Contemporary Business and Online Commerce Law, 7E Henry R. Cheeseman Instructor Manuals.pdf

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Type:

Instructor Manual

Contemporary Business and Resource: Online Commerce Law Edition:

7th Edition

Author(s):

Henry R. Cheeseman

Legal Heritage and the Information Age 1

Chapter 1 Legal Heritage and the Information Age

What Is The Law And Where Do We Find It? Learning Objectives 1. Define law.

2. Describe the functions of law.

3. Explain the development of the U.S. legal system.

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

5. Explain the development of the U.S. legal system.

I.

Teacher to Teacher Dialogue

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

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

The plus side of this dilemma is that because we have such a diverse menu to select from, we are able to pick and choose our areas of emphasis. For example, if your particular teaching and research interests lie in the area of ethics and the schools of jurisprudential thought from which they are derived, then by all means, run with it! Rather than trying to be all things to all people, it is better to focus your efforts on your strengths. This does not mean that you can shortchange the other material. All key objectives of the chapter should be fully outlined and incorporated in both your lecture and materials outline. But if you have a particular interest and expertise in, for example, the Law and Economics School of jurisprudential thought, then use them as focal points of comparison in the evolutionary process that seeks to distinguish the older schools of jurisprudence from newer approaches to these issues. In any event, remember that philosophical .

2 Chapter 1

studies of what law is and what its role is in the larger scheme of things have always posed questions virtually impossible to answer. As has been mentioned, this chapter represents attempts by great thinkers to answer the unanswerable. It would be far too presumptuous for us to think that we can teach, in a few hours, what the great philosophers of the world have tried to do over hundreds of years. Perhaps this is an early lesson in what wisdom is really all about: the more we know of history, the more we know of our own limitations. If we can get that point across, the course is off to a good start.

II.

Text Materials

What Is Law? ▪ The law consists of rules that regulate the conduct of individuals, businesses, and other ▪ ▪

organizations within society.

It is intended to protect persons and their property against unwanted interference from others.

The law forbids persons from engaging in certain undesirable activities.

Functions of Law ▪ Keeping the peace o Including making certain activities crimes ▪ Shaping moral standards o e.g., enacting laws that discourage drug and alcohol abuse ▪ Promoting social justice o e.g., enacting statues that prohibit discrimination in employment ▪ Maintaining the status quo o e.g., passing laws preventing the forceful overthrow of the government ▪ Facilitating orderly change o e.g., passing statutes only after considerable study, debate, and public input ▪ Providing a basis for compromise o Approximately 90 percent of all lawsuits are settled prior to trial ▪ Facilitating planning o e.g., well-designed commercial laws allow businesses to plan their activities, allocate their resources, and assess their risks ▪ Maximizing individual freedom o e.g., the rights of freedom of speech, religion, and association granted by the First Amendment to the U.S. Constitution Fairness of the Law ▪ The American legal system is one of the most comprehensive, fair, and democratic systems of law ever developed and enforced.

Flexibility of the Law ▪ U.S. law evolves and changes along with the norms of society, technology, and the growth and expansion of commerce in the United States and the world.

Landmark Law: Brown v. Board of Education This discusses the application of law where the Supreme Court overturned the “separate but equal” that condoned separate schools for black children and white children.

▪ doctrine Supreme Court reversed prior precedent of Plessy v. Ferguson (1896). .

Legal Heritage and the Information Age 3

▪ ▪

Court held that the separate but equal doctrine violated the Equal Protection Clause of the Fourteenth Amendment to the Constitution.

The case demonstrates that one supreme Court can overrule prior Supreme Court cases to promote justice.

School of Jurisprudential Thought ▪ Natural Law School o Postulates that law is based on what is “correct” o Law should be based on morality and ethics ▪ Historical School o Believes that law is an aggregate of social traditions and customs ▪ Analytical School o Maintains that law is shaped by logic ▪ Sociological School o Asserts that law is a means of achieving and advancing certain sociological goals ▪ Command School o Believes that law is a set of rules developed, communicated, and enforced by the ruling party ▪ Critical Legal Studies School o Maintains that legal rules are unnecessary and that legal disputes should be solved by applying arbitrary rules based on fairness ▪ Law and Economics School o Believes that promoting market efficiency should be the central concern of legal decision making History of American Law English Common Law ▪ Law developed by judges who issued their opinions when deciding a case ▪ The principles announced in these cases became precedent for later judges deciding similar cases.

▪ The English Common Law can be divided into cases decided by the: o Law courts o Equity courts (Court of Chancery) o Merchant courts International Law: Command School of Jurisprudence of North Korea. North Korea’s legal system is based on communist theory and the Command School of Jurisprudence.

International Law: The Adoption of English Common Law in America. All states except LA base their legal system on the English Common Law. Law, equity, and merchant courts have been merged. U.S. law is currently a combination of law created by the judicial system and by congressional legislation.

International Law: Civil Law System of France and For Many ▪ The Romano-Germanic civil law system is the model for countries adopting civil codes.

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▪ ▪ ▪ ▪

The Civil Code and the parliamentary statues that expand and interpret it are the sole sources of law in most civil law countries.

The adjudication of a case is the application of the code or the statutes to a particular set of facts.

In some civil law countries, court decisions do not have the force of law.

This is contrast to Anglo-American common law where laws are created by the judicial system as well as by congressional legislation.

Sources of Law in the United States The U.S. Constitution is the supreme law of the land. Constitutions establish the legislative (make law),▪ executive (enforce law), and judicial (interpret law) branches of government.

Constitutions

▪

▪ ▪

o The U.S. Constitution establishes the federal government and enumerates its powers. o Powers not given to the federal government are reserved to the states. o State constitutions establish state governments and enumerate their powers. o The U.S. Constitution is the supreme law of the land. Constitutions establish the legislative (make law), executive (enforce law), and judicial (interpret law) branches of government.

Codified Law o Statutes are enacted by Congress and state legislatures. o Ordinances are enacted by municipalities and local government agencies. o Both establish courses of conduct that must be followed by covered parties.

Treaties o The president, with the advice and consent of the Senate, may enter into treaties with foreign governments.

Executive orders o Issued by the president and governors of states o They regulate the conduct of covered parties.

Contemporary Environment: How a Bill Becomes a Law? 1 Bill is introduced in one house of congress. . Bill is referred to committee.

2 If committee gives vote, the bill goes to full congress. If second chamber vetoes, it . goes to combined committee.

3 Bill goes to president if it gets majority vote. . President signs or vetoes Bill becomes a law.

4 . Law: Health Care Reform Act of 2010 Landmark 5 1. . Goal was to increase number of persons having health care.

2.

6 Most must have minimum or pay tax penalty.

3. Same subsidies and tax credits. . Funded through tax and other means.

4.

5. There are a number of protests.

Sources of Laws in the United States .

Legal Heritage and the Information Age 5

▪

▪

▪

Administrative agency regulations and orders o Administrative agencies are created by the legislative and executive branches of government. o They may adopt administrative regulations and issue order that regulate the conduct of covered parties.

Judicial decisions o Federal and state courts decide controversies o In doing so, they issue decisions that state the holding of each case and the reasoning used by the court in reaching its decision.

Doctrine of Stare Decisis ▪ Based on the common law tradition, past court decisions become precedent for deciding future cases.

▪ Lower courts must follow the precedent established by higher courts.

▪ Thus, all federal and state courts in the United States must follow the precedents established by U.S. Supreme Court decisions.

▪ Adherence to precedent is called stare decisis.

Priority of Law in the United States ▪ The U.S. Constitution and treaties take precedence over all other laws. statues precedence over federal regulations.

▪ Federal Valid federal lawtake takes precedence over conflicting state or local law.

State constitutions rank as the highest state law.

▪ State statues take precedence over state regulations.

Valid state law takes precedence over local laws.

▪ ▪ ▪ Immigration to the United States ▪ We are a country of immigrants.

▪ Law administered by the USCIS. ▪ Citizenship required.

International Law: Immigrants Who Came Through Ellis Island. This box describers Ellis Island and its purpose.

III.

Answers to Critical Legal Thinking Cases

Fairness of the Law 1.1.

Most students will react that the statute is unfair as it does not afford women equal status in the workplace. In light of today’s standards, that position is well founded. However, it is a useful exercise to consider arguments for the opposite position in the context of the time period. In enacting such a statute, the legislature presumably entertained the view that women had special needs, were subject to certain weaknesses, and therefore the demands made on them had to be accommodated in the workplace. That these premises, i.e., special needs and presumed weaknesses, might be false does not necessarily preclude one from acting morally. Moralists might label this ignorance as excusable in that it is “invincible,” i.e., an ignorance that cannot be destroyed or offers no moral reason for doing so. Of course, modern experience and knowledge require that we question these premises. It almost certainly would not be lawful today. Not only have the items relevant to the test of equal protection broadened under present constitutional interpretations, but Title VII of the Civil Rights Act of 1964 prohibits any discrimination

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on the basis of sex in the “terms, conditions and benefits of employment.”

W.C. Ritchie & Co. v. Wayman, 91 N.E. 695 (Ill. 1910).

IV.

Answers to Ethics Cases

1.2.

The better case is made by the dissent. The law has not been progressive in this instance.

It is likely that legislators entertained an unconscious premise that women should not be required to fight a war. This speculation might be supported by the fact that the majority of the Supreme Court summoned a technical legal point to justify their ruling. The Court held that Congress was the proper party to articulate the public policy that women should not fight at the front, thereby removing themselves from any further consideration of the substantive issue, i.e., whether equality was being served as a matter of fairness. Rostker, Director of the Selective Service v. Goldberg, 453 U.S. 57, 101 S.Ct. 2646, 69 L.Ed.2d 478 (1981).

V.

Answer to Policy Case

1.3

Grutter v. Bollinger Facts: Grutter was denied admission to Michigan’s law school. The school used race as one of the factors (“a plus factor”) in the admissions process. This is an appeal from a reversal of a district court’s ruling in favor of Grutter who alleged, in a class action suit, a violation of the Equal Protection Clause of the Fourteenth Amendment. Racial classes must be analyzed under strict scrutiny.

Does the University policy of using race being applied as “a plus factor” in the law school admission’s process violate the Fourteenth Amendment’s Equal Protection Clause?

No. This does not unduly harm minority applicants. The Supreme Court affirmed the decision of the Court of Appeals.

Grutter v. Bollinger and the University of Michigan Law School, 539 U.S. 306, 123 S.C. 230J, 2003 U.S. Lexis 4800 VI.

Answer to “Briefing the Case” Writing Assignment 1. Case Name, Citation, and Court Anheuser-Busch Inc. v. Schmoke, Mayor of Baltimore City 63 F. 3d 1305 (1995) United States Court of Appeals for the Fourth Circuit 2.

Summary of Key Facts A. In January 1994, the city of Baltimore enacted ordinance 288 that prohibited the outdoor advertising of alcoholic beverages in certain locations in Baltimore City.

B. According to the ordinance, outdoor advertising of alcoholic products can be continued in certain commercial and industrial areas of the city.

C. The areas chosen for the ban were more closely connected to the presence of children.

D. The ban was designed to reduce the exposure of children to unavoidable and involuntary outdoor ads for alcoholic products.

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Legal Heritage and the Information Age 7

E. The basis for the ban is that it contributed to underage drinking and variety of social problems related to use of alcohol by minors.

F. Anheuser-Busch, Inc. contends that this ban constitutes an impermissible restriction on its rights to commercial free speech.

3. The Issue Does this ordinance, as applied by Baltimore City, impermissibly restrict the commercial free speech of Anheuser-Busch, Inc.?

4. Holding No. Summary of the Court’s Reasoning 5.

A. The Court of Appeals for the Fourth Circuit found that the government has a reasonable interest in keeping alcoholic beverages away from minors and that this method of limiting advertising materially advanced that government interest.

B. Although the ordinance as applied was not a “perfect fit,” the problem of underage drinking is severe enough to permit the ordinance to stand. It falls within the range of limitations tolerated by the First Amendment for the regulation of commercial speech.

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Chapter 2

Chapter 2 Constitutional Law for Business and E-Commerce

Why Can’t We Yell Fire In A Crowded Theater?

Learning Objectives: 1. Describe the concept of federalism and the doctrine of separation of powers.

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

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

4. Explain how the freedoms of speech, assembly, religion, and the press are protected by the First Amendment and how commercial speech may be limited.

5. Explain the doctrines of equal protection and due process.

I.

Teacher-to-Teacher Dialogue

Constitutional law is, for many legal academics, not only their reason for loving to teach but it also provides the ultimate challenge in illustrating the constant balance of competing but legitimate rights of the individual vis-à-vis the larger society. The only major drawback to this material is the frustration of having the time constraints inherent in a survey course.

Because of these time limitations, teaching efforts might best be concentrated on two main objectives: 1. The concepts of federalism, dual sovereignty, and the balancing of rights among the often-competing sovereigns of federal and state government.

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

The most impressive fact that surfaces in the study of the Constitution is that it never changes but it always changes. This underscores the importance of the courts. To watch students as they uncover the mysteries found in this document is well worth the effort. *The key objective of this chapter is to introduce students to the role of the U.S. Constitution and its pivotal role in the ultimate distribution of powers between the federal government and the states vis-à-vis the control of business conduct in the United States. This aspect of the chapter will introduce students to key terms which they will be using throughout the rest of the course such as substantive and procedural due process and the like. In all likelihood, because of the

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Constitutional Law for Business and E-Commerce9

breadth of materials covered, the lecture/discussion format will work best for purposes of illustrating as much of the material as possible in the time allowed.

II.

Text Materials

The U.S. Constitution Serves Two Major Functions: 1. It creates the three branches of government (executive, legislative, and judicial) and allocates powers to these branches.

2. It protects individual rights by limiting the government’s ability to restrict those rights.

Federalism and Delegated Powers: ▪ Federalism is the U.S. form of government. The federal government and the 50 state governments share powers.

▪ Reserved Powers: Any powers that are not specifically delegated to the federal government by the Constitution are reserved to the states.

▪ Enumerated Powers—certain powers delegated to the federal government by the states.

Doctrine of Separation of Powers: •

Article I of the Constitution establishes the legislative branch of government.  The part of the government that consists of Congress: ▪ The Senate ▪ The House of Representatives

•

Article II of the Constitution establishes the executive branch of government.  The part of the government that consists of: ▪ The President ▪ The Vice President The president is selected by the Electoral College, not elected by popular vote.

Article III of the Constitution establishes the judicial branch of government.  The part of the government that consists of: ▪ The Supreme Court ▪ Other federal courts that may be created by the Congress 

•

•

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

The Supremacy Clause: • Supremacy Clause—establishes that the federal constitution, treaties, federal laws, and federal regulations are the supreme law of the land.  State and local laws that conflict with valid federal law are unconstitutional.

Case 2.1: U.S. Supreme Court Speaks: Attorney General of Maine v. New Hampshire Motor Transport Authority, 552 U.S. 364, 128 S.Ct., 989, Web 2008 U.S. Lexis 2008 (2010) Facts: U.S. Congress enacted the Federal Motor Carrier Act, among others, deregulating the trucking industry. Maine adapted a statue regulating the industry forbidding non–Maine-licensed tobacco retailers from accepting a delivery and forbidding them from transporting a tobacco product to anyone in Maine. Truckers sued claiming preemption by the Federal statue. The U.S.

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10 Chapter 2

Court of Appeals upheld a district court decision holding the federal law did preempt the Maine statute. Maine appealed the decision.

Issue: Does federal law preempt the Maine statute here?

Decision: Yes, the decision was affirmed.

Reason: The state statute conflicts with the competitive market taxes designed by the federal statutes. If Maine could do it, all states could do it and this is not the purpose of the preemption concept.

Case 2.2: The Supreme Court Speaks: Crosby, Secretary of Administration and Finance of MA v. National Foreign Trade Council, 530 U.S. 3b3, 120 S.Ct. 2288, Wels 2000 U.S. Lexis 4153 (2000) Facts: The National Foreign Trade Council filed a lawsuit against MA to have the state law banning MA from purchasing goods and services from companies doing business with Myanmar declared unconstitutional. Congress had passed a statute giving the President the power to regulate dealings with Myanmar. From rulings in favor of the Council MA appeals.

Issue: Did the MA anti-Myanmar statute violate the Supremacy Clause?

Decision: Yes. The lower decisions were affirmed.

Reason: The MA statute conflicted with the federal law. Congress could not have intended on giving the president power which could be preempted by state statutes such as the one from MA. Commerce Clause: ▪ A clause of the U.S. Constitution that grants Congress the power “to regulate commerce with foreign nations, and among the several states, and with Indian tribes.”

▪ Because this clause authorizes the federal government to regulate commerce, it has a greater impact on business than any other provision in the Constitution.

Federal Regulation of Interstate Commerce: ▪ The commerce clause also gives the federal government the authority to regulate interstate commerce.

▪ The federal government may regulate: o Interstate commerce that crosses state borders o Intrastate commerce that affects interstate commerce Landmark Case: Heart of Atlanta Motel v. United States. In this case, the Supreme Court said that the Civil Rights Act of 1964 properly regulates interstate commerce and thus discrimination in the hotel that was readily accessible to U.S. highways was prohibited.

Note: Interstate Commerce Clause (The Dichotomy) Baseball—Wichard v. Filburn—Today—Gun-Free School Zone Act State and Local Government Regulation of Business: ▪ Police Power—the power of the states to regulate private and business activity within their borders.

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Constitutional Law for Business and E-Commerce 11

▪

No:

States may enact laws that protect or promote the public health, safety, morals, and general welfare as long as the law does not unduly burden interstate commerce.

1. Discrimination 2. Undue burden a. Cannot limit length of passenger trains b. No antifederal ban on truck length c. Permissible local road weight controls.

Cyber Law: E-Commerce and the Commerce Clause A Michigan law permitting Internet sale of wine (among other methods) that discriminated against the other state wineries violated the U.S. Constitution by imposing an undue burden on intestate e-commerce.

State and Local Government Regulation of Business: ▪ State and local governments may regulate: ▪

o Interstate commerce within their borders o Intrastate commerce not exclusively regulated by the federal government Zoning ordinances, state environmental laws, corporation and partnership laws, and property laws are enacted under this power.

Landmark Law: The Bill of Rights The first 10 amendments to the U.S. Constitution are known as the Bill of Rights. In addition, there are 17 other amendments.

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

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

▪ The U.S. Supreme Court places speech into three categories: o Fully protected o Limited protected o Unprotected Note: 1. Commercial speech is subject to time, place, and manner restrictions.

2. Symbolic speech is also protected.

3. State can define what constitutes obscene speech.

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12 Chapter 2

Court Tests 1. Compelling Interest Test (Strict Scrutiny)—Government action sustained only if: a. Overriding or compelling government interest involved b. Government is using narrowest possible means.

2. Reasonable Basis Test—Government action constitutional if: a. Government is pursuing legitimate government purpose b. Some reasonable basis for the action 3. Intermediate Test—Government action sustained if: a. Pursuit of important government objectives b. Significantly related to the attainment of these objectives Use Test 1 for fundamental rights and suspect classifications. Use Test 2 for all others except for classes based on sex or sometimes age—then use Test 3 Case 2.3: The Supreme Court Speaks: Citizens United v. Federal Election Commission, 130 S.Ct. 876, 175 L.Ed. 2d 753, Web 2010 U.S. Lexis 766 (2010) Facts: The documentary “Hillary” depicted Senator and presidential primary Clinton in a very critical light. It was produced by Citizens United (CU) who wanted to promote the movie with ads. CU sued the Federal Election Commission (FEC) alleging violation of free speech. They were challenging Section 441b of the federal campaign law prohibiting corporations and labor unions from using general ways to promote election or defeat of a political candidate. This law is administered by FEC. Issue: Do the challenged restrictions violate CU’s right to free speech?

Decision: Yes. In a 5–4 decision the court held that CU’s free speech rights had been violated.

Reason: The court had recognized that free speech rights extend to corporations and to do otherwise would be censorship. The speech in question contributes to the debate, which is indispensible to decision making.

Case 2.4: The Supreme Court Speaks: Mainstrem Marketing Services, Inc. FTC and FCC, 358, F.3d1228, Web 2004 U.S. App. Lexis 2564 (2004) U.S. Court of Appeals 10th Circuit Facts: FTC and FCC created donor-call registry (the list) prohibiting commercial telemarketers from calling any one on the list. Only charities and fundraisers can call. MMS sued claiming a violation of right to free speech. The FTC and FCC argued a proper regulation of commercial speech (the unsolicited calls).

Issue: Are unsolicited telemarketing calls commercial speech which can be constitutionally regulated by the list?

Decision: Yes. The registry restriction does not violate MMS’s right to free speech.

Reason: The list restricts only commercial calls. It targets calls that include customers privacy; it is an opt-in program, and it allows the government’s ability to protect abusive invasions of privacy. It does act to stop other sales attempts. The list features are within the purpose of the regulation.

Cyber Law: Broad Free-Speech Rights Granted in Cyberspace There is discussion of the Computer Decency Act sections which were declared unconstitutional in part because of its chilling effect on adult free speech.

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Constitutional Law for Business and E-Commerce 13

Freedom of Religion: ▪ The U.S. Constitution requires federal, state, and local governments to be neutral toward religion. o The Establishment Clause—prohibits the government from either establishing a state religion or promoting one religion over another. o The Free Exercise Clause—prohibits the government from interfering with the free exercise of religion in the United States.

Contemporary Environment: Second Amendment’s Right to Bear Arms. the District of Columbia’s restriction on firearms ownership violated the Second Amendment in a 5–4 decision.

Fourteenth Amendment: Equal Protection Clause ▪ As already shown earlier, the Supreme Court has adopted three different standards for reviewing equal protection cases: o Strict Scrutiny Test (also known as compelling benefit test)—applied to classifications based on race. o Intermediate Scrutiny Test—applied to classifications based on protected classes other than race (e.g., sex or age) o Rational Basis Test—applied to classifications not involving suspect or protected class.

▪ State cannot deny equal protection of the laws to any person within its jurisdiction.

Due Process Clause: ▪ The Fifth and Fourteenth Amendments both contain a Due Process Clause.

▪ These clauses provide that no person shall be deprived of “life, liberty, or property” without due process of the law.

▪ Fifth Amendment Clause—applies to federal government action.

▪ Fourteenth Amendment Clause—applies to state and local government action.

▪ Substantive due process requires that the laws be clear and not overly broad.

▪ Procedural due process usually deals with notice and ability to behave.

The Privileges and Immunities Clause: ▪ Article IV of the Constitution and the Fourteenth Amendment contain a Privileges and ▪ ▪

Immunities Clause.

This clause prohibits states from enacting laws that unduly discriminate in favor of their residents.

This clause applies only to citizens. o Corporations are not protected.

Note: No discrimination with respect to essential activites without a substantial reason.

P & I Clause Reasons 1. Acceptable Discrimination a. Recreational hunting license b. Higher tuition costs to state universities for non–tax-paying out-of-staters 2. Unacceptable Discrimination a. Commercial fishing license extreme difference .

14 Chapter 2

b. Right to own property International Law: Human Rights Violations in Myanmar. The human rights issue in Myanmar is discussed.

Answers to Critical Thinking Cases III. Commerce and Supremacy Clauses 2.1.

Yes, the fleet purchase standards are the result of a carefully devised regulatory scheme.

They must comply with federal specs and any state id to pass their tests and undo this scheme. Engine Managers Assoc. v. Santa Coast Air quad tics Mgt. District . 541 U.S. 241, 124 S. Ct. 1756, Web 2004 U.S. Lexis 32 32

Treaty with Native Americans 2.2

Yes, the Ojbue Treaty of 1837 was still valid and had not been extinguished when Minnesota entered into the Union. There was no other Congressional intent to abrogate the rights given by the treaty. Minnesota v. Mille Lass Bard at Chippewa Indians, 526 U.S. 172, 119 S.Ct. 1887, Web 1999 U.S. Lexis 2190

Separation of Powers 2.3.

The U.S. Supreme Court held that the President’s seizure of the steel mills was a violation of separation of powers and unconstitutional. The court held that the seizure order could not stand. Youngstown Company v. Sawyer, Secretary of Commerce, 343 U.S. 579, 72 S.Ct. 863, 96 L. Ed. 1153 (1952).

Privileges and Immunities Clause 2.4.

No, the Alaska Hire statute is not constitutional. The Privileges and Immunities Clause of the U.S. Constitution provides that “the citizens of each state shall be entitled to all privileges and immunities of citizens in the several states.” With few exceptions, this clause prohibits a state from favoring its residents over residents of other states in granting privileges or rights. The U.S. Supreme Court held that the Alaska Hire statute that required that employers give preference to hiring Alaska residents over residents of other states violated the Privileges and Immunities Clause. In so holding, the court stated that the Constitution “was framed upon the theory that peoples of the several states must sink or swim together, and that in the long run prosperity and salvation are in union and not division.” The Supreme Court held that the Alaska Hire statute cannot withstand constitutional scrutiny. Hicklin v. Orbeck, Commissioner of the Department of Labor of Alaska, 437 U.S. 518, 98 S.Ct. 2482, 57 L.Ed.2d 397 (1978).

Commercial Speech 2.5.

Yes, the City of San Diego’s zoning ordinance which prohibits commercial billboards within the city is lawful. What is involved in this case is commercial speech. The U.S. Supreme Court held that although commercial speech such as advertising is protected by the Freedom of Speech Clause of the First Amendment to the U.S. Constitution, it is .

Constitutional Law for Business and E-Commerce 15

accorded a lesser protection than other constitutionally guaranteed expressions. The Supreme Court held that commercial speech is subject to proper time, place, and manner restrictions.

In this case, the Supreme Court held that the twin goals of the zoning ordinance—traffic safety and aesthetic values—advanced the city’s interests and justified the prohibition on commercial billboards within the city. The court reasoned that advertisers had other forms of speech to reach consumers, such as print media, handbills, television, and radio commercials. The Supreme Court held that the San Diego zoning ordinance was a proper time, place, and manner restriction on commercial speech and did not violate the First Amendment. Metromedia, Inc. v. City of San Diego, 453 U.S. 490, 101 S.Ct. 2882, 69 L.Ed.2d 800 (1981).

Equal Protection Clause 2.6.

Metropolitan Life Insurance Company (Metropolitan) wins. The Supreme Court held that the Alabama statute that taxed foreign out-of-state insurance companies at a higher rate than domestic insurance companies violated the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution. The Supreme Court found that Alabama’s aim was purely and completely discriminatory, designed only to favor domestic industry within the state, no matter what the cost to foreign corporations also seeking to do business in the state. The court stated “the Alabama domestic preference tax gives the ‘home team’ an advantage by burdening all foreign corporations seeking to do business within the state.” The court held that under the circumstances, promotion of domestic business by discrimination against nonresident competitors is not a legitimate state purpose. The court found no rational basis for the discriminatory tax, and held it to be an unconstitutional violation of the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution. Metropolitan Life Insurance Company v. Ward, Commissioner of Insurance of Alabama, 470 U.S. 689, 105 S.Ct. 1676, 84 L.Ed.2d 751 (1985).

IV.

Answers to Ethics Cases

2.7.

The Supreme Court held that Congress had the part to enact the Drivers Privacy Protection Act. The United States had argued that the tax personal information in question is a part of intestate commerce. The intervention is used in the stream of commerce. Appellees’ prosecution for burning a flag in violation of the Act is inconsistent with the First Amendment. Although flag desecration, like virulent ethnic and religious epithets, vulgar repudiations of the draft, and scurrilous caricatures is deeply offensive to many, the Government may not prohibit the expression of an idea simply because society finds the idea itself offensive or disagreeable. United States v. Eichman, 496 U.S. 310, 110 S.Ct. 2404, 110 L.Ed.2d 287 (1990).

2.8.

V.

Answers to Public Policy Cases

2.9

This display of the Ten Commandments violated the Supremacy Clause. The First Amendment requires government religion neutrality. The secular purpose of acting must be genuine. Here the impression of events dictates this. This focused on religion and .

16 Chapter 2

carrying anything else would have be a sham in this case.

McCreay County, KY v. ACLU of KY, 565 U.S. 844, 125 S.Ct. 2722, Web 2005 U.S. Lexis 5211 VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Lee v. Weisman 112 S.Ct. 2649 (1992) United States Supreme Court Key Facts 2. A. The policy of public schools in Providence, R.I. has been to invite members of the clergy

3.

4.

to give invocations and benedictions at middle and high school graduations.

B. These invitations were issued at the discretion of school principals. Not all of them elected to take part.

C. Robert E. Lee, principal of Nathan Bishop Middle School in Providence invited Rabbi Leslie Gutterman to deliver prayers at the school’s graduation.

D. Rabbi Gutterman followed the school’s guidelines for such prayers as set out in “Guidelines for Civic Occasions.”

E. Deborah Weisman, a graduating student from Nathan Bishop Middle School, objected to prayer policy and sought a temporary restraining order in the U.S. District Court for the District of Rhode Island.

F. The District Court denied the motion based on lack of time to consider it. The graduation went forward with the prayer policy.

G. Deborah Weisman attended the graduation and then sought a permanent injunction against the prayer policy at future graduations.

H. The District Court held in favor of Deborah Weisman and issued a permanent injunction.

Issue Does the “Establishment Clause” of the U.S. Constitution prohibit the use of prayer policy at Providence schools’ graduation ceremonies?

Holding

Yes. 5. Court’s Reasoning A. The Supreme Court held that the Establishment Clause calls for a three-part test for a practice to be allowed: 1. The practice must clearly reflect a secular purpose.

2. The practice must have a primary effect that neither advances nor inhibits religion.

3. The practice must avoid excessive government entanglement with religion.

B. The net effect of the Providence prayer policy was to coerce participation in the prayer service as part of the graduation ceremony.

C. The policy failed to conform to the three-part Establishment Clause test because of the compulsive nature of attendance at the graduation ceremony, which, in effect, forced unwilling students to participate in a religious exercise.

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Courts and Jurisdiction 17

Chapter 3 Courts and Jurisdiction

How Do The Courts Work?

Learning Objectives: 1.

2.

3.

4.

5.

I.

Describe state court systems Describe the federal court system.

List and describe the types of decisions that are issued by the U.S. Supreme Court.

Compare the jurisdiction of state courts with that of federal courts.

Define personal jurisdiction, standing to sue, and venue Teacher-to-Teacher Dialogue

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

Among these is the average undergraduate’s notion of how trials are conducted and the role of attorneys in that process. Invariably these perceptions center on popular television series such as “Law and Order” and “Court TV”. This is not all bad. Current media focus on numerous lawrelated issues has generated a whole new wave of public interest in the workings of our legal system. The downside is that the media has created many myths on the folklore of law and lawyers. In the world of pop culture, no one knows until the end who really did it until a surprise witness shows up to identify the bad guy. In more modern versions, the attorney first has a business relationship with the client and then proceeds to get him or her acquitted. Regardless of the outcome, the process is always full of glamour and intrigue.

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

Trials are long, tedious, emotionally and financially draining processes for all parties concerned.

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

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

Additionally, a fair amount of time should be spent reviewing the growing trend toward alternative dispute resolution (ADR) mechanisms. Personal experience examples might be helpful

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18 Chapter 3

in illustrating the growing trends toward ADR. To complete the cycle we can then proceed to itemize the key steps used in a court trial in this chapter and in these that follow.

II. Text Materials There are two major court systems in the United States: 1. The federal court system 2. The court systems of the 50 states and the District of Columbia Each of these systems has jurisdiction to hear different types of lawsuits.

The State Court Systems: 1. Limited Jurisdiction Trial Courts a. Hears matters of a specialized or limited nature i. Traffic courts ii. Juvenile courts iii. Justice-of-the-peace courts iv. Probate courts v. Family law courts vi. Small claims courts vii. Courts that hear misdemeanor criminal law cases and civil lawsuits under a certain dollar amount 2. General Jurisdiction Trial Courts a. Hears cases of a general nature that are not within the jurisdiction of limitedjurisdiction courts b. Testimony and evidence at trial are recorded and stored for future reference 3. Intermediate Appellate Courts a. An intermediate court that hears appeals from trial courts b. Reviews the trial court record to determine if there have been any errors at trial that would require reversal or modification of the decision Contemporary Environment: Civil Courts Specialize in Hearing Disputes This discusses its special chancery court to deal with business litigation.

The Federal Court System: 1. Special Federal Courts a. Federal courts that hear matters of specialized or limited jurisdiction b. They include: i. U.S. Tax Court ii. U.S. Court of Federal Claims iii. U.S. Court of International Trade iv. U.S. Bankruptcy Courts v. U.S. Court of Appeals for the Armed Forces vi. U.S. Court of Appeals for Veterans Affairs 2. U.S. District Courts a. The federal court system’s trial courts of general jurisdiction b. They are empower to: i. Impanel juries .

Courts and Jurisdiction 19

ii. Receive evidence iii. Hear testimony iv. Decide cases v. Most federal cases originate in federal district court 3. U.S. Court of Appeals a. The federal Court system’s intermediate appellate courts. b. These courts hear appeals from the district courts located in their circuit. c. These courts review the record of the lower court or administrative agency proceedings to determine if there has been any error that would warrant reversal or modification of the lower court decision. d. No new evidence or testimony is heard.

4. U.S. Supreme Court a. The Supreme Court was created by Article III of the U.S. Constitution. b. The Supreme Court is the highest court in the land and is located in Washington, D.C. c. The Supreme Court hears appeals from federal circuit courts of appeals and, under certain circumstances, from federal district courts, special federal courts, and the highest state courts. d. No new evidence or testimony is heard e. The lower court record is reviewed to determine whether there has been an error that warrants a reversal or modification of the decision. f. The Supreme Court’s decision is final. g. To ask the Supreme Court to hear a case, a petition for certiorari must be filed. If the Court decides to review a case, it will issue a writ of certiorari. Decisions can be unanimous, majority, plurality (different reasons), tie, concurring, or dissenting.

Contemporary Environment: The Process of Choosing a Supreme Court Justice This shows how presidents can cast their ideologies on the U.S. Supreme Court.

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

This discusses the process necessary to win a review by the U.S. Supreme Court.

Case 3.1: U.S. Supreme Court Speaks: Hertz Corporation v. Friend, 130 S. Ct. 43, Web 2009 U.S. Lexis 5114 (2010) Facts: Friend, a California resident, sues Hertz in California for damages under California wages and hour laws. Hertz sought removal of federal court under diversity. Hertz does agent deal at business in California. Friend says Hertz is a citizen of California and thus no diversity existence.

Hertz alleges citizenship in Delaware (state of Inc.) and New Jersey (headquarters), and thus diversity District could agree with Friend.

Issue: Is Hertz a citizen of California?

Decision: No. Hertz’s is not a citizen of California.

Reason: New Jersey (headquarters) is the “real citizen”. The federal diversity jurisdiction statute provides for citizenship, in the state of the company’s principal place of business from which business is in. The latter is New Jersey, not California.

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20 Chapter 3

Case 3.2: The Court Speaks: Bartrum v. Norden, et al. 1590 App., 301 171, 823 N.E. 201, Web 2004 Ohio App., Lexis 550 (2004) Facts: Bartrum and Norden and two friends (all from Ohio) were snowmobiling in Michigan.

Bartrum was hit accidently by Norden. Norden could not stop because of the speed and the situation. Bartrum was hurt and sued the others for negligence in Ohio. Ohio court said Michigan law applied and that Michigan law said that snowmobilers assume the risks. Bartrum loses and appeals alleging Ohio law applied (which had no assumption of risk rule).

Issue: Does Michigan or Ohio law apply?

Decision: Michigan Law applies.

Reason: The accident took place in Michigan. It is irrelevant that they were all from Ohio.

Standing to Sue 1. Standing to sue—need to bring suit-state in the outcome 2. In persona jurisdiction—jurisdiction over the parties; summons is usually served. If parties were within state, long-arm statute extends jurisdiction to nonserved nonresident if sufficient minimum contacts exist. These are defined by long-arm statute.

3. In Rem jurisdiction—jurisdiction are the property of a lawsuit 4. Quasi in Rem jurisdiction—all laws attempt at attaching property in a state to collect judgment 5. Venue—place within a jurisdiction where case will be heard 6. Forum-selection clause—clause that designates the court to hear or for a certain jurisdiction to be applied in contract cases.

7. Long-arm statutes 8. Subject matter jurisdiction Case 3.3: U.S. Supreme Court Speaks: International Shore Co (IS). v. State of Washington Facts: IS was incorporated in DE with a principal place of business in MO with manufacturing, and distribution in many states. In Washington, Shore has sold door-todoor and sometimes at temporary locations. Washington assessed an unemployment tax on IS for the sales reported in the state. IS say they have no minimum contacts. Issue: Were there sufficient minimum contacts? Decision: Yes, the activities were neither irregular, nor casual. Reason: There needs to be SFC such that filing a suit does not of traditional natives of fair play and substantive justice. The SFC was continuous and system continues of which actives for suit arose.

Cyber Law: Obtaining Jurisdiction in Cyberspace Long-arm statutes permit courts located in one state to reach out and make people in another state come to court and defend themselves. Several courts have decided cases involving the reach of a state’s long-arm statute to obtain jurisdiction over someone in another state because of his or her Internet activities. At present the states vary from limited Internet activity being needed for jurisdiction to outside contracts also being required. The Zippo case is highlighted.

International Law: Judicial System of Japan The difference in the Japanese system is discussed. They live to avoid certain firm and contingency fees. Discerner is often limited.

.

Courts and Jurisdiction 21

III.

Answers to Critical Thinking Cases

Federal Question 3.1.

Yes, the federal courts have the jurisdiction to hear Nutrilab’s case. Federal courts have limited jurisdiction, granted to them by the Constitution and Congress. Part of this limited jurisdiction is to hear cases involving federal questions. Federal question cases are cases arising under the U.S. Constitution, treaties, and federal statutes and regulations. Federal courts have original jurisdiction to hear federal question cases.

Nutrilab was disputing the FDA’s application of a federal statute to stop their distribution of Starch Blockers. The Starch Blockers case was therefore one arising under a federal statute, and this gave the federal court original jurisdiction to hear the case. Any lawsuit, such as this one brought by Nutrilab, that involves a federal question, must be brought in a federal court. Nutrilab, Inc. v. Schweiker, 713 F. 2d 335 (7th Cir. 1983).

Jurisdiction 3.2.

Yes. The case can be removed to a federal court on the basis of diversity of citizenship. If a case over which the federal courts have concurrent jurisdiction is brought in a state court, the case can be removed to a federal court. Federal courts have concurrent jurisdiction over cases involving parties with diverse citizenship. This could be citizens of different states, a citizen of a state and a citizen of a foreign country, a citizen of a state and a foreign country where the foreign country is the plaintiff. A corporation is a citizen of the state of incorporation. The amount in question must be satisfied. The lawsuit between Allison and ITE involved a citizen of Mississippi and a citizen of Japan.

Because the amount in question was satisfied, the case could be removed to federal court.

Allison v. ITE Imperial Corp., 729 F. Supp.45, 1990 U.S. Dist Lexis 607 (S.D. Miss.).

IV.

Answers to Ethics Cases

3.3.

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

3.4.

Yes. In this case the petitioners are primary participants in an alleged wrongdoing intentionally directed at a California resident, and jurisdiction over them is proper on that basis. By trying to avoid jurisdiction, they seem to be trying to avoid responsibility.

Calder v. Jones, 465 U.S. 783, 104 S.Ct 1482, Web 1984 U.S. Lexis 4.

V.

Answers to Policy Case:

3.5.

Yes. The forum selection clause is enforceable. A forum selection clause designates the jurisdiction for certain settlements. It limits the number of jurisdictions for a potential suit. It proves confusion as to “where”. This could translate into lower costs. This was

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22 Chapter 3

reasonable and thus enforceable.

Carnival Cruise Lines, Inc. vs. Shate, 499 U.S. 585, 111S.Ct. 1522, Web 1991 U.S. Lexis 2221 VI. Answer to “Briefing the Case” Writing Assignment 1. Case Name, Citation, and Court Peoples Trust Co. of Bergen County v. Kozuck , 98 NJ Super. 235, 236 A.2d 630, 1967 N.J. Super. Lexis 389.

2. Summary of the Key Facts Plaintiff sued on a promissory note to which the defendants deny liability alleging that the plaintiffs improperly filled in the due date. Defendants also contend that service of process was defective as a matter of law because summons and complaint were left outside the door after the defendant refused to answer the door after she had appeared in the window and the doorbell had been rung. The defendant said the server said he would leave them outside. She found them on the stoop.

3. The Issue Can valid service be effected as done in this case?

4. Holding Yes. The jury’s verdict will stand.

5. Summary of the Court’s Reasoning Service must be effected in such a way as to give notice of service. One cannot avoid service by refusing to physically accept them. A person has an obligation to accept service and one’s own wrongdoing cannot be a reason for not accepting service.

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Judicial, Alternative, Administrative, and Online Dispute Resolution 23

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

Is A Trial The Best Approach?

Learning Objectives 1. Describe the pretrial litigation process and how a case proceeds through trial.

2. Describe how a trial court decision is appealed.

3. Explain the use of arbitration and other nonjudicial methods of alternative dispute resolution.

4. Describe e-courts and e-dispute resolution.

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

I

Teacher-to-Teacher Dialogue

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

Among these is the average undergraduate’s notion of how trials are conducted and the role of attorneys in that process. Invariably these perceptions center on popular television series such as “Law and Order” and “Court TV”. This is not all bad. Current media focus on numerous lawrelated issues has generated a whole new wave of public interest in the workings of our legal system. The downside is that the media has created many myths on the folklore of law and lawyers. In the world of pop culture, no one knows until the end who really did it until a surprise witness shows up to identify the bad guy. In more modern versions, the attorney first has a business relationship with the client and then proceeds to get him or her acquitted. Regardless of the outcome, the process is always full of glamour and intrigue.

