor will petition the court for a declaration of emancipation. In most cases, when a minor marries, she or he is considered emancipated. Disaffirmance of the Contract Because their contracts are voidable, minors have the right, until a reasonable time after reaching the age of majority, to disaffirm, or avoid, their contracts. No formalities are required to disaffirm the contract; the minor need only manifest an intention to

B UT W HAT I F  . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Let’s say that in the Case Opener, the court decided that all of the purchases made by the minors were indeed contracts between the minors and Apple. Let’s say that the parents attempted to void the contracts themselves because they are technically the minors’ legal guardians. Would such a move be legal? Why or why not?


In Alabama, Nebraska, and Wyoming, full capacity to contract does not arise until the person reaches the age of 19, which is the age of majority in those states. In Mississippi, the age of majority is still 21.


GLOBAL Context Capacity of a Minor in China United States law allows minors to void certain contracts. The mentality behind this law is that individuals below a certain age cannot be entirely accountable for their decisions. Chinese law holds minors accountable for their contracts in more situations than contracts for necessities. Children between 10 and 18 are deemed competent for entering into certain contracts, appropriate to each child’s mental state. The validity of the contracts made by these minors is normally conditioned on the retrospective

approach of a parent or guardian unless the contract is merely beneficial to the child or is an appropriate contract for the child’s age, intelligence, and mental state. Some of these contracts involve agreements for necessities such as food or clothing, whereas others might involve agreements to purchase a bicycle, depending on the minor’s intelligence and mental state. The contract is void when the mental state of a minor is not sufficient to claim that the minor is a competent party to the contract.

rescind the contract, either by words or by actions. However, the minor must avoid the entire contract; he or she cannot choose to disaffirm only a portion of it. The obligations of the minor on disaffirmance vary from state to state. Traditionally, most states simply required the minor to notify the competent party of the intent to disaffirm and return to the competent party any consideration received under the contract that was still under the minor’s control, regardless of the condition of the consideration. If the consideration has been destroyed or damaged, the minor returns whatever is left of it, and the other party has no recourse against the minor under most circumstances. For instance, if William, a minor, purchased a stereo receiver from Sound Systems, Inc., under a six-month contract and dropped it a week after he took it home, he could return it to the store in its broken condition and tell the owner that he wished to rescind the contract. He would be entitled to the return of his down payment and would owe no further obligations to the store. Such a rule makes sense if you view minors as innocents in need of protection from competent adults who would otherwise take advantage of minors. However, the rule does not encourage competent parties to enter into contracts with minors, and some observers argue that it allows a knowledgeable and unethical minor to take advantage of a competent party. Consequently, a number of states have modified the duty of the minor on disaffirmance, holding that the minor has a duty of restitution that requires her or him to place the competent party back in the position that party was in at the time the contract was made. Thus, continuing with the stereo receiver example, in some states, William would have a duty of restoration that would require him to compensate the store owner for the difference between the value of the receiver in the condition it was in when given to William and its value in the condition it was in when returned. The disaffirmance must occur before or within a reasonable time of the minor reaching the age of majority. What constitutes a reasonable time is determined on a case-by-case basis. Exceptions to the Minor’s Right to Disaffirm the Contract The minor’s right to disaffirm is designed to protect the minor from competent parties that might otherwise take advantage of the minor. But there are certain situations in which, primarily for public policy reasons, either the courts or state legislatures have determined that the minor should not have the right to disaffirm the contract. As a general rule, most states will not allow a minor to disaffirm contracts for life insurance, health insurance, psychological counseling, the performance of duties related to stock and bond transfers and bank accounts, education loan contracts, child support contracts, marriage contracts, and contracts to enlist in the armed services. Most of these exceptions apply in most, but not all, states. Another contractual issue on which the states disagree is the minor’s misrepresentation of his or her age. Although the majority rule is that misrepresentation does not affect a minor’s right to disaffirm a contract, some states hold that when a minor who appears to be of the age of majority misrepresents his or her age and a competent party relies on that misrepresentation in good faith, the minor gives up the right to disaffirm the agreement. One justification for this rule is that any minor who intends to misrepresent his or her age does not need the protection that disaffirmance is designed to provide. 208


Chapter 11 Capacity and Legality

Other states have found a compromise between the two extreme positions either by requiring the minor to restore the competent party to that party’s precontract position before allowing the disaffirmance or by allowing the minor to disaffirm but then giving the competent party the right to sue the minor in tort and recover damages for fraud. Of course, as the previous paragraphs indicate, the laws created to protect minors from being victimized by competent adults do not necessarily protect competent adults from being taken advantage of by knowledgeable and unethical minors. Thus, individuals operating or working in businesses that are subject to laws requiring their customers to be the age of majority or older must familiarize themselves with the laws pertaining to minors because, often, the responsibility of making sure that a business is dealing with people who are of legal age falls on the employees and the owner. However, because some minors use false identification or misrepresent themselves as adults, it is sometimes difficult for business owners and employees to recognize which customers are truly of age. For example, as CEO of Girls Gone Wild (GGW), Joe Francis runs a business that requires him to be familiar with the laws surrounding minors. In fact, Francis has said that GGW has very specific procedures in place to prevent filming underage girls and even teaches its camera crew ways to ensure that the girls the crew is selecting to appear in GGW spring break videos are of age. During the selection procedure, the GGW camera crew is required to check the IDs of girls wanting to be filmed, obtain signed written release forms in which the girls give their consent to be filmed, and videotape the girls’ IDs as well as the actual process of signing the release forms. Despite his company’s strict policies, Francis found himself in the middle of a heated legal battle in 2003 when seven girls claimed that they were underage when the GGW camera crew filmed them on vacation in Panama City, Florida. Francis fought back, saying that the girls misrepresented themselves, knowingly sought out the GGW crew, and wanted to exploit the company to obtain a monetary settlement. After four years of court proceedings and intense media coverage, Francis reached an undisclosed settlement with the women, who reportedly wanted a total of $70 million. Liability of Minors for Necessaries Contracts for necessaries are sometimes considered an exception to the rule that minors can disaffirm their contracts. Technically, a minor can disaffirm contracts for necessaries; however, the minor will be held liable for the reasonable value of the necessary. The purpose of this limitation is to ensure that minors can obtain the basic necessities of life when their parents will not provide them. A contract for a necessary is a contract that supplies the minor with the basic necessities of life, generally thought of as food, clothing, shelter, and basic medical services. It is sometimes difficult, however, to determine whether something is in fact a necessary. Some courts define a necessary as what is needed for the minor to maintain his or her standard of living and financial and social status, but this can lead to a problem when an item that may be considered a necessary for a child of upper-income parents might be considered a luxury to a child of lower-income parents. Whether an item is considered a necessary is also related to whether the minor’s parents are willing to provide the item in question for the minor. For example, in a recent case, a minor chose to live independently, but her parents kept her bedroom open for her and were willing to have her return home any time. When she chose to return home after having fulfilled only two months of a year-long lease, the court found that the lease for the apartment was not a necessary because her parents had always been willing to provide a home for her.3 Ratification Once a person reaches the age of majority, he or she may ratify, or legally affirm, contracts made as a minor. Once ratified, the contract is no longer voidable. Ratification may be either express or implied. An express ratification occurs when, after reaching the age of majority, the person states, either orally or in writing, that he or she intends to be bound by the contract entered into as a 3

Kim Young v. Phillip Weaver, 883 So. 2d 234 (Ala. Civ. App. 2003).

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Contract Law

minor. For example, when she is 17, Marcy enters into an agreement to purchase an automobile from Sam for 10 monthly payments of $1,000. After making the fifth payment, Marcy turns 18 and decides to move out of state. She e-mails Sam and tells him not to worry because even though she is moving, she still intends to make her monthly payments to purchase the car. She has expressly ratified the contract. An implied ratification occurs when the former minor takes some action after reaching the age of majority that is consistent with an intent to ratify the contract. Going back to the previous example, if the day after she turns 18, Marcy enters into an agreement with Joe to sell him the car in six months, that action is obviously consistent with an intent to finish purchasing the car, so she has impliedly ratified the contract. Most courts find that continuing to act in accordance with the contract, such as continuing to make regular payments under a contract after reaching the age of majority, constitutes ratification. For example, if Marcy continued using the car and making payments on it for several months after reaching the age of majority, the courts would probably find that she had ratified the contract. Parents’ Liability for Their Children’s Contracts, Necessaries, and Torts As a general rule, parents are not liable for the contracts entered into by their minor children. Because of this rule, merchants are often reluctant to enter into contracts with minors unless some competent person is willing to agree to cosign the contract. In that way, the competent person will be legally bound to perform the obligations undertaken by the minor if the minor no longer wishes to live up to the terms of the contract. Parents do, however, have a legal duty to provide their children with the basic necessities of life, such as food, clothing, and shelter. Thus, they may be held liable in some states for the reasonable value of necessaries for which their children enter into contracts. In most states, parents are not liable for the torts of their minor children; minors are liable for their own personal torts. In many states, however, parents may be liable when a child causes harm because the parent failed to supervise the child properly, thereby subjecting others to an unreasonable risk of harm from the child.