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

Trials are long, tedious, emotionally and financially draining processes for all parties concerned.

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

.

24 Chapter 4

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

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

II.

Text Materials

The Pretrial Litigation Process 1. Pleadings—complaint contains a prayer for relief (must be done within the statute of limitations) while answer must be filed to avoid a default judgment 2. Discovery—examples are depositions, interrogatories, documents, and examinations— intended to prevent surprises 3. Dismissals and Pretrial Judgments—motions include a motion on the pleadings (win as a matter of fact); summary judgment(no disputed facts) Case 4.1. The Court Speaks: Toote v. Canada Dry and Pathmark, 7A.D. 3d 251 Facts: Toote claimed she fell over cases of soda stacked on Pathmark’s floor when she was shopping. She said she did not see the cases and did not know how long they had been there.

Pathmark moved for summary judgment which was denied and Pathmark appealed.

Issue: Should the motion for summary judgment have been granted.

Decision: No. Motion was denied.

Reason: The testimony does not establish, prima facie, the lack of notice by Pathmark or that it may not be held liable for an independent contractor’s negligence so the motion must be denied.

4. Settlement Conference—intended to facilitate a settlement Contemporary Environment: Cost-Benefit Analysis of a Lawsuit—The choice of whether to defend a lawsuit should be analyzed like any other business decision.

5. Trial—Phases of a trial a. Jury Selection b. Opening Statements c. The Plaintiff’s Case d. The Defendant’s Case e. Rebuttal and Rejoinder f. Closing Arguments g. Jury Instructions h. Jury Deliberation i. Entry of Judgment 6. The Appeal—by either party in a civil case after final judgment is entered; only by the defendant in a criminal case. Notice must be filed in the prescribed time. Grounds usually involve an error of law and rarely an unsupported finding of fact.

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Judicial, Alternative, Administrative, and Online Dispute Resolution 25

Ethics Case: $67 million “Lost Pounds” Lawsuit—The box discusses a potential class action lawsuit dealing with a consumer protection issue filed by administrative law judges. The action was denied.

International Law: British Legal System The English legal system is discussed.

Alternative Dispute Resolution 1. Nonjudicial means of resolving legal disputes 2. Developed in response to the expense and difficulty of bringing a lawsuit 3. ADR usually saves time and money of costly litigation 4. Types of ADR: a. Negotiations—discussions and bargaining b. Arbitration—uses an impartial third party to decide Landmark Law: Federal Arbitration Act This explains the Federal Arbitration Act and discusses which types of disputes should be arbitrated. It is interesting to note how earlier resistance to arbitration has been overcome with the passage of time combined with a society seemingly all too ready to take every dispute to court. c. Mediation—neutral third party proposes a settlement. d. Mini-Trial—involves a shortened version of a case with hopes of a settlement. e. Fact-finding—neutral third party investigates and presents evidence. f. Judicial Referee—court appointed to render a judgment.

Case 4.2. U.S. Supreme Court Speaks:Circuit City Stores, Inc. v. Adams, 532 U.S. 105, Web 2001 U.S. Lexis 2459 (2001).

Facts: In October 1995, Circuit City Stores hired Saint Clair Adams as a sales counselor. He signed a contract that included an arbitration clause that stated that all claims regarding his application or candidacy for employment would be settled exclusively by final and binding arbitration. Two years later, Adams filed an employment discrimination lawsuit against Circuit City. Circuit City sought to enjoin the court proceeding and to compel arbitration. The district court granted Circuit City’s request; the court of appeals reversed; and the U.S. Supreme Court granted certiorari.

Issue: Are employment contracts subject to arbitration if the parties have entered into a valid arbitration agreement?

Decision: Yes. Reason: The Supreme Court held that other employment contracts, including the one between Circuit City and Adams are subject to arbitration if a valid arbitration agreement has been executed.

Cyber Law: E-Dispute Resolution This involves a virtual courthouse where all is basically done electronically.

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26 Chapter 4

Administrative Law Administrative agencies are often created by Congress or the Executive Branch to help. They may regulate business. The Administrative Procedure Act sets procedures. An ALJ presides over proceedings. The agency has only the powers delegated to it. They have the powers to make rules, adjudicate, and investigate. Administrative actions can be reviewed judicially. Generally, legislature enacts a statute and creates an administrative agency. The agency administers. The agencies have legislative (rulemaking, interpreting, issuing policy statements, and licensing), judicial (ALJ) and executive powers.

Landmark Law: The Department of Homeland Security—The Homeland Security Act created the DHS to prevent terrorist attacks and minimize harm.

International Law: Solving Tribal Disputes, Mali, West Africa—Mali procedures are discussed.

III.

Answers to Critical Legal Thinking Cases

Long-Arm Statute 4.1.

Yes, the Oklahoma state court can use the state’s long-arm statute to gain jurisdiction over Magna Verde. A long-arm statute gives a court the ability to gain jurisdiction over an out-of-state business if that business has minimum contacts with the state and the maintenance of the suit does not offend traditional notions of fair play and substantial justice. The exercise of long-arm jurisdiction is generally permitted over nonresidents who have a contract that affects the state, or who transact other business in the state.

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

Minimum Contacts 4.2.

Yes, the defendants are subject to suit in California. The U.S. Supreme Court held that jurisdiction of the California court over the petitioners, who were residents of Florida, was proper because of their intentional conduct in Florida that was allegedly calculated to cause injury to plaintiff Shirley Jones in California. The Supreme Court applied the rule of International Shoe Co. v. Washington, 326 U.S. 310, that the Due Process Clause permits jurisdiction over a defendant in any state in which the defendant has “certain minimum contacts such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice.” The Court applied this rule to the case at hand and found that California was the focal point both of the article that appeared in the National Enquirer and of the distress suffered. The Court noted that the magazine has its largest circulation in California, that the defendant knew that plaintiff Shirley Jones, a professional entertainer and television personality, lived and worked in California, and that the article would have its greatest impact in California. The Supreme Court .

Judicial, Alternative, Administrative, and Online Dispute Resolution 27

concluded that the defendants, as Florida residents, must “reasonably anticipate being hauled into court” in California to answer for the truth of the statements made in the article. Thus, the minimum contacts rule and the Due Process Clause were not violated.

Calder v. Jones, 465 U.S. 783, 104 S.Ct. 1482, 79 L.Ed.2d 804 (1984).

Physical Examination 4.3.

The court will only order Schlagenhauf to be examined by an ophthalmologist. A court has the power to order the physical and mental examination of a party to a case.

However, this power is limited to situations where the physical or mental condition that is the subject of the examination is at issue in the case. The court in this case stated the rule as requiring that parties making a request for examination must make an affirmative showing that the other party’s “mental or physical condition was in controversy and that there was good cause for the examinations requested.” In this case the only issue was Schlagnehauf’s eyesight. Therefore, the court concluded that: Nothing in the pleadings would affect a basis for a belief that Schlagenhauf was suffering from a mental or neurological illness warranting wide-ranging psychiatric or neurological examinations. Nor is there anything stated justifying the broad internal medicine examination.

Therefore, the only examination that the court ordered Schlagenhauf to undergo was one conducted by an ophthalmologist. Schlagenhauf v. Holder, 379 U.S. 104, 85 S.Ct. 234, 13 L.Ed.2d 152 (1964).

Interrogatories 4.4.

Yes, Cine is required to answer the questions submitted by Allied Artists’ attorneys.

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

This information was crucial in determining potential damages in the suit. Because interrogatories are an important part of the discovery process, Cine was required to answer them in a timely and truthful manner. Cine Forty-Second Street Theatre Corp. v.

Allied Artists Pictures Corp., 602 F.2d 1062 (2nd Cir. 1979).

Judgment N.O.V. 4.5.

A Judgment N.O.V. is a motion that asserts that considering the evidence in a light most favorable to the plaintiff, the plaintiff has failed to introduce evidence sufficient for a reasonable jury to have held for the plaintiff. In other words, the judge is being asked to enter a judgment opposite of what the jury has decided because no reasonable jury could have reached the verdict that this jury has entered. The standard used by the court in this case in deciding whether to start a Judgment N.O.V. is “whether the evidence is such that there can be but one conclusion as to the verdict that reasonable men could have reached.” In this case, all of the testimony of the witnesses directly contradicted the statements of Simblest. Where Simblest claimed to have had a green light in his favor, all .

28 Chapter 4

of the other witnesses stated that the traffic light was not operating. Four witnesses also testified that they had observed the lights and sirens of the fire engine working, in direct contradiction with Simblest’s testimony. Because all of the evidence in this case favored the defendant, the judge granted the defendant’s motion for a Judgment N.O.V. Simblest v. Maynard, 427 F.2d 1 (2nd Cir. 1970).

Arbitration 4.6.

Yes, the arbitration agreement between AMF and Brunswick is valid under federal law.

To promote the arbitration of disputes, Congress has enacted the Federal Arbitration Act (FAA). The act provides that arbitration agreements involving “commerce” are valid, irrevocable, and enforceable as long as the agreement is not illegal. The arbitration agreement between Brunswick and AMF was clearly one involving commerce. Because of this fact, the court held that the FAA covered the agreement. The court gave the following reasons for enforcing the agreement, citing the language of the legislation that enacted the FAA: Arbitration agreements are purely matters of contract and the effect of the bill is simply to make the contracting party live up to his agreement.

He can no longer refuse to perform his contract when it becomes disadvantageous to him.

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

Brunswick Corp., 621 F.Supp. 456 (E.D.N.Y. 1985).

IV.

Answer to Ethics Cases

Administrative Regulation 4.7.

Yes the FCC regulation and censoring of Pacifica in this case was lawful and constitutional. The statute in question specifically forbids the use of any “obscene, indecent, or profane language by means of radio communications.” George Carlin’s “Filthy Words” monologue fit into this definition. The court held that communication broadcasting has the most limited First Amendment protection. Radio stations are subject to “time, place, and manner” restrictions regarding broadcasts. The Communication Act’s prohibition against “indecent” broadcasts was justified because broadcast media is pervasive in our lives and is uniquely accessible to children. Justice Brennan wrote a dissent addressing, in part, the rights of adults. FCC v. Pacifica Foundation, 438 U.S. 726, 98 S.Ct. 3026, 57 L.Ed. 2d 1073, Web 1978 U.S. Lexis 135 (Supreme Court of the United States)

4.8.

Yes, the service of process served on Mr. Burnham is good. A court must have personal jurisdiction over the defendant in a lawsuit. One method of obtaining personal jurisdiction over a defendant is to serve personal service on the defendant when he is within the territorial boundaries of the state. In this case, Mrs. Burnham filed a divorce action in California after she and her husband separated and she moved to California from New Jersey. She then filed a divorce action in California Superior Court, naming her husband, who lived in New Jersey, as the defendant. When Mr. Burnham was in California on business, he decided to visit his children who were living with Mrs. Burnham. When there, he was served the summons and complaint of Mrs. Burnham’s divorce action. In this case, the U.S. Supreme Court held that jurisdiction might be .

Judicial, Alternative, Administrative, and Online Dispute Resolution 29

obtained over a nonresident by personal service in the forum state. The Supreme Court reasoned that the fact that American courts have announced the rule since the latter part of the nineteenth century provides a defendant voluntarily in a particular state today with clear notice that he is subject to suit in that forum. The Court held that service of process was good in this case. Therefore, Mr. Burnham must answer and defend himself in the California divorce action filed by his wife. Burnham v. Superior Court of California, 110 S.Ct. 2105, 109 L.Ed.2d 631 (1900).

4.9.

A statute of limitations has the purposes of protecting against stale claims and stimulating assertion of fresh claims, done in a diligent fashion. Here the Norgarts had to bring the cause of action for wrongful death within one year of date of death and thus Kristi’s parents were too late by 5 years. Norgart v. The Upjohn Company, 21 Cal. 4th 383, 87 Cal. Prt. 2nd 453, Web 1999 Cal. Lexis 530 (Supreme Court of California).

V.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation and Court Gnazzo v. G.D. Searle & Co. 973 F.2d 136 (1992) U.S. Court of Appeals for the Second Circuit 2. Summary of the Key Facts A. In November 1974, Ms. Gnazzo purchased and started using an IUD developed, marketed, and sold by Searle. She continued to use it until she had it removed in December 1977 because she was being treated for pelvic inflammatory disease. She brought a product liability action against Searle in Federal District Court in May 1990.

B. Searle responded by asking for a summary judgment in their favor based on the allegation that the suit was time-barred by the Connecticut Statute of Limitations.

The lower court agreed with Searle. This is an appeal of that judgment.

3. The Issue Did the Connecticut Statute of Limitations time-bar Ms.Gnazzo’s lawsuit?

4. Holding The U.S. Court of Appeals for the Second Circuit affirmed the decision and held in favor of Searle.

5. Summary of the Court’s Reasoning A. Generally, statutes of limitations set maximum time periods during which certain actions can be brought. After the time period stated in the statute has run, as a matter of public policy, no action can be brought regardless of whether any cause of action ever existed.

B. Under Connecticut law, a product liability claim must be brought “within three years from the date when the inquiry is first sustained or discovered or in the exercise of reasonable care should have been discovered.” In May 1989, Ms. Gnazzo completed a questionnaire stating she first suspected that the IUD caused her harm sometime in 1981. She chose not to pursue the matter at that time because of domestic difficulties. She decided to bring this action after she was notified, in March 1989,

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30 Chapter 4

that she was infertile and that her condition was most likely related to pelvic inflammatory disease—induced adhesions resulting from her use of the Searle IUD. C. The Court of Appeals believed that her awareness of problems created by this product began in 1981 and that she “discovered or should have discovered through the use of reasonable care” that the Searle product caused such injury. Thus, when she decided to sue in 1990, the action was time-barred by the three-year Connecticut Statute of Limitations. State legislatures have the constitutional authority to decide when claims for injury may be brought. The Court of Appeals affirmed the lower district court decision in favor of Searle, in spite of its sympathy for Ms. Gnazzo’s condition.

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Torts and Strict Liability 31

Chapter 5 Torts and Strict Liability

Why Should They Pay? Learning Objectives: 1.

2.

3.

4.

5.

I.

List and describe intentional torts against persons.

List and explain the elements necessary to prove negligence.

Describe the business-related torts of disparagement and fraud.

Describe special negligence doctrines.

Define and apply the doctrine of strict liability.

Teacher-to-Teacher Dialogue:

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

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

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

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

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

II. Text Materials Introduction: • Tort is a French word for a “wrong”.

• Under tort law, an injured party can bring a civil lawsuit to seek compensation for a • wrong done to the part or the party’s property.

Tort damages are monetary damages that are sought from the offending party. .

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•

Tort law imposes a duty on persons and business agents not to intentionally or negligently injure others in society.

Types of torts: • Intentional • Negligence • Strict liability Intentional Torts Against Persons: • The law protects a person from unauthorized touching, restraint, or other contact.

• The law also protects a person’s reputation and privacy.

• Violations of these rights are actionable as torts.

• Assault o The threat of immediate harm or offensive contact; or o Any action that arouses reasonable apprehension of imminent harm o Actual physical contact is unnecessary • Battery o Unauthorized and harmful or offensive physical contact with another person o Actual physical contact is unnecessary Note: The Doctrine of Transferred Intent—Victim can sue •

•

False Imprisonment o The intentional confinement or restraint of another person without authority or justification and without that person’s consent o Merchant Protection Statue Misappropriation of the Right to Publicity o An attempt by another person to appropriate a living person’s name or identity for commercial purposes o Also know as the tort of appropriation

Case 5.1: The Court Speaks:Walmart Stores, Inc. v. Cockrell, 61 S.W. 3d 774, Web 2001 Tax. App. Lexis 7992 (2001) The Facts: Cockwell was strip searched after he went to the manager’s office by request as he was leaving Walmart. He even was forced to take off a bandage where he had a live transplant.

They found nothing and was let go. Cockwell sued for false imprisonment. Walmart asserted the shopkeeper’s privilege. Cockwell won.

Issue: Does the shopkeeper’s privilege protect Walmart from liability in this case.

Decision/Remedy: No. The judgment was upheld for Cockwell.

Reason: No one saw Cockwell steal. The store employees said they saw “suspicious activities,” but there was no probable clause so no reasonable search. There was evidence of unwanted anguish and Cockwell was humiliated. He was very upset.

•

Invasion of the Right to Privacy

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Torts and Strict Liability 33

A tort that constitutes the violation of a person’s right to live his or her life without being subjected to unwanted and undesired publicity Defamation of Character o False statement(s) made by one person about another. The plaintiff must prove that: a. The defendant made an untrue statement of fact about the plaintiff; and b. The statement was intentionally or accidently published to a third party o Slander—oral defamation of character o Libel—a false statement that appears in a letter, newspaper, magazine, book, photo, video, and so on o Trust is an absolute defense o Reckless disregard for the truth Intentional Infliction of Emotional Distress o A tort that says a person whose extreme and outrageous conduct intentionally or recklessly causes severe emotional distress to another person is liable for that emotional distress Malicious Prosecution • A successful defendant in a prior lawsuit can sue the plaintiff if the first lawsuit was • frivolous • Certain elements must be proven to win a lawsuit for malicious prosecution The courts do not look favorable on malicious prosecution lawsuits o

•

•

•

Contemporary Issue: Is a Rapper Liable for Demotion of Character?

This box discusses the case of DeAngelo Bailey versus Eminem for allegedly slanderous song lyrics. Eminem won.

Disparagements: • False statements about a competitor’s products, services, property, or business reputation • Untrue, published knowledge, found edge of untruth, intent to injure • Intentional misrepresentation of a material fact with the intent to deceive • Material false misrepresentation, knowledge, intent, innocent third party reliance, injury Unintentional Torts (Negligence): • Unintentional Tort o A doctrine that says a person is liable for harm that is the foreseeable consequence of his or her actions • Negligence o The omission to do something which a reasonable person would do; or o Doing something which a prudent and reasonable man would not do To be successful in a negligence lawsuit, the plaintiff must prove that: 1. The defendant owed a duty of care to the plaintiff.

2. The defendant breached the duty of care.

3. The plaintiff suffered injury.

4. The defendant’s negligent act caused the plaintiff’s injury.

• Duty of Care—the obligation not to cause any unreasonable harm or risk of harm o The courts apply a reasonable person standard .

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o Defendants with a particular expertise or competence are measured against a reasonable professional standard • Breach of Duty—a failure to exercise care or to act as a reasonable person would act • Injury to plaintiff—the plaintiff must suffer personal injury or damage to his or her property to recover monetary damages for the defendant’s negligence • Effect on the plaintiff’s life or profession Case 5.2: The Court Speaks: Clancy v. Goad, 858 N.E. 2d 653 Web 2006 Ind. App. Lexis 2576 (2006) Facts: Clancy fell asleep at the wheel of a truck, crossed the center line, and collided with Diana Goad’s motorcycle. Her leg was severed above her knee and she was thrown into a water-filled ditch. Clancy woke up and swerved into the ditch. Clancy called 911 and Robert Goad held Diana’s head above the water. She was taken to the hospital by the paramedics. She was in a coma for two weeks, lost her leg, and suffered a fractured pelvic bone, a fractured left elbow, a lacerated spleen (which was removed). The jury returned a 100 percent fault verdict against Clancy in a negligence suit and Diana was awarded $10 million in compensatory damages.

Clancy appeals claiming damages were excessive.

Issue: Were the damages excessive?

Decision: No. The trial court judgment was affirmed.

Reason: Diana was active and athletic. She earned $45,000/year as a managerial accountant. Her injuries were severe and her medical expenses totaled more than $368,000 and were expected to continue indefinitely. The award was reasonable in this case.

Case 5.3. The Court Speaks: James v. Meow Media, Inc., 300 F. 3d 683, Web 2002 U.S. App. Lexis 16185 (2002) The Facts: After watching various videos dealing with high school students dreaming of shooting teachers and classmates, and after playing regularly, certain violent interactive video and computer games, Carneal, a 14 year old brought a pistol and five shotguns to school, where he shot and killed three students and wounded many others. The parents sued the producers and distributors of the games and movies for wrongful death. The judgment was for the defendants.

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

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

Movies are basically too far removed from the classroom.

Injure to Main: • Personal Injury • Injury to property Ethics: Ouch! The Coffee’s Too Hot

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Torts and Strict Liability 35

This box discusses the famous case of a woman who sued McDonald’s when she suffered burns from their hot coffee. She won but her judgment was reduced. She won in spite of mishandling of the coffee. McDonald’s coffee was too hot with no adequate warning. There are warnings now.

Unintentional Torts (Negligence): • Causation—a person who commits a negligent act is not liable unless his or her act was the cause of the plaintiff’s injuries • Causation in face (actual cause) • Proximate cause (legal cause) • Causation in fact (actual cause) • The actual cause of negligence • A person who commits a negligent act is not liable unless causation in fact can be proven.

• Proximate Cause (legal cause) • Under law, a negligent party is not necessarily liable for all damages set in motion by his • • or her negligent act.

The law establishes a point along the damage chain after which the negligent party is no longer legally responsible for the consequences of his or her actions.

The doctrine of proximate cause was established in Palsgraf v. The Long Island Railroad Company case

Landmark Law: Palsgraf v. The Long Island Railroad Company This box discussed the case of an exploding package of firearms which injured another train passenger. No proximate cause was found. There was no invasion of a legally protected interest.

This was not foreseeable.

• Professional Malpractice—The liability of a professional who breaches his or her duty of ordinary care • Special Negligence Doctrines o Negligent Infliction of Emotional Distress o Negligence Per Se—violation of statute o Res Ipsa Loquitur—exclusive control o Good Samaritan Laws o Dram Shop Acts o Guest Statutes o Fireman’s Rule Defenses Against Negligence: • Superseding or intervening event • Assumption of the risk- needs knowledge edge and voluntary assumption • Contributory negligence—no recovery • Comparative negligence—apportioned damages Case 5.4 The Court Speaks: Lilya v. The Greater Gulf State Fair, Inc., 855 50.2d, 1049, Web 2003 Ala. Lexis 57 (2003)

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Facts: Lilya paid fee to ride a mechanical bull after watching a mechanical bull of defendant throw a rider. He had signed a release assuming all risks and acknowledging their existence. After boarding the bull for a second time, he was thrown, suffering a fractured neck. He sued. Court said he had assumed the risk.

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

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

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

Strict Liability: Strict liability is liability without fault.

A participant in a covered activity will be held liable for any injuries caused by the activity even if he or she was not negligent.

This doctrine holds that: 1. There are certain activities that can place the public at risk of injury even if reasonable care is taken; and 2. The public should have some means of compensation if such injury occurs • •

Contemporary Environment: Strict Liability Imposed on Owner of a Pet III.

Answers to Critical Thinking Cases

5.1.

The ratings and reviews are expressions of opinion. Defamation trade libel was not present. Themed Restaurants, Inc. DBA as Lucky Cheng’s v. Zagat Survey, LLC, 801 N.Y.S. 2d 38, Web 2005 NY App. D.v. Lexis 9275 (Supreme Court of NY, Appellate Division)

5.2.

Wilhelm owed a duty of care to warn Flores of the dangers of working with breaching and was negligent in not doing so. There was sufficient evidence to hold both Wilhelm and Flores 50 percent liable each. Wilhelm v. Flores, 133 S.W.3d 766, Web 2003 Tex. App. Lexis 9335 (Court of Appeals of Texas)

5.3.

The utilities were not liable. They had not breached their duty of care. The utilities did have a duty in placing the poles. This was straight lane road. The utilities could not have reasonably foreseen the dangerous actions and high speed of Mitchell. Mitchell’s negligence relieves the utilities of liability. Carter v. Indianapolis Power and Light Co. and Indiana Bell Telephone Co., Inc., 837 N.E. 2d 509, Web 2005 Ind. App. Lexis 2129 (Court of Appeals of Ind.)

5.4.

Yes. There is no liability to Hurst due to doctrine of assumptive of the risk. The risk of getting hit by a puck is well-known and inherent to the game of hockey. It is common, expected, and urgent. Hurst v. East Cost Hockey League, Inc and Knoxville Cherokees Hockey, Inc., 637 S.E. 2d 560, Web 2002 S.C. Lexis 366 (Supreme Court of SC)

Negligence Per Se 5.5.

Julius Ebanks wins. The Court held that he could recover damages from the New York City Transit Authority for the injuries suffered when his foot became caught in the .

Torts and Strict Liability 37

escalator under the doctrine of negligence per se. In a negligence per se action, the plaintiff must prove (1) that a statute existed, (2) the statute was enacted to prevent the type of injury suffered, and (3) the plaintiff was within the class of persons to be protected by the statute. Under the negligence per se doctrine, the injured party does not have to prove the plaintiff breached his duty because the statute establishes that.

The Court in this case held that the building code established the requirement that a “gap” between an escalator step and escalator wall not exceed 3/8-inch. Evidence showed that the gap in this case in which Ebanks’ foot became caught was 2 inches, therefore violating the building code. The Court held that the building code was adopted by the city to prevent the type of injury suffered by Ebanks and that he was within the class of persons to be protected by the building code. The Court held that the elements for negligence per se had been established. Ebanks v. New York City Transit Authority, 70 N.Y.2d 621, 518 N.Y.S.2d 776, 1987 N.Y. App. Lexis 17294 (N.Y.App. 1986).

Emotional Distress 5.6.

Gregory James wins. The Court held that he may recover for emotional distress he suffered when he saw his sister get killed under the doctrine of negligent infliction of emotional distress. The Nebraska Supreme Court adopted the “foreseeability” test in applying this doctrine. To be successful in a lawsuit for negligent infliction of emotional distress, the plaintiff must prove that (1) a relative was killed or injured by the defendant, (2) the plaintiff suffered severe emotional distress, and (3) the plaintiff’s mental distress resulted from a sensory and contemporaneous observance of the accident. Nebraska does not require that the plaintiff’s mental distress be manifested by some physical injury. In this case, the Court held that all of these elements applied when John Lieb, a driver for Watts trucking service, backed a truck over Demetria James, killing her as her brother Gregory watched. The Court remanded the case for proceedings consistent with its opinion. James v. Watts Trucking Service, Inc., 375 N.W.2d 109, 1985 Neb. Lexis 1209 (Neb. 1985).

5.7.

The jury decided that Walmart did not act reasonably and that it maliciously prosecuted Goodman. Punitive damages were awarded and upheld. Walmart Stores, Inc. Goodman, 789 So. 201 166, Web 2000 Alan Lexis 548 (Supreme Court of Alabam)

IV.

Answers to Business Ethics Cases

5.8.

RKO is liable. The determination of what duty of care is owed is governed by the principle that all persons are to use ordinary care to prevent others from being harmed by their conduct. Foreseeability is of primary importance in determining one’s duty. Given the nature of the contest and the use of a car that would be moving from one location to another, it was foreseeable that the station’s listeners would attempt to follow the car without regard for highway safety in order to claim prizes. Even though third parties inflicted the harm, the negligent act of RKO instigated the actions of the third parties.

Thus, RKO’s acts were a factor in the incident that resulted in the death of Weirum.

Weirum v. RKO General, Inc. 15 Cal. 3d 40, 123 Cal. Rptr. 468, 175 Cal. Lexis 220 (Cal. 1975).

V.

Answer to Policy Cases

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5.9.

Negligent infliction of emotional distress, that is judicially created allowing a family bystander damages for foreseeable tangible injuries caused by viewing a physically injured relative after a traumatic accident. These were after a test is not met. It was at least 10 to 15 minutes after the accident between learning and several minutes later before she was seen. The daughter was not visible to Colbert when he arrived. The defendant is not liable here. Colbert v. Moomba Sports Inc. and Skier’s Choice, Inc. 135 P.3d 485, Web 2006 Wash. App. Lexis 975 (Court of Appeals of Washington)

VI. Answer to “Briefing the Case” Writing Assignment 1. Case Name, Citation, and Court Braun v. Soldier of Fortune Magazine, Inc. 968 F.2d 1110 (1992) United States Court of Appeals for the Eleventh Circuit 2. Key Facts A. Michael Savage placed an ad in Soldier of Fortune Magazine where he offered his services as a “professional mercenary,” skilled in the use of guns.

B. Savage and an associate, Sean Trevor Doutre, were hired by Bruce Gastwirth and John Horton Moore to murder Gatswirth’s business partner, Richard Braun.

C. On August 26, 1985, Richard Braun was shot and killed by Doutre in the company of Savage. Braun’s son, Michael, was also shot and wounded.

D. Braun and his brother, Ian, brought a wrongful death action against Soldier of Fortune Magazine, Inc. for the death of their father. Michael Braun brought a separate tort action for his own injuries.

E. The United States District Court for the Middle District of Alabama considered both actions, and the trial jury found in favor of the Braun brothers on both claims.

3. Issue Under Georgia law, was Soldier of Fortune Magazine, Inc. tortuously liable for negligence by having published Savage’s ad describing himself as a “professional mercenary?”

4. Holding Yes. 5. Court’s Reasoning The Court of Appeals held that: A. An action for negligence in Georgia must show four elements: 1. A legal duty to conform to a standard of conduct raised by the law for the protection of others against unreasonable risks of harm.

2. A breach of this standard.

3. A showing of a legally attributable causal connection between the conduct and the resulting injury.

4. Loss or damage flowing to the plaintiff’s legally protected interest as a result of the alleged breach of the legal duty.

B. All four elements of the Georgia tort statute were met.

C. The Court of Appeals affirmed the District Court’s finding that the negligent publication of Mr. Savage’s ad constituted a proximate cause of the Braun’s injuries, and it upheld the jury awards in favor of the Braun’s.

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Chapter 6 Criminal Law and Cyber Crimes

What Does “Beyond A Reasonable Doubt” Really Mean?

Learning Objectives: 1. List and describe the essential elements of a crime.

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

3. Identify and define business and white-collar crimes.

4. List and describe cyber crimes.

5. Explain the constitutional safeguards provided by the Fourth, Fifth, Sixth, and Eight Amendments to the U.S. Constitution.

I.

Teacher-to-Teacher Dialogue:

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

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

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

The chapter moves from criminal procedure and general classification of crimes to the impact of criminal law on corporate behavior. The chapter then wraps up with an overview of how both individuals and business entities are protected from overzealous governmental intrusions into our .

40 Chapter 6

lives by way of key safeguards detailed in the U.S. Constitution. It is important to note to students that these protections do not always necessarily apply equally to people and business entities.

II.

Text Materials

Crime: Any act done by an individual in violation of those duties that he or she owes to society and for the breach of which the law provides that the wrongdoer shall make amends to the public.

Penal Codes and Regulatory Statutes: • Statutes are the source of criminal law.

• Federal and state statutes define activities that are considered to be crimes within their • jurisdictions.

Many regulatory statutes provide for criminal violations and penalties.

Parties to a Criminal Action: • In a criminal lawsuit, the government is the plaintiff.

• The government is represented by a lawyer called the prosecutor.

• The accused is the defendant.

• The accused is represented by a defense attorney.

Classification of Crimes: • Felonies—most severe • Misdemeanors—less severe • Violations—least severe Intent Crimes: • Two elements must be proven for a person to be found guilty of most crimes: o Criminal Act o Criminal Intent • Strict or absolute liability—standard for imposing criminal liability without a finding of intent.

Note: The same act may be the basis for both a criminal lawsuit and a civil lawsuit.

Non Intent Crimes: • Some states designate some non intent crimes (e.g., involuntary manslaughter) Pretrial Criminal Procedure: • Pretrial criminal procedure consists of several distinct stages including: o Arrest—usually need warrants based on probable cause o Indictment or Information ▪ Felony—grand jury—indictment ▪ Misdemeanor—magistrate—information o Arraignment o Plea Bargaining .

Criminal Law and Cyber Crimes 41

▪

Pleas: guilty, not guilty, nolo contendere

The Criminal Trial: • All jurors must unanimously agree before the accused is found guilty of the crime • • charged If one juror has reasonable doubt about the guilt of the accused, the accused is not guilty of the crime charged.

If all of the jurors agree that the accused did not commit the crime, the accused is innocent of the crime charged.

Note: a. Defendant may appeal b. Government cannot appeal c. Government may retry after a hung jury.

The Contemporary Environment: Criminal Acts as the Basis for Tort Actions Case 6.1 The Court Speaks: State of Ohio v. Wilson, 2004 Ohio 2838, Web 2004 App. Lexis 2503 (2004) Court of Appeals of Ohio Facts: After arguing with girlfriend Spear earlier in the day, Wilson poured gas from a beer bottle on Spear, ignited it, and walked away as she became engulfed in flames. She had severe burns, underwent much medical treatment, and suffered from depression. She was found dead nine months later. Wilson was convicted of aggravated murder and sentenced to 30 years to life. He appealed.

Issue: Was there sufficient causation between Wilson’s act of setting Ms. Spear on fire and Ms. Spear’s death nine months later to warrant a conviction for murder?

Decision: Yes. Conviction was affirmed.

Reason: Causal connection which is absolutely necessary can be shown from a death that occurs later from the defendant’s act. Here the maladies of Spear were the natural, probable, and foreseeable results of Wilson’s activities.

Common Crimes: Robbery: Taking of personal property of another by fear or force.

Burglary: Taking of personal property from another’s dwelling.

Larceny: Taking of personal property from other than another’s dwelling.

Theft: Summary category for previous three.

Receiving Stolen Property:Requires knowledge and intent to deprive.

Arson: Willful and malicious burning of another’s building.

Extortion: Blackmail Forgery: Fraudulent altering or making a written document affecting the legal liability of another.

Fraudulent conversion of property.

Embezzlement: Bribery: Payoffs or kickbacks Criminal Fraud: Obtaining of title to property through deception or trickery.

Murder: Unlawful killing of a human being with malice aforethought. Felony murder rule holds that the intent to commit murder is inferred from the intent to commit another crime if murder is committed during the commission of another crime. .

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Extortion: Obtaining the property of another, with his or her consent, induced by wrongful use of actual or threatened force, violence, or fear.

Criminal Conspiracy: Two or more persons enter into an agreement to commit a crime. An overt act is needed.

Money Laundering: knowingly engaging in money transactions through a financial institution involving property from an unlawful activity with money over $10,000 and knowingly engage in a financial transaction involving the proceeds of an unlawful activity.

Ethics: Corporate Criminal Liability White Collar Crimes: • Crimes that are prone to be committed by businesspersons that usually involve cunning • and deceit rather than physical force.

Examples: o Forgery o Embezzlement o Bribery o Criminal Fraud o Mail Fraud o Wire Fraud o Money Laundering o Identity Fraud Note: Corporations may be held criminally liable for actions of their officers, employees, or agents.

Landmark Law: Racketeer Influenced and Corrupt Organizations Act (RICO) The Racketeer Influenced and Corrupt Organization Act (RICO) was intended to apply only to organized crime, but it has been used against nonorganized crime defendants as well.

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

Cyber Crimes: Committed using computers, e-mail, the Internet, and other electronic means.

Case 6.2. The Court Speaks: U.S.A. v. Deppe, 509 F. 3954, Web 2007 U.S. App. Lexis 28562 (2007) U.S. Court of Appeals.

Facts: Deppe allegedly sold watches over the Internet for funds wire transferred directly to his bank account but never delivered the watches. He was convicted. He appealed arguing a reduction of his sentence for accepting responsibility.

Issue: Did the court error in not reducing Deppe’s jail sentence?

Decision: No. He deserved no reduction.

Reason: At trial account for accepting responsibility is generally retainable. The sentence has presented a sensible punishment.

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Cyber Law: Controlling Unwanted Spam The CAN-SPAM Act prohibits falsified headers in e-mail and deceptive subject lines. It also requires sexually oriented spam to contain a proper label. Opt-out alternative is required. The Act is enforced by the FTC. Cyber Law: Electronic Privacy The ECPA makes it a crime to, without consent, intercept electronic communication.

Cyber Law: Identity Theft Information about another is used to steal one’s identity.

Identity Theft and Assumption Deterrence Act (1998): • A Federal law that criminalized identify fraud • The ACT makes it a federal felony punishable with prison sentences up to 15 years.

Cyber Law: Crime of Intentionally Accessing and AcquiringInformation from a Computer.

The Information Infrastructure Protection (IIP) Act (1996): • Federal law that addresses computer related crimes as distinct offenses.

• The Act provides protection for any computer attached to the Internet.

• The Act makes it a federal crime for anyone to intentionally access and obtain information from a protected computer without authorization.

CFAA makes it a federal crime to access a computer knowingly to obtain restricted federal government, information, and financial needs of financial institutions or consumer reports of consumer reporting agencies. It also makes it a crime to use counterfeit and access unauthorized accessories.

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

2. Evidence from unreasonable search is usually prohibited under the “exclusionary rule”.

Rule usually applies to businesses.

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

4. Double jeopardy does not usually apply across jurisdictions.

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

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

7. Miranda is embedded in routine police practice. .

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8. Sixth Amendment guarantees the rights to a speedy trial by an impartial jury with a lawyer to confront adverse witnesses.

9. There is an Eighth Amendment prohibition of cruel and unusual punishment.

Case 6.3. The Supreme Court Speaks: Kyllo v. United States, 533 U.S. 27, 12 S.Ct. 2038, Web 2003 U.S. Lexis 4487 (2001) Facts: To determine whether marijuana was being grown indoors, government agents used thermal imagers from across the street. The scanning was used to obtain a search warrant. Agents found indoor-growing marijuana plants.

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

Decision: Yes. The Supreme Court reversed an affirmation by the court of appeals of the findings of the trial court. The case was remanded for further proceedings.

Reason: The case involves officers on a public street engaged in more than naked-eye surveillance of a house, the warrantless search of which is very rarely constitutional. Information could not have otherwise been obtained without physical intrusion.

Case 6.4. U.S. Supreme Court.Arizona v. Grant, 129 S.Ct. 1710, 173 L.159. 2d 485, Web 2009 U.S. Lexis 3120 (2009) Facts: The police went to a residence (based on anonymous tip of drug sales) and knocked on the door. Grant opened the door and said the owner would return later. After they left, they searched records and found an outstanding warrant against Grant for driving with a suspended license.

They went back and arrested Grant as he got out of his car. They found a gun and cocaine in his car. Grant moves to suppress the evidence from the car as a violation of warrant requirement of the Fourth Amendment. He was found guilty but the Arizona Supreme Court ruled the evidence inadmissible as an unreasonable search.

Issue:Was the arrest exception of warrantless search of the car justified under the search incident to exercise the warrant requirement?

Decision: No. The search violated the Fourth Amendment and the evidence must be suppressed.

Reason: There was not a way to reach into the car from point of arrest.

International Law: France Does Not Impose the Death Penalty.

France will not extradite a person to stand trial to a country where the death penalty could be imposed.

III.

Answers to Critical Thinking Cases

Search and Seizure 6.1.

No. The warrantless use of a GPS tracking system was not a search and therefore they did not violate the Fourth Amendment. This is merely tracking. Additionally the police had grounds for suspecting the defendant. U.S.A. v. Garcia. Web 2007 U.S. App. Lexis 2272 (U.S. Court of Appeal)

Criminal Liability of Corporations

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Criminal Law and Cyber Crimes 45

6.2.

Yes, a corporation can be held criminally liable for the acts of its representatives.

Moreover, because they cannot be put in prison, they are usually sanctioned with fines or loss of a license or franchise. Traditionally, under the common law, it was held that corporations lacked the criminal mind to be held criminally liable. However, modern courts have held that a corporation can be criminally liable for the acts of its managers, agents, and employees. In this case, the court held that the identification of the particular agents responsible for the antitrust law violations is especially difficult, and their conviction and punishment would be particularly ineffective as a deterrent. On the other hand, the court held that the conviction and punishment of the business entity or corporation is likely to be both appropriate and effective. Accordingly, Hilton Hotels was held criminally liable for its antitrust violations. United States v. Hilton Hotels Corp., 467 F.2d 1000 (9th Cir. 1973).

Criminal Fraud 6.3.

Walton is guilty of criminal fraud, otherwise known as theft by deception. In order to prove that a defendant committed theft by deception, the state must prove beyond a reasonable doubt that the defendant obtained or exercised control over property of another by deception and with the purpose of depriving that person of the property.

Deception occurs when a person intentionally promises performance that is likely to affect the judgment of another in the transaction, which performance the actor does not intend to perform or knows will not be performed. On the other hand, theft by deception does not occur when there is only falsity as to matters having no pecuniary significance, or “puffing” by statements unlikely to deceive ordinary persons. In this case, the court held that Walton’s representations that he would invest Marlowe’s money in gold affected her judgment concerning her investment, and that such evidence was sufficient to convict the defendant of theft by deception. State of Utah v. Roberts, 711 P.2d 235 (Utah 1985).

Bribery 6.4.

They have committed the crime of bribery by a public official. The crime of bribery is defined as the giving or receiving of anything of value in corrupt payment for an “official act” by a public official. In this case, the defendants argued that they were executives of a private nonprofit corporation unaffiliated with the federal government, and as such that they were not “public officials.” The court held, however, that the defendants were acting “for or on behalf of the United States in an official function” under the authority of HUD. Accordingly, the defendant’s lower court convictions for bribery were affirmed. Dixon and Hinton v. United States, 465 U.S. 482, 104 S.Ct. 1172, 79 L.Ed.2d 458 (1984).

Administrative Search 6.5.

Yes, the warrantless search of the safe was a lawful search. Generally, the Fourth Amendment’s prohibition on unreasonable searches and seizures applies to commercial premises, as well as to private homes. However, unlike searches of private homes, legislative schemes authorizing warrantless administrative searches of commercial property do not violate the Fourth Amendment. The Supreme Court has indicated that such searches are permissible for certain closely regulated industries that, by their very nature, require unannounced visits from government agents. One such regulated business is the liquor industry. In this case, the court held that the inspection of the defendant’s premises advances a substantial government interest pursuant to a regulatory scheme of a .

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closely regulated industry. Accordingly, the lower court’s holding that the warrantless search was lawful was affirmed. People v. Paulson, 216 Cal.App.3d 1480, 265 Cal.Rptr.

579 (Cal. App. 1990).

Fifth Amendment’s Privilege Against Self-Incrimination 6.6.

No, the records do not have to be disclosed. The Fifth Amendment provides that no person shall be compelled in any criminal case to be a witness against himself. This applies to compelled oral testimony. In this case, the court held that the subpoena does not force John Doe to restate, repeat, or affirm the truth of the contents of the records.

Thus, the court held that the records are not privileged under the Fifth Amendment. The court went on to hold, however, that the act of requiring production of the documents might not be privileged. A subpoena compels the holder of the documents to perform an act that may have testimonial aspects and an incriminating effect. Moreover, the court found that in this case the act of producing the documents would involve testimonial selfincrimination. Accordingly, the court held that the act of producing the records is protected by the Fifth Amendment’s privilege against self-incrimination. United States v.

John Doe, 465 U.S. 605, 104 S.Ct. 1237, 79 L.Ed.2d 552 (1984).

IV.

Answers to Ethics Cases

6.7.

No. The junkyard is part of a closely regulated business which brings a much lower expectation of privacy. The statue in question is pursuant to a state’s interest in regulating the industry due to the problem of theft at junkyards and dismantlers are a major market for stolen cars and parts. There is, of course, notice given to all in the industry that inspection would be made on a regular basis. New York v. Burger, 482 U.S. 691, 107 S. Ct. 2036, Web 1987 U.S. Lexis 2725 (Supreme Court)

6.8.

Cloud realized that the sale would not go through without lying so he lied. By doing so he hurt the insurance company and its policyholders. He did not consider the effects of his actions on these stakeholders and thus acted unethically. Cloud should be found guilty of aiding and abetting a bank fraud. United States v. Cloud, 872, F.2d 846.

V.

Answers to Policy Cases

6.9.

Yes. The stops without individualized suspicion violate the Fourth Amendment. The primary purpose was to uncover evidence without individualized suspicion. This is not an emergency exception. This search was not reasonable. City of Indianapolis v.

Edmund, 531 U.S. 32, 12, S.Ct. 447, Web 2000, U.S. Lexis 8084 (Supreme Court, 2000)

VI.

Answer to “Briefing the Case” Writing Assignment: 1. Case Name, Citation, and Court Schalk v. Texas 823 S.W.2d 633 (1991) Court of Criminal Appeals of Texas 2. Key Facts .

Criminal Law and Cyber Crimes 47

A. Schalk and Leonard are both former employees of Texas Instruments (TI), specializing in the area of speech research.

B. After leaving TI, they joined Voice Control Systems (VCS), a competitor of TI. C. Sam Kuzbary, another former TI employee, was hired by VCS. D. Kuzbary suspected that some of the information being used by VCS was proprietary to TI and reported that suspicion to TI. TI concluded that Schalk and Leonard downloaded the information before they left TI. E. TI reported this finding to the Dallas District Attorney’s Office, which filed criminal charges under a code section that makes it a crime to make unauthorized copies of trade secrets.

F. Schalk and Leonard claimed that TI did not sufficiently protect the information so as to protect it as a trade secret.

G. The search warrant was overly broad.

3.

Issue What level of protection constitutes statutory criteria for purposes of defining a trade secret?

4. Holding The criteria for the definition of a trade secret were met.

5. Court’s Reasoning The Court of Criminal Appeals of Texas held that: A. The statutory definition of trade secret can include a combination of components, each of which, by itself, is in the public domain, but the unified process and operation of which, in a unique operation, affords a competitive advantage and is a protectable secret.

B. TI did take sufficient measures to prevent the information from becoming generally available, including premises access security, restricted computer access, and nondisclosure agreements with employees.

C. There was no evidence presented by Schalk and Leonard to show TI’s permission for them to make copies of this information.

D. The statute in question set no strict standard of what measures are sufficient for the maintenance of a trade secret.

E. Because the information was found to be a trade secret under the terms of the statute, the search warrant sufficiently described the information and made the information admissible in further proceedings against Schalk and Leonard.

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Chapter 7 Intellectual Property and Cyber Piracy

Without The Law, Who Would Invent?

Learning Objectives: 1. Describe the business tort of misappropriating a trade secret.

2. Describe how an invention can be patented under federal patent laws and the penalties for patent infringement.

3. List the items that can be copyrighted, and describe the penalties of copyright infringement.

4. Define trademarks and service marks, and describe the penalties for trademark infringement.

5. Define cyber privacy, and describe the penalties for engaging in cyber infringement of intellectual property rights.

I.

Teacher-to-Teacher Dialogue

This chapter is of particular interest to business majors because so many of their areas of study revolve around how to gain a competitive advantage while trying to stay within the bounds of law and professional ethics. In the area of business torts, what is the difference between aggressive comparative advertising and the unfair trade practice of disparagement? Or in the area of intellectual property, how far can you take the fair use doctrine before you have crossed the line of copyright infringement?

Going through the list of various forms of unfair competition and giving some personal observations of cases involving those issues might be helpful. For example, in the matter of palming off, I give examples of how the makers of luxury goods are particularly afflicted with this problem. Some of the more famous examples might be the proverbial Rolex knock-off or purses made to look like Chanel bags.

With regard to protection provided for intellectual property, it might be helpful to use examples to illustrate the various rules of patents, copyrights, and trademarks. It might also be worthwhile to review the underlying public policies behind giving these protections in the first place. You can talk about the notion of these rights acting as a form of public-private partnership designed to award innovation, creativity, and uniqueness. Maybe talk about how these protections are, in effect, limited period monopolies that would otherwise go against the grain of our free competition laws. The entire scheme, of course, is to provide financial incentives by creating a legally protected property right. .

Intellectual Property and Cyber Piracy49

In addition, try to show students how the protection of intellectual property rights, trade secrets, and the like must be integrated into the entire business cycle of new and emerging companies whose growth is tied to new technologies. The Internet is changing the way intellectual property laws are interpreted. In many ways, this is one of the most important legal horizons for business today, and that is why students find it so interesting. The best way for students to approach these areas is to recognize that each of these protections carries a benefit– burden dichotomy. The benefits of the statutory protection are accorded to those who know how to use the statute on a continuing basis.

II.

Text Materials

Intellectual Property Rights: •

• •

Intellectual property rights include: o Patents o Copyrights o Trademarks o Trade Secrets o Trade Names o Domain Names These are very valuable business assets Protected by federal and state laws from misappropriation and infringement

Trade Secrets: • A product formula, pattern, design, compilation of data, customer list, or other business • • secret.

• Many states have adopted the Uniform Trade Secrets Act to give statutory protection to • trade secrets.

• State unfair competition laws allow the owner of a trade secret to bring a lawsuit for misappropriation against anyone who steals a trade secret.

To be actionable, the defendant must have obtained the trade secret through unlawful means.

The owner of a trade secret is obliged to take all reasonable precautions to prevent those secrets from being discovered by others.

If the owner fails to take precautions, the secret is no longer subject to protection under state unfair competition laws.

Online Commerce and Internet Law: Economic Espionage Act of 1996 • Makes it a federal crime to steal another’s trade secrets • It is a federal crime for any person: o To convert a trade secret to his or her benefit or for the benefit of others o Knowing or intending that the act would cause injury to the owner of the trade secret Ethics Spotlight:Coca-Cola Employee Tries to Sell Trade Secret to Pepsi-Cola This deals with a possible conspiracy issue. Loyalty to an employer is considered.

Federal Patent Statute of 1952 •

This law is intended: .

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• •

o To provide an incentive for inventors to invent and to make their inventions public; and o To protect patented inventions from infringement Federal patent law is exclusive.

There are no state patent laws.

Changes in U.S. Patent Law (1995) • Patents are valid for 20 years, instead of the previous term of 17 years.

• The patent term begins to run from the date the patent application is filed instead of when • the patent is issued, as was previously the case.

United States follows first to invent rule.

• No patent if the invention was used by public for more than one year (one-year “on sale” doctrine/ public use doctrine).

Patenting an Invention: • To be patented, an invention must be: o Novel o Useful o Nonobvious o Only certain subject matters can be patented • Application is filed with the PTO office in Washington, D.C. Patentable Subject Matter Includes: • Machines • Processes • Compositions of matter • Improvements to: o Existing Machines o Processes o Compositions of matter • Designs for an article of manufacture • Asexually reproduced plants • Living material invented by a person Patent Infringement: • Unauthorized use of another’s patent.

• A patent holder may recover damages and other remedies against a patent infringer.

• Patent holders own exclusive rights to use and exploit their patent.

Ethics Spotlight: Inventor Wipes Infringers, Windshields Clean This box deals with the case of the person who claims he patented the design for electronic intermittent windshield wipers for cars and other vehicles. He filed patent infringement suits against Ford, Chrysler, and other auto manufacturers and lost.

Copyright: Author has exclusive rights to publish, product, sell, license, and distribute qualifying works.

Copyrights and Internet Law: Copyright Revision Act of 1976 .

Intellectual Property and Cyber Piracy51

• • • •

Establishes the requirements for obtaining a copyright Protects copyrighted works from infringement To be protected under federal copyright law, the work must be original work of the author.

Only tangible writings are subject to copyright registration and protection.

Registration of Copyrights: To be protected under federal copyright law: • The work must be the original work of the author.

• A copyright is created when an author produces her work.

• Published and unpublished works may be registered with the U.S. Copyright Office.

• Registration is permissive and voluntary and can be effected at any time during the term • of the copyright.

Berne Convention (an international treaty) eliminated need for symbol © or word.

Copyright Terms: • Individual Copyright Holder—life of the author plus 70 years.

• Corporate Copyright Holder—95 years from the year of first publication or 120 years from the year of creation, whichever is shorter.

Note: Sonny Bono Copyright Term Extension Act Copyright Infringement: • Occurs when a party copies a substantial and material part of the plaintiff’s copyrighted • work without permission.

A copyright holder may recover damages and other remedies against the infringer.

Recovery: 1. Profit 2. Damages 3. Impoundment and destruction 4. Injunction Note: FBI is authorized to investigate violations Case 7.1. The Court Speaks: BMG Music v. Gonzalez, 430 F. 3d 388, Web 2005 U.S. App. Lexis 26903 (2005) U.S. Court of Appeals.

Facts: Gonzalez downloaded 1,370 copyrighted songs using KaZaA. BMG sued for infringement. Gonzalez said it was lawful. The district court granted summary judgment for BMG assessing damages and issuing an injunction. Gonazlez appealed.

Issue: Did Gonzalez engage in copyright infringement?

Decision: Yes. Judgment was affirmed.

Reason: A downloaded copy is a substitute for a purchased copy that should be paid for. No fee was paid here so the authors received nothing. This is not “fair use”.

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Cyber Law: Filing Sharing and Cyber Prices Copyright infringement is discussed by referring to the following: MGM Studios v. Grokster,Ltd. And Stream Cost Networks, Inc., 545 U.S. 913, 125 S.Ct. 2764, Web 2005 U.S. Lexis 5212 (2005) Facts: Grokster and Stream Cost distribute free software allowing sharing of electronics through peer-to-peer networks used primarily to share copyrighted music and movie files without authorization. Ninety percent of the available files are copyrighted. The downloaders are liable for copyright infringement. MGM sued alleging secondary liability because of the acts of the downloaders.

Issue: Is a party who distributes a device with the object of promoting its use to infringe copyrighted works liable for the resulting acts of infringement by third parties using such devices?

Decision: Yes. Judgment was vacated and the case was remanded.

Reason: Gokster and Steam Cost are not merely passive recipients of information about infringing use. They took active steps to encourage infringement. They generated income from selling advertising space which is streamed to users while they are employing the programs. One infringes contributorily by intentionally inducing or encouraging direct infringement.

The Fair Use Doctrine: • The copyright holder’s rights in the work are not absolute.

• The law permits certain limited unauthorized use of copyrighted materials.

The following are protected under this doctrine: 1. Quotation of the copyrighted work for review or criticism or in a scholarly or technical work 2. Use in a parody or satire 3. Brief quotation in a news report 4. Reproduction by a teacher or student of a small part of the work to illustrate a lesson 5. Incidental reproduction of a work in a newsreel or broadcast or an event being reported 6. Reproduction of a work in a legislative or judicial proceeding Case 7.2 The Court Speaks: Newton v. Beastie Boys, 349F. 3d 591, Web 2003 U.S. App. Lexis 22635 (2003) U.S. Court of Appeals Facts: Newton owns the copyright to the composition “Choir”. Beastie Boys use six seconds of “Choir” in their song “Pass the Mic” without obtaining a license. In a suit for copyright infringement, Beastie Boys claimed fair use. Court agreed.

Issue: Does the incorporation of a short segment of a copyrighted musical composition into a new musical recording constitute fair use, or is it copyright infringement?

Decision/Remedy: The court held the “deminimis” sampling was fair use and affirmed.

Reason: This was not substantial copying but “deminimis sampling”. The portion used was relatively small.

Criminal Copyright Law: • No Electronic Theft Act (NET Act) of 1997 .

Intellectual Property and Cyber Piracy53

o Criminalized certain copyright infringement Cyber Law: The Digital Millennium Copyright Act Makes It a Crime to Circumvent Encryption Technology This act prohibits unauthorized access to copyrighted digital works by circumventing the wrapper or encryption technology that protects the intellectual property. It makes it a crime to circumvent encryption technology.

Trademark: Any trade name, symbol, logo, design, or device used to identify and distinguish goods of a manufacture or seller or services of a provider from those of other manufactures, sellers, or providers.

Landmark Law: Lanham Trademark Act of 1946 (as amended) • Establishes the requirements for obtaining a federal mark • Protects marks from infringement • Trademarks are registered with the U.S. Patent and Trademark Office (PTO) • PTO provides for proper filing or electronically through TEAS Trademark Law: • The original registration of a mark is valid for 10 years.

• It can be renewed for an unlimited number of 10-year periods.

• The registrant is entitled to use the registered trademark symbol ® in connection with a • registered trademark or service mark.

Use of the symbol is not mandatory.

Distinctiveness of a Mark: To qualify for federal protection, • A mark must be distinctive—i.e., a brand name that is unique and fabricated; or • Have acquired a “secondary meaning”—i.e., when an ordinary term has become a brand name.

Marks That Can Be Trademarked: • Trademark—a distinctive mark, symbol, name, word, motto, or device that identifies the goods of a particular business. o e.g., IBM, Coca-Cola • Service Mark—used to distinguish the services of the holder from those of its competitors. o e.g., United Airlines, Weight Watchers, Marriott Hotels • Certification Mark—used to certify that goods and services are of a certain quality or originate from particular geographical areas. o e.g., “Florida” oranges, “Napa Valley” wines • Collective Mark—used by cooperatives, associations, and fraternal organizations. o e.g., Boy Scouts of America Marks that cannot be registered: • The flag or coat of arms of the United States, any state, municipality, or foreign nation .

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• • • •

Marks that are immoral or scandalous Geographical names standing alone Surnames standing alone Any mark that resembles a mark already registered with the Federal PTO

Trademark Infringement: • The owner of a mark can sue a third party for unauthorized use of a mark.

• The owner must prove that: o The defendant infringed the plaintiff’s mark by using it in an unauthorized manner, and o Such use is likely to cause confusion, mistake, or deception of the public as to the origin of the goods or services.

Case 7.3: The Court Speaks: Menashe v. Victoria’s Secret Stores, Inc., 409 F. Supp. 2d 412, Web 2006 U.S. Dist. Lexis 7763 (2006) , U.S. District Court Facts: In Fall, 2002, Victoria’s Secret (VS) named a line of lingerie “SEXY LITTLE THINGS”, and began selling them. In 2004, Menashe named a line of lingerie “SEXY LITTLE THINGS”.

They filed an ITV application with the USPTO. They denied knowledge of VS’s line. Later in 2004, VS applied to register the phrase with the USPTO whey they learned of Menashe’s ITO application. VS sent a cease and desist order stating the phrase was a trademark before the ITV application. Menashe stopped production and filed suit against VS seeking a declaratory judgment that there was no trademark infringement and asking for damages. The USPTO suspended act on VS’s application pending disposition of the ITV application.

Issue: Should Menashe be granted a declaratory judgment of trademark non-infringement for using the terms “SEXY LITTLE THING” and “SEXY LITTLE THINGS” for their lingerie?

Decision: No. VS had priority. Petition and case was dismissed.

Reason: VS made bona fide trademark use of “SEXY LITTLE THINGS” in commerce before Menashe filed their ITV application.

Generic Names: • Generic name—a trademark that becomes a common term for a product line or type of service.

• Once a trademark becomes a generic name, the term loses its protection under federal trademark law because it has become descriptive rather than distinctive.

Contemporary Environment: Protection of “Look and Feel” Trade Dress Trade Dress involves the “look and feel” of a product, its packaging, or a service establishment.

Some forms are protected.

Diluting, Blurred, or Tarnishing Trademarks: Federal Dilution Act of 1995 • Protects famous marks from dilution.

• The act provides that owners of marks have a valuable property right in their marks that • should not be eroded, blurred, tarnished, or diluted in any way by another.

The act is designed to stop those who attempt to benefit from the time and money spent by a company to develop and promote its famous marks. .

Intellectual Property and Cyber Piracy55

The act has three fundamental requirements: 1. The mark must be famous.

2. The use by the other party must be commercial.

3. The use must cause dilution of the distinctive quality of the mark.

Dilution: This involves lessening of the capacity of a famous work to identify and distinguish goods and services.

Blurring: Use of another party’s famous mark to designate a product or service in another market weakening the mark’s significance Tarnishment: Linking a famous mark to certain products or portraying in a nonflattering, immoral, or irreprehensible context likely to product negative ideas.

International Law: Illegal Knockoffs of Trademarks and Copyrights • International Protection of Intellectual Property Rights is accomplished through o Paris Convention o Berne Convention o WIPO Copyright Treaty III.

Answers to Critical Thinking Cases

Patent 7.1

No. Barnes and Noble said the Amazon system was copied and cited evidence as follows: 1. Compu-Serve Trend System provided to single-click ordering of stock charts and Internet since the 1990’s.

2. “Web basket” allowed one-click orders.

3. “Olive’s Market” permitted one-click order.

4. The book creating the virtual store provided the one-click ordering online.

The court of appeals reversed. Amazon.com v. Barnes and Noble, 239 F.3d 1343 (2001)

7.2.

Yes. Pfaff’s patent was invalidated. An invention may be patented before it is reduced to practice. Pfaff could have obtained a patent on his novel secret when he accepted the purchase order from TI. The patent filing occurred, more than one year after the contract with TI. Pfaff v. Wells Electronics, Inc., 525 U.S. 55, 119 S. Ct. 204, Web 1998 U.S. Lexis 7268 (U.S. Supreme Court)

Copyright 7.3.

Harper & Row wins. The U.S. Supreme Court held that The Nation engaged in copyright infringement in violation of federal copyright law when it published unauthorized verbatim quotes from President Gerald Ford’s soon-to-be published memoirs. President Ford and his publisher, Harper & Row, owned the copyright to the memoirs. The Nation obtained a prepublication copy of the memoirs and knowingly published the words verbatim from the memoirs.

The Nation argued in defense that its actions were protected under the “fair use doctrine” that permits unauthorized use of another’s copyrighted work if it involves scholarly research, news, or other fair use. The Supreme Court rejected this defense. The Court balanced all of the factors involved in this case and found that the fair use doctrine did not protect The Nation. The court found that the unpublished nature of the work, the .

56 Chapter 7

contract that President Ford had with Harper & Row to publish the memoirs, the commercial nature of the work, and the verbatim use of the words from the work, all worked against The Nation’s claims of fair use. The Supreme Court found that The Nation’s liberal use of the verbatim excerpts posed substantial potential for damage to the marketability of the copyrighted works. The Supreme Court reversed the appellate court’s decision and upheld the district court’s finding that The Nation had engaged in copyright infringement. Harper & Row, Publishers v.

Nation Enterprises, 471 U.S. 539, 105 S.Ct. 2218, 85 L.Ed.2d 588 (1985).

Fair Use Doctrine 7.4.

The National Broadcasting Company wins the suit based upon the fair use doctrine. A copyright holder’s rights in a work are not absolute. The law permits certain limited unauthorized uses of copyrighted materials under the fair use doctrine. Examples of uses that are protected under the doctrine are quotations for review or criticism, use in a parody or satire, and quotations in news reports. Where a fair use is found, the copyright holder cannot recover for copyright infringement. In this case, the court found that the plaintiff, Eismere Music, held a valid copyright for the song “I Love New York.” Neither NBC nor “Saturday Night Live” sought Elsmere’s permission before using the “I Love New York” song in their skit. However, the court held that the use of the tune was in the form of a parody of New York City’s advertising campaign. Because the use of copyrighted material in a parody is protected under the fair use doctrine, Elsmere could not recover from NBC or “Saturday Night Live”. The court dismissed the suit, and the court of appeals affirmed the decision. Elsmere Music Inc. v. National Broadcasting Company, Inc., 623 F.2d 252 (2nd Cir. 1980).

Trademark 7.5.

Yes, the slogans “Hair Color So Natural Only Her Hair Dresser Knows For Sure” and “Does She or Doesn’t She?” could be validly trademarked. A trademark is a distinctive mark, symbol, name, word, motto, or device that identifies the goods of a particular business. A trademark distinguishes the business and its products from those of its competitors. To qualify for protection, a mark must be distinctive or have taken on a “secondary meaning.” A secondary meaning cannot be trademarked. The court held that the two Clairol slogans had become distinctive. Through the use of an advertising campaign that cost more than $22 million, the two slogans had become associated with the products of Clairol, Inc. Both slogans had taken on a secondary meaning, and therefore the words in the slogans were not merely descriptive. Because the slogans had taken on a secondary meaning, the court granted Clairol a trademark. Roux Laboratories.

Inc. v. Clairol Incorporated, 427 F.2d 823 (Cust.Pat.App. 1970).

Generic Name 7.6.

The term “Lite” to identify reduced calorie beer is a generic name that does not qualify for trademark protection under the Lanham Act. Prior to this lawsuit by Miller Brewing Company against Falstaff Brewing Corporation, Miller had also sued G. Heileman Brewing Co. and Joseph Schlitz Brewing Co. for using the term “Lite” to identify their reduced calorie beer. Miller contended that the word “lite” in the “Miller Lite” name for its reduced calorie beers was subject to trademark protection under the Lanham Act. The court, in both Heileman and Schlitz cases, held against Miller and found that the word “lite” was a generic term not subject to trademark protection. The courts held that the .

Intellectual Property and Cyber Piracy57

term “lite” was used by consumers to mean all reduced calorie beers no matter from what brewery. Therefore, Miller could not claim a trademark on a generic term. The court in this case relied on the prior holdings in the Heileman and the Schlitz cases and held in favor of Falstaff, finding that Falstaff could use the word “lite” to identify its reduced calorie beer. The court dismissed Miller’s case against Falstaff. Miller Brewing Company v. Falstaff Brewing Corporation, 655 F.2d 5 (1st Cir. 1981).

IV.

Answers to Ethics Cases

Copyright Infringement 7.7.

This was done for commercial use not for a nonprofit purpose. These videos did not consist of scholarly research. The use caused harm to the copyright holder because it would act as a substitute for the original. Elvis Presley Enterprises, Inc. v. Passport Video, 349 F. 3d 622, Web 2003 U.S. App. Lexis 22775 (U.S. Court of Appeals)

7.8.

Digital Transactions Inc. misappropriated ICM’s trade secrets. A trade secret can exist in a combination of characteristics and components, each of which, by itself, is in the public domain, but the unified process, design, and operation of which, in unique combination, affords a competitive advantage and is a protectable secret. Integrated Cash Management Services, Inc. v. Digital Transactions, Inc., 920 F.2d 171 (2nd Cir. 1990).

V.

Answers to Policy Cases

7.9.

Sexually reproducing hybrid plants are patentable subject matter. The court had previously concluded that living things are patentable and that included man-made micro-organisms. This applies in this case even though such coverage was previously thought technologically infeasible. This situation fits within the broad language of Section 101. J.E.M. Ag Supply, Inc. d.b.a, Farm Advantage Inc. v. Pioneer Hi-Bred International Inc., 534 U.S. 124, 122 S.Ct. 593, 2001 U.S. Lexis 10949 (U.S. Supreme Court)

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Feist Publishing, Inc., v. Rural Telephone Service Co., Inc. 499 U.S. 340, 111 S.Ct. 1282, 113 L. Ed.2d 358 (1991) United States Supreme Court 2. Key Facts A. Rural is a small local phone company that publishes both white and yellow page directories listing its subscribers.

B. Feist Publications publishes regional white and phone directories that are a compilation of several local phone company subscribers’ listings.

C. Feist asked Rural for permission to use its list as part of Feist’s regional directories. Rural refused, claiming that its list was protected by copyright.

D. Feist used Rural’s list without permission. Rural sued for copyright infringement.

E. The lower court ruled in favor of Rural. .

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3. Issue Was Rural’s list of subscribers qualified as a copyrightable work?

4. Holding No. 5. Court’s Reasoning A. The Supreme Court held that the compilation of Rural’s subscribers list, although useful, failed to show enough creativity to qualify for copyright protection. Facts alone are not copyrightable because they do not owe their existence to authorship.

B. Facts can be copyrightable if they are creative and original to the author, but this list, although useful, failed to meet the standard of author-created originality to qualify for copyright protection.

.

Ethics and Social Responsibility of Business 59

Chapter 8 Ethics and Social Responsibility of Business

Why Are “Ethics” Left At The Corporate Door?

Learning Objectives: 1 Describe how law and ethics intertwine. . Describe the moral theories of business ethics.

2 Describe the theories of the social responsibility of business. . Examine the provisions of the Sarbanes-Oxley Act. 3 Describe corporate social audits. . Teacher-to-Teacher Dialogue: I. 4 .

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

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

The process by which morally based ethical behavior is first desired, then expected, and finally mandated is really the evolution of law.

Because so many of our legal and economic activities are conducted in the corporate format, juristic (law-made) business entities cannot ignore this constant and dynamic tug and pull between ethics and law. The bottom line in the study of ethics is ultimately personal, and our job as teachers is to help students prepare for these challenges in both their professional and personal ethical lives.

II. Text Materials

.

60 Chapter 8

Introduction: ▪ Businesses organized in the United States are subject to its laws. are also subject toa the laws of other countries in which they operate.

▪ They Business persons owe duty to act ethically in conduct of their affairs.

Businesses owe a social responsibility not to harm society.

▪ ▪ Law and Ethics ▪ Ethics is a set of moral principles or values that governs the conduct of an individual or a group. Acting ethically involves doing what is right.

▪ What is lawful conduct is not always ethical conduct.

▪ The law may permit something that would be ethically wrong.

Ethics: Bernie Madoff Steals Billions in Pyramid Scheme This describe a Ponzi scheme where investors invest, and the person pays return from the money of other investors just as the money had been invested by the person. Madoff did this with billions of dollars. He did it for 20 years and when investors wanted to cash-in in 2008, he couldn’t pay off. He was arrested by the FBI. Many investors lost their savings. Aside from a prison term he was order to pay $170,000,000 in restitution.

Ethics: Walmart Pays Big For Meal Break Violations This group deals with situations where Wal-Mart was accused of denying meal-break violations.

The distinction is drawn between the law and ethics.

Ethics: Bayer Corporation Ratted Out Under Whistleblower Statute This box discusses the issues surrounding Bayer and its product “Cipro”. Among the possible issues are the legality of Bayer’s actions, its ethics in cheating the Medicaid program, and whistle blowing. Of note is the ease involved in this type of deception.

Theories of Ethics: A Summary 1. Ethical Fundamentalism—Persons look to an outside source or central figure for ethical guidelines.

2. Utilitarianism—Persons choose the alternative that would provide the greatest good to society.

3. Kantian Ethics—A set of universal rules establishes ethical duties. The rules are based on reasoning and require: a. Consistency in application b. Reversibility 4. Rawls’s Social Justice Theory—Moral duties are based on an implied social contract.

Fairness is justice. Rules are established from an original position.

5. Ethical Relativism—Individuals decide what is ethical based on their own feelings as to what is right and wrong.

Note: Kant’s categorical imperative—“Do unto others as you would have them do unto you.”

This is duty ethics, or deontology.

.

Ethics and Social Responsibility of Business 61

Ethics: Proctor& Gamble Wins “Satanism” Lawsuit Several Amway distributors spread rumors that P&G was involved with Satanism, that its logo was a satanic symbol and that P&G gave profits to the Church of Satan. Ethical issues involved.

Social Responsibility of Business: ▪ Business does not operate in a vacuum. made by business business decisions has far-reaching effect on society.

▪ Decision In thedecisions past, many were made solely on a cost-benefit analysis.

Such may cause negative externalities for ▪ Corporations are considered to owe some degree of others. social responsibility for their actions.

▪ ▪ Theories of Social Responsibility: A Summary 1. Maximizing Profits—To maximize profits for stockholders.

2. Moral Minimum—To avoid causing harm to compensate for harm caused.

3. Stakeholder Interest—To consider the interests of all stakeholders, including stockholders, employees, customers, suppliers, creditors, and local community.

4. Corporate Citizenship—To do good and solve social problems.

Case 8.1: The Supreme Court Speaks: Walmart Stores, Inc. v. Samara Brothers, 529 U.S. 205, 120 S.Ct. 1339, Web 2000 U.S. Lexis 2197 (2000) Facts: Walmart was selling knockoff clothes exactly like those being sold by Samara at a price lower then Samara’s retailers were paying Samara for its clothes. The suit was filed alleging violation of the Lanham Trademark Act. The district court ruled for Samara without finding a secondary meaning for Samara’s clothes. The court of appeals affirmed.

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

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

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

Landmark Law: Sarbanes-Oxley Act of 2002 Prompts public companies to adopt code of ethics. Section 406 of SOX requires public company to disclose it has a code of ethics. A typical code is displayed.

Ethics: Requiring Corporate Social Audits Some corporations conduct social audits to prevent unethical conduct by managers, employees, and agents. This discusses procedures for such an audit including the use of an outside firm with whom the company’s personnel do not know, and reporting its findings to the Board for review of the results.

The Corporate Social Audit: ▪ Corporate audits should be extended to include the moral health of the corporation.

▪ Corporations that conduct social audits will be more apt to prevent unethical and illegal ▪

conduct by managers, employees, and agents.

The audit would examine how well: o Employees have adhered to the company’s code of ethics; and .

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o The corporation has met its duty of social responsibility.

International Law: Conducting Business in Russia Russia is viewed as one of the worst countries for corruption and bribery in the world.

III.

Answers to Critical Legal Thinking

False Advertising 8.1.

Whether or not Listerine acted unethically would depend upon the extent to which it knew the claims it was making were false. Ethicists would point out that one does not have to have perfect vision and information in order to recommend a product. The state of science is such that medical positions today will be supplanted by others tomorrow.

For example, in 1879, alcohol, Listerine’s major ingredient was presumed to kill certain germs. This is even today a partial truth.

The company’s claim is misleading. Warner-Lambert was ordered to include a disclaimer that “Listerine does not kill the germs that cause colds” on its labels for two years. The court declined to include prefatory language requested by the FTC, “Contrary to previous claims.” Warner-Lambert Co. v. FTC, 562 F.2d 749 (D.C. Cir. 1979).

Liability 8.2.

Yes, an ethicist applying the utilitarian approach to the question of bankruptcy might approve of the company’s decision to seek bankruptcy protection. Identifying and weighing the good and bad in this case would reveal some of the following. Filing a petition in bankruptcy erects a barrier against those claimants who have already gone to court to demand immediate relief in the form of compensation for their terrible loss. The initial order of relief granted by a bankruptcy court freezes all such proceedings pending in other courts. The benefits (the good) from filing in bankruptcy include preserving the assets of the company so that it can ultimately accept responsibility and compensate many more, if not all, who have a valid claim. Further, it would do the company employees no good for the company assets to be quickly dissipated by payment to those first in line. There are other goods that flow inferentially from those stated above. Given the points raised above the company has met its social responsibility. A director could ethically, and practically, have voted for a filing in bankruptcy for the reasons stated above. In re Johns-Manville Corporation, 36 B.R. 727 (B.C.S.D.N.Y. 1984).

IV.

Answers to Ethics Cases

8.3.

No. The plaintiff either knew or should have known enough about the nutritional issues with regard to McDonald’s food. The plaintiff tried to allege that McDonald’s food was a significant factor in her obesity and should be eliminated. She would also need to allege that the health problems were not just her eating or caused by the environment. Menus have changed in many fast-food locations, due to this issue.

Bradley v. McDonald’s Corporation., Web 2003 U.S. Dist. Lexis 15202 (U.S. District Court.)

8.4.

The Sullivan Principles propose commitments that fit the Corporate Citizenship model. .

Its precepts include more than ethical positions within the company (e.g., provide equal

Ethics and Social Responsibility of Business 63

and fair employment practices), it embraces company action toward improving the lot of the black in South Africa (e.g., assist in schooling, housing, etc.). A company that acts according to the Sullivan Principles is behaving as a Corporate Citizen, a standard somewhat above the ethical duty of business organizations under several approaches.

Duties are owed when they are clear answers to problems. Not all problems have clear solutions. The Utilitarian, for example, might reach a different conclusion regarding the need for a company to withdraw from South Africa. Indeed, this was the strong argument made by those companies who failed to commit to such a plan. The position of these companies was that more bad would come to the region and the affected people than good by their pullout. Where these speculations have validity, the consequentialist could argue that the pressure from withdrawal has less worth than the misery unintentionally caused by the withdrawal of business, and, accordingly, jobs for the needy.

8.5.

8.6.

Universities on the other hand could defend their divestment of holdings in companies who failed to withdraw much easier and with less ill effect on the parties they wish to assist. To the extent that the stock investment manifests a vote for present policies, a divestiture would provide further moral stature to the position regarding apartheid. The duty-based examiner must ask the question as to whether investment is a vote for willing evil by the company’s participation in the business of South Africa. Here, the principle of proportionality requires that the extent to which such holdings contribute to the company would be invoked, a major issue in determining to decide to discontinue stock ownership. The question as to whether companies owe a duty of social responsibility to provide an affirmative action program is dependent upon which ethical view a moral judge takes of the corporate purpose. If corporations are merely organizational vehicles to achieve profit for their owners, the extent to which they should expend assets for the general benefit of society is limited. Following a legal analogy, one can see why a company should donate funds to a local hospital that would ultimately take care of its employees.

That such a company should donate to another hospital in a town some distance away is questionable unless the company entertains a corporate citizenship stance.

By analogy, affirmative action programs are almost like the hypothetical hospital some distance away. Further, affirmative action programs bear an additional burden. The moral position for affirmative action is based on a restitution theory that, unfortunately, looks for relief from those who did not cause the loss. The U.S. Constitution demands equality, equal protection, and an ethical position. To suspend such equality for the purposes of restitution seems fair if the party required to contribute caused the loss.

In this case, the training program is legal under Title VII. Despite the plain language of the statute, which prohibits discrimination in the terms, conditions, and benefits of employment, the Court reasoned that: this situation was one the statute was intended to remedy; the method chosen was agreed to by the union as representative of all workers; the number and duration of the minority preference was limited to such time as the percentage of minorities in skilled jobs mirrored the population in the local workforce. Steelworkers v. Weber, 443 U.S. 193 (1979).

No. There was no showing of a direct nexus between the value Conferredon the public official and the official act performed by the public official is the favor of the given.

Merely showing a recipient “capacity to influence is not enough”. Nexus must be proven.

U.S. v. Sun-Diamond Groves at California, 526 U.S. 398, 119 S.Ct. 1462, Web 1999, U.S. Lexus 3001 (U.S. Supreme Court)

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V.

Answers to Policy Cases

8.7.

No. The court found that the slogan was mere puffery and a statement of that was not false advertising. Puffery involves not saying anything specific that could interfere with a reasonable man. “Better” simply refers to opinion. Pizza Hut, Inc. v. Papa John’s International, Inc., 227 F. 39 489, Web 2000 U.S. App. Lexis 23444 (U.S. Court of Appeals)

IV.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Ramirez v. Plough, Inc.12 Cal.RPTR.2d 423 (1992) 15 Cal. App.4th 1110, Court of Appeals of California 2. Key Facts A. Jorge Ramierz, through his guardian, brought suit against Plough, Inc., a marketer and distributor of St. Joseph Aspirin for Children (SJAC).

B. Ramierz, whose primary language is Spanish, contends that he contracted Reye’s syndrome after having ingested SJAC in March 1986.

C. In March 1986, voluntary warning labels were placed on SJAC that warned of a possible association between aspirin and Reye’s syndrome. These labels were made mandatory in June 1986.

D. Ramierz’s claim was summarily dismissed at the lower court level by summary judgment that said: “There is no duty to ward in a foreign language, and there is no causal relationship between plaintiff’s injury and defendant’s activities.”

3. Issue Did the defendant, Plough, have a duty to warn in a foreign language?

4.

Holding Yes. The court of appeals of California held that a manufacturer of a dangerous or defective product is not immune from liability by English-only warnings when it is expected that non- English literate persons are likely to use the product.

5. Court’s Reasoning A. Although public policy generally favors English as an official language, that policy does not provide immunity from liability when an English-only warning does not adequately inform non-English literate persons likely to use the product.

B. The burden of placing non-English warnings is not overly burdensome in light of the fact that more than 23 million Americans speak a language other than English at home.

C. The defendant knew that a non-English literate population used its products, and in fact, the defendant marketed its product directly to this population through various Spanish media outlets.

D. To grant summary judgment would give broad immunity to the defendant in this circumstance, and that decision should be left to the legislature and not the courts.

E. The lower court’s grant of summary judgment was overruled. .

Nature of Traditional and E-Contracts65

Chapter 9 Nature of Traditional and E- Contracts

Learning Objectives:

What Is A Contract?

1. Define contract.

2. List the elements necessary to form a valid contract 3. Distinguish between bilateral and unilateral contracts.

4. Describe and distinguish between express and implied-in-fact contracts.

5. Describe and distinguish among valid, void, voidable, and unenforceable contracts.

I.

Teacher-to-Teacher Dialogue

What elevates a mere agreement between two or more private parties into a legally recognized contract is the willingness of the public, through its courts, to enter the fray and enforce the contract rights and duties.

Students need to have some exposure to some of the working vocabulary of contract law. As is the case with all specialized forms of endeavor, a contract has a language all its own, and a basic knowledge of some of the key terms used in contracts is essential. The key contract terms used tend to be dichotomous, and you can use that dichotomy as a learning tool. Take for example, the number of parties to a contract. At least two parties are required in all contracts. One of those two parties has to initiate the contract formation process. The person starting the mutual assent process with a promise is the offeror, the other person is the offeree. Next, look at the dichotomy of the promises being used: is it a promise for a promise (bilateral) or is it a promise for an act (unilateral)? Have these promises been expressly made or can they somehow be implied from the circumstances? Does the form that this agreement is taking require certain formalities (such as a negotiable instrument), or can it be done in any manner chosen by the parties (informal) as long as the elements of contract are met?

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

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66 Chapter 9

II.

Text Materials

Contract: A contract is an agreement that is enforceable by a court of law or equity.

Introduction: ▪ Contracts are the basics of many daily activities.

▪ They provide the means for individuals and businesses to sell and otherwise transfer property, services, and other rights.

▪ Without enforceable contracts, commerce would collapse.

▪ Contracts are voluntarily entered into by parties.

▪ The terms of the contract become private law between the parties.

Legally Enforceable Contract: If one party fails to perform as promised, the other party can use the court system to enforce the contract and recover damages or other property.

Parties to a Contract: Every contract involves at least two parties: ▪ Offeror—the party who makes an offer to enter into a contract.

▪ Offeree—the party to whom an offer to enter into a contract is made.

Elements of a Contract: ▪ Agreement ▪ There must be agreement between the parties. requires offer by the offeror an acceptance of the offer by the offeree.

▪ This There must beanmutual assent by theand parties.

▪ ▪ Consideration ▪ The promise must be supported by a bargained-for consideration that is legally sufficient.

Gift promises and moral obligations are not considered supported by valid consideration.

Contractual Capacity ▪ The parties to a contract must have contractual capacity.

▪ Certain parties, such as persons adjudged to be insane, do not have contractual capacity.

▪

▪

▪

Lawful Object ▪ The object of the contract must be lawful.

▪ Contracts to accomplish illegal objects or contracts that are against public policy are void.

Defenses to the Enforcement of a Contract: ▪ Genuineness of Assent ▪ The consent of the parties to create a contract must be genuine.

▪ There is no real consent if the consent is obtained by: • Duress • Undue influence • Fraud ▪ Writing and Form .

Nature of Traditional and E-Contracts67

▪ ▪

The law requires that certain contracts be in writing or in a certain form.

Failure of these contracts to be in writing or be in proper form may be raised against the enforcement of the contract.

Contemporary Environment: The Evolution of the Modern Law of Contracts This box fits in nicely with the notions of private versus public participants in the contract process as discussed in the teacher-to-teacher dialogue at the beginning of this chapter. It also allows you to get students thinking early on about the “battle of forms” and how the extensive use of forms has severely limited the real bargaining power of the average lay person.