MENTALLY INCAPACITATED PERSONS Persons suffering from a mental illness or deficiency may have full, limited, or no legal capacity to enter into a binding contract, depending on the nature and extent of their mental deficiency. If a person suffers from mental problems yet still understands the nature of the contract and the obligations imposed by it, the person may enter into a binding, legal agreement. Suppose, for example, that Gina suffers from the delusion that she is a rock star. When an encyclopedia salesperson comes to her door, she buys a set of encyclopedias from him because she believes that it is important for her to be knowledgeable to set a good example for her fans. As long as she understands that she is binding herself through a contract to make monthly payments for two years to pay for the encyclopedias, she is bound to the contract. If, after making a year of payments, she no longer suffers from her delusions and wishes to disaffirm the contract, she will not be able to do so because her delusions did not affect her understanding of what she was legally agreeing to do. However, a person has only limited capacity to enter into a contract if he suffers from a mental illness or deficiency that prevents him from understanding the nature and obligations of the transaction he is entering into. If, in the preceding scenario, Gina’s delusions prevented her from understanding that she was signing a contract, and she thought she was giving the salesperson her autograph when she signed the contract, the contract is voidable. She may disaffirm it at any time until a reasonable time after she no longer suffers from the mental deficiency. Once the mental deficiency has been removed, she may also choose to ratify the contract. As with contracts of minors, a contract of a person suffering from a mental deficiency that is for necessaries can be enforced for the reasonable value of the necessary. If a person’s mental deficiencies have resulted in him being adjudicated insane and a guardian has been appointed for him, he has no capacity to enter into contracts, and any contract he attempts to enter into is void. Guardians may be appointed not only for those who are adjudicated


Chapter 11 Capacity and Legality

insane but also for those who are adjudicated habitual drunkards and those whose judgment has been impaired because of a condition such as Alzheimer’s. In any case, although the person for whom the guardian has been appointed no longer has the legal capacity to enter into contracts, the guardian has the legal capacity to enter into contracts on that person’s behalf.

B UT W HAT IF  . . . WHAT IF THE FACTS OF THE CASE OPENER WERE DIFFERENT? Let’s say in the Case Opener that it was not a child making a purchase but a mentally disabled person named Chloe. Let’s say that Chloe was convinced that she owned a dog, even though she didn’t, and ordered $1,000 worth of dog food. Which kind of legal capacity would Chloe have? Could she then avoid her contract? What if Chloe had been adjudicated insane and committed to a mental institution but was staying with her sister on a weekend visitation pass when she made the purchase?

INTOXICATED PERSONS For purposes of determining capacity, intoxicated persons include those under the influence of alcohol or drugs. There is some variation among states in the treatment of the capacity of intoxicated persons to enter into contracts. As a general rule, most states follow the Restatement of Contracts, Section 16, which provides that contracts of an intoxicated person are voidable by the intoxicant if the other party had reason to know that because of the intoxicated person’s condition, that person was unable to understand the nature and consequences of the transaction or is unable to act in a reasonable manner in relation to the transaction. If the intoxication merely causes someone to exercise poor judgment, the person’s capacity to enter into a legally binding contract is not affected. Likewise, if one party has no way of knowing that the other was intoxicated at the time the agreement was made, and the agreement is a fair one, it will be upheld by most courts. For example, Lisa e-mails Rob and offers to buy his antique car from him for $8,000. Rob has just broken up with his girlfriend and has been drinking nonstop all day. He gets the e-mail message and immediately responds in the affirmative. Lisa had no way of knowing Rob was intoxicated, so they would have a valid contract in most states. Once sober, the intoxicant has the ability either to ratify or disaffirm the contract. Because public policy does not favor intoxication, the courts tend to be unsympathetic to intoxicants and will fairly liberally interpret behavior that seems like ratification as ratifying the contract. If Jim became intoxicated at a bar one evening, and Randi took advantage of the situation by getting him to sign a contract to sell her his 2004 SUV for $8,000, any act Jim takes consistent with ratification after becoming sober will result in a binding contract. If Randi appears at his house the next morning with the cash, shows him the contract drafted on a napkin that he signed, and asks for the keys and the title, then by giving her the keys and saying, “I knew I shouldn’t have drunk that much,” Jim has entered into a binding contract. If the contract is disaffirmed on the basis of intoxication, each party to the contract must return the other to the condition she or he was in at the time the contract was entered into. Also, as with contracts of persons who have limited capacity, a contract of an intoxicated person for necessaries will be enforced for the reasonable value of the necessaries.

Legality To be enforceable, a contract must have a legal exchange as its subject and must be able to be performed legally. In the event of a contract with an illegal subject, it is the agreement or the bargain that is illegal, not the contract. By definition, contracts are legal. That is why when a

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contract is overturned due to being contrary to law, the contract is frequently declared void, as if it never existed, as opposed to being declared illegal. It is important to recognize, however, that contracts can be determined illegal even if they are not against a specific statute. When contracts are against generally accepted public policy, these agreements are determined to be unenforceable, and not void. No remedy is available for unenforceable agreements.

A term applied to a contract that, because of a law, cannot be enforced by the courts.

Contract Law

CONTRACTS THAT VIOLATE STATE OR FEDERAL STATUTES As previously stated, certain agreements are illegal because either the subject or the performance of the agreement violates a state or federal statute. Given the various state and federal statutes, there are a large number of possible ways in which contracts can violate a statute. Some of the more common ways are discussed below. Agreements to Commit a Crime or Tort Contracts cannot be for an illegal subject or be carried out by illegal means. Therefore, any agreement to commit a crime or tort is illegal and unenforceable. However, if a legal contract is formed and then the subject of the contract becomes illegal under a new statute, the contract is considered discharged by law. For example, Jim agrees to work for Heather for one year as a poker dealer at her casino. After Jim and Heather enter into this employment agreement, the state government passes a law saying that poker may no longer be offered in casinos in the state. Because it would now be illegal for Jim to work as a dealer, the contract is discharged by law. Licensing Statutes All 50 states have statutes requiring people who work in certain professions to obtain a license before practicing their craft. For example, doctors of all varieties, plumbers, cosmetologists, lawyers, electricians, teachers, and stockbrokers are all required to obtain a license before practicing. Although this list of professions is far from exhaustive, it demonstrates how widespread the licensing requirement can be in various states. When licensing is required by law, people in certain fields must obtain a license before they can legally enter into an agreement to perform the restricted services. Frequently, such licenses can be obtained only after extensive schooling or training. The requirement of schooling and licensing demonstrates the concern society places on proper performance of duties in the designated professions. In addition to indicating concern with proper performance, licensing statutes have two main purposes. The first is to give the government an avenue by which to regulate the specific industries. By requiring professionals to obtain a license, the government has some say over who can perform which jobs as well as how many people can perform these jobs. The second main purpose of licensing statutes is more closely related to the public interest. This second purpose is to protect the public’s health, safety, and welfare. By imposing legal standards on a profession, the government is attempting to prevent people from being harmed due to substandard work. For example, surgery is a delicate, complicated process. It is not in the public’s best interest to allow an unqualified person to perform surgery. Therefore, to limit the number of people who might be harmed during surgery, the government steps in and requires surgeons, even after extensive schooling, to obtain a license. Given the different reasons for licensing various professionals, there are different outcomes when someone enters into an agreement with a person who is not lawfully licensed. The state in which the unlicensed person is practicing is also relevant because many licensing statutes occur at the state level and thus vary from state to state. For example, in some states, the statutes specify “no license, no contract.” These states will not enforce any agreement with an unlicensed professional. However, in a state that does not explicitly bar the enforcement of all contracts with unlicensed professionals, the courts typically examine the profession in question to determine why professionals in that field are required to be licensed. If the purpose of licensing is to provide government control over the profession, most states allow enforcement of the contract. Although the unlicensed professional is acting in violation of the law, there are no grave reasons that the contract should not be carried out. Nonetheless, because the professional is in violation of the law, he or she is usually required to pay a fine for working without the necessary license.

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Capacity and Legality


Conversely, if the licensing statute is intended to protect the public’s health, safety, or welfare, the agreement is typically deemed illegal and unenforceable. Licensing statutes do not protect the public if people without the necessary licenses are allowed to practice the restricted professions. Returning to the example of surgeons, the public is made safer when the government allows only licensed professionals to perform surgery. Therefore, people cannot enter into a contract for professional service with unlicensed professionals when the law requires a license and the statute is intended to protect the public. Case 11-1 illustrates how failure to obtain a license can preclude a party from suing to enforce a contract.