Evolution of the Modern Law of Contracts; ▪ Classical law of contracts—parties were free to negotiate contract terms without government interference.

▪ Modern law of contracts—parties may negotiate contract terms subject to government regulation.

Sources of Contract Law: ▪ The Common Law of Contracts ▪ Contract law developed primarily by state courts ▪ The Uniform Commercial Code (UCC) ▪ Comprehensive statutory scheme that includes laws that cover aspects of ▪

commercial transactions.

The Restatement of the Law of Contracts ▪ Compilation of model contract law principles drafter by legal scholars.

▪ The Restatement is not law.

▪ However, lawyers and judges often refer to it for guidance in contract disputes.

Landmark Law: Uniform Commercial Code (UCC) International Law: United Nations Convention on Contracts for the International Sale of Goods (CISG) The CISG is a model act for international sales contracts.

Objective Theory of Contracts: ▪ Holds that the intent to enter into an express or implied-in-fact contract is judged by ▪

the reasonable person standard.

The subjective intent of a party to enter into a contract is irrelevant.

E-Commerce: Sales and leases of good, services, other property, and software licensing over the Internet or by other electronic means.

Cyber Law: Electronic Contracts and Licenses UCITA is a model act that establishes uniform rules for electronic contracts. .

68 Chapter 9

Uniform Computer Information Transaction Act (UCITA): ▪ Establishes uniform legal rules for the formation and enforcement of electronic contracts and licenses ▪ Addresses most of the legal issues that are encountered while conducting e-commerce over the Internet ▪ It is a model act that is the basis for the creation and enforcement of cyberspace contracts and licenses Classification of Contracts: Formation Bilateral ▪ AContract contract entered into by way of exchange of promises of the parties ▪ “A promise for a promise” Unilateral Contract ▪ A contract in which the offeror’s offer can be accepted only by the performance of an act by the offeree ▪ “A promise for an act” Express Contract ▪ An agreement that is expressed in written or oral words Implied-in-Fact Contract ▪ A contract where agreement between parties has been inferred from this conduct Quasi-Contract (Implied-in-Law Contracts) ▪ Allows a court to award monetary damages to a plaintiff for providing work or services to a defendant even though no actual contract existed between the parties.

▪ Intended to prevent unjust enrichment and unjust detriment.

Case 9.1. The Court Speaks: Wrench v. Taco Bell, 256 F.3d 446, Web 2001 US. App. Lexis 15097 (209) U.S. Court of Appeals The Facts: Rinks and Shields, through their company Wrench, created an advertising campaign for Taco Bell at their request using their cartoon character “Psycho Chihuahua”. Wrench suggested that they use a real male dog passing by a female dog to get to Taco Bell. No express contract was entered. Instead, Taco Bell gave Wrench’s material to Chiat/Day who made the same proposal which they say they came up with on their own. Taco Bell aired its commercials as suggested by Chiat/Day without paying anything to Wrench who sued for breach of an impliedin-fact contract. The district court granted summary judgment in favor of Taco Bell.

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

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

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

Case 9.2. The Court Speaks: Powell v. Thompson-Powell, Web 2006 Del. C.P. Lexis 10 (2006) Court of Common Pleases of Arkansas Facts: Samuel, Jr. and Susan [husband and wife (H&W)] borrowed money and pledged two pieces of land as collateral—one was 2.7 acres of marital property and the other inherited by Susan. Upon default, Sam, Jr. borrowed money from Sam, Sr. whereby Sr. orally agreed to pay

.

Nature of Traditional and E-Contracts69

the mortgage and taxes and Jr. would pay him back. Sr. paid. Susan was not a party. Upon divorce the 2.7 acre lot was ordered sold and the proceeds to be divided 50–50. Jr. paid Sr. but Susan would not.

Issue: Is Susan liable for her half under quasi-contract?

Decision: Yes. Sr. was entitled to recover from Susan.

Reason: An implied-in-law contract usually requires recovery for the amount for which the party in question has benefited at the expense of the other party in order to preclude unjust enrichment.

This occurred in this case.

Formal Contracts ▪ Contracts that require a special form or method of creation ▪ Contracts Under Seal ▪ Recognizances Instruments ▪ Negotiable Letters of Credit ▪ Informal Contracts ▪ No special form or method is required for their Fully enforceable and may be sued upon if ▪ creation breach, e.g.: ▪ Leases Contracts ▪ Sales Service Contracts ▪ Classifications of Contracts: Enforceability Valid ▪ Contract Contract that meets all the essential elements to establish a contract ▪ Enforceable by at least one of the parties Void Contract ▪ A contract that has no legal effect obligated ▪ Neither Neither party party is can enforce to theperform contract ▪ Voidable Contract ▪ Contract where one or both parties have the option to avoid their contractual obligations ▪ If a contract is avoided, both parties are released from their contractual obligations Unenforceable Contract ▪ A contract where the essential elements to create a valid contract are not met ▪ However, there is some legal defense to the enforcement of the contract Classifications of Contracts: Performance Executed Contract ▪ A that has been fully performed on both sides A contract completed contract ▪ Executory Contract ▪ A contract that has not been fully performed by one or both parties Equity: A doctrine that permits judges to make decisions based on fairness, equality, moral rights, and natural law.

Ethics: Equity Saves a Contracting Party from the Terms of Their Contract

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70 Chapter 9

As students examine cases, they should be asked not only to review them in the technical sense, but even more important, what is their sense of essential fair play as it relates to the situation at hand? If that sense is being violated, perhaps they may be missing an alternative answer that better takes into account the overriding equities. This is a perfect example of where the court did just that. Equity is a doctrine that permits judges to make decisions based on fairness, equality, moral rights, and natural law.

International Law: International Contract Law in India International countries are necessary to the growing economy of India.

III.

Answers to Critical Thinking Cases

9.1

Yes. The recipient of a valuable idea accepted and used the information without paying for it knowing compensation was expected. Here the disclosure of the manuscript is confidential for the use of obtaining permits in using the scrabble, and payment unconditional as noted in landscape is express intentional exploit the manuscript commercially. They did not have any evidence that the defendants acted in good faith.

Landsen v Selcho & Richter Company, 802 F. 2d 1193, Web 1986 U.S. App Lexis 23453 (U.S. Court of Appeals)

Bilateral or Unilateral Contract 9.2.

The contract is a bilateral contract. A contract is bilateral if the offeror’s promise is answered with the offeree’s promise of acceptance. The court found that the agreement between Mr. Bickham and the bank on January 23, 1974, was a bilateral agreement.

Bickham agreed to do his banking in return for the bank’s agreement to make loans at 7 1/2 percent. If Bickham had said “If you promise to loan me money at 7 1/2 percent, I will do all my banking with your bank,” the offer would have been to create a unilateral contract.

The court further held that bilateral contracts can only be altered with the consent of both parties and that the bank acted unilaterally in changing the interest rates on the loans. Therefore, the Appellate Court upheld the trial court’s ruling that the bank had breached its contract.

In addition, the court held that each of the subsequently executed notes were bilateral contracts. The court stated that although the agreement was silent at the time, it would impute a “reasonable time” into the agreement. Bickham v. Washington Bank & Trust Company, 515 So.2d 457, 1987 La. App. Lexis 10442 (La.App. 1987).

Implied-in-Fact Contract 9.3.

Yes, an implied-in-fact contract can result from the conduct of unmarried persons who live together. An implied-in-fact contract arises where (1) the plaintiff provided property or services to the defendant, (2) the plaintiff expected to be paid for the property or services, and did not provide the property or services gratuitously, and (3) the defendant was given an opportunity to reject the property or services, but failed to do so.

Here the plaintiff provided services while the defendant provided property. There is no more reason to presume that services are contributed as a gift. It is better to presume that the parties intended to deal fairly with each other. To hold otherwise would disproportionately enrich one partner at the expense of the other. Therefore, the court held that courts may inquire into the conduct of the parties to determine whether that .

Nature of Traditional and E-Contracts71

conduct demonstrates an implied-in-fact contract.

Marvin v. Marvin, 557 P.2d 106, 134 Cal. Rptr. 815, 1976 Cal. Lexis 377 (Cal. 1976).

IV.

Answers to Ethics Cases

9.4.

The contract is a unilateral contract. A unilateral contract is one in which the offer can only be accepted by the performance of an act by the offeree. Here, there is no contract until the offeree performs the requested act. The offer cannot be accepted by Chenard promising to get a hole-in-one. This would constitute a bilateral agreement. The court held that where Chenard, the offeree, shot a hole-in-one, he had accepted the offeror’s offer of a unilateral contract thereby obligating performance of the promise. Accordingly, the Appellate Court upheld the Superior Court’s ruling that Chenard is entitled to the car.

Chenard v. Marcel Motors, 387 A.2d 596, 1978 Me. Lexis 911 (Maine 1978).

9.5.

No, Winkle does not receive the profit-sharing bonus. Under the equitable doctrine of quasi-contract, a court may award monetary damages to a plaintiff for providing work or services to a defendant even though no actual contract existed between the parties. This doctrine does not apply where there is an enforceable contract between the parties. In this case, there was a written employment contract between the parties. Thus, for Winkle to be entitled to the profit-sharing bonus, the court must find that the written employment contract was altered in writing or by an executed oral contract.

Winkle testified that the agreement to receive profit-sharing was an oral agreement. Thus, the question becomes whether the oral agreement was executed, that is, fully performed. The court held that because Winkle had not been paid his salary and bonus, the contract was not executed. Accordingly, the Appellate Court reversed the trial court’s holding that Winkle was entitled to his bonus. Winkel v. Family Health Care, P.C., 668 P.2d 208, 1983 Mont. Lexis 785 (Mont. 1983).

V. Answers to Policy Cases 9.6.

The Mitchell’s, who bought the safe, own the money. Under the objective theory of contracts, the outward manifestation made by each party to the other is conclusive of the contract. Here, reasonable persons would conclude intent on the part of the person to sell the safe and its contents, no statement of reservation having been made by the auctioneer.

City of Everett, Washington v. Mitchell, 63, P.2d 366, Web 1981 Wash. Lexis 1139 (Supreme Court of Washington)

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Mark Realty, Inc. v. Rogness 418 So.2d 373 (1982) District Court of Appeals of Florida 2. Key Facts A. Tilman A. Rogness entered into four separate agreements with Mark Realty, Inc. that gave Mark an “exclusive right of sale” over certain properties owned by Rogness.

B. Rogness sold the properties during the time period covered by the agreements. .

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C. Rogness argued that these contracts were unilateral in nature (a promise in exchange for an act) and that Mark did not provide the act (finding buyers). Rogness claimed a right to cancel and revoke the contracts.

D. Mark argued that these are bilateral contracts (a promise for a promise), and, as such, could not be unilaterally cancelled by Rogness.

3. Issue Were the contracts bilateral or unilateral?

4. Holding The contracts are bilateral and could not be cancelled by Rogness during the time provided for in the agreements.

5. Court’s Reasoning A. The nature of the contracts is such that both parties made mutual promises.

B. The owner promised to pay if a buyer is found during the contract period.

C. The realty company promised to provide its best good faith effort to locate a buyer. These efforts were evidenced by “an earnest and continued effort to sell.”

D. Because both parties made bilateral promises, neither party had the power to revoke.

E. Rogness’s sales were in breach of the terms of the contracts. Mark Realty, Inc. was entitled to the sales commissions from those sales.

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Agreement and Consideration73

Chapter 10 Agreement and Consideration

When Do We Have A Deal?

Learning Objectives: 1.

2.

3.

4.

5.

I.

Define agreement, offer, and acceptance.

Define counteroffer and describe the effects of counteroffers.

Describe how offers are terminated by acts of the parties and by operation of law.

Define consideration and analyze whether agreements are lacking consideration.

Apply the equity doctrine of promissory estoppels.

Teacher-to-Teacher Dialogue:

Agreement The first element of contract is finding mutual assent between the contracting parties. Mutual assent is defined as a reciprocal agreement between all of the parties to a contract. The steps leading to mutual assent start with the offer and acceptance process. These steps can be broken down into subparts, and a familiarization of those subparts is essential to the study of contract law.

The offer is broken down into three main subcomponents: intent, certainty, and communication. As an alternate memorization device, students may consider using an anagram called the QQC test. The first Q represents quality of the offer. In the eyes of the offeree, does this offer sincerely represent an objective intent to be bound? The second Q stands for quantity of the offer. If necessary, can a court, looking at this offer, find a basis upon which it could be measured, that is, is the quantity of the offer readily determinable? The C represents communication. The offer must be communicated to the offeree in order to be effective.

Once a good offer is made, the other player must make his or her opening response.

Remember, that response is dictated in many ways by the terms of the offer. Under the traditional common law mirror image rule, the acceptance must reflect the terms of offer. If it fails to do so, it may be deemed to be a rejection of the offer. And if it brings new terms to the table, it may be deemed a counteroffer. A counteroffer is, in fact, a new offer and sets the whole cycle of play into motion again from the reverse angle. The original offeror is now the new offeree. Of additional importance is the application of the mailbox rule, especially as it relates to digital contracts.

Remember, as long as the acceptance is usually sent by mail (or a similar medium), is the agreed upon method or is an answer to a previously mailed offer, acceptance is usually effective upon dispatch.

Once we have a good offer, coupled with a good acceptance, the first element of contract, agreement or mutual assent, is arrived at. There are many variations on this basic theme as .

74 Chapter 10

illustrated by the common law rules on advertising, auctions, and implied contracts based on the actions of the parties. They all have one common denominator: sooner or later some sort of basis for mutual assent must be found before a court will go forward with enforcement of the agreement.

Consideration Consideration is the second of the four elements of contract. Spotting consideration, in a contractual setting, sounds easier than it really is. When consideration is missing, the result is not necessarily an absence of contract. Perhaps an historical footnote on the issue may be of value.

Consideration is that element of a contract that is designed to show the underlying inducement to enter into the contract. It is meant to place value on the contract in order to assure evidence of a bond between the parties. In the Middle Ages, contracts between members of the privileged classes did not require consideration because a man’s word was his bond. A noble’s family seal evidenced that bond. The seal was affixed to the contract by way of pressing the signatorius annulus (signet ring) against melted wax onto the contract. Not everyone was a member of nobility, but all wanted their contracts to be binding. Thus, the concept of looking to bargainedfor value in place of the seal evolved into the modern day law of contracts.

Consideration today is made up of two subcomponents: detriment and bargain theory.

Detriment represents the value of the contract, that is, the glue that brought the parties to the table in the first place. It is actually a very practical requirement. Without value being put at issue, a court looking at the situation may simply say the matter is moot (nothing in controversy).

Detriment is usually divided into two main categories: affirmative detriment, where a person promises to do something he or she has no obligation to do but for the contract; and negative detriment, where a person abstains from doing something he or she has a legal right to do but for the contract. Consideration is usually what is bargained for. It is what is given up by one party to induce a similar action by the other. Value means nothing.

What if you have examined an agreement for consideration and found it lacking? You may still have a contractual result based on either the equitable doctrine of promissory estoppel or on specific statutory grounds that allow for a consideration waiver or substitute. Promissory estoppel literally means that a promise made, even though not supported by consideration, will not be allowed to be withdrawn, because of the harm that would befall the other party. The second major category of consideration exceptions from contracts is found in statutory provisions based on public policy. For example, the U.S. Bankruptcy Code allows for court-approved reaffirmation of debts that have already been discharged. Another example is found in many state statutes that provide protection to charitable organizations making pledges as enforceable contracts even though the donors may not be getting any consideration in return for their gifts.

II.

Text Materials

Introduction: • Contracts are voluntary agreements between the parties.

• One party makes an offer that is accepted by the other party.

• Without mutual assent, there is no contract.

Agreement: • The manifestation by two or more persons of the substance of a contract • Offeror o Person who makes an offer • Offeree o Person to whom an offer has been made .

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Offer: • “The manifestation of willingness to enter into a bargain, so made as to justify another person in understanding that his assent to that bargain is invited and will conclude it.”

(Section 24 of the Restatement (Second) of Contracts) For an offer to be effective: 1. The offeror must objectively intend to be bound by the offer.

2. The terms of the offer must be definite or reasonable certain.

3. The offer must be communicated to the offeree.

Note: Manifestation of willingness to enter into a bargain—effective when received Objective Intent • The intent to enter into a contract is determined using the objective theory of contracts. o That is, whether a reasonable person viewing the circumstances would conclude that the parties intended to be legally bound • Offers that are made in jest, anger, or undue excitement do not include the necessary objective intent.

Note: Does not include jokes, anger, or opinion.

Case 10.1. The Court Speaks: Marder v. Jennifer Lopez, 450 F.3d 445, Web 2006 U.S. App Lexis 14330 (2006) U.S. Court of Appeals Facts: Jennifer Lopez starred in a video stemming the movie, “Flashdance” based on the life of Maureen Marder. Marder was paid $2,300 and signed a General Release releasing Paramount from any claims, even those based on any filming or exploitation of the film. The movie grossed over $150 million. Marder believed that the video contained scenes from the movies. She sued for rights as a co-author and co-owner of the movie. This is an appeal of the district court’s dismissal of the claims.

Issue: Was the General Release an enforceable contract?

Decision: Yes. The district court’s dismissal was affirmed.

Reason: The Release was very broad and covered “each and every claim.” Marder’s claims reasonably fall within these terms. Although it may look like an unfair arrangement, there was no evidence of uncertain consent.

Definiteness of Terms: • • •

The terms of an offer must be clear enough to the offeree to be able to decide whether to accept or reject the terms of the offer.

If the terms are indefinite, the courts cannot enforce the contract or determine an appropriate remedy for its breach.

An offer (and contract) must contain the following terms: o Identification of the parties o Identification of the subject matter and quantity o Consideration to be paid o Time of performance .

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•

Implied Terms o The court can supply a missing term if a reasonable term can be implied. o Terms that are supplied in this way are called implied terms.

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

Special Offer Situations: Advertisements • A general advertisement is an invitation to make an offer.

• A specific advertisement is an offer.

Special Offer Situations: Rewards • An offer to pay a reward is an offer to form a unilateral contract.

• To collect a reward the offeree must: 1. Have knowledge of the reward offer prior to completing the requested act.

2. Perform the requested act.

Special Offer Situations: Auctions Auction with Reserve • Unless expressly stated otherwise, an auction is an auction with reserve, that is., the seller retains the right to refuse the highest bid and withdraw the goods from the auction Auction Without Reserve • An auction in which the seller expressly gives up his or her right to withdraw the goods from the sale and must accept the highest bid.

Termination of an Offer: • Revocation of the Offer by the Offeror o Withdrawal of an offer by the offeror terminates the offer o An offeror can revoke an offer at any time prior to its acceptance by the offeree o Revocation effective upon direct or indirect receipt unless an option with consideration • Rejection of the Offer by the Offeree o Express words or conduct by the offeree the rejects an offer o Rejection terminates the offer o Rejection effective upon receipt • Counteroffer by the Offeree o A response by an offeree that contains terms and conditions different from or in addition to those of the offer o A counteroffer terminates an offer o By operation of law • Destruction of the Subject Matter o The offer terminates if the subject matter of the offer is destroyed through no fault of either party prior to its acceptance • Death or Incompetency of the Offeror or Offeree o The death or incompetency of either party terminates the offer • Supervening Illegality o The enactment of a statute, regulation, or court decision that makes the object of an offer illegal • Lapse of Time o An offer terminates when a stated time period expires .

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Contemporary Environment: Option Contracts An offeree can prevent the offeror from revoking his or her offer by paying the offeror compensation to keep the offer open for an agreed-upon period of time. This is called an option contract.

Option Contracts: • •

An option contract is created if an offeree pays the offeror compensation to keep an offer open for an agreed upon period of time.

The offeror cannot sell the property to anyone else during the option period.

Acceptance: • A manifestation of assent by the offeree to the terms of the offer in a manner invited or required by the offer as measured by the objective theory of contracts.

(Section 50 of the Restatement (Second) of Contracts) • Only the offeree can legally accept an offer and create a contract.

• The offeree’s acceptance must be unequivocal.

• Mirror image rule requires the offeree to accept the offeror’s terms.

• Silence is not considered acceptance even if the offeror states that it is.

• Silence can be acceptance if offeree agrees or prior dealings indicate.

Case 10.2. The Court Speaks: Montgomery v .English, 902 So. 2d 836, Web 2005 Fla. App. Lexis 4704 (2005) Court of Appeals of Florida Facts: English made an offer to purchase the Montgomery’s house and several items of their personal property. The Montgomerys made several changes and signed the counteroffer. English initialed some but not all of the changes. English sued for specific performance upon the Montgomerys’ refusal to sell the house. The Montgomerys appealed from a trial court decision favoring English.

Issue: Was an enforceable contract made between English and the Montgomerys?

Decision: No. The trial court’s decision was reversed and the case remanded for summary judgment in favor of the Montgomerys.

Reason: Because the acceptance was not the mirror image of the offer and the counteroffer was not accepted, no enforceable contract was created.

Time of Acceptance: •

•

Mailbox Rule o A rule that states that an acceptance is effective when it is dispatched, even if it is o lost in transmission.

Also called the acceptance-upon-dispatch rule. o If an offeree first dispatches a rejection and then sends an acceptance, the mailbox rule does not apply to the acceptance.

Proper Dispatch Rule o The acceptance must be properly dispatched. o The acceptance must be properly addressed, packaged, and posted to fall within the mailbox rule. o Under common law, if an acceptance is not properly dispatched, it is not effective until it is actually received by the offeror.

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Mode of Acceptance: Express Authorization • A stipulation in the offer that says the acceptance must be by a specified means of • communication Use of an unauthorized means of communication make acceptance not effective Implied Authorization • Mode of acceptance that is implied from what is customary in similar transactions, usage of trade, or prior dealings between the parties Timeline 1. Offer—Effective upon receipt 2. Acceptance—Effective upon receipt except when mailbox rule is appropriate 3. Revocation—Effective upon receipt if before acceptance unless option says no revocation 4. Rejection—Effective upon receipt Example (Mailbox rule in effect) Offer sent on 1/1—Received on 1/5 Acceptance sent on 1/8—Received on 1/12 Revocation sent on 1/6—Received on 1/10 Contract is valid on 1/8 Consideration: • Consideration—something of legal value given in exchange for a promise.

• Consideration is a necessary element for the existence of a contract.

• Common types of consideration are: o A tangible payment (money or property); or o Performance of an act (e.g., providing legal services) Note: Both must be inducements for each other.

Requirements of Consideration: Legal Value • Under the modern law of contracts, a contract is considered supported by legal value if: 1. The promisee suffers a legal detriment; or 2. The promisor receives a legal benefit Bargained-For Exchange • Exchange that parties engage in that leads to an enforceable contract.

• Gift or gratuitous promise is an unenforceable promise because it lacks consideration.

Case 10.3. The Court Speaks: Cooper v. Smith, 800 N.E. 2d 372, Web 2003 Ohio App. Lexis 5446 (2003) Court of Appeals of Ohio Facts: Cooper purchased a number of items for Smith (while they were engaged) without any bargained-for consideration. After they split-up, he sued for them on their value. The case was dismissed by the magistrate and the dismissal was affirmed by the trial courts.

Issue: Can Cooper recover the gifts or their value?

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Decision/Remedy: No. The judgment was affirmed.

Reason: Other than a ring (not in question here), gifts exchanged during engagement are irrevocable absent any donor intent to the contrary.

Contracts Lacking Consideration: 1. Illegal Consideration—Promise to refrain from doing an illegal act.

2. Illusory Promise—Promise where one or both parties can choose not to perform their obligation.

3. Moral Obligation—Promise made out of a sense of moral obligation or honor or love or affection. Some states enforce these types of contracts.

4. Preexisting Duty—Promise based on preexisting duty of the promisee to perform. The promise is enforceable if a. The parties rescind the contract and enter into a new contract. b. There are unforeseen difficulties.

5. Past Consideration—Promise based on the past performance of the promise.

Contemporary Environment: Special Business Contracts Special types of business contracts allow a greater degree of uncertainty concerning consideration. They include: output contracts, requirement contracts, and best-effort contracts.

Settlement of Claims: • Accord—an agreement whereby the parties agree to accept something different in satisfaction of the original contract.

• Satisfaction—the performance of the accord.

• If the accord is not satisfied, the other party can sue to enforce either the accord or the original contract.

Promissory Estoppel: • A doctrine that prevents the withdrawal of a promise by a promisor if it will adversely affect a promisee who had adjusted his or her position in justifiable reliance on the promise.

• For the doctrine of promissory estoppel to be applied, the following elements must be shown: 1. The promisor made a promise.

2. The promisor should have reasonably expected to induce the promisee to rely on the promise.

3. The promisee actually relied on the promise and engaged in an action or forbearance of a right of a definite and substantial nature.

4. Injustice would be caused if the promise were not enforced.

International Law: Contract Law in China Many aspects of the UCL differ from U.S. contract law. China enacted the UCL in 1999.

III. Answers to Critical Thinking Cases Solicitation to Make an Offer .

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10.1. No. The advertisement was a solicitation to make an offer. To rule it to be an offer would be unreasonable. The language clearly indicates the Mesaro’s signed form was an offer, and Mint was free to accept or not. Mesaro v. U.S., 845 F.2d. 1576, Web 1988 U.S. App. Lexis 6055 (U.S. Court of Appeals) Agreement 10.2.

No. The court said this was a counteroffer that was not accepted by McLaughlin. This is because the changes are violations of the “mirror image rule”. This was a rejection and a counteroffer that was withdrawn before accepted. McLaughlin v. Heikkila, 697 N.W. 201231, Web 2005 Minn. App. Lexis (Court of Appeals of Minnesota)

Gift Promise 10.3. No. This was a gratuitous executory premise that supported by consideration. There were no gifts and plaintiff suffered no detriment. There was no delivery of a gift because there was no needed complete domain and control of the gift surrendered. Alden v. Presley, 637 S.W. 3d 862, Web 1982 Tenn. Lexis 340 (Supreme Court of Tennessee) Consideration 10.4.

No. Consideration is not a promise to pay for something already owed. This is “past consideration” and could not have been made to induce the actions. There was no bargaining. Dementas v. Estate of Tallas, 764 P.2d. 628, Web 1988 Utah App. Lexis 174 (Court of Appeals of Utah)

Counteroffer 10.5.

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

In the instant case, the court held that the process of settlement is best served by allowing the law of contracts to control. Thus, the court held that the tenant’s qualified acceptance of the settlement offer, conditioned upon the execution of a new lease, constituted a counteroffer that terminated its ability to accept the settlement offer. The trial court’s denial of the tenant’s motion to compel entry of judgment due to the existence of the settlement was therefore affirmed. Glende Motor Company v. Superior Court, 159 Cal.App.3d 389, 205 Cal.Rptr. 682 (Cal.App. 1984)

Past Consideration 10.6.

No, A.J. Whitmire does not receive the property. Generally, past consideration will not support a subsequent promise. In the case at bar, A.J. had performed the services that he argues constituted his consideration from the period between 1923 until 1944. The Supreme Court of Georgia held that where the only consideration for the 1944 promise was past consideration, there was no enforceable contract requiring transfer of the property. The directed verdict in favor of the defendant and denying specific performance was affirmed. Whitmire v. Watkins, 267 So.2d 6 (GA 1980).

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IV.

Answers to Ethics Cases

10.7.

The pledge agreement was supported by consideration. There is a written statement with an agreement to be bound. The premise to establish a scholarship fund is the needed consideration. In the Matter of Wirth, 14 A.D. 3d 572, 789 N.Y.S. 2d 69, Web 2005 NY. App. Div. Lexis 424 (Superior Court of NY)

10.8.

V.

Answers to Policy Cases

10.9.

VI.

There was no consideration to support the transfer of the deed. The transfer was fraudulent. The story was not believable. West America Housing Corporation v. Pearson, 207 WY 184, 171 P.3d 539, Web 2007 Wyo. Lexis 196 (Supreme Court of WY)

The agreement was an enforceable contract transferring ownership in the logo. Glende Dees, d/b/a David Dees Illustration v. Saban Entertainment, Inc., 131 F.3d 146, Web 1997 U.S. App. Lexis 39173 (U.S. Court of Appeals) Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Traco, Inc. v. Arrow Glass Co., Inc. 814 S.W.2d 186 (1991) Court of Appeals of Texas 2. Key Facts A. Traco, Inc. is a supplier of pre-engineered aluminum and glass sliding doors and windows.

B. Arrow Glass was a subcontractor engaged in the construction of USAA Towers in San Antonio, TX. C. Traco wanted a contract to supply aluminum and glass sliding doors to Arrow in conjunction with the USAA project. Its solicitation was rejected because its product did not comply with the original specifications called for by the project.

D. Traco modified its original bid to come into compliance with the specifications. Arrow relied on this revised bid and got the subcontract for the door work.

E. Subsequently, there were numerous quality problems with the doors delivered by Traco.

Arrow sought to have these problems resolved. Traco offered to supply a higher-grade door at an additional cost of $300,000.

F. Arrow refused to purchase the more expensive Traco product and sent the project out for bids.

G. Arrow sued for the difference between its original price with Traco and the higher price it paid to the third party on the basis of promissory estoppel.

3. Issue Does the contract remedy of promissory estoppel apply?

4. Holding Yes. 5. Court’s Reasoning

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A. The remedy of promissory estoppel is a “rule of equity” applied to promote the ends of justice.

B. The three basic elements of promissory estoppel were in place: a promise by Traco to supply doors per the original standard at a set price; foreseeable reliance on Arrow’s part in lowering its bid to the USAA general contractor; and actual reliance by Arrow, which led them to underbid the cost of the job and have to pay more for the doors to a third party.

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Chapter 11 Capacity and Legality

Did They Know What They Were Doing?

Learning Objectives: Define and describe the infancy doctrine.

Define legal insanity and intoxication and explain how they affect contractual capacity.

Identify illegal contracts that are contrary to statutes and those that violate public policy.

Describe covenants not to compete and exculpatory clauses and identify when they are lawful.

5. Define unconscionable contract and determine when such contracts are unlawful.

1.

2.

3.

4.

I.

Teacher-to-Teacher Dialogue

This chapter embarks upon the third and fourth of the four elements of contract—capacity and legality. The need for both capacity and legality is quite self-evident to students. They readily understand that contracts are important, and should be entered into by persons who are recognizably able to do so.

The self-evident and common sense basis of having legality as one of the elements of contract is usually readily understandable. The more difficult aspect in teaching this element surrounds issues of collateral or incidental illegality as well as dealing with contracts which appear legal on their face (such as a buy-sell), but which have an anticipated outcome that is in violation of public policy (if the buy-sell creates an illegal price-fix).

The fabric of contract law is thoroughly interwoven with a concern that parties entering into these agreements are doing so with free will, full knowledge of all the material circumstances, and a recognized capacity to contract. Capacity is the legal qualification, competency, and fitness to enter into contracts. It is the third of the four essential ingredients to a contract. As with the other three elements, if the capacity element is missing, a contract cannot result from the agreement in question.

Capacity Capacity to contract is presumed between adults. It is protected legally in the federal and all state constitutions. Before this legally sanctioned right is limited, such limitations must be justified on the basis of sound public policy. An important area of concern in the law of contract capacity limitation is found in the public policies that seek to protect certain individuals from sometimes-harsh results of contracts. Even though protection can sometimes be seen as a euphemism for punishment on the part of the protected party, the simple reality is that sometimes people do need to be protected from themselves and others.

The first category of persons needing protection is the young, that is, the legal minor. All states have established certain minimum age requirements as a threshold which must be crossed .

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before a person is allowed to contract on his or her own (now age 18 in most jurisdictions). Prior to that threshold age, attempts to contract by such young persons may have limited success. In the areas of necessities and certain statutorily recognized areas such as insurance and military enlistment, these contracts may be enforceable against a minor. But as a matter of public policy, the general rule is that the minor is allowed, for his or her own protection, to legally avoid the consequences of contractual entanglement. This avoidance is not always a free ride. If there is misrepresentation by the minor or equity concerns for an adult who dealt with the minor in good faith, some reimbursement may be due from the minor. The contract can be ratified by action after the minor reaches the age of majority.

The second major area of public policy-based protection from contract capacity is found in the area of persons with varying degrees of limited mental capacity. Just as we do not want very young people signing mortgages, we do not want documents enforced against persons who had no real ability to comprehend the material elements of those documents. This is not a matter of excusing someone from the binding effects of a contract based on simple ignorance. What this area of law is concerned about is a real lack of capacity to protect oneself. Because contract results can be harmful, a lack of a mental ability to protect one’s self-interest is considered fatal to the contract process.

A person who has been judged incompetent simply has lost the power to contract for himself or herself and needs to have someone else act in his best interest in a fiduciary (trust) role.

Attempts to contract with persons legally declared incompetent are void. Persons who are not legally declared incompetent can seek to avoid contracts based on some sort of lesser capacity. Be it based on mental limitations, drunkenness, drug use, or other affliction, they must prove to a court that at the time they entered into the disputed agreement, they lacked the cognitive ability to understand the material elements of the transactions. The burden of proof is on the person raising the issue of limited capacity, and courts will look at those issues on a case-by-case basis. Simple ignorance, emotional weakness, or a predilection for doing stupid things is not sufficient grounds for avoidance of a contract. As with minors, contracts with persons of limited capacity can be later ratified. If the contract is disaffirmed, restoration or restitution maybe appropriate depending on the individual circumstances of each case.

Now to introduce the element of legality and its role in the formation and enforcement of contracts. Most people think of a contract as a two party situation. A contracts with B, each legally capable of providing recognized legal value. Note how the phrase “legal” keeps cropping up through the language of contracts. That is because a contract is not only a two party situation.

All contracts have a “hidden” third party which is the larger society represented by the courts. If A and B have a dispute about what the contract terms really provided, where must they ultimately turn to get an answer? Courts are the designated agents of the larger society, C, whose job it is to provide a resolution of the problem between A and B. In the process of resolving a contract problem, can anyone realistically expect courts to use any other ground rules other than their own? The legality element of contract simply refers to those ground rules. If A and B want their agreement honored in a court of law as a valid and binding contract, that agreement must be recognized first and foremost as a legal agreement. To do otherwise would be asking a court to become a party to an agreement that contravenes the basis for its existence.

When a court examines an agreement for its legality component, there are three key questions it asks: 1. Is this agreement illegal per se?

2. If this agreement is legal on its face, may it have an intent or consequence that is against public policy?

3. If there is an element of illegality or violation of public policy, is it a material aspect of this contract, or is the problem incidental or collateral to the agreement?

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Capacity and Legality 85

The first question is really the easiest to answer. If the agreement calls for an illegal act on its face, the agreement is void and cannot be raised to the status of a legal contract. Thus, a contract for a murder by an underworld figure cannot and will not be enforced by a court of law.

The second question is much more difficult to answer in that public policy is a moving target.

Courts look at the reality of these agreements, even if they appear legal on their faces. For example, a simple buy-sell agreement looks perfectly legal. But what if the agreement is designed to act as a restraint of trade by discriminating as to who can sell to whom at fixed prices? Or what if we are looking at a prenuptial agreement that looks fair on its face but gives all the property to the party against whom a divorce action is brought? Is this really just a liquidation of property or an illegal punitive measure against a party who is exercising a legal prerogative? What about an exculpatory clause that goes too far?

The third area of concern goes to the issue of enforceability once the problem area is identified. Not all illegalities are fatal to the entire contract. If a court finds that the illegality or public policy concern is not at the heart of the contract, it may still enforce the agreement, because the illegality is considered collateral or incidental.

II.

Text Materials

Licensing Statutes: Regulatory—Public protection—No recovery for unlicensed persons Revenue-raising—Raise revenue—Often enforceable Capacity: • The law presumes that the parties to a contract have the requisite contractual capacity to • enter into the contract.

Certain persons do not have this capacity: o Minors o Insane persons o Intoxicated persons • The common law of contracts and many state statutes protect persons who lack • contractual capacity from having contracts forced on them.

• The person asserting incapacity bears the burden of proof.

An essential element for the formation of a contract is the object of the contract be lawful.

Minors: • Minors do not always have the maturity, experience, or sophistication needed to enter • into contracts with adults.

Common law defines minors as: o Females younger than the age of 18; and o Males younger than the age of 21 • Many states have enacted statutes that specify the age of majority o The most prevalent age of majority is 18 years of age for both males and females • • Any age below the statutory age of majority is called the period of minority.

Thus, a minor is: o A person who has not reached the age of majority The Infancy Doctrine:

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A doctrine that allow minors to disaffirm (or cancel) most contracts they have entered into with adults.

Doctrine based on public policy that reasons that minors should be protected from unscrupulous behavior of adults.

• Disaffirmance—the act of a minor to rescind a contract under the infancy doctrine. o Disaffirmance may be done orally, in writing, or by the minor’s conduct.

• Competent Party’s Duty of Restitution—if the minor has transferred consideration to the competent party before disaffirming the contract, that party must place the minor in status quo.

• Minor’s Duty of Restoration—a minor obligated only the return the goods or property he or she has received from the adult in the condition it is in at the time of disaffirmance.

• Minor’s Duty of Restitution—most states provide that the minor must put the adult in status quo upon the disaffirmance of the contract if the minor’s intentional or grossly negligent conduct caused the loss of value to the adult’s property.

• Misrepresentation of Age o Minors who misrepresent their age must place the adult in status quo if they disaffirm the contract. o A minor who has misrepresented his or her age when entering into a contract owes the duties of restoration and restitution when disaffirming it.

• •

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

Necessaries of Life: • Minors are obligated to pay for the necessaries of life that they contract for: • o Food, shelter, clothing, medical services • Generally, necessaries of life or public policy.

The seller’s recovery is based on the equitable doctrine of quasi-contract rather than on the contract itself. o The minor is obligated to pay the reasonable value of the goods and services.

Contemporary Environment: Special Types of Minors’ Contracts There are certain types of contracts that minors may not assert the infancy doctrine against. They include in part medical care, life insurance, and educational loan agreements.

Parent’s Liability for their Children’s Contracts • Parents owe a legal duty to provide food, clothing, shelter, and other necessaries of life • • for their minor children.

Parents are liable for their children’s contracts for necessaries of life if they have not adequately provided such items.

The parental duty of support terminates if a minor becomes emancipated.

Mentally Incompetent Persons:

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The law protects people suffering from substantial mental incapacity from enforcement of contracts against them.

To be relieved of his or her duties under a contract, the law requires a person to have been legally insane at the time of entering into the contract.

• Legal Insanity—a state of contractual incapacity as determined by law.

• The law has developed two standards concerning contracts of mentally incompetent persons: • Adjudged Insane • Insane, But Not Adjudged Insane • Adjudged Insane o A person who has been adjudged insane by a proper court or administrative agency. o A contract entered into by such a person is void. o Neither party can enforce the contract.

• Insane, But Not Adjudged Insane o A person who is insane but has not been adjudged insane by a court or administrative agency. o A contract entered into by such a person is generally voidable. o The competent party cannot void the contract.

• •

Case 11.1. The Court Speaks: Campbell v. Carr, 361 S.C. 252, 603 S.E. 2d 625, Web 2004 S.C. App. Lexis 276 (2004) Court of Appeals of South Carolina Facts: Carr, who suffered from schizophrenia and depression for which she took prescription medication, inherited a tract of land. She agreed to sell to Campbell who told Carr that the Tax Assessor assessed the property at $54,000. A written agreement for that amount was entered into and earnest money was paid by Campbell. Carr missed the closing, returned the money, and refused to sell. Campbell sued for specific performance. Evidence was introduced valuing the property at $162,000 and that Campbell knew of this. The court ordered Carr to specifically perform and Carr appealed.

Issue: Did Carr, because of her mental diseases, lack the mental capacity to enter into the contract with Campbell?

Decision: Yes. The decision ordering specific performance was reversed.

Reason: The inadequate consideration combined with Carr’s weakness of mind, due to the diseases, makes it inequitable to order specific performance which is an equitable remedy.

Intoxicated Person: • A person who is under contractual incapacity because of ingestion of alcohol or drugs to • • the point of incompetence.

Most states provide that contracts entered into by such intoxicated persons are voidable by that person.

The contract is not voidable by the other party if that party had contractual capacity.

Legality: • One requirement to have an enforceable contract is that the object of the contract must be • • lawful.

Contracts with an illegal object are void and therefore unenforceable.

There are two key categories of illegality: o Contracts contrary to statutes .

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o

Contracts contrary to public policy

Contracts Contrary to Statutes: • Federal and state legislatures have enacted statutes that prohibit certain types of conduct • Contracts to perform an activity that is prohibited by statue are illegal contracts • Usury Laws • Gambling Statutes • Sabbath Laws • Contracts to Commit a Crime • Licensing Statues o Regulatory Statue o Revenue-Raising Statue Case 11.2. The Court Speaks: Parente(Pa) v. Pirozzoli(Pi), 87 Conn. App. 235, 866A. 2d 629, Web 2005 App. Lexis 25 (2005) Appellate Court of Connecticut Facts: Pa (holding a criminal record) and Pi formed a partnership to operate a bar. Pa, due to his record, could not get a liquor license, so Pi agreed to operate it as a corporation and signed a partnership agreement with Pa. Pi terminated but kept the business. Pa sued Pi for breach. Pi defended saying it was illegal.

Issue: Was the partnership agreement void and illegal and thus unenforceable?

Decision: Yes. It was illegal, void, and unenforceable.

Reason: The partnership agreement had an illegal purpose to evade liquor control laws. It was made to foster illegal activities. The result of settlement has no bearing on the decision.

Ethics: Illegal Gambling Contract Courts will not enforce an executor illegal gambling contract, even if there was delivery and a gift.