CASE 11-1


FACTS: The defendants, Roseann and Bryan Riedl entered into a contract with the plaintiff, Jim King of King Home Services to make improvements to the Riedls’ house. The improvements entailed work throughout the entire property, including work to the yard and demolition and installation work to the house. The defendants paid the plaintiff a total of $14,075 for some, but not all, of the work specified in the contract. The plaintiff was not at any time a licensee of the Alabama Home Builders Licensure Board. The defendants were unsatisfied with the work contracted for and performed by the plaintiff. Consequently, they filed a small-claims complaint in the small-claims division of the Madison District Court, alleging that the plaintiff had damaged their house. The defendants sought compensation for repair work performed by other parties. In response, the plaintiff filed an action in the Madison Circuit Court against the defendants, alleging a number of claims, including breach of contract. In the district court, the plaintiff requested the district-court action to be consolidated with the circuit-court action. After the defendants also requested consolidation, the district-court action was transferred to the circuit court, and the two actions were consolidated. The defendants filed a motion for a summary judgment in the circuit court, asserting that the plaintiff lacked standing to institute the circuit-court action against them because he was an unlicensed home builder. In response, the plaintiff claimed that he did not need a license to enforce his contract with the defendants. After a hearing, the circuit court entered a summary judgment in favor of the defendants, dismissing all of the plaintiff ’s claims against them. The plaintiff filed an appeal of the summary judgment entered in the circuit-court action, which was transferred to the Court of Civil Appeals of Alabama.

ISSUE: In Alabama, can a plaintiff home builder bring a breach of contract claim if that home builder is not licensed by the Alabama Builders Licensure Board? REASONING: In Alabama, a residential home builder is defined as a home builder when the cost of the undertaking exceeds $10,000. All residential home builders must be licensed by the Alabama Home Builders Licensure Board to be permitted to bring a breach of contract claim against a customer. In this case, the plaintiff argued that the cost of the undertaking in the present case was less than $10,000 because the work done to the defendants’ porch, doggie doors, and fence should not have been included in calculating the cost of the undertaking. The plaintiff further argued that the defendants had full control over the subcontractors and, thus, that he should have been exempted from obtaining a license by § 34–14A–6(5). However, the plaintiff’s argument that work done to the porch, doggie doors, and fence should be considered separately from work performed on the house in calculating the total cost of the undertaking, as well as his argument that he did not have sufficient control over the subcontractors, falls within an exemption to the licensing scheme. As such, the cost of the undertaking of all the work performed by the plaintiff was considered greater than $10,000. Because there was evidence that the cost of the undertaking was greater than $10,000, there was reason to believe that the plaintiff violated Alabama law and, thus, had no standing to bring his breach-of-contract claim against the defendants. DECISION AND REMEDY: The Court of Civil Appeals affirmed the decision in favor of the defendants. SIGNIFICANCE OF THE CASE: This case explains the importance of a home builder being licensed by the state for that home builder to be able to file any necessary breach of contract claims against a customer.


CRITICAL THINKING When a judge or judicial panel makes a decision, it must do so on the basis of the information available to it. What is an illustration of a fact that, were it true, would have caused this case to have provided King standing with respect to his breach of contract action? What fact was especially important in moving the decision in the direction of summary judgment?

ETHICAL DECISION MAKING The statute spelling out the need for a residential home builder license has an exemption for small contracts. What stakeholders are being especially advantaged by the exemption?

usury The lending of money at an exorbitant or unlawful rate of interest.

gambling An agreement in which a party pays consideration (money placed during bets) for the chance, or opportunity, to obtain an amount of money or property.


Usury Almost as widespread as licensing statutes, statutes prohibiting usury exist in nearly every state. Usury occurs when a party gives a loan at an interest rate exceeding the legal maximum. The legal maximum interest rate varies from state to state, but it is easy to determine the rate in any given state. Although usury statutes act as a ceiling in terms of setting a maximum possible rate, there are a few legal exceptions whereby loans may exceed the predetermined maximum. One exception relates to corporate loans. Most states with usury statutes allow corporations to lend and borrow at rates exceeding the maximum. The rationale behind the corporation exception is that if a business needs money to expand and is willing to pay the higher interest rate, the corporation should be afforded the opportunity to borrow. The converse is that if a corporation is willing to borrow at a high interest rate, parties should be allowed to lend at that rate for corporations only. The intent is to facilitate business transactions to keep the economy in a healthy state. Another exception to usury statutes applies to smaller loans. Many states allow parties to make small loans at rates above the maximum to parties that cannot obtain a needed loan at the statutory maximum. The belief is that if people need money and the statutory maximum is not inducing people to lend, certain parties will make the necessary loans at a higher rate as long as the loan is small, which is defined however the state chooses to define it. This exception is the principle that allows cash advancement institutions to operate. If there is no exception that allows a usurious loan, the legal outcome varies by state. A minority of states declare all usurious loans void, which means the lending party is not entitled to recover either the interest or the principal. A larger number of states allows lenders to recover the principal amount they loaned, but these parties cannot collect any interest on the loan. In addition, a final group of states allows lenders to recover the principal as well as an amount of interest up to, but not exceeding, the statutory maximum. In essence, these states allow the lenders to recover all but the excess interest, as if the loan were given at the statutory maximum rate. Gambling As with licensing statutes, all states engage in at least some regulation of gambling. In this chapter, the term gambling refers to agreements in which parties pay consideration (money placed during bets) for the chance, or opportunity, to obtain an amount of money or property. Although gambling is still illegal in the vast majority of states, many states allow casino gambling. The states most notable for casino gambling are Nevada, New Jersey, and Louisiana. Some states allow certain other types of gambling, either intentionally or through legal loopholes. For example, given California’s definition of gambling, betting on draw poker is legal. Some states make other exceptions, such as for horse tracks, casinos located on Native American reservations, or legal state-run lotteries.

E-COMMERCE and the Law Observing Sabbath Days Online Sabbath days stem from the religious traditions that were so widespread in America’s early days. Among the religions that still observe Sabbath days today is Judaism, which has very strict laws in relation to refraining from conducting business on the Sabbath. This prohibition even extends to the online realm. Not only are those of the Jewish faith told to abstain from conducting online transactions on the day of the Sabbath, but they are also prohibited from making

transactions online even if the individual in question has no awareness of it. For example, if an individual schedules to pay for an item when it ships, and the item happens to be shipped on the day of the Sabbath, that individual is considered to have broken Sabbath law. Laws against conducting certain types of business are still active even today, though they may not be rigidly enforced. Source: http://belogski.blogspot.com/2008/03/must-your-online-shop-shut-on-shabbat .html

Sabbath Laws A large number of states still have what are known as Sabbath, Sunday, or blue laws on the books. Sabbath laws limit the types of business activities in which parties can legally engage on Sundays. In most states with Sabbath law restrictions, these laws date back to colonial times. In fact, the term blue law is a reference to the blue paper on which New Haven, Connecticut, printed its Sabbath laws in 1781. New Haven’s 1781 law prohibited shops from being open and prohibited all work on the “Lord’s day” (Sunday). The activities restricted today by Sabbath laws vary from state to state. Most Sabbath laws pertain to the sale of alcoholic beverages. These laws tend to prohibit the sale of all alcohol or at least specific types either all day or at restricted times on Sundays. Some Sabbath laws go as far as to make it illegal to enter into any contractual relationship on a Sunday. However, an executed, or fully performed, contract created on a Sunday cannot be rescinded. There are exceptions to Sabbath laws. Most states with Sabbath laws allow the performance of charity work on Sundays. In addition, Sabbath laws do not typically apply to contracts involving procurement of necessities, typically defined as prescription medication, food, or anything else related to health or survival. Regardless of how widespread Sabbath laws are, the vast majority of states do not enforce all, or at least some, of their Sabbath laws. In fact, some Sabbath laws have in the past been deemed unconstitutional according to the First Amendment. Nevertheless, if Sabbath laws are on the books, despite convention to the contrary, they can be applied, and some states do apply such laws. As a businessperson, you should always find out whether Sabbath laws exist and, if they do, whether authorities enforce these laws.

Sabbath laws Laws prohibiting the performance of certain activities on Sundays.

AGREEMENTS THAT VIOLATE PUBLIC POLICY Unlike agreements that are precluded by statute, some types of agreements are not illegal per se, because they are not in violation of any statute or legal code, but are unenforceable because courts have deemed them to be against commonly held public policy. Public policy involves both the government’s concern for its citizens and the beliefs people hold regarding the proper subject of business transactions. The focus is on what is in society’s best interest. Contracts in Restraint of Trade It is a widely held belief in economics, as well as in America in general, that competition drives down prices, which is good for consumers. Accordingly, agreements that restrain trade are viewed as being harmful to consumers and thus against public policy. These restraints on trade are also known as anticompetitive agreements. Not only are anticompetitive agreements against public policy, but they also frequently violate antitrust laws. There is an exception that allows specific types of restraints on trade. When a restraint on trade is reasonable, as determined by the courts, and the restraint is part of a subordinate, or ancillary, clause, the restraint is typically allowed. Such restraints are known as covenants not to compete, or restrictive covenants. Covenants not to compete tend to come in two varieties. The first involves noncompetition in the sale of an ongoing business, and the second involves noncompetition in employment, both of which are discussed below.

covenant not to compete An agreement not to compete against a party for a set period of time within a designated geographic area.



Part II

Contract Law

The first category of permissible restraints on trade is covenants not to compete that involve the sale of an ongoing business. Ongoing refers to the status of the business being sold: The business is still running and will still run on its own; it is not being merged and is not closing down. The public policy argument in favor of supporting restrictions with the sale of a business involves the fairness of the sale. Let us examine a hypothetical situation to see why this restraint on trade is allowed. Suppose you purchase a jewelry store from Ann Smith. Ann is a wellrespected member of the community, and her business has been around for many years. The people in the community know the store, and they trust Ann to provide fair exchanges. As a wellinformed businessperson, you know about Ann’s reputation. In fact, her good reputation made the purchase more appealing. Now suppose Ann turns around and opens another jewelry store a block away one month later. Ann’s loyal customers are likely to go to her new store because they still trust her. In the meantime, Ann’s good name is no longer associated with your store, and your business suffers accordingly. You entered into the sales agreement thinking you would benefit from Ann’s good name, but in the end you overpaid for a business that lacks the benefit of Ann’s name because Ann took her name with her when she went into competition with your store. In the interest of self-proclaimed fairness, courts are willing to impose restrictions preventing Ann, or others in her position, from going into immediate competition with you or others in your position. Public policy requests fairness in business transactions, and this fairness does not occur when people profit from a business transaction and then start a new business that destroys the business they just sold. Consequently, the restraints to trade being discussed with the sale of an ongoing business involve the seller’s ability to open up another business within a certain geographic location within a designated time period. As previously mentioned, to be enforceable, a covenant not to compete needs to be in a subordinate clause in the contract. If the covenant not to compete is part of the main agreement, and therefore not subordinate, the agreement is typically considered unenforceable and void because it goes against public policy by providing unreasonable restraints to trade. The unreasonableness arises because when the covenant is an integral part of the contract, it cannot be objected to. In contrast, when the covenant is subordinate, the specific noncompetition clause can be removed and the agreement can go forward as planned. Case 11-2 illustrates the analysis of the court in a case involving a covenant not to compete signed in conjunction with the sale of a business. The second category of permissible restraints on trade is covenants not to compete that involve employment contracts. The covenants in employment contracts are similar to those in sales contracts. However, with employment, the employee is agreeing not to compete with her boss, if she leaves, for a designated period of time within a designated geographic area.

CASE 11-2


FACTS: Miller operates or has ownership interest in numerous restaurant and bar establishments in Florida under the “Ale House” name. Preefer also operates or has ownership in numerous restaurant and bar establishments

throughout Florida, some under the name of “Ale House.” In 1992, Miller and nine associated companies sued the Preefer defendants for trademark and service mark infringement. The parties agreed in 1994 to settle the dispute when

(continued) they entered into a mediated settlement agreement. Part of the agreement included a covenant not to compete. Miller agreed not to conduct a restaurant-related business in Palm Beach County, Florida, for a period of 50 years. This agreement was incorporated into the final judgment of the dispute. In 2002, Preefer sued Miller, alleging violations of the 1994 agreement. Miller counterclaimed, in part alleging that the covenant not to compete was unenforceable because it was illegal restraint of trade against public policy. The parties settled this dispute as well. Shortly afterward, Miller filed suit against Preefer, alleging that the covenant not to compete provision within the 1994 settlement was unenforceable. In 2007, the trial court ruled in favor of Preefer, finding that the covenant was valid and enforceable as being part of a valid final judgment. Miller appealed, arguing that the Florida law expressly prohibits all agreements not to compete except those defined in legislation. ISSUE: Is a covenant not to compete illegal when signed in conjunction with a settlement agreement? If so, does the illegal covenant not to compete void the final judgment of a dispute? REASONING: Florida law provides for four situations in which covenants not to compete are enforceable: (1) the sale

of the goodwill of a business; (2) an employment, agency, or independent contractor relationship; (3) a licensing relationship; or (4) a partnership. The situation in the settlement agreement met none of these four provided situations. The inclusion of a void or illegal provision in a final judgment does not, in itself, render the final judgment void. Thus, the final judgment could not be attacked at any time. Because the settlement agreement contained an illegal restraint of trade, the final judgment in the 1994 case was voidable. Accordingly, Miller could have filed a timely appeal or timely motion and had the settlement agreement within the final judgment struck down. However, Miller did not act in a timely manner to dismiss the settlement agreement not to compete. Instead, he operated within the confines of the final judgment and enjoyed the benefits of the agreement for 13 years. DECISION AND REMEDY: The case was affirmed in favor of the Preefer defendants in light of Miller’s lack of timely appeal of the original settlement agreement. SIGNIFICANCE OF THE CASE: The case illustrates a situation in which an illegal covenant not to compete will be upheld as being enforceable.

CRITICAL THINKING Do you agree with the court’s argument in this case? Why or why not?

ETHICAL DECISION MAKING How do the classical ethical guidelines help explain why the timeliness of Miller’s action led to the court’s decision? In other words, what is the ethical aspect contained in the court’s reasoning? These covenants in employment contracts are not unusual. In fact, many middle or upper-level managers enter into agreements not to compete with their employers. In such a covenant, the employee is agreeing not to work for competitors or to start his or her own competing business.

Covenants not to compete in employment contracts are legal in most states. However, to be legal, the covenant needs to protect a legitimate business interest. Furthermore, the covenant needs to be for a reasonable period of time and geographic area so that it does not unlawfully impinge on the employee’s right to earn a living. The agreement must not be for a longer period of time or larger geographic region than is necessary to protect the employer’s legitimate business interest. Given the variations from state to state in other areas of the law, it should come as no surprise that the enforceability of covenants not to compete also varies from state to state. For example, California does not allow any covenants not to compete. On a different note, Texas requires the employee to gain a specific benefit from a contract, beyond employment, before its courts will 217


Part II

Contract Law

enforce a covenant not to compete. The employee must be given, or gain, something even if the covenant not to compete is for a reasonable period of time and geographic region.

LO 11-4

unconscionable A term applied to a contract in which one party has so much more bargaining power than the other party that the powerful party dictates the terms of the agreement and eliminates the other party’s free will.

procedural unconscionability Unconscionability that derives from the process of making a contract.

adhesion contract A contract created by a party to an agreement that is presented to the other party on a take-itor-leave-it basis. Such contracts are legal but are sometimes rescinded on the grounds of unconscionability and the absence of one party’s free will to enter a contract.

substantive unconscionability Unconscionability that derives from one-sided, unjust, or overly harsh substance in a contract.

exculpatory clause A statement in a contract that frees one party (usually the drafter of the agreement) from all liability arising out of performance of the contract; generally based on factors such as consumer ignorance or a great deal of unexplained fine print that serve to deprive the less powerful party of a meaningful choice.

Unconscionable Contracts or Clauses When courts are asked to review contracts, fairness is not usually high on the courts’ lists of things for which to look. Instead, courts typically assume that the contracting parties are intelligent, responsible adults. The belief is, barring proof of coercion, that parties enter into contracts because they want to do so. Nevertheless, there are times when agreements are so one-sided, or heavy-handed against one party, that the courts will not make the harmed, innocent person fulfill his or her contractual duties. These heavily one-sided agreements are known as unconscionable agreements. The term unconscionable refers to the fact that the agreement in question is so unfair that it is void of conscience. Rules against unconscionable contracts exist in both the Restatement (Second) of Contracts and the Uniform Commercial Code. However, before the Restatement and the UCC existed, the common law would not enforce contracts the courts deemed too unfair, or unconscionable. Now UCC Section 2-302 states: (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 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.