Ethics: Murder, She Wrote Contracts Contrary to Public Policy: • Contracts that have a negative impact on society or that interfere with the public’s safety • • and welfare • Such contracts are void • Immoral Contracts • Contracts in Restraint of Trade Exculpatory Clauses Restraints and covenants cannot be unreasonable Effect of Illegality: • Such illegal contracts are void, the parties cannot sue for nonperformance.

• The court will generally refuse to enforce or rescind an illegal contract.

• The court will generally leave the parties where it finds them.

Exceptions to the General Rule: Certain situations are exempt from the general rule of the effect of finding an illegal contract: .

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1. Innocent persons who were justifiably ignorant of the law or fact that made the contract illegal 2. Persons who were induced to enter into an illegal contract by fraud, duress, or undue influence 3. Persons who entered into an illegal contract withdrawn before the illegal act is performed 4. Persons who were less at fault than the other party for entering into the illegal contract Special Business Contracts: • Contracts in restraint of trade—unlawful • Licensing Statute o Licensing Statutes: Regulatory—Public protection—No recovery Revenue-raising—Raise revenue—Often enforceable • Exculpatory Clause—relief from that liability system and negligence • Covenant not to compete: o Covenants not to compete that are ancillary to a legitimate sale of a business or employment contract are lawful if they are reasonable in three aspects: ▪ The line of business protected area protected ▪ The The geographical duration of the restriction ▪ Unconscionable Contracts: • Some lawful contracts are so oppressive or manifestly unfair that they are unjust.

• To prevent the enforcement of such contracts, the courts have developed the equitable • doctrine of unconscionability.

A contract found to be unconscionable under this doctrine is called an unconscionable • contract, or a contract of adhesion.

Elements that must be shown to prove that a contract or clause is unconscionable: o The parties possessed severely unequal bargaining power o The dominant power unreasonably used its unequal bargaining power o The adhering party had no reasonable alternative Remedies for Unconscionability: • Where a contract or contract clause is found to be unconscionable, the court may do one of the following: o Refuse to enforce the contract o Refuse to enforce the unconscionable clause but enforce the remainder of the contract o Limit the applicability of any unconscionable clause so as to avoid any unconscionable result Case 11.3. The Court Speaks: Muhammad v. County Bank of Rehoboth Beach, 189, N.J.1, 912 A. 2d 99, Web 2006 N.J. Lexis (2006) Supreme Court of NJ. Facts: Muhammad borrowed money from the bank and was charged 608.33 percent for 21 days.

He signed agreements forcing arbitration and disallowing class certain suits. Muhammad filed a class action suit arguing the arbitration agreement was unconscionable based on the class action view.

Issue: Was the class action waiver in the arbitration agreement unconscionable? .

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Decision: Yes. The clause could be severed allowing the class action suit to be heard by an arbitration panel.

Reason: Class actions allow claimants to equalize adversaries so that individual small claims could be valuable. Such suits are valuable for litigants, the courts, and public interest. The verdicts are severable, however.

III.

Answers to Critical Thinking Cases

Infancy Doctrine 11.1. Yes. The doctrine of necessities states that a minor may not avoid a contract for goods or services necessary for his health and substance to avoid any just enrichment. There are two contracts: one with parent and second with (implied-in-law) the minor. In this case the facts indicate the application of the second contract. Yale Diagnostic Radiology v.

Estate of Fountain, 267 Conn. 251, 838 A.2d 179, Web 204 Conn. Lexis 7 (Supreme Court of Connecticut) Contract Contrary to Public Policy 11.2. Yes. It was void based on public policy. A beneficiary in a life insurance policy is not entitled to the proceeds of the insurance if they feloniously killed the insured. The law cannot sanction any scheme that has as its purpose infliction of death for financial gain through life insurance proceeds. Flood v. Fidelity of Guaranty Life Insur. Co., 254, 354 So. 201 1311, Web 1981 La. App. Lexis 3538 (Court of Appeals of Louisiana) Minor 11.3. Yes. He ratified the contract by continuing for 10 months after reaching majority, to perform under the contract. The purpose of protection of a minor is upheld by allowing disaffirmance after reaching majority or by not accepting further benefits. This did not happen in this case. Jones v. Free Flight & Spart Aviation, Inc, 623 P.2d 370, Web 1981, Colo. Lexis 571 (Supreme Court of Colorado) Intoxication 11.4. Betty wins and may void the settlement contract. A contract of a person of unsound mind, but not entirely without understanding, made before her incapacity has been determined judicially upon application for the appointment of a guardian, is subject to rescission.

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

Galloway v. Galloway, 281 N.W.2d 804 (N.D. 1979).

Licensing or Revenue-Raising Statute 11.5. Wilson wins and may recover his architectural fees from the defendants. Where a licensing statute provides criminal liability but is silent as to civil liability, courts have .

Capacity and Legality 91

distinguished between statutes enacted to raise revenue and statutes enacted to protect the public against incompetence and fraud. If the purpose of the statute is for the collection of revenue, the express statutory penalties are held to be exclusive and contracts made without a license are not thereby rendered unenforceable. On the other hand, if the statute is for the protection of the public, it is more likely that the statute’s violator will be denied the enforcement of his bargain.

In this case, the court held that although the provisions of the statute requiring initial registration are clearly designed to protect the public from unfit and incompetent practitioners of architecture, the provision requiring renewal is purely for the purpose of raising revenue. Renewal involves nothing more than the remittance by the registrant of the annual $15 fee. Reexamination and reinvestigation play no part in the renewal process and there is no relationship between the payment of the annual fee and the competence or character of an architect. Because Wilson simply failed to comply with the renewal provision of the statute, the court concluded that the contract between Wilson and the defendants was enforceable. Wilson v. Kealakekua Ranch, Ltd. and Gentry Hawaii, 551 P.2d 525 (Hawaii 1976) Exculpatory Clause 11.6. Yes, the exculpatory clause in this case is effective and valid. Exculpatory agreements, such as the one signed by Koch, have been held not to be against public policy. However, such an agreement may be set aside if there is either fraud in the inducement or fraud in the execution of the agreement. In this case, the record reveals that Koch has been involved in racing for ten years and that he had signed similar agreements in the past. He admitted that he had not read the agreement, that he was not prevented from doing so prior to signing it, and that he knew the word “release” meant the racetrack was not liable should an accident occur. Moreover, the document was clearly captioned and the signature lines have a statement regarding reading the release on each line. The court held that these facts should have alerted the plaintiff as to the nature of the document he was signing and that he was not fraudulently induced to execute the release. Thus, the agreement clearly bars any action for negligence against the racetrack or Spaulding.

Koch v. Spaulding, 529 N.E.2d 19 (Ill.App.1988).

IV.

Answers to Ethics Cases

11.7.

Williamson was mentally incompetent by reason of intoxication when she signed.

Smith’s action, if not unethical are definitely questionable, taking advantage of a terrible situation. Smith v. Williamson, 429 S.2d 598, Web 1982 Ala. Civ App. Lexis 1418 (Court of Civil Appeals of Alabama)

11.8.

The contract was illegal and void. Ordinarily, a contract between an attorney and one not an attorney, providing that the latter shall procure the employment of the former by a third person for the prosecution of suits to be commenced in consideration of a fee to be procured or collected therein, is void as against public policy, independent of statutes prohibiting same. Moreover, courts generally will not enforce illegal contracts. The policy is not to protect or punish either party to the contract, but is for the benefit of the public.

On appeal Plumlee attempted to avoid the well-settled law by arguing summary judgment was improper because he was not in pari delicto with appellees; denial of recovery affords appellees unjust enrichment; and denial of recovery is against public .

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policy. However, none of these arguments is valid. It is true there are cases that hold when the parties to an illegal contract are not in pari delicto, the party least culpable may recover. However, such cases depend upon the knowledge of peculiar facts by the defendant, not known by the party seeking to enforce the contract, in other words, a mistake of fact. This case does not involve any mistake of fact. Both parties were aware of the facts surrounding the entering of their contract. It is simply irrelevant that Plumlee maintains ignorance that this type of contract was illegal. Plumlee v. Paddock, Lovless, and Roach, 832 S.W. 2d 757 (Tex. App. 1992).

V.

Answer to Policy Cases

11.9.

Yes. She has a minor and minor’s contracts are generally speaking, voidable. The other party is, however, bound. Lindsey effectively voided the contract by filing the lawsuit.

Strapes v. The Finish Line, Inc., Web 2005 U.S. Dist. Lexis 6975 (U.S. District Court for the Easter District of Tennessee, 2005)

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Carnival Leisure Industries, Ltd. v. Aubin 938 F2d 624 (1991) United States Court of Appeals for the Fifth Circuit 2. Key Facts A. While on a visit to the Bahamas, George J. Aubin incurred $25,000 in debt evidenced by bank drafts from a Texas bank to the plaintiff, Carnival Leisure Industries, Ltd. (CLI).

B. Mr. Aubin issued a stop payment order on the Texas bank draft and CLI sued for enforcement of the debt in Texas.

C. The lower court granted CLI’s motion for a summary judgment, and Aubin appealed.

D. Mr. Aubin’s appeal alleges that Texas public policy bars the collection of debts arising from gambling.

3. Issue Does the public policy of Texas continue to ban the collection of gambling debts in light of the limited forms of gambling made legal in Texas since 1973?

4. Holding Yes, the Texas public policy against the enforcement of gambling debt remains.

5. Court’s Reasoning A. The newer forms of gambling allowed in Texas center around “social gambling,” such as bingo, raffles, and racing.

B. These are not considered to be the same as the broad-based forms of casino gambling from which this debt arose.

C. Even if there was a shift in the public policy against gambling “per se,” there was no evidence of any shift in the policy against enforcement of debts arising out of gambling activities.

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Chapter 12 Genuineness of Assent and Statute of Frauds

Did I Really Agree To That?

Learning Objectives: 1. Explain genuineness of asset.

2. Describe how intentional misrepresentation (fraud), duress, and undue influence excuse performance.

3. List the contracts that must be in writing under the statute of frauds.

4. Describe the formality of the writing of contracts and the parol evidence rule.

5. Define the equitable doctrine of undue influence, promissory estoppels, and part performance.

I.

Teacher-to-Teacher Dialogue

Genuineness of Assent The first set of defenses to the enforcement of contracts in this chapter revolves around the issue of free will. Where free will is compromised, mutual assent is also compromised, and the agreement may not stand as a contract. What makes this area of law difficult is that courts and juries are asked to exercise 20/20 hindsight when looking back on how the parties were thinking as they were embarking on the road to contract formation. The subjectivity of measuring intent has always been a troublesome puzzle to unravel; yet without it, the objective facts placed before a court may not show the reality of consent. Because of the potential harshness of a bad contract, courts want to be very sure that the assent element of contracts is just that—a free and real consent to the agreement.

At on end of the spectrum is an innocent mistake that can be either unilateral or bilateral. In a contract mistake, one or both of the parties is acting under an erroneous belief about the subject matter of the contract. Normally, if only one (unilateral) of the parties is mistaken, there will be no grounds for recission unless that mistake is coupled with some sort of bad faith or abuse on the part of the nonmistaken party. Where the mistake is mutual (bilateral), either party may seek recission if the mistake is considered material (so important that no real meeting of the minds ever occurred).

The next issue is found in the area of misrepresentation or concealment. A problem occurs when a person is actively seeking to misrepresent. Here we can see that freedom of assent is even further compromised than in mistake alone. Now the element of scienter (guilty mind) enters the picture, and the grounds for recission are greatly increased. If the misrepresentation is material, known to be so by the maker, made with the intent to deceive, and is justifiably relied upon by an innocent and injured party, then the elements of fraud are in place. With a finding of fraud, the injured party may seek recission or civil damages. In addition, the state may choose to prosecute .

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the wrongdoer under the penal code. Contract fraud, unfortunately, not only sits at the other end of the spectrum but can also be found at the top of the charts on the most popular white collar criminal list. As with so many areas of criminal behavior, the consumer pays the ultimate cost of these crimes through passed on costs for insurance, credit, and any number of other services undermined by these kinds of activities.

Another highly sensitive area of mutual assent is found in the law of undue influence. Undue influence involves taking away a person’s free will through any manner of physical, emotional, or psychological manipulation. It can happen in any relationship, and where it is alleged, the person claiming to be the victim of undue influence has the burden of proof in showing the alleged duress. One important exception to this general rule involves persons who act in a fiduciary role. A person in a fiduciary role is entrusted with acting for the benefit of another. Most professionals in law, accounting, the healing arts, and business find themselves in fiduciary roles to one degree or another. As for the fiduciary, the burden of proof is now reversed. In dealing with their respective clients, patients, or beneficiaries, a contract is presumed to be under undue influence, and the burden of proof is on the fiduciary to show that the transaction is at arm’s length, that is, it is fairly arrived at.

Writing Requirement As a practical matter, most contracts of any importance should be in writing. Most students already intuitively know this. The more important concern is to recognize how, when, and where the writing should be used and when exceptions should be made to the general rule. A three-step logic in the classroom might be helpful: 1. First, be sure to recognize which categories of contracts are covered by the Statute of Frauds, including the major exceptions, such as partial performance or orders for specially made goods under the UCC. 2. Second, have students learn how to use the parol evidence rule. Explain the whys and wherefores of the rule from both the theoretical as well as the practical point of view.

3. Finally, because the bottom line is to make sure that equity is done, explain both the public policy and practical necessity of having exceptions to the parol evidence rule.

The second set of defenses to the enforcement of contracts revolves around writing requirements associated with certain contracts. The genesis of the writing requirement for certain contracts is found in two roots: one historical and one practical. The historical root goes back to early English common law as developed under William the Conqueror and his successors. Status in that society was almost entirely measured by how much land one owned or had control over.

Being Lord of the Manor meant privilege, power, and rank. Thus, contracts involving the transfer of land ownership were of utmost importance because of the bearing they had on social status.

Highly ritualized written processes of titled transfers to land evidenced these important contracts.

The original title to the land was often traceable to a knights’s fief or fee for services provided to the sovereign. From this phrase, the highest recognized ownership in land today is still called fee simple absolute.

The second root of the writing requirement is found on a more mundane level, having less to do with knights in shining armor and more with practicality. A writing is considered the best and most neutral evidence of the parties’ intent at the time the agreement was entered into. The writing does not lose its memory; it does not take sides. Thus, when English lawmakers wrote the Statute of Frauds, they decided the statute would serve them with the best of both worlds--impose a writing requirement on the most important contracts to act as the best evidence in a court of law.

The English version of the Statute of Frauds has been carried over to our legal system virtually intact for more than three hundred years. All U.S. states have adopted their own versions of the statute, and they are virtually uniform in that they require contracts involving interest in land, consideration of marriage, one year plus, third party guarantees, and others to be in writing. .

Genuineness of Assent and Statute of Frauds 95

The most significant addition to this list came with the adoption of the Uniform Commercial Code. Under the provisions of the UCC, contracts for the sale of goods for more than $500 need to be in writing. Thus, the first question which needs to be answered is: Does the statute cover this contract or not?

Once you have decided the contract is covered, what are the effects of having failed to use a writing? Several possibilities may occur at this juncture. The parties may proceed to voluntarily perform the contract. But if one or both decide to assert the statute, its teeth are found in it being used as a defense to enforcement, that is, if the party against whom contract enforcement is sought has not signed, it may not be enforced against him or her. There are equity-based exceptions to this general rule based on partial performance and promissory estoppel.

Once the contract is finally reduced to writing, the next element of the Statute of Frauds takes hold: the parol evidence rule and the exceptions to it. The exclusion face of the rule states that the writing is intended to express the final intent of the parties. All prior or contemporaneous statements must ultimately have been reflected in writing and will remain barred from the interpretation of the instrument. This provision is designed to prevent a rewrite of the document after the fact with new evidence to prevent fraud.

The converse is found in the exceptions to the parol evidence rule. Long ago, an anonymous legal scholar first said: “The Statute of Frauds should not be used to perpetuate frauds.” The exceptions to the parol evidence rule are designed to let in additional information not shown on the original writing in certain limited circumstances. These special circumstances are grounded in public policy and simple practical necessity. Public policy provides an overriding basis in cases involving fraud, misrepresentation, deceit, bad faith, power to avoid based on age or mental capacity, duress, undue influence, and mistake. All these elements are considered in the best interest of public policy and will be allowed into evidence, notwithstanding the statute, if the facts warrant it.

The second area of exception to the parol evidence rule is explaining ambiguities. If the contract, as written, contains ambiguous language, parol evidence is allowable to clear the ambiguity as long as it is consistent with the original terms. The nature of the evidence allowable under this rule can range from oral statements made by the parties on up to entire standards of usage and trade used by a particular industry. This exception is particularly important in contracts covered by the UCC. II. Text Materials Introduction: • A contract may not be enforced even if all the required elements of a legal contract are • met.

This can happen when the party against whom the enforcement is sought raises certain defenses against its enforcement. o Genuineness of assent o The contract did not meet the requirements of the Statute of Frauds Mistakes: • A mistake occurs where one or both of the parties has an erroneous belief about the • • subject matter, value, or some other aspect of the contract.

Mistakes may be either unilateral or mutual. In a unilateral situation, look to what the nonmistaker thought.

The law permits rescission of some contracts made in mistake. .

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Case 12.1:The Court Speaks:Wells Fargo Credit Corp. v. Martin , 650 So. 2d 531, Web 1992 Fla. App. Lexis 9927 (Court of Appeals of Florida) Facts: Wells Fargo Credit Corporation (Wells Fargo) appeals an order denying its motion to set aside a judicial sale and an order denying its motion for relief from judgment. Essentially, both motions sought relief from the judicial sale because an avoidable, unilateral mistake by Wells Fargo’s agent resulted in a grossly inadequate sales price.

Wells Fargo obtained a judgment of foreclosure on a house owned by Mr. and Mrs. Clevenger. The total indebtedness stated in the judgment was $207,141. Wells Fargo was represented at this sale by a paralegal employed by its attorney. The paralegal was experienced with public foreclosure sales and had attended more than one thousand similar sales. She brought a form document that had been prepared either by Wells Fargo or its attorneys, containing specific information and instructions for this sale. The instructions informed her to make one bid of $115,500. This was the tax-appraised value of the property after deducting the homestead exemption. Unfortunately, the form was filled in by hand, and the handwriting was not very clear.

The first “1” in the number was close to the “$” and slightly separated from the “15,500.” The paralegal misread the bid instruction as $15,500.

Mr. Harley Martin also attended this sale. This was the first such foreclosure sale he had ever attended. After the paralegal announced her bid, he bid $20,000. The court clerk checked to make certain Mr. Martin had prepared the required bid information sheet for the clerk’s office. After confirming that Mr. Martin was qualified to bid, the clerk gave ample opportunity for another bid and then announced: “$20,000.00 going once, $20,000.00 going twice, sold to Harley —.”

Just after the clerk announced, “Sold,” the paralegal screamed: “Stop, I have another bid,” or “Stop, I’m sorry I made a mistake.” When Mr. Martin indicated that he was content to keep his new home, the clerk took the matter to a circuit court judge. After confirming that the clerk had announced, “sold,” the judge ordered the clerk to issue the certificate of sale.

Issue: Could the judicial sale be set aside on the basis of Wells Fargo’s unilateral mistake?

Decision: The unilateral mistake did not entitle Wells Fargo to relief from the judicial sale.

Reason: Altenbernd, J. The general rule is that, standing alone, mere inadequacy of price is not a ground for setting aside a judicial sale. But where the inadequacy is gross and is shown to result from any mistake, accident, surprise, fraud, misconduct, or irregularity upon the part of either the purchaser or other person connected with the sale, with resulting injustice to the complaining party, equity will act to prevent the wrong result.

The failure of a party to take the required steps necessary to protect its own interests, cannot, standing alone, be grounds to vacate judicially authorized acts to the detriment of other innocent parties. The law requires certain diligence of those subject to it, and this diligence cannot be lightly excused.

Unilateral Mistakes: • Occur when only one party is mistaken about a material fact regarding the subject matter • • of the contract.

In most cases the mistaken party will not be permitted to rescind the contract.

The contract will be enforced on its terms Mutual Mistakes Mutual Mistake of Fact • A mistake made by both parties concerning a material fact that is important to the subject matter of the contract.

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Genuineness of Assent and Statute of Frauds 97

In Raffles v. Wichelhaus, the court held that a mutual mistake of fact excused performance of the contract.

Mutual Mistake of Value • A mistake that occurs if both parties know the object of the contract but are mistaken as • to its value.

The contract remains enforceable by either party because the identity of the subject matter of the contract is not an issue.

•

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

Elements of Fraud: 1. The wrongdoer made a false representation of material fact.

2. The wrongdoer intended to deceive the innocent party.

3. The innocent party justifiably relied on the misrepresentation.

4. The innocent party was injured.

Legal Consequence if Fraudulent Misrepresentation Is Found: The innocent party may: 1. Rescind the contract and obtain restitution, or 2. Enforce the contract and sue for damages Common Types of Fraud: • Fraud in the inception • o An innocent person is deceived as to the nature of his or her act • Fraud in the inducement o The wrongdoer fraudulently induces another party to enter into a contract.

Fraud by concealment o The wrongdoer takes specific action to conceal a material fact from the other party.

• Silence as misrepresentation o The wrongdoer remains silent when he or she is under a legal obligation to disclose a material fact.

• Misrepresentation of law o A professional who should know what the law is intentionally misrepresents the law to a less sophisticated party.

Case 12.2. The Court Speaks: Krysa v. Payne, 176 S.W.3d 150, Web 2005 Mo. App. Lexis 1680 (2005) Court of Appeals of Missouri Facts: While shopping for a truck to pull their trailer, the Krysas, after a test drive, purchased one from Crane, a used car salesman for Payne. Crane had told the Krysa that the truck would tow their trailer, would make it to 400,000 miles, and was a “one-owner trade-in.” A number of things went wrong with the truck in a relatively short time. The Krysas noticed that a window had been replaced and that there was glass on the floor. The truck was not able to tow the trailer after two miles without smoke pouring out of the back of the truck while using a lot of oil. A CAR FAX report eventually showed 13 prior owners. Evidence showed that the truck was really two halves of different trucks welded together. An expert said it was unsafe. Payne told Krysa that he would .

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credit what was paid toward another purchase but would not return the money. Krysa could not find a satisfactory substitute. Upon suit by the Krysas, the jury returned a verdict awarding the Krysas $18,449 in compensatory damages and $500,000 in punitive damages. Payne appealed the punitive damages.

Issue: Did Payne engage in fraudulent nondisclosure, fraudulent misrepresentation, and reckless disregard for the safety of the Krysas and the public to support the award of $500,000 in punitive damages?

Decision: Yes. The award was justified.

Reason: Payne sold a vehicle that he knew or should have known was unsafe, recklessly disregarding the Krysas’ and the public’s safety. Here there was also a finding of intent to deceive and also affirmative misrepresentation of the condition of the truck. The potential physical damages here were so great that merely using a ratio of punitive damages to actual damages was not enough and $500,000 (27:1) was justified.

Innocent Misrepresentation: • • •

Occurs when a person unintentionally makes an assertion that is not in accord with the facts.

The innocent party may rescind the contract but cannot recover damages.

Innocent misrepresentation is not fraud.

Duress: • Occurs when one party threatens to do some wrongful act unless the other party enters • • into a contract.

A contract entered into under duress cannot be enforced.

Types of duress: o Physical duress o Extortion Undue Influence: • Occurs when one person takes advantage of another person’s mental, emotional, or • • physical weakness and unduly persuades that person to enter into a contract.

The persuasion by the wrongdoer must overcome the free will of the innocent party.

The following elements must be shown to prove undue influence: 1. A fiduciary or confidential relationship must have existed between the parties.

2. The dominant party must have unduly used his or her influence to persuade the servant party to enter into a contract.

Statute of Frauds: State statute that requires the following types of contracts to be in writing: 1. Contracts involving the transfer of interests in real property 2. Contracts that cannot be performed within one year of their formation 3. Collateral contract where one person promises to answer for the debts of duties of another person 4. Promises made in consideration of marriage, such as prenuptial agreements 5. Agents’ contracts to sell real property 6. Contracts for the sale of goods costing $500 or more Ethics: Doctrine of Part Performance Saves an Oral Agreement for the Purchase of Real Estate. The equitable doctrine of part performance is applied here. .

Genuineness of Assent and Statute of Frauds 99

Ethics: Paralegal Loses $900,000 in Funds Because of the Statute of Frauds. The statute of frauds is often harsh.

Collateral Promises: 1. One person agrees to answer for the debt of another 2. Must be in writing.

3. Must be secondary to require a writing 4. Original contract does not fall under this rule 5. If main purpose is pecuniary benefit to guarantor, then no writing required.

Promissory Estoppel: • Equitable doctrine that prevents the application of the Statute of Frauds • Permits the enforcement of oral contracts that should otherwise be in writing under the Statue of Frauds in order to prevent injustice or unjust treatment Case 12.3. The Court Speaks: Page v. Gulf Coast Motors, 903 S. 2d 148, Web 2004 Ala. Civ. App. Lexis 982 (2004) Court of Civil Appeal of Alabama Facts: Glenn borrowed money at various times from seller in an informal loan process for 2years.

Only small payments were made. Mary (Glenn’s wife) orally guaranteed to repay the loans but she denied the promise or the request by the seller.

Issue: Was Mary’ alleged promise to guarantee her husband’s debts an enforceable guaranty contract?

Decision: No. They were not in writing as required by the statute of frauds.

Reason: The promises were within the statute of frauds and were not in unity and were not enforceable.

Sufficiency of the Writing: • Formality of the writing o A written contract does not have to be formal or drafted by a lawyer to be enforceable. o Informal contracts are enforceable contracts.

• Required signature o The party against whom enforcement of the contract is sought must have signed the contract.

• Integration of several writings o Several writings may be integrated to form a contract. o Express reference—one document incorporates another document. o Implied reference—documents are physically attached by staple or by paper clip or are placed in the same envelope.

Interpreting Contract Words and Terms There are standards of interpretation where parties have not defined the words and terms in a contract. See the rules listed in the chapter.

1. Ordinary words are given usual meaning.

2. Technical words are given a technical meaning. .

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3. Specific qualifies general.

4. Meaning in trade is used if appropriate.

5. Typed prevails over preprinted and handwritten prevails over both.

6. Ambiguity against the drafter.

Parol Evidence Rule: • Parol evidence—any oral or written words that are outside of the four concerns of a written contract.

• Parol evidence rule—provides that if a written contract is a complete integration, any prior contemporaneous oral or written statements are inadmissible as evidence to alter or contradict the terms of the written contract • Parol evidence may be admitted in court to: o Prove mistake, fraud, misrepresentation, undue influence, or duress o Explain ambiguous language o Explain a prior course of dealing or course of performance between the parties or a usage of trade o Fill in the gaps of a contract o Correct obvious clerical or typographical errors International Law: Seals Used as Signatures in Japan, China, and Other Asian Countries This illustrates the use of seals as a signature.

III.

Answers to Critical Thinking Cases

Unilateral Mistake 12.1

Because Schultz could have checked the zoning ordinances but didn’t, this is a case of unilateral mistake and the contract will probably not be rescinded. The due diligence necessary will not be lightly excused.

Fraud 12.2. Campbell wins and may recover damages from McClure for fraud. The essential elements of fraud are (1) a false statement, (2) knowledge that the statement was false, (3) intent that the statement induced another to act in reliance thereon, and (4) actual reliance resulting in damage. In this case, the court found ample evidence to support a finding of intentional fraud and justifiable reliance. McClure signed the escrow instructions which guaranteed the accuracy of his sales brochure while also admitting on the stand that he knew the business did not make as much money as he represented.

Moreover, expert testimony established that the business records were misleading.

Knowing the problematic nature of the business records, Campbell would not have bought the business unless he was assured that the business generated at least $150,000 in net income. McClure allowed Campbell to believe such representation, with no reasonable basis to conclude it was true. Accordingly, the court held McClure made the warranty to induce Campbell to buy the business by deceiving him as to the size of the profits, that when he made the warranty McClure knew it was false and had no reasonable grounds to conclude it was true, and that Campbell relied upon the warranty in purchasing the business. The court awarded compensatory and punitive damages for

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Genuineness of Assent and Statute of Frauds 101

fraud in the inducement, and also granted rescission of the contract. Campbell v.

McClure, 182 Cal.App.3d 806, 227 Cal.Rptr. 450 (Cal.App. 1986).

Duress 12.3

The threat of a civil lawsuit does not constitute duress. Duress occurs when one party threatens to do some wrongful act unless the other party enters into a contract. The threat to hold back her clothes might in a minor way. There is probably, however, not enough to rescind the contract.

Statute of Frauds 12.4. Hoffman and Frey do not win. Pursuant to the Statute of Frauds, an agreement for the sale of real property is invalid unless the agreement or some note or memorandum thereof be in writing and subscribed by the party to be charged. Failure to comply with the Statute of Frauds renders an oral agreement unenforceable both in an action at law for damages and in a suit in equity for specific performance. In this case, the lot sale agreement was never signed by Sun Valley. Moreover, the letter sent by Hoffman was not sufficient to constitute a memorandum. It did not evidence the maturity date of the note, a point of beginning for the installment payments, the amount of the installment payments, or if and how the note was to be secured. Accordingly, the court affirmed the judgment of the lower court denying specific performance of the oral agreement between the parties. Hoffman v. Sun Valley Company, 628 P.2d 218 (Idaho 1981).

Guaranty Contract 12.5. No, the Wests are not liable on the guaranty contract. It is well settled that an agreement to guarantee the debt of another must be in writing. In this case, the lower court found that the bank reasonably relied on Mr. West’s statements and applied the doctrine of equitable estoppel to find that the West’s were liable under the guarantee. The Supreme Court of Idaho, however, held that the bank could not have relied on the oral statements made by Mr. West because the bank was in the business of making loans to its customers on a regular basis and knew, or should have known, that a guarantee for the debt of another had to be in writing. Moreover, the court held that there was no meeting of the minds between the Wests and the bank, and without such a meeting of the minds, there is no enforceable contract. Accordingly, the court held that the bank simply jumped the gun in giving Brown the loan and that the Wests were not liable as guarantors on the loan.

First Interstate Bank of Idaho, N.A. v. West, 693 P.2d 1053 (Idaho 1984).

Sufficiency of Writing 12.6. Because the memorandum including all the necessary terms of the deal was initialed or signed, there is a valid and enforceable contract and Knight is not correct. Note, a specific type of signature is not required nor is there a specifically required location for the signature on the document.

IV.

Answers to Ethics Cases

12.7.

Barber wins. As a general rule, one cannot rescind based on a unilateral mistake, but if the mistake was innocent and rescission would have no adverse effect on the mistaken .

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

12.8. Affirmed for the son. Delaware law requires both an interest in land and a testamentary disposition to be in writing. Neither requirement is met by the father’s oral promise. But if there is clear and convincing proof of part performance an exception to the writing requirement makes the oral promise enforceable. The evidence clearly shows that the son fully performed his obligation, and thus, provided consideration for the father’s promise creating an oral contract. Because of the son’s performance, the part performance exception applies. The oral contract is enforceable without a writing. Shepard v.

Mozzetti, 545 A.2d 621 (Del. 1988).

V.

Answers to Policy Cases

Undue Influence 12.9. Yes, the conservator of the estate can cancel the deed transferring the farm to Lawrence.

The court found that Conrad was subject to the influence of Lawrence, who was acting in a confidential relationship, that the opportunity to exercise undue influence existed, that there was a disposition on the part of Lawrence to exercise such undue influence, and that the conveyance appeared to be the effect of such influence. The court held this was sufficient to establish a prima facie case of undue influence and that Lawrence had the burden of going forward with the evidence. Moreover, the court stated that one of the most important elements in determining whether this presumption can be rebutted is whether the grantor received independent counsel. In affirming the lower court’s judgment in favor of the conservator, the court found that it was apparent that Conrad was not afforded the opportunity to seek independent advice from any source other than Lawrence. Schaneman v. Schaneman, 291 N.W.2d 412 (Neb. 1980).

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Hampton v. Federal Express Corp.

917 F.2d 1119 (1990) U.S. Court of Appeals 2. Key Facts A. A child was awaiting a bone marrow transplant and five samples were sent by the hospital. The samples were never received.

B. There was a contract with Federal Express with a $100 limitation of liability which was not raised even though an opportunity to do so was present.

C. The transplant did not happen and the child died.

D. The Hamptons sued Federal Express for personal injury, wrongful death, and loss of services.

E. They were granted $100 and they appealed.

.

Genuineness of Assent and Statute of Frauds 103

3. Issue Can a carrier limit its liability for damages in a contract?

4. Holding Yes. Judgment was affirmed.

5. Court’s Reasoning A. Under federal common law, “a common carrier may not exempt itself from liability for negligence but may limit the liability.”

B. There was a contract with a clear limitation of liability that was not raised.

C. Federal Express did not know the package contents and could not reasonably foresee the injury.

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Chapter 13 Third-Party Rights and Discharge

Who Else Has Rights In The Contract?

Learning Objectives: Describe assignment of contract rights and what contract rights are assignable.

Define intended beneficiary and describe this person’s rights under a contract.

Define covenant.

Distinguish between conditions precedent, conditions subsequent, and concurrent conditions.

5. Explain when the performance of a contract is excused because of objective impossibility or commercial impracticability.

1.

2.

3.

4.

I.

Teacher-to-Teacher Dialogue

Although it is relatively easy to talk about intended beneficiaries, talking about assignments and the like represents “the wall” to many students. Over and over again, student feedback identifies the materials on after-formation introduction of third parties as the most difficult concept to grasp. This difficulty makes it especially important to have a good game plan going into the class session. Not to have one leaves you open, as an instructor, to an often open-ended and obtuse discussion of the minutiae of assignment as opposed to presenting picture.

Due to the difficulty ofthe thisbig topic, it might be wise to discuss intended beneficiaries first. In this part of the presentation, use of examples really helps the students. Moving on to afterformation third party involvement and a review of performance obligations might work next.

In this section you can possibly first give an overview of why third parties get involved, such as credit or commodity trading transactions. Then use a diagram on the board to illustrate some of the key aspects of assignment and novation. Maybe remind students of notice duties between the old and new parties to the contract. All in all, the more examples you use to illustrate these points, the better.

This chapter has four essential subparts to it: third party involvement ab initio, third party involvement after formation, the role of conditions, and discharge of performance. Third parties can become involved in a contract ab initio (from its inception) or after the fact. Contracts with third party involvement from the beginning are generically labeled intended beneficiary contracts.

These contracts are broken down to into two subcategories: donee and creditor. The donee beneficiary contract is probably the one most students will be familiar with and most likely to be

.

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a participant in. Insurance contracts are good examples of these. The insured child becomes a third party intended (donee) contract beneficiary. And if his rights have vested under the contract, the contract cannot be altered, canceled, or rescinded without his consent. Other examples of third party donee beneficiaries can be found in trusts and contracts to make a will.

The second category of intended third party beneficiaries is found in the law of creditors rights. When there is a preexisting debtor–creditor relationship, this relationship may act as the basis for a second contract where the named creditor beneficiary may be protected as an intended beneficiary. For example, suppose A borrows money from B to buy a car, and the car is used as collateral for the loan. B can now be named as a loss-payee (a person named in the policy to be paid in case of loss) up to the amount owed, even though B has not paid for or been a signatory to the insurance policy between A and his or her insurance company.

The third category, dealing with incidental beneficiaries, is not really a category of intended beneficiaries at all. The law is very straightforward on this point: if you do not qualify as an intended beneficiary based on donee or creditor grounds, you are classified as an incidental beneficiary and will not have any legally recognized standing to sue for protection under the contract. There is one minor exception to this rule in certain government contracts. Ordinarily, a taxpayer who objects to these contracts is classified as an incidental beneficiary, with no standing to sue, unless he or she can show that he belongs to a class for whose primary and immediate benefit the government contract was made.

The second category of third party involvement in contracts is the introduction of a third party after the contract already was formed. This party becomes involved by way of assignment or novation. In assignment, one of the original parties transfers rights or duties to a new third party participant. Compare this with a novation, derived from the Latin nova, meaning new. In a novation, the original contract with A and B is ended when a new contract is entered into between one of the original parties and a new party, C. The most common example is found in the assumption of mortgage obligations. In these forms of after-formation involvement of third parties, the law of assignment is far more important. Public policy in the law of contracts favors the transferability of contract rights and duties. Consider the world of finance, commodities, and the like. All of these commercially critical practices are facilitated by the transfer of contract rights from one person or business entity to another.

The second objective of this chapter is to introduce students to the concept of performance obligations and discharge from contracts. The rules of performance and breach of contract are rooted in common sense. Most contracts are completed legally when the parties have lived up to their reciprocal obligations under that contract. Conversely, a breach is found when a failure of performance is not somehow excused by law. We are expected to live up to our performance obligations and no more. If those obligations are not met, breach of contract is the result.

The evaluation process of contract performance issues is best broken down into time sequence subparts: precontract, during the contract, and postcontract. In precontract issues, what are the covenants entered into before performance is to be initiated? Were there any conditions that may affect the rights and duties of the parties to contract? Conditions are certain events that have a triggering effect on the obligations of contract. The timing of conditions can be superimposed upon the contract. A precondition or condition precedent calls for the event to take place before the contract goes into effect. For example: “I will buy this car if my mechanic signs off on the engine inspection.” A concurrent condition calls for two or more events to coincide in time. Consider an escrow where a third party is used as a holder of property and is instructed to act vis-à-vis that property only upon satisfaction of mutually dependent acts of third parties. This is a common form of property transfer used in the sale of real estate. The escrow holds the deed to the property from the seller until the buyer has delivered the purchase price in a form acceptable to both parties. A condition subsequent is found where performance may be excused by a certain event after the contract was entered into. For example, a parolee is allowed to stay out of prison as long as the conditions of the parole release are met. .

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There are certain circumstances that will act to excuse nonperformance. These circumstances are also based in common sense. Can it really be reasonable to expect personal service contracts to be enforced after death or disability? Or does it make sense to accept performance after destruction of a unique subject matter of the contract? A third form of excuse is found in subsequent illegality. If a contract was legal at the time it was formed, but subsequent events have made its enforcement illegal, courts will no longer enforce its performance covenants based upon the new illegality.

In addition to excused nonperformance, there are a number of possible circumstances that may result in a discharge from any further contractual performance. These fall into two main categories: discharge by acts of the parties or by operation of law. Discharges by acts of the parties are voluntary postcontract formation events such as mutual recission, reformation, accord and satisfaction, a substituted contract, or novation. In all these scenarios, the parties have, in effect, reentered the bargaining and created a new deal.

In an operation of law discharge, something has happened where the court steps in and declares that this contract performance obligation can no longer be enforced. Examples of such legal impediments to enforcement would include the running of a statute of limitation or bankruptcy. In both cases, any further performance under the contract has been legally ended. If, however, the contract duty has not been discharged, excused, or performed, and the absolute duty to perform has been breached, one must examine what remedies are available to the nonbreaching party.

II.

Text Materials

Introduction: Privity of Contract: • The state of two specified parties being in a contract.

• Contracting parties have a legal obligation to perform the duties specified in their • contract.

If one party fails to perform as promised, the other party may enforce the contract and sue for the breach.

Third Party Rights: • Third parties generally do not acquire any rights under other people’s contracts • Two exceptions are: 1. Assignees to whom rights subsequently are transferred, and 2. Intended third-party beneficiaries to whom the contracting parties intended to give rights under the contract at the time of contracting Assignment of Rights: • Assignment—the transfer of contractual rights by the obligee to another party • Assignor—the obligee who transfers the right • Assignee—the party to whom the right has been transferred Rights That Can and Cannot Be Assigned: • Personal service contracts. Contracts for the provision of personal services are generally • not assignable.

Assignment of future rights. Usually, a person cannot assign a currently nonexistent right that he or she expects to have in the future. .

Third-Party Rights and Discharge 107

• •

Contracts where assignment would materially alter the risk. A contract cannot be assigned if the assignment would materially alter the risk or duties of the obligor.

Assignment of legal actions. Legal actions involving personal right cannot be assigned.

Note: Also include anti-assignment clauses where valid.

Case 13.1. The Court Speaks: Accrued Financial v. Prime Retail, 298 F.3d 291, Web 2002 App. Lexis 15238 (2002) U.S. Court of Appeals Facts: AFS conducted an audit of Prime Retail, a landlord, on behalf of tenants that had signed assignment agreements granting AFS the right to file suit on their behalf. AFS brought suit against Prime Retail. The U.S. District court dismissed the case.

Issue: Does the assignment by a tenant of legal claims against a landlord violate public policy? Is it therefore illegal?

Decision/Remedy: Yes. Decision was affirmed.

Reason: AFS really became a promoter of litigation. The tenant lost the right to not bring suit even if they thought there was no course of action.

Successive Assignments: • If the obligee makes successive assignments of the same right, one of the following rules applies: o American Rule (or New York Rule) o English Rule o Possession of Tangible Token Rule Note: Assignee must notify obligor. If not, obligor can continue to deliver performance to the assignor.

Delegation of Duties: • Delegation—a transfer of contractual duties by the obligor to another party for performance • Delegator—the obligor who transferred his or her duty • Delegatee—the party to whom the duty has been transferred Note: Delegator remains liable Effect of Delegation of Duties: • If assumption, can sue delegate • If declaration, cannot sue delegate Duties That Can and Cannot Be Delegated:

.