Every state, with the exceptions of California and Louisiana, has incorporated the preceding UCC section into its state’s UCC. Section 208 of the Restatement also incorporates this section from the UCC. There are two main types of unconscionable agreements, procedural and substantive. Procedural unconscionability relates to conditions that would impair one party’s understanding of a contract and to the integration of terms into a contract. Regarding impaired understanding of contractual terms, the factors can be anything from tiny, hard-to-read print on the back of an agreement to excessive use of legalese (unnecessarily technical legal language) or even the inability of a person to read over a contract fully and ask any questions before he or she was required to sign. Most frequently, procedural unconscionability arises when one party presents the other with an adhesion contract. An adhesion contract is a contract created by a party to an agreement that is presented to the other party on a take-it-or-leave-it basis. That is, the contract is presented as complete and as the only chance the presented party (known as the adhering party) will have to enter into the agreement. Although adhesion contracts are themselves legal, the presence of one does raise some potential problem indicators for courts. Given that adhesion contracts usually do not allow for debate regarding the agreement, courts tend to examine adhesion contracts to see whether they can determine how voluntary the agreement really was. Conversely, substantive unconscionability involves overly harsh or lopsided substance in an agreement. That is, if an agreement is terribly one-sided, it is probably invalid on the basis of substantive notions of fairness and fair dealing. Courts would find the following, for example, to be substantively unconscionable: high differences between cost and price in a sales agreement; agreements in which one party gains vastly more than the other; agreements in which one party is prevented from having any sort of equal benefit; agreements in which one party has little to no legal recourse, according to the agreement; and portions of an agreement that are completely unrelated to anything having to do with either party’s business risk. Exculpatory Clauses An exculpatory clause is a statement releasing one of the parties to an agreement from all liability, regardless of who is at fault or what the injury suffered is. Because tort law attempts to return the wronged party to the state he or she was in before the wrong occurred, anything preventing this corrective mechanism is against public policy. It does not benefit society to allow some parties to get away with not having to pay for wrongs they commit simply because they state they will not be liable in various contracts. In fact, the patently unfair nature of an exculpatory clause is closely tied to the idea of unconscionable contracts.

Chapter 11

Capacity and Legality


Exculpatory clauses frequently show up in rental agreements for commercial or residential property. These clauses are often found to be against public policy. The reasoning is that sometimes people are injured while on property they are renting from another, and sometimes the injuries are due to the carelessness, negligence, or other wrongdoings of the owner. Once again, it does not serve the public’s interest to allow landlords, especially when it comes to residential property, simply to disavow all liabilities in advance. If they were allowed to do so, landlords would not be required to fix problems in their rental units, including potentially lethal problems such as faulty electric wiring or lead-based paint. A basic test to determine whether an exculpatory clause is unenforceable is to see whether the enforcing party engages in a business directly related to the public interest. Examples of such businesses include banks, transportation providers, and public utilities. Courts believe it is against the public interest to release businesses engaging in work in the public’s interest from accountability to the public they are serving. Another concern with large businesses that are serving the public interest is the unfair bargaining power they can possess in negotiating a contract. Given the power these businesses have, they could simply demand that all customers must accept the exculpatory clause, thus escaping all possible liability. Although the idea of these businesses not being liable is bad, what is worse is that there would be no punitive financial motive for them to conduct their business operations carefully, or so the argument goes. As a result, the potential for increased accidents would be large. Obviously, it is not in the public’s interest to have unsafe businesses that are not accountable to the public. Thus, these businesses cannot enforce exculpatory clauses. Case 11-3 details a court’s determination that an illegal exculpatory clause existed.

CASE 11-3


FACTS: Eric Lucier and Karen A. Haley, a young married couple, were first-time home buyers. They contracted with the Williamses to purchase a single-family residence. Lucier and Haley engaged the services of Cambridge Associates, Ltd. (CAL), to perform a home inspection. Al Vasys had formed CAL and was its president. Lucier dealt directly with Vasys, and Vasys performed the inspection and issued the home inspection report on behalf of CAL. The home inspection agreement contained a provision limiting CAL’s liability to “$500, or 50% of fees actually paid to CAL by Client, whichever sum is smaller.” This provision, and several others in the form agreement prepared by CAL, was followed by a line for placement of the client’s initials. Lucier initialed this provision. The fee for the home inspection contract was $385, which Lucier paid to CAL. Lucier claims that when he began to read the agreement, in Vasys’ presence, he felt that some of the language was unfair and confusing. According to Lucier, Vasys stated that he would not change any provisions, it was a standard contract based on home inspections done in New Jersey, and Lucier would have to sign the agreement as

is or not at all. Vasys does not dispute this but relies on Lucier signing the agreement and initialing the limitationof-liability clause. Likewise, Lucier does not deny signing the contract or initialing that clause. Lucier and Haley obtained title to the property from the Williamses. Shortly after, they noticed leaks in the house. They engaged the services of a roofing contractor and found out the roof was defective. Lucier and Haley argue that Vasys should have observed and reported the problem to them. The cost of repair was about $8,000 to $10,000. Lucier and Haley brought suit against the Williamses, CAL, and Vasys, seeking damages to compensate them for the loss occasioned by the alleged defect. CAL and Vasys moved for partial summary judgment, seeking a declaration that the limit of their liability in the action, if any, was one-half the contract price, or $192.50. The motion for partial summary judgment was granted. Lucier and Haley then filed an appeal, seeking review of the partial summary judgment order. ISSUE: Was the limitation of liability clause in the home inspection contract unconscionable?

(continued) REASONING: The courts find unconscionability to be “an amorphous concept obviously designed to establish a broad business ethic.” To avoid a contract on grounds of unconscionability, a court must first find that the contract is one of adhesion. Then it will examine “the subject matter of the contract, the parties’ relative bargaining positions, the degree of economic compulsion motivating the ‘adhering’ party, and the public interests affected by the contract.” When the potentially unconscionable provision limits a party’s liability, the court pays particular attention to any inequality in the bargaining power and status of the parties as well as the substance of the contract, keeping in mind the public policy against allowing parties to immunize themselves from liability for their own negligence, meaning that any limitation on such liability should be sufficient to provide a realistic incentive for the party to act diligently. In the words of the court: Applying these principles to the home inspection contract before us, we find the limitation of liability provision unconscionable. We do not hesitate to hold it unenforceable for the following reasons: (1) the contract, prepared by the home inspector, is one of adhesion; (2) the parties, one a consumer and the other a professional expert, have grossly unequal bargaining status; and (3) the substance of the provision eviscerates the contract and its fundamental purpose because the potential damage level is so nominal that it has the practical effect of avoiding almost all responsibility for the professional’s negligence. Additionally, the provision is contrary to our state’s public policy of effectuating the purpose of a home inspection contract to render reliable evaluation of a home’s fitness for purchase and holding professionals to certain industry standards. This is a classic contract of adhesion. There were no negotiations leading up to its preparation. The contract was presented to Lucier on a standardized preprinted form, prepared by CAL,

on a take-it-or-leave-it basis, without any opportunity for him to negotiate or modify any of its terms. The bargaining position between the parties was grossly disparate. Vasys has been in the home inspection business for 20 years. He has inspected thousands of homes. He has an engineering degree. He has served as an expert witness in construction matters. He holds various designations in the building and construction field. He advertises his company and holds it and himself out as possessing expertise in the home inspection field. Lucier and Haley, on the other hand, are unknowledgeable and unsophisticated in matters of home construction. They are consumers. They placed their trust in this expert. They had every reason to expect he would act with diligence and competence in inspecting the home they desired to purchase and discover and report major defects. The disparity in the positions of these parties is clear and substantial. The foisting of a contract of this type in this setting on an inexperienced consumer clearly demonstrates a lack of fair dealing by the professional. The cost of homes in New Jersey is substantial. The limitation of liability clause here is also against public policy. First, it allows the home inspector to circumvent the state’s public policy of holding professional service providers to certain industry standards. Second, it contravenes the stated public policy of New Jersey regarding home inspectors. With professional services, exculpation clauses are particularly disfavored. The very nature of a professional service is one in which the person receiving the service relies upon the expertise, training, knowledge, and stature of the professional. Exculpation provisions are antithetical to such a relationship.

DECISION AND REMEDY: The contract was unconscionable, and therefore the court reversed the decision and remanded it back to the lower court for trial. SIGNIFICANCE OF THE CASE: Although courts do not frequently find contracts to be unenforceable due to unconscionability, this case provides a good illustration of when the court will find the doctrine applicable.

CRITICAL THINKING From the facts you have about the case, does the judge seem to be making any assumptions without an adequate factual basis to support those assumptions?

ETHICAL DECISION MAKING Examine the ethical nature of the parties to the case. Whose behavior was particularly blameworthy? Whose was praiseworthy? What facts from the case and what ethical guidelines support your characterizations?


Although businesses closely linked to the public interest cannot enforce exculpatory clauses, not all exculpatory clauses are unlawful. To be able to enforce an exculpatory clause, the party seeking enforcement must be a private business or an individual and must not be important to the public interest. Such private businesses or individuals provide nonessential services and thus do not have the same bargaining power as the previously discussed groups, such as banks, utilities, and airlines. Given their lack of huge bargaining power, it is assumed that private businesses and individuals will enter on relatively equal terms and will voluntarily agree on or decline the final contract.

Chapter 11


Capacity and Legality

Examples of private businesses that can enforce exculpatory clauses include skiing facilities such as resorts or rental places, private gyms or health clubs, any business offering skydiving or bungee jumping, and amusement parks, to name a few. Because the services provided by all these businesses, as well as others in this category, are not something related to the public interest and not something in which people must engage, these parties are allowed to deny liability if the party with which they are contracting agrees to the exculpatory clause. Just because these parties might be able to enforce an exculpatory clause, however, does not mean the clause is always automatically enforceable. The following Case Nugget looks at an interesting situation involving an exculpatory clause.

CASE Nugget Can Parents Enter into Contracts on a Minor’s Behalf? Trent Woodman v. Kera LLC Supreme Court of Michigan 486 Mich. 228 (2010) Five-year-old Trent Woodman was injured on his birthday at Bounce Party, an indoor play area operated by Kera LLC. Before Trent began playing at the play area, his father signed a liability waiver including an exculpatory clause on Trent’s behalf. Mr. Woodman signed the form as the parent, and Trent’s name was printed on the form as “participant,” meaning he was the one participating in the activity for which the exculpatory clause was drafted. When Trent broke his leg after jumping off an inflatable slide, Trent’s mother, as next friend, filed suit against Kera LLC, on behalf of her son, alleging negligence, gross negligence, and violation of the Michigan Consumer Protection Act (MCPA). Kera LLC filed a motion for summary judgment, claiming that the claims were barred by the exculpatory clause. Michigan common law prevents parents from entering their children into contracts that waive, release, or compromise a minor’s claims. Because parents’ authority of a minor is limited to the care and custody of the minor, any contract that a parent might enter into on his or her minor’s behalf is unenforceable. The Michigan Supreme Court upheld the common law in this case by finding that the waiver that Trent’s father signed was unenforceable. The court refused to change common law because it believed that the court lacked the tools to measure the risks involved in such a policy change adequately. Therefore, the better vehicle for changing the common law is through legislature. Trent’s case was remanded for further proceedings.

EFFECT OF ILLEGAL AGREEMENTS Generally speaking, when an agreement is deemed illegal, courts will label the contract void. The reason most illegal agreements are void is that, in most cases, both parties are equally responsible for the illegal agreement. In the law, when both parties are equally responsible for an illegal agreement, the parties are said to be in pari delicto. When both parties are at fault, it does not make sense for the courts to attempt to salvage the agreement or reward either party. Therefore, most illegal agreements are void, meaning neither party can enforce the agreement and neither party is entitled to recovery. However, it is not always the case that both parties are at fault. If one party is not responsible for an illegal agreement, or special circumstances forgive the illegality, it makes sense sometimes to allow one party to an illegal agreement to recover various damages. The first exception to the general rule occurs when a member of a protected class is involved in an agreement that contradicts a statute intended to protect the specific class. In the event of such a contradiction, the member of the protected class is allowed to sue for performance. The reasoning is that if a statute is intended to protect a specific class, people outside the class should not be allowed to use the statute to harm those inside the class.

LO 11-5

in pari delicto In equal fault.


Part II

Contract Law

For example, a work agreement between a truck driver and his or her employer may specify that the driver gets paid for the number of hours worked. Yet certain statutes limit the number of hours truck drivers may drive in a given time period. If the truck driver accidentally drives more than the allowable hours, the driver has technically violated a statute. However, this violation does not allow the employer to refuse to pay the driver for the extra hours. Rather, the driver may sue the employer to enforce the work agreement. The second exception to the voiding of illegal agreements occurs when there is a justifiable ignorance of facts. A justifiable ignorance of facts is one party’s lack of knowledge regarding a provision of the agreement that would make it illegal. Although ignorance of the law does not excuse illegal behavior, not knowing that the other party to a contract intended to fulfill the agreement through illegal means does function as an excuse. When one of the parties is relatively innocent in the whole deal, the court may give back any consideration that party gave or may require an exchange for partial performance such that both parties can be returned to the positions they were in before they entered into the agreement. Conversely, if one party is completely innocent of any illegality and has completed his or her portion of the contract, then—depending on the reason the contract is considered illegal and depending on which state’s laws are in question—the court might enforce the entire agreement. A third exception to the general rule occurs when one of the parties withdraws from an illegal agreement. The key to any recovery is that the party must have withdrawn before any illegality occurred. If this is the case and if part or full performance has occurred, the party may recover value for whatever portion has been completed. However, if the party is involved in any way in the illegal activity, the party cannot recover at all.

LO 11-6 severable contract A contract that contains multiple parts that can each be performed separately.

indivisible contract A contract that requires complete performance by both parties.

Severable Contracts A severable contract, also known as a divisible contract, contains multiple parts that can each be performed separately. In addition, separate consideration is offered for each individual part. In essence, a severable contract is like numerous contracts in one. Conversely, an indivisible contract requires complete performance by both parties, even if it appears as though the contract contains multiple parts, similar to a severable contract. With respect to illegality, severable contracts have a huge advantage over indivisible contracts: If a severable contract has both legal and illegal portions, the court has the option of declaring void only those sections of the agreement that are illegal. The court can then enforce the remaining, legal portions of the contract. Indivisible contracts must be enforced or rejected in their entirety. For a court to be able to enforce parts of a severable contract, the parts that are enforced must still represent the main purpose of the original agreement. If declaring parts of a contract void substantially alters the contract, the court is not likely to enforce the remaining portions of the agreement. Courts ultimately want to facilitate business transactions and enforce the legal wishes of parties, and severable contracts enable courts to do so. And, of course, since severable agreements are subject to a court’ interpreting each section for legality, it is probably unwise to enter into such an agreement when the legality of some sections is questionable.

SUMMARY Capacity

Natural persons over the age of majority are presumed to have the full legal capacity to enter into binding, legal contracts. A person has only limited capacity to enter into a legally binding contract if the person is: • • •

A minor. Suffering from a mental deficiency that prevents the person from understanding the nature and obligations of contracts. Intoxicated.

A person has no capacity to enter into a contract if the person: • • •

Has been adjudicated insane. Has been adjudicated a habitual drunkard. Has had a legal guardian appointed to enter into contracts on his or her behalf.

Chapter 11


Capacity and Legality


Contracts that do not have a legal object are not valid. Contracts may lack a legal object because they violate a statute or violate public policy. If the illegal portion of a contract can be severed from the legal portion, the courts may simply refuse to enforce the illegal parts and enforce the remaining legal parts.

Point/Counterpoint Should the Law Allow Mentally Incompetent Individuals to Void Their Contracts? YES


Holding mentally incompetent individuals to their contracts sharply increases the likelihood of fraud. If contract law bound such individuals to their contracts, unscrupulous sellers could legally encourage mentally incompetent individuals to enter into fraudulent contracts, and courts, bound to apply the law, would enforce those contracts. Hence, permitting mentally incompetent individuals to escape their contracts sends a message to opportunistic individuals that the law will not sanction their fraudulent practices. In addition to discouraging fraud, contract laws that permit mentally incompetent individuals to void their contracts protect the most vulnerable members of society. The law binds mentally competent individuals to their contracts under the assumption that they are capable of looking out for their best interests. But mentally incompetent individuals lack the ability to protect their best interests. Critics call these types of laws paternalistic, but a major function of the law is to protect individuals such as the mentally incompetent who cannot protect themselves. Indeed, if the justification for contract law is rooted in our desire for individuals to be able to enter into mutually beneficial exchanges, allowing mentally incompetent individuals, who by definition cannot determine what is in their selfinterest, to void their contracts is consistent with this justification.

The great majority of mentally incompetent individuals live with mentally competent relatives, friends, or guardians who watch out for their best interests. Compared to judges, these guardians are much more likely to be able to act in the best interests of the mentally incompetent. Moreover, this government regulation hurts mentally incompetent individuals more than it helps them. If mentally incompetent individuals can legally void their contracts, competent individuals will be less willing to enter into fair contracts with them. As a result, mentally incompetent individuals will have fewer opportunities to enter into contracts consistent with their best interests. Hence, although the purpose of allowing mentally incompetent individuals to escape their contracts is well meaning, the result is malicious to the very individuals the law intends to help. Proponents of allowing mentally incompetent individuals to void their contracts argue that doing so would discourage fraud. But their position encourages fraud against mentally competent individuals. If mentally incompetent individuals can escape their contracts, they have an incentive to enter risky contracts with mentally competent individuals. Finally, proponents of binding mentally incompetent individuals to their contracts highlight courts’ lack of institutional competence to determine mental competence. How can courts, they ask, reliably determine which individuals lack the mental competence to look out for their own interests?

Questions & Problems 1. How does the concept of the age of majority in Great Britain differ from that in the United States? 2. Explain the obligations of a minor who chooses to disaffirm a contract. 3. Go back to the discussion of contracts that cannot be disaffirmed by minors and explain the policy reasons that support each of the exceptions. Can you make an

argument for any additional kinds of contracts that should not be subject to disaffirmance by minors? 4. If all you know about a man is that his neighbors think he is crazy, you do not know whether a contract he entered into was valid, voidable, or void. Why not? 5. What factors determine whether a covenant not to compete is legal or illegal?