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•

•

If the obligee has a substantial interest in having the obligor perform the acts required by the contract, duties may not be transferred o Personal service contracts calling for the exercise of personal skills, discretion, or expertise o Contracts whose performance would materially vary if the obligor’s duties were delegated Also include anti-delegation clauses

Third-Party Beneficiaries: • Third parties sometimes claim rights under other’s contracts • Such third parties are either: o Intended beneficiaries, or o Incidental beneficiaries

Note Donee (gift)—Donee beneficiary can sue promisor agreeing to perform Creditor (debt)—Creditor beneficiary can sue debtor or promisor Incidental—No rights

Case 13.2: The Court Speaks: Ramos/Carson/DePaul, a Joint Venture v. The Phillies, L.P., Web 2006 Phila. Ct. Corum Pl. Lexis 397 (2006) Common Pleas. Court of Phil. County, PA. Facts: Phillies contract with DH to act as construction manager for building Citizens Bank Park (the project). DH hired RCD as a subcontractor to install contract foundations. After many disruptions RCD claimed the Phillies and DH owed them more. They claimed they were intended beneficiary of the Phillies—DH agreement. The Phillies agreed they were incidental beneficiary.

Issue: Was RCD an intended or incidental beneficiary of the Phillies-DH Agreement?

Decision/Remedy: Incidental. They could not sue the Phillies as a third-party beneficiary.

Reason: There was no promise in the agreement over the evidence allowing claim payments, which is needed undefined restatement (Second of Centers). There has, intact, a disclaimer of any in the agreement.

Covenants and Conditions: •

•

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

Types of Conditions: 1. Condition Precedent—A specified event must occur (or not occur) before a party is obligated to perform contractual duties.

2. Condition Subsequent—The occurrence (or nonoccurrence) of a specified event excuses the performance of an existing contractual duty to perform.

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Third-Party Rights and Discharge 109

3. Concurrent Condition—The parties to a contract are obligated to render performance simultaneously. Each party’s duty to perform is conditioned on the other party’s duty to perform.

4. Implied Condition—An implied-in-fact condition is implied from the circumstances surrounding the contract and the parties conduct.

Tests for Conditions Precedent 1. Personal satisfaction—subjective and in good faith 2. Reasonable person—objective Contemporary Environment: “Time of the Essence” Contract. Performance by the stated time is an express condition.

Discharge of Performance: •

A party’s duty to perform under a contract may be discharged by: o Mutual agreement of the parties o Impossibility of performance o Operation of the law

Discharge by Impossibility: 1. Objective Impossibility a. Death or incapacity b. Subject material destruction c. Super ailing illegality Discharge by Agreement: 1. Mutual rescission—both enter into new agreement terminating the first 2. Substituted contract—new contract revokes and discharges prior one 3. Novation—substitution of a party 4. Accord and satisfaction—accepting different consideration Case 13.3. The Court Speaks: Parker v. Arthur Murray, Inc, 29 5 N.E. 29 487, Web 1973 Ill. App. Lexis 2760 (Appellate of Court of Illinois) Facts: Parker contracted with Arthur Murray for dance lessons. Even though he was not progressing, he was encouraged to enter into additional contracts that required prepayment. The contracts contained noncancellation and no-refund clauses. Parker was injured in an accident and was unable to continue the lessons. He sued for return of his prepayments. The trial court decided for Parker, and Arthur Murray appealed.

Issue: Does impossibility excuse Parker and allow him to rescind the contract?

Decision: Yes. Parker wins.

Reason: Arthur Murray claims that the general rule on impossibility does not apply here because the clauses of the contracts indicated the intent of the parties to waive the rights of excuse because of impossibility. But, the court stated that nothing indicates that Parker intended to waive the specific right by the general language of the clauses. because the clauses are ambiguous on this point and were drafted by Arthur Murray, they are construed in favor of Parker. Therefore, because they do not specifically provide for waiver of the right of excuse due to impossibility, Parker did not waive that right and may enforce it rescinding the contracts.

Commercial impracticability is a necessary yet difficult concept to teach in contract law. It is necessary because there are so many variables in the world of commercial trade. These variables .

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make it difficult to write a totally comprehensive instrument that can take all the possible scenarios into account when writing up the contract in the first place. Thus, we see the need for the commercial impossibility doctrine. The doctrine is, in effect, an economic equity bailout to be used only in extreme or unexpected situations. It is not meant to be a back door out for every deal that goes sour. I remind students that courts are reluctant to use this doctrine, and one should never rely on it as an initial course of action. It is a legal favor, not an entitlement. See Alimenta v. Cargill, Inc. Force Majeure Clauses Parties may agree in their contract that certain events, such as labor strikes, shortages of raw

materials, and the like, will excuse nonperformance of the contract. These are called force majeure clauses.

Discharge: Commercial Impracticability Modern contract law recognizes that, sometimes, unforeseen circumstances make the performance of a contract highly impracticable or very expensive and excuses nonperformance in certain circumstances.

Contemporary Environment: Commercial Impracticability Excuses Look to nature of agreement and not to physical possibility of performance.

International Law: Negotiation of Contracts in Foreign Countries Discharge by operation of the law 1. Statute of Limitations 2. Bankruptcy III.

Answers to Critical Thinking Cases

Third-Party Beneficiary 13.1.

Lucas wins and may recover the $75,000 from Hamm. Generally, contracts made expressly for the benefit of a third person are enforceable. However, enforcement by persons who are only incidentally or remotely benefited is not permissible; intent to benefit a third person must be shown. Moreover, no specific manifestation of such intent is required. It is sufficient that the promisor understood that the promisee had such intent.

The liability to a third party is also a matter of policy involving the balancing of many factors. Such factors included the extent to which the transaction was intended to affect the plaintiff, the foreseeability of harm to him, the degree of certainty that plaintiff suffered injury, closeness of the connection between the defendant’s conduct and the injury suffered, and prevention of future harms. In this case, the court found that the main purpose of the transaction between the defendant and the testator was to provide for the transfer of property to the plaintiff, that the damage to the plaintiff was foreseeable, and that it was certain that upon the testator’s death the plaintiff would have received the property contemplated, absent negligence of the defendant. The court concluded that if persons such as the plaintiff were not permitted to recover for such negligence, no one would be able to do so, and the policy of preventing future harm would be impaired. .

Third-Party Rights and Discharge 111

Accordingly, the court held that the intended beneficiary of a will, who loses his testamentary rights because of the failure of an attorney to properly draft that will, can recover as a third-party beneficiary. Lucas v. Hamm, 364 P.2d 685, 56 Cal.2d 583, 15 Cal.Rptr. 821 (Cal. 1961).

Assignment 13.2.

Yes, Cunningham’s contract was validly assigned to the new owners. Generally, a personal service contract requiring special skills and based upon the personal relationship between the parties cannot be assigned without the consent of the party rendering the services. However, where the character of the performance will not be changed, such contracts are assignable. The policy against assignability of personal service contracts is to prohibit an assignment in which the obligor undertakes to serve only the original obligee. In this case, the court found that the rendition of services by Cunningham could not have been affected by the personalities of successive corporate owners. Cunningham was not obligated to perform differently for the plaintiffs than he was for the Southern Sports Club. Accordingly, the court held that the contract was assignable to the new owners under the facts presented. Munchak Corporation v. Cunningham, 457 F.2d 721 (4th Cir. 1972).

Assignment 13.3.

The Pillsbury Company wins. It is well settled that personal service contracts, including distributorship agreements, which are silent regarding assignment, cannot be assigned without the prior consent of the other party. In this case, the court held that the oral contract between Pillsbury and Berlinger was a personal service contract and was therefore not assignable. The court stated that it would defy common sense to require a manufacturer to leave the distribution of its products to a distributor under the control of a competitor or potential competitor. Accordingly, the court held that the Pillsbury Company rightfully terminated the distributor agreement with Berlinger. Berlinger Foods Corporation v. The Pillsbury Company, 633 F.Supp. 557 (D.Md. 1986).

Delegation of Duties 13.4.

Milford wins, and McKinnie must permit the stud services of Hired Chico provided in the Milford-Stewart agreement. In Texas, a party to a contract may perform his duty through a delegate by assigning or transferring the contract to a third party unless the other party has a substantial interest in having his original promisor perform or control the acts required by the contract. Moreover, all rights of a buyer can be assigned except where the assignment would materially change the duty of the other party, increase materially the burden of risk imposed on him by his contract, or impair materially his chance of obtaining return performance.

A general assignment of the contract will assign the rights and delegate the performance of the duties of the assignor, and its acceptance by the assignee constitutes a promise by him to perform those duties. This promise is enforceable by either the assignor or the other party to the contract, and the assignee becomes liable for the contractual performance of the original buyer, even though the original buyer remains liable on the contract. In this case, the court found that because none of the above exceptions applied, Stewart was permitted to delegate his duty of making the horse available to Milford and that McKinnie’s acceptance, with full knowledge of the contractual obligations, constitutes a promise by McKinnie to perform those duties. .

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Accordingly, the court held that Stewart’s promise is enforceable by Milford and that McKinnie must permit the stud services of Hired Chico as provided in the Milford-Stewart agreement. McKinnie v. Milford, 597 S.W.2d 953 (Tex. 1980).

Condition 13.5.

Pace wins the lawsuit and does not have to pay OBS. Until a condition precedent is satisfied, the other terms of the contract are not enforceable. In most subcontract agreements, payment by the owner to the contractor is not intended to be a condition precedent to the contractor’s duty to pay the subcontractor. In order to properly shift the risk to the subcontractor, the subcontract must unambiguously express such an intention.

In this case, the subcontract clearly states that payment from the owner shall be a condition precedent to the contractor’s obligation to make final payment to the subcontractor. Accordingly, the court held that OBS must bear the risk of nonpayment by the owner. Pace Construction Corporation v. OBS Company, Inc., 531 So.2d 737 (Fla.App. 1988).

Excuse of Condition 13.6.

Barrows wins. Delays and nonperformance, although they amount to a failure to perform a contract, are excused where the other party to the contract prevents performance of the contract. Barrows had sued for a commission on the net profits from a roofing contract.

Barrows v. Maco, Inc., 419 N.E. 2d 634 (Ill. App. 1981).

IV.

Answers to Ethics Cases

13.7.

Outdoor Services is a creditor beneficiary of an agreement between Pabagold and Mediasmith, and can enforce the contract. The judgment of the arbitrator in Outdoor Services’ favor is affirmed. Under American law, a third party beneficiary to a contract, other than an incidental beneficiary, can enforce its terms. The reasons for Pabagold’s decision not to pay are not clear and would not be ethically defensible without a very good explanation, such as “the work performed was not acceptable.” Outdoor Services, Inc. v. Pabagold, Inc., 185 Cal.App.3d 676, 230 Cal.Rptr. 73 (Cal.App. 1986).

13.8.

Glueck wins. To determine whether satisfaction has been received pursuant to a contract that conditions a party’s duty of performance upon his own satisfaction, courts will apply either a good faith standard or a reasonable person standard. Under the reasonable person standard, dissatisfaction cannot be claimed arbitrarily, capriciously, or unreasonably.

Satisfaction is received if a reasonable person in exactly the same circumstances would be satisfied. This standard is employed when a contract involves commercial quality, operative fitness, or mechanical utility that other persons can judge.

Under the good faith standard, the recipient of the work performed must be genuinely satisfied. This includes subjective satisfaction, although the mere statement by the recipient that he is dissatisfied is not conclusive. Most courts will recognize the recipient’s dissatisfaction only when he is honestly, even though unreasonably, dissatisfied and acts in good faith. The good faith standard is employed when the contract involves personal aesthetics or fancy.

In this case, the construction of a parking lot concerns commercial quality and operative fitness rather than personal aesthetics. Therefore, the court applied the reasonable person standard and held that Tri-City breached the agreement by .

Third-Party Rights and Discharge 113

unreasonably withholding approval.

Indiana Tri-City Plaza Bowl, Inc. v. Estate of Glueck, 422 N.E.2d 670 (Ind.App. 1981).

V. Answers to Policy Cases 13.9.

No. The Gillispes were not intended beneficiaries of the contract between Bain and Big 10. They were incidental beneficiaries with no right to sue. There was not the required intent. This was clear in this situation. Barin v. Gillispie, 357 N.W. 201 47, Web 1984, Iowa App. Lexis 1964 (Court of Appeals of Iowa)

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Chase Precast Corp. v. John J. Paonessa Co., Inc. 409 Mass. 371, 566 N.E.2d. 603 (1991) Supreme Judicial Court of Massachusetts 2. Key Facts A. The Commonwealth of Massachusetts entered into two contracts with John J. Paonessa Co., Inc. to resurface and improve two stretches of Route 128.

B. Paonessa entered into a subcontract with Chase Precast Corp. to supply 25,800 linear feet of concrete median barriers to be used in the project.

C. Due to objections by local residents, the Commonwealth of Massachusetts entered into an agreement where no further concrete barriers would be used in the project.

Approximately half of the original number were already delivered to the site and had been paid for by Paonessa.

D. Upon notification from the Commonwealth of its decision not to proceed with any further use of concrete barriers, Paonessa cancelled the remainder of its contract with Precast.

E. Precast sued Paonessa for its lost profits on the remainder of its original contract. The lower court held against Precast on the basis of impossibility of performance, and the appeals court affirmed that holding, but held that the doctrine of frustration of purpose more accurately described the situation.

3. Issue Does the doctrine of frustration of purpose apply in this case?

4. Holding Yes. 5. Court’s Reasoning The Supreme Judicial Court of Massachusetts held that: A. The doctrine of frustration of purpose is used when an event neither party anticipated, nor caused, the risk of which was not stipulated in the contract, destroys the object or purpose of the contract, thus destroying the value of performance. This doctrine excuses the parties from further performance.

B. Precast had experience with prior contracts with the Commonwealth of Massachusetts and was aware of its power to eliminate items or portions of supplies called for in the original contracts.

C. Paonessa bore no responsibility for the Commonwealth’s decision not to order the original number of concrete barriers. .

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D. There was no allocation in the contract for any lost profits that may arise out of this cancellation.

E. Therefore, the doctrine of frustration of purpose applied.

.

Breach of Contract and Remedies 115

Chapter 14 Breach of Contract and Remedies

Why Can’t We Always Find Damages?

Learning Objectives 1. Describe complete, substantial, and inferior performance of contractual duties.

2. Describe compensatory, consequential, and nominal damages awarded for the breach of traditional and e-contracts.

3. Explain rescission and restitution.

4. Define the equitable remedies of specific performance, reformation, and injunction.

5. Describe torts associated with contracts.

I.

Teacher-to-Teacher Dialogue

How, when, and where the end comes to a contract is what this chapter is about. Putting a time-line on the steps of performance really helps students identify not only when the duty obligations are met, but also when a breach has taken place. Seeing how the conditions affect the ultimate rights of the parties also helps students formulate what remedies should be used in case of a breach.

The remedy portion of this chapter could be broken down into the traditional law/equity dichotomy. Examples are usually helpful here.

As noted in the prior chapter, we are expected to live up to our performance obligations. If these obligations are not met, a breach of contract is often the result in the eyes of the law. There are a number of possible circumstances that may result in a discharge from any further performance. These fall into two main categories: discharge by acts of the parties or by operation of law. Discharge by acts of the parties in voluntary postcontract formation might occur in many ways such as mutual rescission, reformation, accord and satisfaction, substituted contract, or novation. In all of these scenarios, the parties have, in effect, reentered the bargaining and created a new deal.

In addition, contract obligations may have been met and breached with less than full performance. In substantial performance, 100 percent of the performance was not involved. If the breach was not material or intentional, the nonbreaching party may sue for damages but not rescission. For example, if a $100,000 house has the wrong doorknob in it, and replacement will cost $100, the original contract can still be enforced less the price of the current doorknob. .

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Compare this with a house with no doors. The failure to provide doors may be construed as only partial performance because of lack of security. The nonbreaching party may then sue for rescission or recover damages.

In this chapter we can introduce students to remedies in contract after a breach has taken place. An overview of the remedies available to the nonbreaching party in contract can be compared to the various directions posted on a map when your car has broken down. Because your trip has been brought to an abrupt halt, you must decide which options make the most sense to you. Do you try to go back where you started? Can the car be fixed where you are, or do you need a tow to your original destination? By analogy, contracts can be also brought back (rescission), fixed (damages or reformation), or taken forward to their original destination (specific performance). The majority of remedies provided by the courts for contract breach fall into the category of a repair by way of monetary damages. In this repair process, there is an attempt to provide the innocent party with a financial replacement for the benefits that he or she had under the original contract.

Think of monetary damages as an ascending staircase, starting at the bottom with token or nominal damages and going all the way to punitive damages. Nominal damages are applicable where there is little real economic consequence arising from the breach. In a nominal damage award, the winner wins in principle but not in significant monetary terms.

The next step is found in compensatory or actual damages. These damages seek to restore the benefit of the bargain by providing a monetary substitute for what was lost due to the breach. For example, if Mario had a deal with Zoomo Motors to buy a new car for $20,000 and had to buy a comparable model from Zamay Motors for $30,000 due to Zoomo’s breach, the actual measure of compensatory damages would be $10,000. If Mario had a resale contract for the car to A.J. for $40,000 and Zoomo knew of this second contract, Zoomo may also be liable for an additional $10,000 in consequential damages to Mario. In addition, had Zoomo’s breach been related to a bad faith tort within the contract setting, the court might also grant punitive damages. Punitive damages are a form of court-imposed civil punishment. Normally, punitive damages are not granted for contract breach alone, but if the bad faith involved shocks the conscience of the court, tort damages may be applicable.

One other damage measure possibility lies in the area of liquidation or agreed upon damages set by the parties. A court will examine these damages to make sure that they are not a disguised penalty.

The other two paths available to the nonbreaching party are going backward or going forward with the contract. In going backward, a court is asked to return the parties to their precontract position by way of rescission or restitution, that is, undo the contract. A common example of rescission is found in return of deposit clauses in purchase contracts or in consumer protection statutes which provide for a three day cooling off period after a contract is signed. These statutes generally allow for a unilateral right of rescission within the three-day period by the buyer.

Another category of remedies involves going forward with the original terms of the agreement. These remedies are classified as equitable remedies because the breach cannot be adequately compensated by normal economic damage measures. The underlying theory is that the contract must somehow be enforced as a matter of equity and fair play rather than substituted by money alone. Equitable remedies are often found in modern day versions of specific performance, quasi-contract, and injunctive relief.

The last category of remedies regards to contract-related torts. Where the contract is related to situations involving intentional interference with contract relations or breach of an implied covenant of good faith and fair dealing, a court may grant punitive damages.

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II.

Text Materials

Breach (Unexcused Nonperformance) Remedies 1. Damages a. Compensatory b. Consequential c. Liquidated d.

Nominal e.

Punitive?

2. Equity a. Specific performance b. Reformation c. Quasi-contract d. Injunction 3. Others a. Rescission b. Restitution Performance and Breach: • If a contractual duty has not been discharged or excused, the contracting party owes an absolute duty (covenant) to perform the duty.

• Breach of contract—if a contracting party fails to perform an absolute duty owed under a contract Types of Performance: 1. Complete Performance—The contract is discharged.

2. Substantial Performance (Minor Breach)—The nonbreaching party may recover damages caused by the breach.

3. Inferior Performance (Material Breach)—The nonbreaching party may either: a. Rescind the contract and recover restitution b. Affirm the contract and recover damages Anticipatory Breach: • A breach that occurs when one contracting party informs the other that he or she will not • • perform his or her contractual duties when due.

This gives an immediate cause of action to the nonbreaching party to sue for breach of contract.

This is also called anticipatory repudiation.

Case 14.1. The Court Speaks: Chodos v. West Publishing Company, Inc., 292 F.3d 992, Web 2002 U.S. App. Lexis 10823 (2002) U.S. Court of Appeals Facts: Chodos and Bancroft-Whitney (now merged with West Publishing) signed a publishing contract. From July 1995 through June 1998. Chodos spent time writing the manuscript and working with the editors in developing and editing it. He spent considerable time away from his practice. The final manuscript was declined in June, 1998. In December 1998, West assured

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Chodos of a first quarter 1999 publication. In February 1999, Chodos received West’s letter saying it would not publish the manuscript because of commercial reasons and business reasons, even though the work was high quality. U.S. District Court granted summary judgment in favor of West in a suit by Chodos alleging breach of contract.

Issue: Did West Publishing breach the author agreement it had with Chodos?

Decision/Remedy: Yes. The decision was reversed and remanded to enter a summary judgment of liability for Chodos.

Reason: West’s description of the manuscript as high quality and decision to not publish due to business reasons requires a decision of breach of contract as a matter of law.

Enforcement of remedies: Judgment is by: 1. Writ of attachment: seize and sell property 2. Writ of garnishment: satisfy witnesses Monetary Damages: • A nonbreaching party may recover monetary damages from a breaching party • Monetary damages are available whether the breach was minor or material: o Compensatory damages o Consequential damages o Liquidated damages o Nominal damages Examples: 1. Compensatory a. Sale of goods: market price minus contract price at time of delivery b. Construction: can include lost profits c. Employment: costs to hire new employee plus increase in salary 2.

3. Consequential a. Needs knowledge Liquidated a. Cannot be a penalty Contemporary Environment: Liquidated Damages Awarded to Breach of Contract at Trump World Tower. It is the 25 percent nonrefundable deposit.

Uzan v. 845 UN Limited Partnership Facts: Trump Tower holds luxury condos sold by 845UN which required a 25 percent nonrefundable down payment which was to be treated as liquidated damages. Donald Trump was the managing general partner of 845UN. Cem and Hakan Uzan paid the 25 percent of their purchase price for two condos on the top floor over a 2 year period but after 9/11 feared additional possible terrorist attacks and asked for a rescission. 845UN sent default letters and eventually kept the 25 percent. The Hakans believed this was an unenforceable penalty. The trial court granted 845UN partial summary judgment for 10 percent and 845UN appealed.

Issue: Is the 25 percent nonrefundable down payment enforceable liquidated damages, or is it an unconscionable and unenforceable penalty?

Decision: It was an enforceable liquidated damages clause. Summary judgment was granted to 845UN. Reason: The 25 percent was part of an arm’s-length negotiated deal to compensate for the substantial time between signing and closing. This is also standard in the industry and the Hakan’s were fully aware of the details. .

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Mitigation of Damages: • A nonbreaching party is under a legal duty to avoid or reduce damages caused by a • breach of contract.

The extent of mitigation depends on the type of contract involved.

Rescission and Restitution: Rescission • An action to undo the contract • Available if there has been: o A material breach of contract o Fraud o Undue influence o Mistake Restitution • Returning of goods or property received from the other party to rescind a contract.

• If the actual goods or property is not available, a cash equivalent must be made.

Case 14.2. The Court Speaks: Hickman v. Bates, 889 So.2d, 249, Web 2004 La. App. Lexis 3076 (2004) Court of Appeals of Louisana.

Facts: Patricia inherited ½ interests in two large Louisiana properties. She was 20 years old and had a mental condition. After a call from her dad Joe, who lived with Christine (Joe’s sister) and her husband, she went to visit him. Joe told her he wanted her to sell her interests in the property to Keith (first cousin and son of Christine) and Sheila. Patricia agreed to sell to Keith for $500 and she signed legal documents. Patricia, subsequently, through a friend sued Keith and Sheila to rescind and alleged fraud. Experts valued the property at $279,700. The trial court found fraud and rescinded the contract but Patricia did not get attorneys’ fees. Both sides appealed.

Issue: Should the sales contracts be rescinded because of fraud and should Patricia get attorneys’ fees?

Decision: Yes. The fraud and rescission judgment was affirmed while the denial of attorneys’ fees was reversed.

Reason: Consent may be vitiated by fraud which is a misrepresentation or suppression of the truth done intentionally to get an unfair advantage over or to cause loss to another. Patricia’s condition as well as her father’s and her trust in her father and cousin led the court to believe Keith had a responsibility to fully inform Patricia and that she understand everything she was doing, including the price of the properties. Failure to do this was fraud.

Types of Equitable Remedies: 1. Specific Performance—Court orders the breaching party to perform the acts promised in the contract. The subject matter of the contract must be unique.

2. Reformation—Court rewrites a contract to express the parties’ true intentions. Usually used to correct clerical errors.

3. Injunction—Court order that prohibits a party from doing a certain act. Available in contract actions only in limited circumstances.

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Case 14.3. The Court Speaks: Alba v. Kaufmann, 27 A.D. 39 816, 810 N.Y.S. 2d 539, Web 2006, N.Y. app. Div. Lexis 2321 (2006) Supreme Court of NY, Appellate Division Facts: The Kaufmanns listed property for sale for $350,000. The Albas offered the full price, paid a deposit, obtained a mortgage, had a house inspection, got title insurance, and both executed a contract for sale. Prior to the set closing date the Kaufmanns e-mailed a desire to cancel the deed. The Albas e-mailed an intent to go to closing. Mrs. Kaufmann e-mailed that the thought of the sale was making her ill due to her MS. The Kaufmanns refused to close and the Albas sued for specific performance and move for summary judgment. The motion was denied and the Albas appealed.

Issue: Was an order of specific performance of the real estate warranted in this case?

Decision: Yes. The denial of the Albas’ motion was reversed and the motion for summary judgment was granted and specific performance was ordered.

Reason: The Albas showed they were ready, willing, and able to perform but the Kaufmanns were able but unwilling. Also, specific performance is routinely the remedy in real estate cases.

The court found such a remedy in this case would not be unreasonably harsh. Also volitional unwillingness does neither furnish grounds for cancellation nor create a defense against the contract’s specific performance.

Torts Associated with Contracts: • •

•

The recovery for breach of contract usually is limited to contract damages.

The major torts associated with contracts are: o Intentional interference with contractual relations o Breach of the implied covenant of good faith and fair dealing Intentional interference usually involves some inducement to breach a known and enforceable contract.

Tort Damages: Compensatory Damages • These include compensation for personal injury, pain and suffering, emotional distress, and other injuries caused by the defendant’s tortious conduct.

Tort Damages: Punitive Damages • Damages that are awarded to: o Punish the defendant. o Deter the defendant from similar conduct in the future. o Set an example for others.

• These are recoverable against a defendant for intentional or egregious conduct.

Ethics: Insurance Company Assessed Punitive Damages for a Bad Faith Tort.

O’Neill v. Gallant Facts: Navvaez carried the $20,000 minimum amount of liability insurance legally permitted with Gallant Insurance Company. Navvaez’s car struck O’Neill after a two-year-old set the running car in motion after Navvaez had exited the running car. Medical bills were $105,000. A settlement offer of the policy limit was suggested by Gallant’s representatives. The executive VP refused to settle until the evening of the trial but O’Neill refused. A jury returned a verdict of $731,063. Gallant paid $20,000 leaving Navvaez liable for $711,063. Navvaez assigned her claims against Gallant to O’Neill. In a trial for a bad faith act of breaching a covenant of good

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faith and fair dealing, the jury found for O’Neill in the amount of $710,063 in actual damages against Gallant and $2.3 million in punitive damages.

Issue: Was Gallant liable for a bad faith tort?

Decision/Remedy: Yes and judgment was upheld.

Reason: “Where an insurer is pursued for its refusal to settle a claim, bad faith lies in an insurer’s failure to give at least equal consideration to the insured’s interest when the insurer arrives at a decision to settle the claim.” Gallant had chosen its own interest above those of Navvaez. There were a number of other minor cases against Gallant.

III.

Answers to Critical Thinking Cases

Performance 14.1.

Drennen wins and can recover the full price under the contract, less the cost of repairs. A contractor who has substantially performed the work is entitled to be paid, subject to deduction for reasonable costs of repair for any deficiencies proved by the owner or the reasonable diminution in value of the work caused by any partial failure of performance.

In this case, the court concluded that the evidence presented sufficient proof of the necessary defects and that Drennen was entitled to be paid $42,324 under the contract, less $26,715 for repairs. Wallace C. Drennen, Inc. v. Haeuser, 402 So.2d 771 (La.App. 1979).

Anticipatory Repudiation 14.2.

No, MSGB does not have to wait until the date of performance to sue Ali under the contract. Generally, where a party’s words or actions make it clear that he is unwilling to perform, the other party may treat such repudiation as a breach of contract. In this case, when Ali announced his retirement, it was clearly a stated intention of his refusal to perform under the terms of the contract. Therefore, MSGB could have treated such actions as a breach. Accordingly, the court held that MSGB had the right to sue for that breach before performance was due under the contract. Madison Square Garden Boxing, Inc. v. Muhammad Ali, 430 F.Supp. 679 (N.D.Ill. 1977).

Damages 14.3.

Yes, Microform materially breached its contract with Hawaiian Telephone. When a contract provides for a definite time for performance, a failure to meet such deadline results is a material breach of the contract. In this case, Microform was unable to design a system that handled 15,000 calls per hour with a one-second response time by the midFebruary deadline. The court held that the failure to meet the delivery deadline was a material breach and that such inability to meet the contract specifications was a further breach. Accordingly, the court upheld the lower court’s judgment awarding breach of contract damages to Hawaiian Telephone. Hawaiian Telephone Co. v. Microform Data Systems, Inc., 829 F.2d 919 (9th Cir. 1987).

Damages 14.4.

Yes, Gundersons can recover the lost profits on the remaining two-thirds of the contract to build the golf course. A contractor is entitled to recover, from a breaching defendant, .

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damages sufficient to place it in the position in which it would have been had the breach not occurred, including any incidental or consequential damages caused by the breach.

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

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

Specific Performance 14.5.

Yes, an order of specific performance is an appropriate remedy in this case. Specific performance may be decreed where the goods are unique or in other circumstances where money damages do not adequately compensate the plaintiff. In this case, the court found that the uniqueness of Claiborne’s cosmetics line, including its distinctive package, is obvious. Moreover, the court found that money damages would not adequately compensate Claiborne for such intangibles as how the destruction of the Claiborne cosmetic line will affect the other business carried on under the Claiborne name. The closing of a much-publicized venture and its failure to supply stores would do nothing to enhance its reputation with suppliers, distributors, retailers, and customers. Therefore, the court held that money damages would be inadequate to compensate Claiborne for damages to its reputation and ordered Avon to fill and deliver in a timely and diligent fashion, all purchase orders placed by Claiborne in accordance with the contract. Liz Claiborne, Inc. v. Avon Products, Inc., 530 N.Y.S.2d 425, 141 A.D.2d 329 (N.Y.Sup.App. 1988).

Injunction 14.6.

No, an injunction is not an appropriate remedy in this case. Generally, a contract to render personal services cannot be specifically enforced. An unwilling employee cannot be compelled to continue to provide services to his employer by ordering specific performance. To hold otherwise would be a violation of the constitutional right against involuntary servitude. Accordingly, Beverly Glen is prohibited from enjoining Baker from performing the contract with Warner. In this case, however, Beverly Glen is also seeking to enjoin Warner from employing Baker. The court held that to do so would have the same effect and intent as enjoining Baker herself; she would be deprived of her livelihood and pressured to return to Beverly Glen. Moreover, Beverly Glen has an adequate remedy by way of damages; an injunction adds nothing to Beverly Glen’s recovery other than to coerce Baker to honor her contract. Accordingly, the court affirmed the order of the trial court denying injunctive relief. Beverly Glen Music, Inc. v.

Warner Communications, Inc., 178 Cal.App.3d 1142, 224 Cal.Rptr. 260 (Cal.App. 1986).

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IV.

Answers to Ethics Cases

14.7.

The facts of this case warranted the equitable remedy of an injunction to protect Walgreen’s interests. Injunctions to enforce exclusivity clauses are quite likely to be justifiable by just the considerations present here—damages are difficult to estimate with any accuracy and the injunction is a one-shot remedy requiring no continuing judicial involvement. Walgreen Co. v. Sara Creek Property Co., 966 F.2d 273 (7th Cir. 1992).

14.8.

Crisci wins based on the insurance company’s breach of covenant of good faith and fair dealing implied in an insurance contract. In every contract, including policies of insurance, there is an implied covenant of good faith and fair dealing that neither party will do anything that will injure the right of the other to receive the benefits of their agreement. The elements of this cause are as follows: 1. The contract must be such that the parties are in inherently unequal bargaining positions.

2. The motivation for entering the contract must be a nonprofit motive, that is, to secure peace of mind, security, or future protection.

3. Ordinary contract damages are not adequate, because: a. They do not require the party in the superior position to account for its actions, and b. They do not make the inferior party whole.

4. One party is especially vulnerable because of the type of harm it may suffer, and of necessity places trust in the other party to perform.

5. The other party is aware of his vulnerability.

6. There is a “special relationship” between parties.

In this case, the court concluded that it is common knowledge that one of the usual methods by which an insured receives protection under a liability insurance policy is by settlement of claims without litigation. The obligation of good faith and fair dealing requires the insurer to settle in an appropriate case although the express terms of the policy do not impose such a duty. The insurer must give the interests of the insured at least as much consideration as it gives to its own interest. Moreover, other courts have held that there is a “special relationship” between the insurer and the insured, characterized by elements of public interest, adhesion, and fiduciary responsibility.

Accordingly, the court held that where there is a great risk of recovery beyond the policy limits so that the most reasonable manner of disposing of the claim is settlement that can be made within those limits, a consideration in good faith of the insured’s interest required the insurer to settle the claim. The judgment of the lower court in favor of Crisci was therefore affirmed. Crisci v. Security Insurance Company of New Haven, Connecticut, 426 P.2d 173, 66 Cal.App.2d 425, 58 Cal.Rptr. 13 (Cal.App. 1967).

V. Answers to Policy Case 14.9.

C and H can recover the liquidated damages from Sunship. The clause was placed in to reasonably estimate damages from nondelivery by Sunship. This was a promise and should be enforced, there were no misrepresentations nor were there any unfair dealings.

There is no evidence that was a penalty. The damages were agreed to by the two experienced parties.

VI.

Answer to “Briefing the Case” Writing Assignment

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1. Case Name, Citation, and Court E.B. Harvey & Co. v. Protection Systems, Inc. 1989 Tenn. App. Lexis 105 (1989) Court of Appeals of Tennessee 2. Key Facts A. E.B. Harvey & Co., Inc. is engaged in the manufacture and wholesale distribution of jewelry. It maintains an inventory of jewelry valued at approximately $1 million.

B. Harvey entered into a contract with Prospective Systems to install and monitor a burglary alarm system that complied with Underwriter’s Laboratories for insurance purposes.

C. The contract between Harvey and protective contained a liquidated damages clause that limited the amount of damages to be paid in case of failure of the alarm system.

D. The alarm system failed, in part, due to a telephone system failure and a burglary that took place on July 22, 1984.

E. Harvey sued for the fair $200,000 market value of the loss, and Protective claimed its liability was limited to the liquidated damages set out in the contract.

F. The trial court held in favor of Protective, and Harvey appealed.

Issue 3.

Is the liquidated damages clause of the contract enforceable in this case?

4. Holding Yes. 5. Court’s Reasoning The Court of Appeals held that: A. Public policy holds that these clauses do not ordinarily protect against fraud or intentional misrepresentation.

B. There was no showing of fraud or intentional misrepresentation in this case.

C. The limitations, as used in this contract, have generally been deemed to be reasonable and have been sustained against the providers of burglary and fire alarm systems.

D. The holding of the lower court was affirmed.

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Chapter 15 Digital Law and E-Commerce

The Law Was Never Built For The Internet.

How Can We Fix It? Learning Objectives: 1. Describe laws that protect privacy in cyberspace.

2. Define Internet domain names and describe how domain names are registered and protected.

3. Describe the laws that apply to e-contracts and e-commerce.

4. Describe e-licensing and the provisions of the Uniform Computer Information 5. Transactions Act (UCITA).

Describe the provisions of the Federal Electronic Signatures in Global and National Commerce Act (E-Sign Act).

I.

Teacher-to-Teacher Dialogue

Every generation has the good fortune, and sometimes misfortune, of being witness to events that become the landmarks by which future generations will measure history. These landmarks can take place as social upheavals such as civil rights movements, horrible conflagrations such as wars, or social-economic migrations such as our nation’s conversion from an agrarian to an industrial society. A key hallmark of all such events is that the road of history has taken a sharp turn from which there is little possibility of turning back.

One such major turn that we are now facing is the advent of the Internet. Future generations will look upon our time as a road land-marked by the information age. This turn in the road is coupled and driven by incredible technological advancements symbolized by the Internet.

Originally intended only for a select group of military and academic uses, it has virtually exploded onto every continent and every country to facilitate a level of communication never imagined before. It has made planet earth “smaller” than ever through unprecedented connectivity while simultaneously creating an uncharted frontier for all who travel down this exciting path.

As teachers of law and ethics, it is our job to make our fair contribution to the evolution of this new cyberspace highway. We must first help our students appreciate that this path has been built and protected by a legal and regulatory environment that is founded on an underlying principle of social order and ethical decision making. We must help our students understand and appreciate the roles that both government and business play in attaining the social goods that can come from these new technologies. We must also help students recognize the legal issues and risks that will confront them as they travel down this road. And most of all, we must do our part to help them develop both the critical thinking skills and ethical sensitivity to see that not only good can come from the information age, but so too, can there be great harm. .

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How then do we start to teach the laws of e-commerce and the Internet? It has taken the greatest technological minds of our generation to build this highway. It will take visionary thinking to help steer that technology toward the goals common to all law studies: which is to not only explain what it is but how it can be used as a socially responsible tool for the betterment of both our nation and the larger global community. Our challenge is to interpolate the lessons learned through virtually thousands of years of legal evolution governing every manner of human conduct into the virtual world of the Internet. We are concerned with all aspects of privacy concerns and intellectual property rights. The Internet is impacting governmental regulation, employment law, consumer protection, business formation, and agency laws today. We must take the lessons of history learned in those key areas of business law and remember that they are rooted in an orderly legal system. How, when, and where do we, as a society, allocate the respective rights and duties of its members? That allocation of rights and duties continues everyday in new ways on the Internet.

Precedent has extraordinary value in charting the new methods of business conducted over the Internet. Consider, for example, the corollaries found between the long-standing Uniform Commercial Code (UCC), the newer Uniform Electronic Transactions Act (UETA), and the Uniform Computer Information Transactions Act (UCITA). The UCC has long provided us with a tool by which to foster and protect commerce. These new proposals, although surely seen as imperfect by many, are evolutionary efforts to do the same for e-commerce. They seek to expand the economic well being of our nation while still seeking to protect the legitimate concerns of individual rights of privacy and the like. We may be involved in transactions measured by milliseconds through cyberspace, but they are still contracts, and as such, need to be bounded by all the rules of good conscience first evolved in the common law and transferred to the UCC. For example, on the privacy front, we may be looking at unprecedented accumulations of personal information though the use of “cookies” and the like. However, the basic rules of rights of privacy should not be abrogated simply because it is technologically possible. Technology used in a harmful manner can only magnify the original problem. Good legal environments must steer new technologies along the well-precedented path of good faith and good conscience.

In the end, the art of teaching the law of e-commerce and the Internet is basically the same as it has been since the beginnings of law. We must balance the good that can come from the information age with the lessons learned through centuries of the development of an orderly society. It is not easy to do this, and it takes a certain leap of faith to teach law in an area where our students are very often more technologically “savvy” than we are. As an old proverb says: “the act of faith is jumping off a cliff with the knowledge that you will be ok.” So it is in the interpolation of the law and the world of the electronic commerce. We have to jump because we have no choice: that is where this road is taking us. But we must have faith in the law’s ability to land safely.

II.

Text Materials

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

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Electronic Mail (E-mail) • Electronic written communication between individuals using computers connected to the • Internet Controlling the Assault of Non-Solicited Pornography and Marketing Act o Called the CAN-SPAM Act o Prohibits spammers from using falsified headers in e-mail messages o Requires spammers who send sexually oriented e-mail to properly label it as such Cyber Law: Regulation of E-Mail Spam As an answer to the junk e-mail or spam bombardment, Congress passed the CAN-SPAM Act prohibiting the use of false headers in e-mail messages and requiring proper labeling of sexually oriented e-mail.

Privacy in Cyber Space: • •

ECPA: crime to intercept an electronic communication Exceptions: o Party or entity providing electronic communication service o Government and law enforcement entities (investigating)

Online Privacy: 1. ECPA—crime to intercept electronic communications with exception: employer, government, and law enforcement.

2. Cyber Crimes a. Internet and Technology: Counterfeit Access and Device and Computer Fraud and Abuse Act: Criminal Computer Activity is discussed. b. Internet and Technology: EFTA EFTA regulates payment and deposit of funs using electronic funds transfers. c. Internet and Technology: Cyber Identity Fraud—Identity Theft and Assumption Deterrence Act of 1998: This act criminalizes identity fraud. d. Internet and Technology: IIP Act Computer-related crimes are addressed as distinct offenses.

3. State Criminal Laws 4. Internet and Technology: Computer Hacker Found Guilty of Cyber Crime 5. Kevin Mitnick became the underground icon of computer hackers.

Case 15.1. The Court Speaks: Lim v. The TV Corporation International 99 Co. 11 App. 4th 684, 121 Cal.Rptr. 2d 323, Web 2002 Cal. App. Lexis 4315 (2002) Court of Appeal of California Facts: The island of Tuvalu was awarded the domain name dot TV. They held an auction for “golf.tv” which was won by Lim for $11,000. The domain name was sold. After a saleconfirming e-mail was sent to Lim, dot TV said it was releasing Lim because of an e-mail error.

Dot TV then publically offered “golf.tv” at a beginning bid of $1 million and said this was different than “golf”, which was invalid and Lim refused delivery of “golf.tv”.

Issue: Did Lim properly state a cause of victim for breach of contract against dot TV? Decision: Yes. Lim’s case against dot TV was reinstated.

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Reason: Lim bid on “golf.tv” and it was accepted. This was a contract not a counteroffer. The e-mail was acknowledgment of Lim’s winning bid.

• •

Internet Corporation for Assigned Names and Numbers (ICANN) o Approves registrars of domain names Domain names may be registered by filing the appropriate form with the domain name registration service and paying the appropriate fee.

Cyber Law: Domain Names Sold for Millions www.business.com sold for $350 million to Rlt Donnelley, unregistered domain names became harder to sell.

Cyber Law: Federal Law Prohibits Cyber Squatting on Domain Names You cannot register as domain names, names of famous companies and hold them hostage (in bad faith). Cease and desist orders, injunctions, and orders to turn over the names are possible remedies as are penalties.

Case 15.2. The Court Speaks: NY Yankees Partnership d/b/a The New York Yankees Baseball Club, Claim #FA0609000803277 (2006) National Arbitration Forum Facts: Monika registers NYyankees.com to sell tickets to Yankees games and merchandise without the Yankees permission.

Issue: Did Monika violate ICAN’s Unitary Domain Names Resolution Policy?

Decision: Yes. NYyankees.com had to be transferred to the Yankees.

Reason: Moniker’s domain name is confusingly similar to the NY Yankees name. The purpose of the Website is to confuse people into thinking it has the same relationship to the Yankees. This was intended to disrupt the business of the Yankees and was in bad faith.

E-Contracts and E-Commerce: • • •

E-mail is sometimes the method used to negotiate and agree on contract terms and to send and agree to the final contract.

Assuming that all of the elements to establish a contract are present, an e-mail contract is valid and enforceable.

Electronic contracts meet the writing requirements of the Statute of Frauds for most contracts.

Cyber Law: Electronic Signatures in Global and National Commerce Act (E-Sign Act) • Electronic contracts need the unity of requirement of the statute of frauds.

• E-signatures are recognized with technological neutrality.

• The e-signature needs to be warranted.

Electronic Signatures: • Electronic Signature in Global and National Commerce Act (E-Sign Act) o Recognizes and gives electronic signatures the same force and effect as a peninscribed signature on paper. .

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The act is technology neutral.

That is, the law does not define or decide which technologies should be used to create a legally binding signature in cyberspace.

The act specifies ways to verify electronic signatures.

o o o

Cyber Law: Uniform Computer Information Transactions Act (UCITA) • A model act that provides uniform and comprehensive rules for contracts involving: o Computer information transactions o Software licenses o Information licenses Licensing: • Intellectual property and information rights are valuable assets of individuals and businesses.

• License—a contract that transfers limited rights in intellectual property and informational rights.

• Licensor—the owner of intellectual property or informational rights who transfers rights in the property or information to the licensee.

• Licensee—the party who is granted limited rights in or access to intellectual property or informational rights owned by the licensor.

• Exclusive License—the license that grants the licensee exclusive rights to use informational rights for a specified duration.

• Exclusive license grants the licensee exclusive rights to use informational rights for a • specified duration.

Licensing agreement sets forth the express terms of the agreement between the licensor and licensee.

E-Licenses: Contract whereby owner of digital application grants limited right to the owner of a computer or digital device to use the software and or digital application for a limited period and under specified conditions.

Cyber Law: E-LicensingClick-Wrap Licenses Click-wrap licenses are enforceable.

Cyber Law: Consumers Saved from Electronic Errors Electronic Errors: • The Uniform Computer Information Transactions Act (UCITA) provides that consumers are not bound by their unilateral electronic errors if the consumer : 1. Promptly upon learning of the error notifies the licensor of the error 2. Does not use or receive any benefits from the information, or make the information or benefit available to a third party 3. Delivers all copies of the information to the licensor or destroys all copies of the information, pursuant to reasonable instructions from the licensor 4. Pays all shipping, reshipping, and processing costs of the licensor [UCITA § 217] • Section 217 of the UCITA only applies to consumers who make electronic errors in contracting .

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Note: UCITA was drafted to answer problems dealing with licensing Forming contracts over the Internet Enforcing e-commerce contracts Providing consumer protection Express Warranty: • Any affirmation of fact or promise by the licensor about the quality of its software or • • information.

The UCITA does not require a licensor to make an express warranty about the quality of its software or information [UCITA § 402].

The UCITA permits a licensor to disclaim all implied warranties [UCITA § 406(c )].

Breach of License Agreements: • Any affirmation of fact or promise by the licensor about the quality of its software or • information.

• The UCITA does not require a licensor to make an express warranty about the quality of • its software or information [UCITA § 402].

• The UCITA permits a licensor to disclaim all implied warranties [UCITA § 406(c )].

• Licensee’s refusal of defective tender.

Licensee’s revocation of acceptance.

Adequate assurance of performance.

Remedies: • The UCITA provides various remedies that injured parties can obtain against breaching parties: o Cancellation o Licensor’s damages o Licensor’s right to cure o Licensee’s damages o Specific performance o Liquidation of damages Limitations of Remedies: • The UCITA provides that the parties to an agreement may limit the remedies available • for breach of the contract.

Limitation of remedies in licenses subject to the UCITA are enforceable unless they are unconscionable [UCITA § 803].

Case 15.3. The Court Speaks: M.A. Mortenson Company, Inc. v. Timberline Software Corporation, 93 Wn. App. 819, 970 P. 2d 803, Web, 1999 Wash. App. Lexis 185 (Court of Appeals of Washington) Facts: Timberline Software Corporation produces software programs that are used by contractors to prepare bids to do work on construction projects. Timberline’s software license agreement contained a limitation of remedies clause. Mortenson, a customer of Timberline, claimed that the software did not work correctly and resulted in a bid that was too low. Mortenson sued to recover consequential damages alleging that the software calculated an inaccurate bid. Timberline .

Digital Law and E-Commerce131

defended, alleging that the limitation of remedies clause in the software license prevented Mortenson’s lawsuit.

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

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

International Law: International Internet Law III.

Answers to Critical Thinking Cases

15.1. No. A Web host can not be classified as an aider and abetter just like the phone company or the post office. GTA is not a publisher or speaker as is needed by the CDA of 1996.

John Doe v. GTE Corp., 347 F3d 4656, Web 2003 U.S. App. Lexis 21345 (U.S. Court of Appeals) Domain Name 15.2

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

E-Mail Contract 15.3.

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

Electronic Signature 15.4.

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

The act gives the e-signature the same force and effect as a pen-inscribed signature on paper. Therefore, in this scenario, Inet can recover the license fee against David Abacus.

License 15.5.

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

License

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15.6.

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

IV.

Answers to Ethics Cases

15.7.

Under the Anticybersquatting Consumer Protection Act, the test of violation of the law is bad faith. Although BluePeace.org may have had the best of intentions, unless it could prove that General Motors, Macy’s, and Exxon Oil were guilty of the crimes depicted on their Website, it was acting in bad faith, and General Motors, Macy’s, and Exxon Oil win.

15.8.

15.9.

V.

Apricot.com wins. He didn’t pay and cancellation is a remedy. He was not ethical because of the theft but neither was Apricot.com because of the language.

E. & J. Gallo Winery v. Spider Webs, 286 F.3d 270, Web 2002 U.S. App. Lexis 5925 (2002) U.S. Court of Appeals The Facts: “Ernest & Julio Gallo” is a registered trademark of Gallo Winery. Spider Web Ltd. registered more than 2,000 domain names including ernestandjuliogallow.com.

They sell domain names. Gallo sued alleging violation of the ACPA. Spider Web was ordered to transfer the domain name in question to Gallo.

Issue: Did Spider Web Ltd. and the creators, the Thurmans, act in bad faith in registering the Internet domain name ernestandjuliogallo.com?

Decision/Remedy: Yes. The order was upheld.

Reason: Bad faith could include not having Spider Web in the domain name and no prior use of the domain name in selling foods and services as well as the fact that Spider was engaging in selling domain names.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Toys “R” Us Inc. v. Abir 1999 WL 61817 (1999) U.S. District Court, S.D. New York 2. Key Facts A. The plaintiff, Toys “R” Us, Inc. owns the trademark on a family of businesses which are centered around the use of “R” Us language.

B. The defendant registered two Internet domain trade names through Website Management for his companies. These trade names were “Toysareus” and “Kidsareus.”

C. Toys “R” Us sued for an injunction to prevent the defendant from using names that it alleged would dilute its well-known family of trade names.

D. Toys “R” Us also sued to collect attorneys’ fees on the basis that defendant’s actions were willful and in bad faith.

3. Issue Was this a deliberate and bad faith attempt to dilute the Toys “R” US family of trademark names? .

Digital Law and E-Commerce133

4. Holding Yes. 5. Court’s Reasoning The District Court for the Southern District of New York held that: A. The trade names used by the defendant did dilute the Toys “R” Us family of protected trade names.

B. This attempted dilution was willful, intentional, deliberate, and in bad faith.

C. The plaintiff’s requests for both injunctive relief and claims for reimbursement of attorneys’ fees were therefore granted.

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Chapter 16 Formation of Sales and Lease Contracts

Can the Law Help Business To Be Business?

Learning Objectives: 1.

2.

3.

4.

5.

Describe sales contracts governed by Article 2 of the Uniform Commercial Code (UCC).

Describe lease contracts governed by Article 2A of the UCC. Describe the formation of sale and lease contracts.

Define the UCC’s firm offer rule, additional terms rule, and written confirmation rule.

Describe how Revised Article 2 (Sales) and Article 2A (Leases) permit electronic contracting.

Teacher-to-Teacher Dialogue

I. Students, for a number of reasons, sometimes meet the introduction of materials on the UCC with a degree of resistance. First, it appears to be more technically complicated than the common law of contracts or torts. Second, it seems to be somewhat repetitive in that it sounds like “Contracts Verse Two.” Because of these predispositions to the UCC, it might be worth it to stress the importance of the law as being a facilitator, rather than an impediment, to the flow of commerce and to discuss the concept of “merchant” from a business sense.

This might include examples of the need for holding merchants to a high standard of imputed knowledge about the usage and trade or norms within their respective areas of commerce.

Possibly remind students that the UCC is designed for the “fast track” of commerce by providing for maximum flexibility vis-à-vis formation, modification, and termination of commercial contracts. Also, it might be helpful to remind them of the simple truth that the essential ingredients of common law notions of fair play, good faith, and the like are carried over into the UCC by way of the doctrine of conscionability.

Of importance to an understanding of the UCC is to examine the Code as a specialized body of contract law, appearing to have eclipsed the common law of contracts, maintaining the portions of the common law it needs. The UCC is intended to cover a number of areas of contract formerly resolved by common law, but the basic elements for both are the same. What is vastly different is the implementation of how those elements are arrived at in the light of commercial realities.

Early on, the Law Merchant of England set up special rules for commercial contracts with the realization that the law should be written to foster and encourage commerce rather than encumber

.

Formation of Sales and Lease Contracts 135

it. The early faire courts were established by and for merchants. They were designed to have law reflect the needs of commerce. Some of the principles that evolve included: 1. Holding merchants to a higher standard 2. Providing for uniformity of interpretation for commercial contracts 3. Providing for more flexibility in the formation, modification, and termination of commercial contracts 4. Retaining the common law essential ingredients of equity, fair play, good faith, and conscionability in commercial dealings The UCC is the descendent of the Law Merchant. Its predecessor, the 1906 Uniform Sales Act, was ultimately adopted by thirty-seven states. It was, in turn, eclipsed by the UCC beginning in 1952. The authors believed that the law should reflect the realities of commerce that are working rather than impose unnecessary obstacles or impediments to business. The UCC has been adopted, at least in part, in all fifty states. It continues to be one of the single most important legislative enactments in American legal history. It is updated and revised in order to keep up with changing realities of the marketplace.

II.

Text Materials

Landmark Law: Uniform Commercial Code • • • • • • • • • • •

Article 1 Article 2 and Article 2(revised) Article 2A and Article 2A (revised) Article 3 Article 4 Article 4A Article 5 Article 6 Article 7 Article 8 Article 9 and Article 9(revised)

General Provisions Sales Leases Negotiable instruments Bank deposits and collections Fund transfers Letter of Credit Bulk transfers and Bulk Sales Documents of title Investment securities Secured transactions

The UCC is continually being revised to reflect changes in modern commercial practices and technology.

Scope of Article 2: • All states except Louisiana have adopted some version of Article 2 (Sales) of the UCC. • Article 2 is also applied by federal courts to sales contracts governed by federal law.

• Article 2 established rules that govern the sale of goods (tangible things), available at time of identification to a contract if a sale is part goods and part services (mixed sale) follow the part that is most dominant.

• Article 2 has recently been revised. o Has been adopted by some states

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136 Chapter 16

Case 16.1. The Court Speaks:Brandt v. Boston Scientific Corporation and Sarah Bush Lincoln Health Care, 204 Ill. 2d 640, 792 N.N. 2d 296, Web 2003 Ill. Lexis 785 (2003) Supreme Court of Illinois Facts: Brandt was admitted to HC for treatment of a urinary infection. She had a sling implanted.

They were recalled and Branett needed surgical removal of the device due to complications. BS and HS were sued for breach of care. HC argued they provided a service and the UCC implied warranty for the sale of goods (merchantability) did not apply.

Issue: Was the transaction between Branett and Health Center predominantly the provision of services or sale of goods?

Decision: Services was the predominant feature of the transaction.

Reasoning: In a mixed contract (goods and services) we look to the predominant feature. Here a majority of the charges were for services. They were the primary purpose of the transaction.

Relevant Terms: Sale: passing of title from seller to buyer for a price Goods: tangible things that are movable at the time of their identification to a contract Merchant: a person who deals in the kind of goods involved in the transaction or who holds himself or herself out (because of occupation) as having knowledge or skill peculiar to the goods involved in the transaction Lease: transfer of the right to the possession and use of the named goods for a set term for consideration Lessor: person who transfers the right of possession and use of the goods under the lease Lessee: person who acquires the right to possession and use of goods under the lease Scope of Article 2A (Leases): • • • •

Article 2A applies to leases involving goods.

Article 2A does not apply to real estate or others leases.

Many states have adopted Article 2A. Finance lease is a three-party transaction between lessor, lessee, and supplier (lessor usually buys goods from supplier for the lease).

Contract Law 1. Goods a. UCc i. If no special provision, follow common law ii. If provision is present, follow UCC A. Open offer B. Firm offer rule C. Statute of Frauds D. Modifications E. Remedies 2. Other than goods a. Common law b. Other statutes Contemporary Environment: Revised Article 2 (Sales) and Revised Article 2A (Leases). .

Formation of Sales and Lease Contracts 137

The revisions took place in 2003.

Formation of Sales and Contracts: • Any rules established by Articles 2 and 2A take precedence over the common law of • contracts.

Offer o A contract for the sale or lease of goods may be made in any manner sufficient to show agreement. o This includes conduct by both parties that recognizes the existence of a contract [UCC 2-204(1), 2A-204(1)].

• Open Terms • Sometimes the parties to a sales or lease contract leave open a major term in the contract o Open Price Term o Open Payment Term o Open Delivery Term o Open Time Term o Open Assortment Term • These open terms are permitted to be read into a sales or lease contract.

• This rule is commonly referred to as the gap-filling rule [UCC 2-204(3), 2A-204(3)].

Open Explanation: Price—reasonable (market) Payment—at delivery Delivery— seller’s place Time—reasonable Assortment—buyer chooses Contemporary Environment: UCC Firm Offer Rule The firm offer rule states that a merchant who offers to buy, sell, or lease goods and gives a written and signed assurance on a separate form that the offer will be held open cannot revoke the offer for the time stated or, if no time is stated, for a reasonable time (up to three months).

Formation of Sales and Lease Contracts cont.: • Firm Offer Rule [UCC 2-205, 2A-205] o A merchant who (1) offers to buy, sell, or lease goods, and (2) gives a written and signed assurance on a separate form that the offer will be held open, o Cannot revoke the offer for the time states or, o If no time is stated, for a reasonable time o Three months is the maximum amount of time permitted under this rule • Acceptance o The UCC provides that a contract is created when the offeree (i.e., the buyer or lessee) sends an acceptance to the offeror, not when the offeror receives the acceptance. o The UCC permits acceptance by any reasonable manner or method of communication [UCC 2-206(1), 2A-206(1)]. .

138 Chapter 16

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

Contemporary Environment: “Battle of the Forms” There is a contract based on original terms unless the additional terms so materially alter the terms of the original offer that the parties cannot agree on the contract or limitations are in contract or notification of nonacceptance of modification. Note that an accommodation shipment is a counteroffer.

Formation of Sales and Lease Contracts cont.: • Accommodation Shipment o A shipment that is offered to the buyer as a replacement for the original shipment when the original shipment cannot be filled. o The accommodation is a counteroffer from the seller to the buyer. o The buyer is free either to accept or to reject the counteroffer [UCC 2-204(1)(b)].

• Consideration o The formation of sales and lease contracts requires consideration. o Under the UCC, an agreement modifying a sales or lease contract needs no consideration to be binding [UCC 2-209(1), 2A-208(1)]. o Modification of a sales or lease contract must be made in good faith [UCC 1203].

UCC Statute of Frauds: • A rule that requires all contracts for the sale of goods costing $500 or more, and lease contracts involving payments of $1,000 or more be in writing [UCC 2-201(1), 2A201(1)]. The amounts were raised to $5,000 and $20,000 by the revisions.

• The writing must be sufficient to indicate that a contract has been made between the parties.

Statute of Frauds and the UCC 1. $500 2. Exceptions for written between merchants 3. Exception for specially manufactured goods 4. Exception for part performance Parol Evidence Rule and The UCC 1. Course of performance exception 2. Course of dealing exception 3. Usage of trade exception Contemporary Environment: UCC Written Conformation Rule UCC 2-201(2) stipulates that the confirmation is sufficient when the party to whom it is sent has reason to know its contents. Needs reasonable time and no written objection within 10 days.

.

Formation of Sales and Lease Contracts 139

International Law: Letters of Credit Support International Trade The letter of credit has been developed to manage risks in international sales.

Electronic Sales and Lease Contracts Terms of Importance: • Electronic: electrical, digital, magnetic, wireless, optical, electromagnetic, or similar • • capabilities • Electronic agent: computer program or electronic means used to initiate action or response (e.g., Internet) Electronic record: stored, created, generated, sent, communicated, revised, or stowed electronically Recall: inscribed on a tangible medium III.

Answers to Critical Thinking Cases

Goods or Services 16.1.

No, Article 2 does not apply to this transaction. Article 2 applies solely to transactions in goods. Sometimes a sale involves the provision of services and a good. This is called a mixed sale. Article 2 only applies if the provision of the good is the predominant part of the transaction. Courts decide whether a given transaction is primarily for goods or services based upon the facts of the case. In this situation, the court held that the contract was primarily one for services. The contract described the transaction as a furnishing of labor and materials. The contract also stated that Stylarama was to construct the pool and install a vinyl liner. Because Article 2 of the UCC does not cover service contracts, Gulash was not able to recover against Stylarama by referring to the UCC. Gulash v.

Stylarama, 364 A.2d 1221 (Conn. 1975).

Statute of Fraud 16.2.

Yes, a valid sales contract existed between St. Charles and Eagle. The formation of a sales contract requires both an offer and an acceptance. The UCC holds that an offer may be accepted by the shipping of conforming or nonconforming goods. However, the UCC also holds that conduct by both parties that recognizes the existence of a contract is sufficient to form a contract. The court held that the telephone conversations between St. Charles and Eagle were sufficient to constitute an offer. When Eagle shipped the descramblers, even if they were nonconforming, the offer was accepted. The court also held that the actions by both St. Charles and Eagle were such that both parties recognized the existence of a contract. Both parties behaved as if a contract had been formed, St. Charles by making payments, Eagle by shipping goods and accepting returns. Because there had been an offer and acceptance, and the parties’ conduct recognized the existence of a contract, the court found that a valid sales contract existed between the parties. St. Charles Cable TV v. Eagle Comptronics, Inc., 687 F.Supp. 820 (S.D.N.Y. 1988).

Firm Offer 16.3.

Coronis wins the lawsuit; the UCC recognizes an acceptance to the common law rule that allows an offeror to revoke his offer any time prior to its acceptance. This exception is .

140 Chapter 16

known as the firm offer rule. This rule provides as follows: if a merchant offers to buy or sell goods and gives a written and signed assurance on a separate form that the offer will be held open, the offeror cannot revoke the offer for the time stated, or if no time is stated, then for a reasonable time. In this situation, the court held that the firm offer rule did not apply. Although the letter from Coronis to Gordon may have been a signed form sent between merchants, it only quoted a price. The letter gave no assurance that the bid would be held open. In order for the firm offer rule to apply, the offeror must explicitly state that the offer will be held open. Because they had made no such statements, Coronis had properly revoked its offer on June 1. E.A. Coronis Associates v. M. Gordon Construction Co., 216 A.2d 246 (N.J. Super. 1966).

Battle of the Forms 16.4.

No, the clauses in the delivery memo were not part of the contract. Because the court found Miller and Newsweek to be merchants in regards to photographs, UCC Section 2-207 applies. If two merchants negotiate a sales contract and then exchange preprinted forms, the additional terms materially alter the original contract. In this case, the court held that a valid contract had been formed between Newsweek and Miller during their phone conversation. The two parties had agreed on the price of the photographs, the delivery date, and the terms, that is, Newsweek was to pay for each photo used. The delivery memo contained terms additional to the original contract. The court held that the additional terms materially altered the contract because Newsweek probably would not have agreed to them in the original contract, and they would work a great hardship upon Newsweek. The court did not believe that Newsweek would agree to pay more than $100,000 if it accidentally lost the photos. Because the inclusion of this term was a unilateral action by Miller, the court held that it materially altered the original contract.

Applying UCC 2-207, additional terms do not become part of contracts between merchants if they materially alter the contract. Therefore, Miller was not able to collect $1,500 a piece for the missing photos. Miller v. Newsweek, Inc., 660 F.Supp. 852 (D.Del. 1987).

Open Terms 16.5.

Yes, a valid sales contract had been formed. Under the UCC, a contract does not fail for indefiniteness if (1) the parties intended to form a contract, and (2) there is a reasonably certain basis for giving an appropriate remedy. The UCC allows “open terms” to be determined at a later date. One such open term is the price, which may be determined by a market rate. If the market price is not available, the court will imply a reasonable price.

The court did not agree with Schmieding’s claim that the contract was void for indefiniteness. The court found that the contract specified the type of potatoes ordered, the quantity in terms of acreage, and the approximate delivery date. Market prices for commodities such as potatoes are readily available from government agencies. The court determined that the parties had intended to form a contract, and that it was possible to supply any open terms in that contract. Although this agreement would have been too indefinite under the common law, the appellate court found it to be a valid contract under the UCC. H.C. Schmieding Produce Co. v. Cagle, 529 So.2d 243 (Ala. 1988).

Statute of Frauds 16.6.

No, the court will not enforce the agreement between Donzi and Wallach. The UCC includes a Statute of Frauds provision that applies to sales contracts. Generally, the UCC .

Formation of Sales and Lease Contracts 141

requires that a contract for the sale of goods for the price of $500 or more must be in writing. The writing must be signed by the party against whom enforcement is sought or by his authorized agent. If the contract is not in writing it is not enforceable. In this situation, the court applied the UCC to a contract for the sale of a dealership. The facts clearly showed that no written agreement was ever made between Donzi and Wallach.

The price of the dealership was in excess of $500. Under the UCC, courts generally cannot enforce oral sales contracts for more than $500. Because the oral agreement between Donzi and Wallach violated the Statute of Frauds, the court would not enforce it. Wallach Marine Corp. v. Donzi Marine Corp., 675 F.Supp. 838 (S.D.N.Y. 1987).

IV.

Answers to Ethics Cases

16.7.

Perschke wins the suit. The contract between Perschke and Sebasty is not unenforceable due to the Statute of Frauds because the statute can be satisfied by a written confirmation. When both parties to an agreement are merchants, the Statute of Frauds is met if (1) one of the parties to an oral agreement sends a written confirmation of the sale to the other party within a reasonable time and (2) the other party does not give written notice of an objection to the contract within 10 days of receiving the confirmation. In this case, the court held that the memorandum sent by Perschke’s office manager was a written confirmation.

Because the memorandum was sent on the same day Perschke had his phone conversation with Sebasty, it was sent within a reasonable time. Finally, there was no evidence that Sebasty had ever made a written objection to the contract.

Because Perschke’s memorandum was a written confirmation of an oral sales contract, the Statute of Frauds did not bar his claim against Sebasty. Sebasty v.

Perschke, 404 N.E.2d 1200 (Ind.App. 1980).

16.8.

When nonnegotiable terms are a preprinted form and there is a disparate bargaining power, Corp., they are unconscionable, and nonenforceable. A&M Produce Co. v. FMC 135 Cal. App. 3d., Web 1982 Cal. App. Lexis 1922 (Court of Appeal of California)

V.

Answers to Policy Cases

16.9.

The installation was not the sale of a good and not subject to the UCC. Cedais-Sinei is not liable for breach of duty under the UCC. Hector v. Cedais-Sinei Meidcal Center, 180 Cal. App. 3d 493, 225 Cal. Rptus. 595, Web 1986 Cal. App. Lexis 1523 (Court of Appeal of California)

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Cafazzo v. Central Medical Health Services, Inc. 668 A.2d 521(1995) Supreme Court of PA Key Facts 2.

A. Cafazzo underwent surgery for implantation of a mandibular protheses which was defective.

B. He sued claiming strict liability alleging a defect in design unsafe for intended use, and insufficient warning. .

142 Chapter 16

3. Issue Are doctors and hospitals who provide medical services sellers and therefore liable under strict liability?

4.

Holding No.

5. Court Reasoning A. Section 402A of the Restatement (Second) of Torts grants strict liability for sale of a product in a defective condition unreasonably dangerous with certain stipulations.

B. Provision of medical services is not the sale of a product and case law distinguishes products from services.

C. A patient goes to a hospital to get treatment not to buy products.

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Performance of Sales and Lease Contracts 143

Chapter 17 Performance of Sales and Lease Contracts

Did We Do What We Promised?

Learning Objectives: 1 Identify when title to goods passes in shipment and destination contracts. . Define shipment and delivery terms.

2 Describe who bears the risk of loss when goods are lost or damaged in shipment. . Identify who bears the risk of loss when goods are stolen and resold.

3 Define good faith purchaser for value and buyer in the ordinary course of business. .

I. 4 Teacher-to-Teacher Dialogue .

5 The rules of UCC contract performance, remedies, and the like constitute a set not only of . standards of commercial behavior, but also of fallback expectations imposed on the parties if they fail to anticipate the issue in the initial contract. The same holds true in the law of wills. If the decedent did not act on how his or her estate is to be disposed of, the state decides for him or her by way of an interstate statute. The second lesson to be learned is an implied message that one has much more control over one’s rights in UCC commercial contracts than one thinks. It is just that the law is not necessarily coined to protect the legally lazy. A third point is that all contract obligations under the UCC come under the umbrella of good faith and conscionability. This includes not only the performance obligations listed in this chapter’s materials, but also any contractual modifications entered into by the parties.

One major issue that must be faced is the possibility that goods are damaged or claimed before they arrive. Who then bears the risk of loss or has the titled passed? Does any of this affect either parties’ obligations? This is the focus of this chapter. Other performance issues are addressed later in the text. The problem here is one of timing. If the answer is built into the contract, use it. Otherwise we must look to default rules. But make sure to enforce the concept of common sense because it does work here.

II.

Text Materials

Introduction: • Article 2 of the UCC establishes precise rules for determining the passage of title in sales • contract. [UCC 2-401] • Article 2 adopts concise rules for risk of loss that are not tied to title.

Parties to the sales contract have the right to insure the goods against loss if they have an “insurable interest” in the goods.

Identification of Goods:

.

144 Chapter 17

• • •

Distinguishing the goods named in the contract from the seller’s or lessor’s other goods.

Identification of goods can be made at any time and in any manner explicitly agreed to by the parties to the contract.

In the absence of such an agreement, the UCC mandates when identification occurs.

[UCC 2-501(1), 2A-217]

Note: Future goods are not yet in existence. Existing goods are.

Passage of Title: • Look to contract first.

• Once the goods exist and have been identified, title to the goods may be transferred from • the seller to the buyer.

Article 2 of the UCC established precise rules for determining the passage of title in sales • contracts.

• Lessees do not acquire title to the goods they lease.

Under UCC 2-401(1), title to goods passes from seller to the buyer in any manner and on any conditions explicitly agreed upon by the parties: o Shipment contracts [UCC 2-401(2)(a)] o Destination contracts [UCC 2-401(2)(b)] o Document of title [UCC 2-401(3)(a)] Transfer of Title 1. Contract 2. Terms a. Shipment Contract i. Title passes at shipment b. Destination Contract i. Title passes upon tender of delivery 3. Documents of Title a. Title passes when document delivered 4. Default a. Time and place of contracting Risk of Loss/Transfer of Title: • Generally, goods shipped via carrier are considered to be sent pursuant to a shipment contract or a destination contract.

• Shipment contract—the buyer bears the risk of loss during transportation. [UCC 2509(1)(a)] • Destination contract—requires the seller to deliver conforming goods to a specific destination. [UCC 2-509(1)(b)] o The seller bears the risk of loss during transportation.

Contemporary Environment: Commonly Used Shipping Terms Terms such as free on board point of shipment, free alongside, and cost, insurance, and freight are explained. .

Performance of Sales and Lease Contracts 145

Sales contracts often contain the following terms: • (free on board) point of shipment F.O.B. • (free alongside) or F.A.S. (vessel) port of shipment F.A.S. • (cost, insurance, and freight) and C. & F. (cost and freight) C.I.F. • place of destination F.O.B. • Ex-ship (from the carrying vessel • No arrival, no sale contract Noncarrier Cases: No Movement of Goods: A sales contract may stipulate that the buyer is to pick up the goods, either at the seller’s place of business or another specified location.

• Who bears the risk of loss if the goods are destroyed or stolen after the contract date and before the buyer picks the goods up from the seller?

• Merchant-Seller Rule: If the seller is a merchant, the risk of loss does not pass to the • buyer until the goods are received.

Nonmerchant-Seller Rule: o Nonmerchant-sellers pass the risk of loss to the buyer upon “tender of delivery” of the goods.[UCC 2-509(3)] • Goods in the Possession of a Bailee o (i.e., a warehouse)—goods sold by a seller to a buyer are sometimes in the possession of a bailee.

• If such goods are delivered to the buyer without moving them, the risk of loss passes to the buyer. [UCC 2-509(2)] •

Risk of Loss: Conditional Sales: • Sale on Approval o There is no actual sale unless and until the buyer accepts the goods. o In a sale on approval, the risk of loss and title remain with the seller. o They do not pass to the buyer until acceptance. [UCC 2-327(1)] • Sale or Return Contract o The seller delivers goods to a buyer with the understanding that the buyer may return them if they are not used or resold within a state or reasonable period of time.

The risk of loss and title transfer to the buyer when he or she takes possession of o the goods. [UCC 2-327(2)] • Consignment o A seller (the consignor) delivers goods to a buyer (the consignee) for sale. o The consignee is paid a fee if he or she sells the goods on behalf of the consignor. o A consignment is treated as a sale or return under the UCC [UCC 2-326(3)] Risk of Loss: Breach of a Sales Contract: Generally the breach party bears risk of loss.

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

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Risk of Loss: Lease Contracts • If the parties to a lease contract do not agree as to who will bear the risk of loss of the goods if they are lost or destroyed, the UCC supplies risk of loss rules: o Ordinary Lease—risk of loss is retained by lessor. o Finance Lease—risk of loss passes to the lessee. o Tender of delivery of goods fails to conform to the lease contract—the risk of loss remains with the lessor or supplier until cure or acceptance.

Contemporary Environment: Insuring Goods Against Risk of Loss • Determine the value of goods subject to the sales or lease contract.

• Purchase insurance from a reputable insurance company covering the goods subject to the • contract.

• Maintain the insurance by paying the premiums when they are due.

Immediately file the proper claim and supporting documentation with an insurance company if the goods are damaged, destroyed, lost, or stolen.

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

[UCC 2-201(1), 1-201(44)(d), UCC 2-403(1)] Good Faith Purchase for Value o A person to whom good title can be transferred from a person with voidable title. o The real owner cannot reclaim goods from a good faith purchaser for value.

Good Faith Subsequent Lessee o A person to whom a lease interest can be transferred from a person with voidable title. o The real owner cannot reclaim goods from the subsequent lessee until the lease expires.

Ethics: Entrustment Rule Protects Buyers in the Ordinary Course of Business • If an owner entrusts possession to a merchant, the latter can transfer all rights to a BOCB. • The entrustment rule also applies to leases.

• If a lessor entrusts the possession of his or her goods to a lessee who is a merchant who deals in goods of that kind, the merchant-lessee has the power to transfer all the lessor’s and lessee’s rights in the goods to a buyer or sublessee in the ordinary course of business.

[UCC 2A-305(2)] Case 17.1. The Court Speaks: Lindholm v. Brant, 283 Conn. 65, 925 A. 2d 1048, Web 2007 Conn. Lexis 264 (2007) Supreme Court of Connecticut.

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Performance of Sales and Lease Contracts 147

Facts: Lindholm, through an art dealer (Malmberg), purchased “Red Elvis” which was created by Andy Warhol. Lindholm agreed to have “Red Elvis” shown at the Guggenheim as part of an Andy Warhol Exhibition. Lindholm also agreed, by letter, to loan “Red Elvis” to the Louisiana Museum. Malmberg was to make delivery. Instead Malmberg, claiming ownership, sold it to Brant, a collector, after Brant found no claims or liens in a UCC lien search and search of the relevant Art Loss Registry. Brant received an invoice from Malmberg. Lindholm then discovered the fraud and sued in Connecticut to recover “Red Elvis” from Brant who argued was a buyer in the ordinary course of business. Issue: Was Brant a buyer in the ordinary course of business who had a claim of ownership to “Red Elvis” that was superior to that of the owner Lindholm? Decision: Yes. Reason: Brant’s claim as a buyer in the ordinary course was superior to Lindholm’s ownership claim because Lindholm had entrusted “Red Elvis” an art dealer who sold the stolen “Red Elvis” to Brant. “Entrusting” includes any delivery and acquiescence regardless of whether the procurement of the entrusting or possessor’s disposition of the goods have been such as to be larcenous under the criminal law. A good faith purchaser, under these terms, has superior rights to the owner. The letter constituted the entrustment here and Brant honestly believed, after sufficient investigation, that Malmberg was the owner.

Electronic Communication and Signatures: • Record or signature okay even if solely in electronic form.

• If receipt is good, it is good even if no individual is aware of it.

• Electronic agent is treated as a real agent.

• Electronic acknowledgement proves that the communications received.

III.

Answers to Critical Thinking Cases

Identification of Goods 17.1.

Yes, the fire truck was identified to the sales contract. Until a seller identifies goods to a sales contract, title to the goods remains with the seller. Identification means that the goods in the contract have been distinguished from the seller’s other goods. Identification can occur in different ways. The good sold can be specifically named in the contract. In the case of a good that is part of a large mass of goods, the good is identified when the seller explicitly separates or designates the good sold to the buyer. In this case, the court held that the fire truck had been identified to the contract when Hamerly painted the fire department’s name on the cab. By painting the fire department’s name on the truck, Hamerly, as the seller, was distinguishing this particular truck from other trucks they owned. This had the effect of separating or designating the specific item sold to the fire department. Because the specific truck sold had been distinguished from the seller’s other trucks, the court held that the goods had been identified to the contract. Big Knob Volunteer Fire Co. v. Lowe & Meyer Garage, 487 A.2d 953 (Pa.Super. 1985).

Stolen Goods 17.2.

Michaels Jewelers has valid title to the stolen jewelry. It is true that a good faith purchaser for value can obtain valid title to goods from a seller who only has voidable title to them. However, a good faith purchaser cannot obtain valid title to goods sold by a .

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seller who has void title to them. A thief only has void title to the goods he has stolen.

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

Passage of Title 17.3.

The title to the car goes back to Coghill. A buyer who buys goods with a check that is dishonored receives voidable title to that good. A good faith purchaser for value can acquire good title. “Good faith” means honesty in fact in the conduct or transaction concerned. “Value” means that the purchaser paid sufficient consideration for the goods.

The court found that when Bellman bought Coghill’s Rolls Royce with a forged check, he received voidable title to the car. However, the court also determined that Hyken was not a good faith purchaser for value. Although there was some question as to whether Hyken had paid sufficient money for the car, the trial court’s main concern was with Hyken’s honesty. The irregularities in the ad for the car, Bellman’s identification, and in the title document to the car should have put an experienced buyer like Hyken on notice that there was something wrong. When Hyken chose to ignore these warning signs, he was acting dishonestly with respect to this transaction. Because of this dishonesty, Hyken was not a good faith purchaser for value, and the appellate court gave title of the car back to Coghill. Landshire Food Service, Inc. v. Coghill, 709 S.W.2d 509 (Mo.App. 1986).

Entrustment Rule 17.4.

Ryan has a valid title to the house. The UCC provides that: where an owner entrusts the possession of his or her goods to a merchant who deals in goods of that kind, the merchant has the power to transfer all rights (including title) to the goods to a buyer in the ordinary course of business. The real owner cannot reclaim goods from this buyer.

The court in this case found that MMM was a dealer in respect to prefabricated homes.

On at least seven occasions MMM had sold Fuqua modular houses to retail customers.

Ryan was a buyer in the ordinary course of business because he had no knowledge of the security interest Fuqua held in the house that MMM sold to him. Because MMM was a merchant of prefabricated homes, they were able to transfer title to Ryan as a buyer in the ordinary course of business. Ryan now holds title to the home and Fuqua cannot reclaim it. Fuqua Homes, Inc. v. Evanston Bldg. & Loan Co., 370 N.E.2d 780 (Ohio App. 1977).

Risk of Loss 17.5.

Knitwear wins the case, and All America must pay for the stolen yarn. A contract that specifies the delivery terms F.O.B. point of shipment is a shipment contract. An F.O.B. point of shipment contract requires that the seller place the goods in the carrier’s possession. The seller bears the expense and risk of loss until the goods are placed in the carrier’s possession. If the goods are destroyed during transportation, the risk of loss falls on the buyer. The court in this case held that even though the term F.O.B. seller’s plant was used in reference to price, this was enough to make the agreement a shipment contract. When Knitwear placed the yarn in the possession of the truck, the risk of loss passed from Knitwear to All America. Because the yarn was stolen when All America .

Performance of Sales and Lease Contracts 149

bore the risk of loss, All America must pay for the yarn. A.M. Knitwear v. All America, Etc., 390 N.Y.S.2d 832, 41 N.Y.2d 14 (N.Y.App. 1976).

Risk of Loss 17.6.

Mitsubishi bore the risk of loss. A sales contract that requires the seller to deliver conforming goods to a specific destination is a destination contract. In such a contract the seller bears the risk of loss to the goods during their transportation. Therefore, the seller is required to replace any goods lost or destroyed in transit, and the buyer does not have to pay for any destroyed goods. The court held that this was a destination contract because the sales agreement for the plywood specified that Mitsubishi deliver it to Crown’s plant in Atlanta. Because Mitsubishi was a seller in a destination contract, it bore the risk of loss of the plywood during its transport. Mitsubishi must now pay to replace the plywood destroyed during shipping and deliver replacement goods to Crown.

The court held that because Mitsubishi bore the risk of loss of the plywood, it could sue the railroad to indemnify itself for that loss. Georgia Ports Auth. v. Mitsubishi International Corporation, 274 S.E.2d 699 (Ga.App. 1980).

IV.

Answers to Ethics Cases

17.7.

Affirmed for Charles. Triangle had voidable title and under the UCC, Triangle could pass good title to a good faith purchaser for value that Campus was. Thus, Campus had good title and passed that title to its buyer, Charles. Therefore, Charles had good title and passed good title to Lee. Lee Oldsmobile-Cadillac, Inc. v. Labonte, 30 UCC Rep. 74 (R.I. 1980).

17.8.

Affirmed for the farmers. The UCC provides that if you entrust your goods to a merchant who deals in the goods of the kind you empower that merchant to pass your title to a

purchaser in the ordinary course of business. Executive allowed Tri-County to retain possession of the tractors. This constituted an entrusting. Thus, Tri-County was empowered to pass Executive’s title to purchasers in the ordinary course of V. 17.9.

business. The farmers were suchCases purchasers. Therefore, the farmers received good title. Executive Answer to Policy Financial Services, Inc. v. Pagel, 715 P.2d 381 (Kan. 1986).

Preuatt is not responsible for the loss of the coins in the mail. This is a sale on approval of a contract and the risk of loss remains with the Seller. Using the postal service was justified and there was no implied duty to use Federal Express. Prewitt v. Namismatic Funding Corp., 245 F.2d 1175, Web 1984 U.S. App. Lexis 17926 (U.S. Court of Appeals) Answer to “Briefing the Case” Writing Assignment

VI. 1. Case Name, Citation, and Court Burnett v. Purtell 1992 Ohio App. Lexis 3467 (1992) Court of Appeals of Ohio

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2. Key Facts A. The parties entered into a contract for the sale and transfer of a mobile home and shed.

B. On March 3, 1990, the seller transferred to the buyer a certificate of title and one of the keys to the mobile home.

C. The seller retained both keys to the mobile home and the shed in order to later remove his contents.

D. The next day, the mobile home was destroyed by fire through the fault of neither party.

E. The buyer claimed that the risk of loss had not passed because there was no tender of delivery and wants a refund.

F. The lower court held in favor of the buyer; the seller appealed.

Issue 3. Did tender of delivery take place so as to have shifted the risk of loss to the buyer?