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Contract Law

6. What is the relationship between contracts in restraint of trade and unconscionable contracts? 7. Three salesmen worked for Sentient Jet, a small luxury airline charter service. They signed a noncompete agreement, promising not to go to work for a competing employer within a year after working for Sentient and not to take any confidential information with them when they left the firm. When there was a change in the CEO of their firm, and talk of the company possibly being bought out, the employees left the firm and went to work for Apollo Jets, a competitor, and allegedly took proprietary information with them that allowed them to solicit former Sentient clients. The plaintiff sought damages and an injunction to ban the employees from working for a competitor for a year. Defendants argued that material changes in circumstances should have made the noncompete agreement unenforceable. How do you think the jury decided in this case? [Sentient Jet v. MacKenzie, January 2013.] 8. Washington State resident Patty Gandee entered into a debt adjustment contract with Freedom Enterprises. She subsequently sought to file a class action against them for violations of the state debt adjusting act and the Consumer Protection Act. The company sought to compel arbitration based on a binding arbitration clause she had signed. The clause provided that any disputes under the contract were to be submitted to arbitration that would take place in Orange County, California, under American Arbitration Association rules, and the prevailing party would be entitled to reasonable legal fees and costs, including attorney fees. Both the trial court and the Washington Supreme Court refused to enforce the binding arbitration clause. Explain why they would not enforce the clause. [Patty J. Gandee v. LDL Freedom Enterprises, Washington State Supreme Court, Case No. 87674-6, February 7, 2013, available at http://lawyersusaonline.com/wp-files/pdfs-5/ gandee-v-ldl-freedom-enterprises.pdf] 9. Priscilla Howard was 16 when she signed a binding arbitration agreement with her employer, Food, Folks & Fun, Inc. She later sued her former employer on grounds that she suffered sexual harassment during her employment and that she was constructively discharged because of her complaints about the work environment. The defendant employer filed a motion to compel arbitration regarding Howard’s claims. Howard responded by arguing that her filing of the lawsuit amounted to disaffirmance of the contract regarding the arbitration agreement. Additionally, she argues that she did not understand when she signed the arbitration agreement what the ramifications of that agreement would mean and that the defendant never informed her of what arbitration even was. The defendant argued that Howard’s disaffirmance was

not timely because it came eight months after her eighteenth birthday and had the assistance of counsel. Do you think the binding arbitration agreement was enforceable? Why or why not? [Howard v. Food, Folks & Fun, Inc., 2010 U.S. Dist. LEXIS 133190.] 10. The Finches hired Inspectech to perform a home inspection of a property they were purchasing. The contract they signed included a clause that read: “It is understood and agreed that the COMPANY [Inspectech] is not an insurer and that the inspection and report are not intended to be construed as a guarantee or warranty of the adequacy, performance, or condition of any structure, item or system at the property address. The CLIENT [the Finches] hereby releases and exempts the COMPANY and its agents and employees of and from all liability and responsibility for the cost of repairing or replacing any unreported defect or deficiency and for any consequential damage, property damage or personal injury of any nature. In the event the COMPANY and/or its agents or employees are found liable due to breach of contract, breach of warranty, negligence, negligent misrepresentation, negligent hiring or any other theory of liability, then the liability of the COMPANY and its agents and employees shall be limited to a sum equal to the amount of the fee paid by the CLIENT for the inspection and report.” After the inspection, which reported no significant defects, the Finches purchased the house. Within one week of closing, the Finches discovered water damage; prior repairs to correct said water damage; and water infiltration in the basement of their new home as well as structural problems affecting the house’s foundation. The Finches alleged that these defects were not obviously visible because of the location of a workbench owned by the sellers. They sued to recover the $39,000 they had to spend to repair the water and structural damage. Based upon this contractual language, the circuit court awarded summary judgment to Inspectech, concluding that the release prohibited the Finches from asserting their claims against Inspectech for damages they claim were occasioned by Inspectech’s failure to identify and disclose various defects in their new home. The court concluded that the clause was unambiguous and conspicuously placed in the contract and that the Finches had specifically agreed to its terms and its inclusion in the parties’ Inspection Agreement contract. On what grounds do you think the West Virginia Supreme Court overturned the granting of summary judgment to Inspectech? [David Finch and Shirley Finch v. Inspectech, LLC, West Virginia Supreme Court of Appeals, No, 11-0278, May 24, 2012, available at http://lawyersusaonline.com/wpfiles/pdfs-4/finch-v-inspectech.pdf]


Contract Law

2 12 C H A P T E R

Reality of Assent

CASE OPENER Disagreement Over an Agreement In spring 1989, Michael Jordan and the Chicago Bulls were in Indianapolis, Indiana, to play against the Indiana Pacers. At the same time, Karla Knafel was singing with a band at a hotel in Indianapolis. After Knafel’s performance, a National Basketball Association referee approached her and introduced her to Jordan by telephone. Knafel and Jordan began a long-distance telephone relationship that continued for several months. In December 1989, Knafel traveled to Chicago to meet with Jordan, where the couple had unprotected sex for the first time. In November 1990, the couple had unprotected sex again while in Phoenix, Arizona. Shortly after this second meeting, Knafel learned that she was pregnant. Knafel was convinced that she was “carrying Jordan’s baby” despite having had sex with other male partners. Later, during spring 1991, Knafel informed Jordan she was pregnant with his child. As a result of several conversations about the baby, Knafel alleged that the two had agreed that Jordan would pay her $5 million when he retired from professional basketball. In return, Knafel promised she would not file a paternity suit against him and would keep their relationship a secret. In July 1991, the baby was born. Jordan paid some hospital bills and medical costs, and he paid Knafel $250,000 for “her mental pain and anguish arising from her relationship with him.” Knafel continued to keep the relationship and paternity a secret. After Jordan retired from professional basketball, a lawsuit arose between the parties in 2000. Jordan sought declaratory judgment and an injunction against Knafel, who had been approaching him for the $5 million. Knafel filed a counterclaim for Jordan’s alleged breach of contract. The trial court dismissed all claims, but the appellate court remanded Knafel’s claim for breach of contract. Although Jordan had originally denied the existence of the agreement, on remand he did not contest the existence of the alleged settlement agreement. Instead, Jordan argued that the alleged agreement was not enforceable because it either was fraudulently induced or was based on a mutual mistake of fact. In support of his argument, Jordan produced the affidavit of Dr. Storm, who, after DNA testing, concluded that Jordan was not the child’s father. In response to Jordan’s argument, Knafel claimed that the paternity of the child was irrelevant to the enforceability of the alleged agreement. An obstetrician had told Knafel that the baby was conceived on November 19 or 20, 1990 (while she was in Phoenix with Jordan). As a result of this information, Knafel



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believed that the baby was Jordan’s. Additionally, Knafel asserted that the paternity was irrelevant because Jordan entered into the agreement knowing that she had been having sex with other men. The trial court ruled in favor of Jordan, finding that “as a result of Knafel’s fraudulent misrepresentation to Jordan that he was the child’s father or, alternatively, as a result of a mutual mistake of fact, the alleged settlement contract is voidable and is therefore unenforceable against Jordan.” Knafel appealed. 1. 2.

Imagine you are the judge in this case. Do you think that both parties were able to assent to the agreement legally? Under which ethical system, if any, should Knafel be able to recover the $5 million for breach of contract?

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

LO 12-1

Why is genuine assent important?

LO 12-2

What are the elements of mistake?

LO 12-3

What are the elements of misrepresentation?

LO 12-4

What are the elements of undue influence?

LO 12-5

What are the elements of duress?

LO 12-1

voidable A term applied to a contract that one or both parties have the ability to either withdraw from or enforce.

rescind To cancel a contract.

The Importance of Genuine Assent When two people talk to each other in the hope that an exchange will take place, all kinds of things can go wrong. Global business needs dependability. Just imagine what it would be like if “Yes” meant “Maybe”! Deals would be closed only to be reopened again and again. The costs of all purchases would soar. Businesses would be forced to charge extra to pay for all the extra time they had to spend to finally get to the point when “Yes” really meant “Yes.” To make business transactions smoother and more dependable, the law has developed rules about when “Yes” means “Yes.” As Chapter 8 explained, you need an offer and an acceptance to form a contract. Sometimes, however, there is a problem with the acceptance. Certain problems with the acceptance, or the yes, may give rise to the claim that the acceptance was not really genuine and, therefore, that the resulting contract is not valid. In this chapter, we examine the problems that may arise with an acceptance that will make the resulting contract voidable. When a contact is voidable, it may be rescinded, or canceled. The cancelation of a contract permits the person who canceled it to require the return of everything she gave the other party. At the same time, the person who rescinds the contract must


Chapter 12 Reality of Assent

herself return whatever she has received from the other party. A major theme of this chapter is that good business managers aim for genuine assent in their contracts. This chapter shows you how to achieve genuine assent. It explains the major obstacles to genuine assent: mistake, misrepresentation, undue influence, and duress. Knowing about these potential problems will help you avoid them.

Mistake When people agree to buy or sell, they do so with a particular understanding about the nature of the good or service they are about to exchange. However, one or both parties may think they consented to exchange a particular thing only to find out later that no meeting of the minds had occurred. People may misunderstand either some fact about the deal or the value of what is being exchanged. We focus on misunderstandings about facts because they are the only issues that raise the potential of rescission in American courts. European courts take a different approach to mistakes about the value of performance of a contract. In general, they agree with the reluctance of American courts to interfere with a contract just because the value of the item in question has changed since the agreement. The parties are assumed to have accepted the risk, when they made the contract, that the value might change later. However, European courts permit rescission of the contract for a mistake of value when the mistake involves more than 50 percent of the value at the time of the contract. Legal assent is absent when a legal mistake occurs. The term mistake in contract law has a special meaning that deserves special attention because it is not quite the same as the ordinary use of the term. A mistake is an erroneous belief about the facts of a contract at the time the contract is concluded. There is one more important aspect of the definition of mistake. Later in this chapter, when we discuss misrepresentation, our focus will be on incorrect beliefs about the facts of the contract caused by the other party’s untrue statements. Mistakes in contract law do not result from the untrue statements of the other party to the contract. Mistakes may be unilateral, the result of an error by one party about a material fact, that is, a fact that is important in the context of the particular contract. Alternatively, they may be mutual, shared by both parties to the agreement. This distinction is important in determining which contracts are voidable.

UNILATERAL MISTAKE In general, a unilateral mistake does not void a contract. Courts are hesitant to interfere with a contract when one of the parties has a correct understanding of the material facts of the agreement. For instance, a widow seeking to rescind her and her husband’s election to have his retirement benefits paid out over his life was not permitted to receive survivor’s pension benefits. The court held that representatives of the retirement system had provided sufficient information to the plaintiff and her husband before they elected that particular form of payout.1 Sometimes, however, rescission is permitted for even unilateral mistakes. Because our economic well-being depends so heavily on reliable contracts, we want to be fully aware of the circumstances under which unilateral mistakes permit rescission. Any of the following conditions would permit a court to invalidate a contract on grounds of unilateral mistake: 1. One party made a mistake about a material fact and the other party either knew or had reason to know about the mistake. 2. The mistake was caused by a clerical error that did not result from gross negligence. 3. The mistake was so serious that the contract is unconscionable, that is, so unreasonable that it is outrageous. 1

Ricks v. Missouri Local Government Employees Retirement System, 1999 WL 663217 (Mo. App. WD).

LO 12-2

mistake An erroneous belief about the facts of a contract at the time the contract is concluded. When a mistake occurs, legal assent is absent.

unilateral mistake The result of an error by one party about a material fact, that is, one that is important in the context of a particular contract.

mutual mistake The result of an error by both parties about a material fact, that is, one that is important in the context of a particular contract.


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Contract Law

These situations are rare, but it is important to be aware of them because any rescission can be costly in terms of time and lost opportunities.

MUTUAL MISTAKE When both parties to a contract are mistaken about either a current or a past material fact, either party can choose to rescind the contract. Rescinding such a contract is fair because any agreement between the parties was an illusion: An ambiguity in some key fact prevented the parties from being in actual agreement. The famous story of the ship Peerless2 has taught generations of students the importance of being very clear in defining material facts in any contract. The parties to the contract that led to the contract disagreement had agreed that the vessel Peerless would deliver the cotton they were exchanging. Unfortunately for them, there were two ships named Peerless. So when the deal was made, one party had one Peerless in mind while the other meant the second Peerless. The times the ships sailed were materially different, so the court rescinded the contract.

CASE Nugget A Questionable Mistake Mary W. Scott (Respondent-Appellant) v. Mid-Carolina Homes, Inc. (Appellant-Respondent) Court of Appeals of South Carolina 293 S.C. 191 (1987) Mary Scott signed a contract to purchase a repossessed 1984 mobile home from MidCarolina Homes, Inc., for $5,644, to be paid in full before delivery. She gave the salesperson a check for $2,913.71 and agreed to pay the balance before the end of the month. Within the next week, the salesman called and told her he could not sell her the home because it had a bent frame, and the South Carolina Manufactured Housing Board would not permit him to sell a home with a bent frame. She offered to buy it as is and sign a waiver, but the salesman said that would not be legal. A few weeks later, Mid-Carolina sold the mobile home to another couple for $9,220. Scott sued and was awarded $3,600 actual damages and $6,400 punitive damages for breach of contract accompanied by a fraudulent act and $3,000 actual damages for violation of a state consumer protection law. The appeals court upheld the award. On appeal, Mid-Carolina argued that it was entitled to rescind the contract because the salesperson was acting under a mistake of fact when he gave Scott the sales price. In upholding the award, the state supreme court explained that a contract may be rescinded for unilateral mistake only when the mistake has been induced by fraud, deceit, misrepresentation, concealment, or imposition of the party opposed to the rescission, without negligence on the part of the party claiming rescission, or when the mistake is accompanied by very strong and extraordinary circumstances that would make it a great wrong to enforce the agreement. Mid-Carolina had not demonstrated the presence of any of the circumstances that would justify a rescission. The salesperson was in the superior bargaining position to know the price, and the buyer’s reliance on a salesperson’s representation of the price was reasonable.


Raffles v. Wichelhaus, 159 Eng. Rep. 375 (1864).

Chapter 12 Reality of Assent


Warning: Anticipate ambiguity in the material facts and clarify them in advance to save yourself headaches later. For a mutual mistake to interfere with legal consent, it must involve all the following: 1. A basic assumption about the subject matter of the contract. 2. A material effect on the agreement. 3. An adverse effect on a party that did not agree to bear the risk of mistake at the time of the agreement. Courts will not void contracts for reason of mutual mistake if even one of the preceding attributes is missing. For instance, to rise to the level of a basic assumption, the mistake would need to be about the existence, quality, or quantity of the items to be exchanged. To meet the second condition, the mistake must involve the essence of the agreement. A fact is material when it provides a basis for a person’s agreement to enter into the contract. In the case opener, Knafel was basing her appeal on the argument that the paternity of her baby was not material to Jordan’s decision to enter into the contract. Do you think she has a good argument? The second element is not satisfied when the person attempting to avoid the contract simply claims that the item to be exchanged is not the one he had intended to exchange. The third condition is necessary to protect those who bargain with someone who agreed, at the time of the agreement, to bear the risk of mistake but then later wants to avoid that risk when the contract does not work out as well as he or she had planned. This situation might arise, for instance, if the adversely affected party had agreed in the contract to accept the items as is but later felt they were not worth the price paid. Case 12-1 illustrates the application of this doctrine of mutual mistake.

CASE 12-1


FACTS: When the plaintiff and defendant divorced in 2006, they split their $13.5 million in assets. Most of the plaintiff’s $5.4 share of the settlement was invested in Bernie Madoff’s Ponzi scheme, whereas the defendant received a cash settlement. Then in 2008, the plaintiff thought the terms of the divorce contract should be renegotiated because he lost almost all of his divorce proceeds when it came to light that his investment in Madoff’s business turned out to be fraudulent. The plaintiff further argued that both he and his ex-wife had shared in the mistake of investing funds into Madoff’s project, yet only the plaintiff received the invested funds in the divorce settlement, and the defendant received cash. The plaintiff also argued that because his funds never existed as an investment because they had already vanished in the Ponzi scheme, he never really received an equal share of their existing assets. Thus, he asked the defendant whether the two could renegotiate

the contract. When she refused, the plaintiff sued. A lower court granted the plaintiff the right to sue. The defendant appealed this decision. ISSUE: Should the plaintiff be permitted to use a mutual mistake claim in the context of a marital settlement agreement? REASONING: A plaintiff may be permitted to use a mutual mistake claim in the context of a marital settlement agreement if the mutual mistake existed at the time that the contract was entered into and if the mistake is “material.” In this case, the core allegation underpinning husband’s mutual mistake claim—that the Madoff account was nonexistent when the parties executed their settlement agreement in June 2006 does not amount to a material mistake of fact as required by our case law. The premise of husband’s argument is that the parties mistakenly believed

(continued) that they had an investment account with Bernard Madoff when, in fact, no account ever existed. In husband’s view, this case is no different from one in which parties are under a misimpression that they own a piece of real or personal property but later discover that they never obtained rightful ownership, such that a distribution would not have been possible at the time of the agreement. But that analogy is not apt here. Husband does not dispute that, until the Ponzi scheme began to unravel in late 2008—more than two years after the property division was completed—it would have been possible for him to redeem all or part of the investment. In fact, the amended complaint contains an admission that husband was able to withdraw funds (the amount is undisclosed) from the account in 2006 to partially pay his distributive payment to wife. Given that the

mutual mistake must have existed at the time the agreement was executed in 2006, the fact that husband could no longer withdraw funds years later is not determinative. Given the extensive and carefully negotiated nature of the settlement agreement, we