4. Holding No. 5. Court’s Reasoning The Court of Appeals of Ohio held that: A. Under the UCC, if the seller is a merchant, the risk of loss passes on the receipt of goods.

B. Where the seller is a nonmerchant (as in this case), the risk of loss does not pass until there is a tender of delivery.

C. Because the seller retained keys to both the mobile home and the shed and because the seller had not yet removed his contents, he had not put the property at the disposition of the buyer.

D. Therefore, tender of delivery had not taken place.

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Chapter 18 Remedies for Breach of Sales and Lease Contracts

What Can We Sue For? Learning Objectives: 1.

2.

3.

4.

5.

I.

Describe the performance of sale and lease contracts. List and describe the seller’s remedies for the buyer’s breach of a sales contract. List and describe the buyer’s remedies for the seller’s breach of a sales contract. List and describe the lessor’s remedies for the lessee’s breach of a lease contract. List and describe the lessee’s remedies for the lessor’s breach of a lease contract.

Teacher-to-Teacher Dialogue

In UCC sales contracts, the seller makes the opening performance gesture. The seller’s duties are twofold: he or she must tender delivery of goods, and those goods must conform perfectly to the terms of the contract. If these obligations have been met, the duty shifts to the buyers to live up to their end of the deal. The basic duties of a buyer are found in the inspection process, acceptance of the delivery, and payment for the goods. Where both parties have lived up to their respective obligations, the normal performance obligations of the UCC have been satisfied.

Sometimes, extraordinary situations arise which may modify or excuse these basic performance duties. These sections of the code attempt to anticipate and answer problematic situations that arise in the fast-pace world of business. The interesting and innovative aspect of many of these modifications of basic performance duties is that the UCC seeks to provide anticipatory sorts of changes, that is, changes which seek to mitigate the problems rather than waiting too long and letting too much damage occur. Take, for example, the doctrines of anticipatory repudiation and adequate assurance. In both cases, the UCC says if one of the parties is seeing himself sink into commercial quicksand, he should not have to wait until he is neck deep before he can yell for legal help. These provisions are designed to allow performance modifications that will lessen the ultimate harm done by the breaching party.

The second set of UCC performance obligations reviewed in this chapter center around lease contracts entered into under Article 2A. One of the most interesting recent trends in the nation is the explosive growth of personal property leasing by both business entities and individuals. Prior to this trend, leases were considered to be the domain of real property law. The advent of highly leveraged buyouts and sophisticated techniques has made the use of debt rather than equity a way of life for many. In that light, it is really no surprise to see widespread leasing replace ownership .

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in many areas of commerce. For example, a very high percentage of autos are leased rather than owned. Article 2A is the UCC’s attempt to keep up with this economic reality.

Because Article 2A is designed to reflect existing leasing practices while clarifying the respective rights and duties of the parties to the transaction. The basic rules of common law contracts, as amended by the UCC, are carried over into Article 2A. The writing requirements have been tailored to fit the lease transaction, and the exceptions to the writing requirement are virtually the same as found in Article 2 of the code as are the performance obligations and remedies.

Finally, the UCC allows for excuse from performance in a limited set of circumstances.

These circumstances are impossibility and commercial impracticability. In both cases, the circumstances need to have been unforeseeable and to enforce performance now would be inequitable in light of the changed situation. One must keep in mind, however, that these doctrines are not intended to be used as a back door to get out from under binding contract obligations. The burden of proof on the person claiming excuse is a heavy one.

II.

Text Materials

Introduction: • Obligation—an action a party to a sales or lease contract is required by law to carry out.

• Breach—failure of a party to perform an obligation in a sales or lease contract.

• When one party breaches the lease or sales contract, the UCC provides the injured party with variety or prelitigation and litigation remedies.

Seller’s and Lessor’s Performance: Tender of Delivery: • The obligation of the seller to transfer and deliver goods to the buyer or lessee in • accordance with the sales or lease contract.

Requires the seller or lessor to: 1. Put and hold conforming goods at the buyer’s or lessee’s disposition; and 2. Give the buyer or lessee any notification reasonably necessary to enable the buyer or lessee to take delivery of the goods. [UCC 2-503(1), 2A-508(1)] Seller’s and Lessor’s Performance: Place of Delivery: • Many sales and lease contracts state where the goods are to be delivered.

• If the contract does not expressly state where the delivery will take place, the UCC will stipulate place of delivery on the basis of whether a carrier is involved. [UCC 2-504, 2503] • Noncarrier: seller’s or lessor’s place of business • Carrier: depends on if shipment or destination contract • Bailee—a holder of goods who is not a seller or buyer o That is, a warehouse • Shipment Contract—a sales contract that requires the seller to send the goods to the buyer, but not a specifically named destination.

• Destination Contract—a sales contract that requires the seller to deliver the goods to the buyer’s place of business or another specified destination.

Seller’s and Lessor’s Performance: Perfect Tender Rule: • The seller or lessor is under a duty to deliver conforming goods.

• If the goods or tender of delivery fails in any respect to conform to the contract, the buyer or lessee may opt either to: .

Remedies for Breach of Sales and Lease Contracts 153

Reject the whole shipment.

Accept the whole shipment.

Reject part and accept part of the shipment.

o o o

Note: Cure is the opportunity given by the U.C.C. to fix a nonconforming delivery: 1. Time not expired and 2. Notification • • • •

Exceptions to the perfect tender rule: o Agreement of the parties o Substitution of carriers Cure Installment contracts—language needed to separate lots Destruction of goods—void contract if totally destroyed; partially destroyed can be accepted

Contemporary Environment: Seller’s and Lessor’s UCC Opportunity to Cure Ethics Spotlight: UCC Imposes Duties of Good Faith and Reasonableness This box discusses good faith and reasonableness from the UCC point of view.

Sellers and Lessor’s Performance: General Obligations: The UCC has adopted several broad principles that govern the performance of sales and lease contracts: • Good Faith • Reasonableness • Commercial Reasonableness Buyer’s and Lessee’s Performance: Right of Inspection • Unless otherwise agree, the buyer or lessee has the right to inspect goods that are tendered, delivered, or identified to the sales contract prior to accepting or paying for them. [UCC 2-513(1), 2A-515(1)] • If the goods conform to the contract, the buyer pays for the inspection.

• Buyers who agree to C.O.D. (cash on delivery) deliveries are not entitled to inspect the goods before paying for them. [UCC 2-513(3)] Buyer’s and Lessee’s Performance: Payment • Duty to Pay—goods that are accepted must be paid for.

• Unless the parties agree otherwise, payment is due from a buyer when and where the goods are delivered even if the place of delivery is the same as the place of shipment.

[UCC 2-310, 2A-516(1)] Buyer’s and Lessee’s Performance: Acceptance • Occurs when the buyer or lessee takes any of the following actions after a reasonable opportunity to inspect the goods [UCC 2-606, 2A-515 ]: .

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Signifies to the seller or lessor in words or by conduct that the goods are conforming or that the buyer or lessee will take or retain the goods despite their nonconformity, or o Fails to effectively reject the goods within a reasonable time after their delivery or tender by the seller or lessor o

Buyer’s and Lessee’s Performance: Revocation of Acceptance • A buyer or lessee who has accepted goods may subsequently revoke acceptance if: 1. The goods are nonconforming; 2. The nonconformity substantially impairs the value of the goods to the buyer or lessee; and 3. One of the following factors is shown: a. The seller’s or lessor’s promise to reasonably remedy the nonconforming is not met; b. The goods were accepted before the nonconformity was discovered and the nonconformity was difficult to discover; or c. The goods were accepted before the nonconformity was discovered and the seller or lessor assured the buyer or lessee that the goods were conforming Seller’s and Lessor’s Remedies: Right to Withhold Delivery • Delivery of the goods may be withheld if the seller or lessor is in possession of them • when the buyer or lessee breaches the contract.

This remedy is available if the buyer or lessee: o Wrongfully rejects or revokes acceptance of the goods; o Fails to make payment when due; or o Repudiates the contract Seller’s and Lessor’s Remedies: Right to Stop Delivery of Goods in Transit • In Transit—a state in which goods are in the possession of a bailee or carrier and not in the hands of the buyer, seller, lessee, or lessor.

• A seller or lessor may stop delivery of goods in transit if he or she learns of the buyer’s of • lessee’s insolvency.

The same remedy is available if the buyer or lessee: o Repudiates the contract, o Fails to make payment when due, or o Otherwise gives the seller or lessor some other right to withhold or reclaim the goods Seller’s and Lessor’s Remedies: Right to Reclaim Goods.

• The right of a seller or lessor to demand the return of goods from the buyer or lessee • under specified situations.

To exercise the right of reclamation, the seller or lessor must send the buyer or lessee a written notice demanding return of the goods.

Seller’s and Lessor’s Remedies: Right to Dispose of Goods .

• If the buyer or lessee breaches or repudiates the seller or lease contract, before the seller or lessor has delivered the goods, the seller or lessor may resell or release the goods and recover damages from the buyer or lessee.

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•

This right also arises if the seller or lessor has reacquired the goods after stopping them in transit.

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

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

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

Seller’s and Lessor’s Remedies: Right to Cancel the Contract • A seller or lessor may cancel a sales or lease contract if the buyer or lessee: o Rejects or revokes acceptance of the goods; o Fails to pay for the goods; or o Repudiates the contract in part or in whole Note: Seller or lessor’s right to seek damages is retained.

Contemporary Environment: Lost Volume Seller This box centers on the issue of how to establish an appropriate measure of damages where the goods in question are sold to a new third party. At first, it appears that no real harm is done to the seller. Yet, most students eventually come around to the “lost volume” measure of damages in the commercial setting. What if the goods were custom designed or artistic in nature? Would or should the same apply?

Summary: Seller’s and Lessor’s Remedies: Goods in the possession of the seller: Seller’s or Lessor’s Remedies: 1. Withhold delivery of goods. .

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2. Demand payment in cash if buyer is insolvent.

3. Resell or re-lease the goods and recover the difference between the contract or lease price and the resale or re-lease price.

4. Sue for breach of contract and recover damages.

5. Cancel the contract.

Goods in the Possession of the Carrier Bailee Seller’s or Lessor’s Remedies 1. Stop goods in transit.

2. Carload, truckload, planeload, or larger shipment if the buyer is solvent.

3. Any size shipment if the buyer is insolvent.

Goods in the Possession of the Buyer: Seller’s or Lessor’s Remedies 1. Sue to recover the purchase price or rent.

2. Reclaim the goods.

Buyer’s and Lessee’s Remedies: • Right to reject nonconforming goods or improperly tendered goods • Right to recover goods from an insolvent seller or lessor • Right to obtain specific performance • Right to cover • Right to replevy goods • Right to cancel the contract • Right to recover damages for nondelivery or repudiation • Right to recover damages for accepted nonconforming goods Contemporary Environment: Buyer’s and Lessee’s UCC Right to Cover Note: Cover involves substituted goods Damages now = cost of cover – contract price Replevy involves recovering scarce goods Summary: Buyer’s and Lessee’s Remedies Situation: Seller or lessor refuses to deliver the goods or delivers the goods or delivers the noncomforming goods that the buyer or lessee does not want.

Buyer’s or Lessee’s Remedy: 1. Reject noncomforming goods.

2. Revoke acceptance of noncomforming goods.

3. Cover.

4. Sue for breach of contract and recover damages.

5. Cancel the contract.

Situation: Seller or lessor tenders noncomforming goods and the buyer or lessee accepts them.

Buyer’s or Lessee’s Remedy: 1. Sue for ordinary damages.

2. Deduct damages from the unpaid purchase price. .

Remedies for Breach of Sales and Lease Contracts 157

Situation: Seller or lessor refuses to deliver the goods and the buyer or lessee wants them.

Buyer’s or Lessee’s Remedy 1. Sue for specific performance.

2. Replevy the goods.

3. Recover the goods from an insolvent seller or lessor.

Additional Issues Affecting Performance and Breach: 1. Assurance of Performance 2. Statute of Limitations 3. Agreements Affecting Remedies Liquidating Damages: • Pre-established damages • Must be reasonable Ethics: UCC Doctrine of Unconscionability The doctrine of unconscionability says that if a contract is unconscionable, the court may either refuse to enforce the contract or limit the application of the unconscionable clause.

• The UCC Article 2 (Sales) and Article 2A (Leases) have adopted the equity doctrine of • unconscionability.

To prove unconscionability, there must be proof: o That the parties had substantial unequal bargaining power; o That the dominant party misused its power in contracting; and o That it would be manifestly unfair or oppressive to enforce the contract • This doctrine also applies to Web contracts.

III.

Answers to Critical Thinking Cases

Nonconforming Goods 18.1.

Hartz wins the lawsuit based upon the buyer’s right to reject nonconforming goods. Sales transactions are subject to the perfect tender rule. This rule states that the seller is under a duty to deliver conforming goods. If the goods or tender of delivery fails in any way to conform to the contract, the buyer may elect to reject the whole shipment, accept the whole shipment, or reject part and accept part. The court held that Coleman had violated the perfect tender rule by shipping soybeans with a 65 percent germination level, instead of the contracted 80 percent level. Thus, because the soybeans failed to conform to the contract, Hartz elected to reject the entire shipment. The Appellate Court ruled that Hartz’s action was appropriate, based upon the buyer’s right to reject nonconforming goods. Jacob Hartz Seed Co., Inc. v. Coleman, 612 S.W.2d 91 (Ark. 1981).

Right to Cure 18.2.

Grady wins the lawsuit. When the buyer rejects a nonconforming tender where the seller had reasonable grounds to believe that it would be accepted by the buyer, the seller may have additional “reasonable time” to substitute a conforming tender if he reasonably notifies the buyer. Reasonable time is determined on a case-by-case basis. Thompson objected to the trial court’s decision that Grady had not given Thompson a reasonable .

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time to cure the nonconforming tender, the defective Chevette. The court held that because Thompson believed that Grady would accept the car, Thompson had a reasonable time to cure the defect. In the court’s opinion, because Grady had allowed Thompson more than two months to repair the car, there was an adequate opportunity for Thompson to cure the defect. Subsequently, when Thompson was unable to repair the Chevette in this two-month period, Grady was able to revoke the sales contract. The Appellate Court affirmed the trial court’s decision that Grady had given Thompson an adequate opportunity to cure the defect. General Motors Acceptance Corp. v. Grady, 501 N.E.2d 68(Ohio App. 1985).

Seller’s Right to Resell Goods 18.3.

Meuser wins the lawsuit. Under the UCC, when a buyer breaches or repudiates a sales contract, the seller may resell the goods if he is still in possession of them. When the goods are rightfully resold, that is, resold in good faith and in a commercially reasonable manner, the seller may recover both the contract-resale measure of damages, that is, the loss incurred on the sale, and any incidental damages incurred on the resale. The Court held that McMillan breached the contract when he stopped payment on his check.

Because this occurred when Meuser still had possession of the bulldozer, Meuser had the right to resell it. The Appellate Court held that Meuser could properly recover the amount spent on the upkeep of the equipment as incidental damages. However, the amount that the trial court awarded for contract-resale damages was reduced because the Appellate Court felt that a resale fourteen months after a breach was not commercially reasonable. Meuser still won the lawsuit and the Appellate Court awarded the company a reduced amount. McMillan v. Meuser Material & Equipment Co., 541 S.W.2d 911 (Ark. 1976).

Right to Recover Lost Profits 18.4.

Saber has the right to recover its lost profits. When a buyer has breached a sales contract for specially manufactured goods, the seller can be made whole by reselling the goods and then suing the buyer for the difference between the resale and contract price.

However, this remedy will not put the seller of ordinary items in the same position as if the buyer had performed the sales contract. When the goods are ordinary items or of relatively unlimited supply, the seller would have made two sales instead of one if the original buyer had not breached. Therefore the seller can be awarded its lost profits, including reasonable overhead, on the contract.

Saber was the seller of an ordinary item, gasoline. When Tri-State breached its contract, the gasoline Tri-State had originally bought was resold. However, Saber would have been able to make this second sale even if its supply of gasoline had not been increased by Tri-State’s breach. In other words, Tri-State’s breach meant that Saber made only one sale instead of two. Because of this situation, the court held that Saber was entitled to its lost profits. Tri-State Petroleum Corp. v. Saber Energy, Inc., 845 F.2d 575 (5th Cir. 1988).

Specific Performance 18.5.

Sedmaks can obtain specific performance of the sales contract for the limited edition Corvette. When a sales contract is for a unique good, the UCC provides that a buyer may obtain specific performance because an award of monetary damages is not a sufficient remedy. Sales contracts for works of art and antiques are the type of contracts for which .

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courts will order specific performance. In this case the court held that the Indy Pace Car Special Edition Corvette was a unique good. Even though the car was not one of a kind, it was sufficiently limited in number so that an award of monetary damages would not be a sufficient remedy. The fact that Charlie’s was attempting to auction the car indicates that the Corvette was unique and was worth more than its sticker price. When Charlie’s breached the sales contract for the Corvette, the Sedmaks were entitled to obtain specific performance. The court ordered Charlie’s to sell the Indy Pace Car Corvette to the Sedmaks. Sedmak v. Charlie’s Chevrolet, Inc., 622 S.W.2d 694 (Mo.App. 1981).

Right to Cover 18.6.

Nowlin wins the lawsuit. If a seller fails to make a delivery of goods, the buyer may cover by purchasing substitute goods. A buyer’s cover must be made in good faith and without unreasonable delay. If the buyer covers the undelivered goods, the buyer may sue the seller to recover as damages the difference between the cost of cover and the original contract price. This is called the cover minus the contract price measure of damages. The court held that C&E had failed to make a delivery when it shipped Nowlin only 2,099 tons of paving material instead of the contracted 20,000 tons. C&E’s failure to deliver gave Nowlin the right to cover. By immediately contracting with another commercial supplier of gravel, Gallop Sand and Gravel Company, Nowlin covered in good faith and in reasonable time. Because Nowlin covered in good faith, the company was entitled to the difference between the original contract price and the price paid to Gallup. The court awarded Nowlin the cover minus the contract price measure of damages. Concrete Sales & Equipment Rental Company, Inc. v. Kent Nowlin Construction, Inc., 746 P.2d 645 (N.M. 1987).

IV.

Answers to Business Ethics Cases

18.7.

Ybarras wins. Revocation must be given in a reasonable time and by a reasonable manner. Four years is a reasonable time under the circumstances. In addition, the plaintiffs’ continuous complaint was due notice that the trailer was defective and they were not satisfied. Therefore, the requirements of the UCC have been met.

Ybarras v. Modern Trailer Sales, Inc., 609 P.2d 331 (N.M. 1980).

18.8.

Yes, it was commercially reasonable for Lincoln to request the delivery of sand during December. The UCC does not specifically define what is commercially reasonable.

Instead, the term is defined in reference to the course of dealing between the parties, the usage was of trade, and other factors. In this case, the court held that Lincoln’s request reasonable, and Allsopp’s refusal of the request was unreasonable. Lincoln’s

request was reasonable because it came within the one-year period covered by the contract, and the contract did mention the availability of delivery by special arrangement. Lincoln’s

offer to send an employee to help with the loading also favorably influenced the court’s decision. Because Allsopp already had the sand stockpiled, it was not reasonable for it to charge. an extra amount to load during December. Therefore, its refusal of Lincoln’s request was unreasonable. Because the court found that Allsopp had not acted in a commercially obligations. reasonable manner, Lincoln was allowed out of its contractual Allsopp Sand and Gravel v. Lincoln Sand and Gravel, 525 N.E.2d 1185 (Ill.App. 1988).

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V. Answers to Policy Cases 18.9.

Joe Oil has a right to cure the defect in its delivery. Joe Oil had reasonable grounds to believe for the original shipment would be acceptable or would have tried to cure if not acceptable and given reasonable time. Joe Oil USA, Inc. v. Consolidated Edison Company of NY’s, Inc. 457 N.Y.S. 2d 458, 443 N.E 2d 932, Web 1982 N.Y. Lexis 3846 (Court of Appeals of NY) VI.

Answer to “Briefing the Case”Writing Assignment

1. Case Name, Citation, and Court LNS Investment Co., Inc. v. Phillips 66 Co. 731 F. Supp. 1484 (1990) United States District Court 2. Key Facts A. The plaintiff entered into a UCC contract to supply blended, labeled, and packaged quart plastic bottles of motor oil for the defendant.

B. Under the terms of the contract, the number of bottles to be provided could be as high as 4 million by December 31, 1986, if new production molds were online by that date.

C. If the new molds were not up and running, the plaintiff was to supply as many as possible

by December 31, 1986.

D. Because of production problems, plaintiff was unable to supply enough bottles of satisfactory quality. On December 16, 1986, defendant informed plaintiff that it would not renew any commitments to purchase goods from plaintiff.

E. Plaintiff sued alleging a breach of the original contract by the defendant.

F. Defendant claims it was entitled to but did not get a UCC-based adequate assurance of performance.

3. Issue Was the defendant entitled to adequate assurance of performance?

4. Holding Yes. 5. Court’s Reasoning The United States District Court held that: A. The products supplied by plaintiff were commercially defective.

B. Defendant put the plaintiff on notice that it was entitled to adequate assurance of performance to cure the defects.

C. Because plaintiff did not provide commercially adequate assurance of performance, defendant was entitled under the UCC to terminate the contract. Thus, defendant did not breach the contract.

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Chapter 19 Warranties and Product Liability

How Can We Make Sure We Get What We Pay For? Learning Objectives: 1. Identify and describe express warranties.

2. Describe the implied warranty of merchantability and the implied warranty of fitness for a particular purpose.

3. Identify warranty disclaimers and determine when they are unlawful.

4. Describe product liability and define the doctrine of strict liability.

5. Describe the product defects in manufacture, design, and failure to warn.

I.

Teacher-to-Teacher Dialogue

Buyer beware! Throughout the history of common law, the law’s expectations of buyer protection started and ended with the buyers themselves. A person entering the marketplace was expected to personally know the seller and to resolve any differences directly with him or her.

The roles of government and its courts as sources of buyer protection were expected to be minimal. That all worked well enough in the preindustrial age populated by small communities with direct dealings between the buyer and seller. What are the realistic chances today of an aggrieved buyer working out a problem directly with representatives of many of the major companies? The postindustrial global marketplace has become too complex to expect a buyer to resolve these issues directly with the seller. The law has stepped in with numerous remedial measures to help alleviate the shortcomings created by caveat emptor.

The issues covered in these materials go far beyond the question of who pays for what harm.

These matters take students into the realm of how a society chooses to conduct business, how it allocates the “costs” of doing that business, and most important of all, how much value society places on the balancing process between business latitude and individual rights. A discussion of the concepts of negligence and strict liability seems to be an excellent way to start the chapter.

Teaching the strict liability portion of this chapter right after torts is probably a good way to start. The warranty material can be done as part of the UCC section on Article 2. In the end, the sequence to be used is best selected by each individual instructor. Regardless of the sequence chosen, students should eventually be exposed to the multiple paths available to remedy the victim of a products’ harm. .

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After going over the history of the early strict liability cases, it might be helpful to go over a listing of the arguments on the current state of affairs in the product liability arena. The possibilities for debate and open-ended discussion on these matters are endless. Products liability remains one of the great socioeconomic and legal dilemmas of our day.

The section of this chapter on warranties gives us a timely opportunity to remind students of the multifaceted aspects of the issues covered in this chapter. Warranty issues invariably raise the possibilities of common law tort remedies as well as the whole gambit of products liability law.

We probably should constantly try to remind students of the wide and varied menu of remedies they have to work with.

The UCC rules of warranty are a statutory set of buyer protections. There are five common denominators applicable to all warranties. First, determine whether any sort of warranty may be in existence either by acts of the parties or by imposition of law. Examine the scope and nature of the promises or assurances made under the alleged warranty. Second, decide if there has been any nonconformance with the terms of the warranty in the time frame covered by the transaction. This time frame may be limited to just the initial sale, or the period of performance may have been extended by way of post sale promises. Third, if there has been a breach of warranty by reason of nonconformity to the promises made, has this breach caused an injury of any sort? Fourth, ascertain the measure of the alleged injury. Finally, are there any defenses, contractual or otherwise, applicable in this case? Remember also, warranties represent only one path to dealing with the problem. Other avenues may include tort law, consumer protection statutes, and equitable remedies.

The early cases rising out of strict liability holdings for ultra-hazardous activities lead to the first signs of holding businesses liable for the harms created by their products. The second stream of cases arose out of the warranty aspects of UCC sales.

Arguments in favor of strong product liability laws: In the area of tort law, many argue that traditional negligence doctrines have failed to adequately protect consumers hurt by defective products. Courts led the way to newer avenues of recourse by way of the doctrine of strict liability. The two sides of the public policy debate surrounding this doctrine are set out below. On the side of product users, the following points are worth considering: a. Traditional tort law doctrines based on fault and defenses related thereto have not always adequately served the injured person. The evolution of strict liability doctrines is a logical consequence of having this deficiency in the law. b. Contract law, both common and UCC, has also failed to provide adequate assurance to the victims of product harm. Consumers traditionally have had less real bargaining power in the contracting process when it comes to attaching responsibility for harm created by a product. c. Various legislative enactments at both local and national levels designed to protect consumers tend to be reactive rather than proactive. Bans on products are enacted only after so many injuries have occurred that the products continued existence in the marketplace can no longer be tolerated. d. As a practical matter, the protection against defects in products is best provided by the manufacturers of those products. Compared to the consumer, they have the resources to research, develop, and test against harm. Can you as a buyer of an automobile really test the airbag before you buy the car? e. Finally, the sanctions imposed by law for defective products should act as a deterrent to further introduction of faulty products into the marketplace. If sellers of goods know this, they will try harder to make products safer in the first place.

Arguments in favor of restricting the use of product liability doctrines: .

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As persuasive as some of these arguments may be, the other side of the coin has its own convincing points. Some key arguments raised against the current products liability systems are as follows: a. The cost of the present system is simply out of control and is a model of inefficiency. b. Technology never has been and cannot be expected to be 100 percent precise. The potential harm created by products is dependent on the state of the art at the time, and to require more is to impose 20/20 retroactive hindsight. c. The present day procedural rules have allowed a deep pocket mentality to set in. Rules such as joint and several liability of cotortfeasors allow an entity with only a small percentage of responsibility to be liable out of proportion to that level of responsibility based only on their financial resources. d. Many socially beneficial products are kept out of the U.S. marketplace because of fears raised by our product liability system in the eyes of potential importers. Conversely, the enhanced cost of U.S. products based on built-in liability insurance costs makes U.S. products less competitive overseas. This diminished participation in the worldwide marketplace hurts all of us. The rules of product liability in the United States compared to those of Japan illustrate this point. e. Finally, there is a prevailing “lottery” mentality as a result of large damage awards from product liability costs. The harm one suffers may be minimal, but the pain and suffering losses coupled with potential punitive damages have inspired too many consumers to sue.

II.

Text Materials

Product Issues (Nonconformity or Defect) 1. Warranty (Contract) a. Express b. Implied 2. Negligence (Tort) 3. Strict Liability (Tort) Note: Warranty—buyer or lessee’s assurance that the goods meet certain standards.

Warranties of Quality: • Seller’s or lessor’s assurance to buyer or lessee that the goods meet certain standards of • quality.

If the good fail to meet a warranty, the buyer or lessee can sue the seller or lessor for breach of warranty.

• Warranties may be expressed or implied.

• Must be a basis of the bargain.

• Opinion (puffing) are not warranties.

Express Warranties: • Created when a seller or lessor make an affirmation that the goods he or she is selling or leasing meet certain standards of quality, description, performance, or condition. [UCC 2-313(1); UCC 2A-210(1)]

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•

It is not necessary to use formal words such as warrant or guarantee to create an express warranty. [UCC 2-313(2); UCC 2A-210(2)]

Cast 19.1. The Court Speaks: Milicevic v. Fletcher Jones Imparts, Ltd. And Mercedes-Benz USA, 402 F. 3d 912, Web 2005 U.S. App. Lexis 4905 (2005) U.S. Court of Appeals.

Facts: Milicevic bought a new Mercedes from Jones. Mercedes made a new car express limited warranty that authorized Center would repair any defects for the length of the warranty. By the end of the warranty, the car had been in the shop for various defects up to 55 days. Some of the defects were not covered. Milicevic wanted a replacement.

Issue: Was there a breach of express warranty by Mercedes that would permit Milicevic to rescind the purchase of the Mercedes-Benz automobile and recover the value of the car and damages?

Decision: Yes. Mercedes had breached the express/limited warranty.

Reason: There was a written warranty. Because some of the defects were never corrected, there was a breach.

Implied Warranty of Merchantability: • Unless properly disclosed, a warranty is implied when sold or leased goods are fit for the ordinary purpose for which they are sold or leased and other assurances.

[UCC 2-314(1); UCC 2A-212(1)] The implied warranty of merchantability does not • apply to sales or leases by nonmerchants or casual sales.

Implied Warranty of Merchantability: Standards That Must Be Met • The goods must be fit for the ordinary purposes for which they are used.

• The goods must be adequately continued, packaged, and labeled.

• The goods must be of an even kind, quality, quantity within each unit.

• The goods must conform to any promise or affirmation of fact made on the container or • label.

The quality of the goods must pass without objection in the trade.

• Fungible goods must meet a fair average or middle range of quality.

Cast 19.2 The Court Speaks: Denny v. Ford Motor Company, 87 N.Y. 2d 248, 662 N.Y. 2d 730, 639 N.Y.S. 2d 250, Web 1995 N.Y. Lexis 4445 (Court of Appeals of NY) Facts: Nancy Denny purchased a Bronco II, a small SUV that was manufactured by Ford Motor Company. When Denny slammed on her brakes on a paved road to avoid hitting a deer, the Bronco II rolled over and Denny was severely injured. She sued to recover damages for breach of the implied warranty of merchantability, claiming that the Bronco II presented a significantly higher risk of rollover accidents than did ordinary passenger vehicles.

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

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

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Implied Warranty of Fitness for Human Consumption: • A warranty that applies to food or drink consumed on or off the premises of: o Restaurants o Grocery stores o Fast-food outlets o Vending machines Consumer Expectation Test • A test to determine merchantability based on what the average consumer would expect to find in food products.

Foreign Substance Test • A test to determine merchantability based on foreign objects that are found in food.

Implied Warranty of Fitness for a Particular Purpose: • A warranty that arises where a seller or lessor warrants that the goods will meet the • • buyer’s or lessee’s expressed needs.

The warranty is breached if the goods do not meet the buyer’s or lessee’s expressed needs.

That warranty applies to both merchant and nonmerchant sellers and lessor.

Warranty Disclaimers:

• Warranties can be disclaimed or limited.

• If an express warranty is made, it can only be limited if the disclaimer and the warranty • can he reasonably construed with each other. asas is,with all All implied warranties of quality may be disclaimed by expressions such faults, or other language that makes it clear to the buyer that there are no implied warranties.

Cyber Law: Warranty Disclaimers in Software Licenses This discusses disclaimer of warranty and limitation of liability clauses that are included in a typical software license.

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

1. Damages: a. Compensatory = warranted value – actual value (at acceptance) b. Consequential c. Incidental Other Warranty Issues: • Overlapping and inconsistent warranties • Warranty disclaimers • Conspicuous display of disclaimer • Unconscionable disclaimers • Warranty disclaimers in software licenses • Third-party beneficiaries of warranties .

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Product Liability Based on Fault: Misrepresentation • A buyer or lessee who is injured because a seller or lessor fraudulently misrepresented • the quality of a product can sue the seller under the tort of intentional misrepresentation.

Seller or lessor either: o Affirmatively misrepresents the quality of a product; or o Conceals a defect in it • Recovery is limited to persons who were injured because they relied on the misrepresentation.

Product Liability Based on Fault: Negligence • Negligence—a tort related to defective products where the defendant has breached a duty of care and caused harm to the plaintiff.

• Failure to exercise due care includes: o Failing to assemble the product carefully o Negligent product design o Negligent inspection or testing of the product o Negligent packaging o Failure to warn of the negligent propensities of the product Strict Liability: • In Greenmun v. Yuba Power Products, Inc., the California Supreme Court adopted the • • doctrine of strict liability in tort as a basis for product liability actions Most states have adopted this doctrine as the basis for product liability actions Removes many of the difficulties for the plaintiff associated with other theories of product liability Strict Liability—Specific Considerations 1. All parties in the chain of distribution are strictly liable for the injuries caused by the product.

2. Privity of contract is not required.

3. Sellers and lesser are liable to the ultimate user or consumer including family members, guests, employees and the like (possibly bystanders).

4. Punitive damages can be allowed with intent or seeking disregard for safety.

The Concept of Defect: • To recover for strict liability, the injured party must first show that the product that • caused the injury was somehow defective.

Plaintiffs can allege multiple product defects in one lawsuit.

The most common types of defects are defects in manufacture, design, and packaging and failure to warn.

1. Defects in manufacture: Assemble, test, check 2. Defects in design: Risk-utility analysis; consumer expectation test 3. Defects in packaging 4. Failure to warn 5. Failure to provide adequate instructions: assembly and use

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Case 19.3.The Court Speaks: Shoshone Coca-Cola Bottling Company v. Dolinski, 82 Nev. 439, 420 P.2d 855, Web 1966 Nev. Lexis 260 (Supreme Court of Nevada) Facts: Dolinski purchased a bottle of “Squirt” and began to consume it. After drinking a portion of the contents, he became ill. Upon examination, part of a decomposed mouse was discovered in the bottle. Dolinski suffered physical and mental distress and had an aversion to soft drinks.

Dolinski sued Shoshone under the doctrine of strict liability. Although Nevada had not previously recognized the doctrine, the trial adopted it and ruled in favor of Dolinski. Shoshone appealed.

Issue: Should the doctrine be adopted, and if so, did a defect cause the harm?

Decision: The doctrine was adopted and Dolinski wins.

Reason: Public policy demands that someone who places a bottled beverage in a dangerous condition on the market be strictly liable for harm resulting from usage. Even though Shoshone argues that only the legislature can adopt such a policy, case authority in most other states is the opposite. The plaintiff still must prove that his injury was caused by a defect in the product and such defect existed when the product left the hands of the defendant. There was sufficient evidence that the plaintiff met his burden of proof.

Case 19.4. The Court Speaks: Higgins v. Intex Recreation Corporation, 123 Wa. App. 821, 99 P.3d 421, Web 2004 Wash. App. Lexis 2484 (2004) Court of Appeals of Washington.

Facts: Intex designed and sold the Extreme Tube II to ride down hills with no steering device at a speed as high as 30 mph. The rider could end up going down backward. Falkner used it the day he bought it, but spun around aiming at 7-year-old Potter. Higgins got Potter out of the way but was hit and thrown into a spinal cord injury leaving him a quadriplegic. Higgins sued Intex based on strict liability. Evidence showed the lack of a guidance or steering mechanism and that Intex made a Sno-Boggan with bottom ridges that prevented rotation. Higgins was awarded 35 percent of damages after a jury finding of a design defect.

Issue: Was the Extreme Sno-Tube II defectively designed, thus supporting the judgment?

Decision: Yes. The judgment was affirmed.

Decision: The two tests for design defect are the risk utility test requiring a showing that the likelihood and seriousness of harm outweighs the burden to the manufacture on a design that could have prevented injury, and the consumer-expectation test requiring a showing of danger greater than an ordinary consumer would expect based on an alternative design. A reasonable jury could enter an expectation of rotation by a reasonable consumer.

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

Ethics: Strict Liability Imposed on Aboveground Pool Manufacture This deals with a damage award against Hotfiger awarded in a personal injury lawsuit. The court stated that “…the evidence revealed the lack of a persuasive label on the limit of diving and outlining the consequences of diving into the pool was a substantial factor in causing the injury.”

Note: In product liability cases, a court can award damages if it finds that the defendant’s actions were done with intent or reckless disregard for human life. They are meant to punish. .

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Defenses to Product Liability: 1. Supervening event 2. Generally known dangers 3. Assumption of the risk 4. Government contractor defense 5. Misuse of the product 6. Statute of limitations 7. Contributory and comparative negligence III.

Answers to Critical Thinking Cases

Design Defect 19.1.

Yes. There is a design defect. Available safety features were not installed by Sta-Rite on its drain pumps. Punitive damages were awarded. Sta-Rite Industries, Inc. V Peterson, 837 So. 2d 988, Web 2003 Fla. App. Lexis 1673 (Court of Appeal of Florida, 2003)

Express Warranty 19.2.

The Court Speaks: Daughtrey v. Ashe, 243 VA 73, 413 S.E. 2d 336, 1992 Va. Lexis 152 (Supreme Court of Virginia) Facts: Daughtrey sold a diamond bracelet to Ashe for $15,000 after Ashe completed and signed an appraisal term stating that the diamonds were “H color and v.v.s. quality”. One year later and the jeweler indicated that the diamonds were of substantially lower grade than v.v.s. Daughtrey filed a specific performance suit for an appropriate replacement or damages. Daughtrey appealed a trial court denial verdict.

Issue: Was an express warranty made by Ashe regarding the quality of the diamonds in the bracelet?

Decision: Yes. The trial court’s decision was reversed and the case was rewarded for appropriate damages.

Reason: Formal words are not necessary for an express warranty. Here Ashe specifically described the diamonds and their quality. Because he had superior knowledge and was not just offering it as an opinion, there was an express warranty.

Failure to Warn 19.3.

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

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Warranties and Product Liability 169

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

Implied Warranty of Fitness for a Particular Purpose 19.4.

The Court Speaks: Mack Massey Motors, Inc. v. Garnica, 814 S.W. 2d 167, Web 1991 Tex., Lexis 1814 (Court of Appeals of Texas) Facts: Garnica went to Massey to ask about a Jeep Cherokee to tow a 23 ft. Airstream trailer she had on order. Garnica explained requirements and got the specifications of the trailer from Airstream. Massey’s sales manager said the Jeep would work. Garnica bought the Jeep, but had it in for repairs for a slipping transmission several times. She was eventually told to go to another dealer and the driveshaft twisted at 7,229 miles.

Garnica sued Massey and Jeep for damages alleging breach of the implied warranty of fitness for a particular purpose. Garnica wins and Massey and Jeep appealed.

Issue: Did the defendant make and breach an implied warranty of fitness for a particular purpose?

Decision: Massey did make and breach the warranty but Eagle did not.

Reason: Massey said the Jeep would work after knowing the requirements. Massey had

superb knowledge and expertise and Garnica had inquired and relied on this.

Warranty Disclaimer 19.5.

Yes. The disclaimer was conspicuous and all express and implied warranties were disclaimed. Conspicuous includes in writing, printed in capital letters (as done here), language in the body of the form is larger than the rest (as done here). This was conspicuous and did disclaim the implied warranty of merchantability. Mitsch v.

Rockenbach Chevrolet, 359 Ill. App. 3d 99, 833 N.E. ed 936, Web 2005 Ill. App. Lexis 699 (Appellate Court of Illinois)

Crashworthiness Doctrine 19.6.

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

General Motors contended that defective design was not properly at issue in the case because a design is defective only if it results in a product that is unsafe for its intended use. Here, General Motors asserts, no evidence was produced to show the .

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station wagon was unsafe for its intended use—operation on the highway. The court rejected this assertion, stating that this theory had been repudiated in Cronin v. J. B. E. Olson Corp., 8 C. 3d 121, 104 Cal. Rptr. 433 (Cal. 1972), where the Court stated: The argument that the van was built only for “normal” driving is unavailing. We agree that strict liability should not be imposed upon a manufacturer when injury results from a use of its product that is not reasonably foreseeable. Although a condition may not be the “normal” or intended use of a motor vehicle, vehicle manufacturers must take accidents into consideration as reasonably foreseeable occurrences involving their products. The design and manufacture of products should not be carried out in an industrial vacuum but with recognition of the realities of their everyday use.

The court held that a motor vehicle manufacturer is required to foresee that, as an incident of normal operation in the environment in which his product will be used, accidents will occur, including high-speed collisions between vehicles.

Because of this possibility, the manufacturer is required to design its vehicle to minimize unreasonable risks of injury and death. From this duty it follows that a motor vehicle manufacturer must take into account the possibility of a high-speed collision when it selects a location for the fuel tank in the vehicle. The manufacturer must evaluate the crashworthiness of its product and take such steps as may be reasonable and practicable to forestall particular crash injuries and mitigate the seriousness of other problems. The court ordered a new trial in this case. Smith v. General Motors Corporation, 42 C.A.3d 1, 116 Cal.Rptr. 575 (Cal.App. 1974).

IV. 19.7.

19.8.

Answer to Ethics Questions The Court Speaks: Glenn v. Overhead Door Corporation, 935 S. 2d 1074, Web 2006 Miss. App. Lexis 60 (Court of Appeals of Mississippi) Facts: Glenn left her 3 year old in a closed garage with the car running. The child died from carbon monoxide poisoning. The garage door and garage door opener was manufactured by Overhead. The child’s father sued Overhead for strict liability based on design defect and failure to warn. He agreed that the opener should have had a sensor and warnings should have been given about the dangers of a closed door. The trial court granted summary judgment to Overhead.

Issue: Was Overhead liable under the doctrine of strict liability for either design defect or failure to warn?

Decision: No. The summary judgment order was affirmed.

Reason: To prove failure to warn one must show that the user was ignorant of the danger. There is no such duty for open and obvious dangers that are common knowledge to the ordinary observer or consumer.

No, Ingersoll-Rand is not liable for the breach of implied warranty of merchantability because it properly disclaimed any such warranty. Disclaimers of the merchantability warranty must specifically mention the term “merchantability.” If the disclaimer is in writing, it must be conspicuous. The court held that the UCC applies to contracts for leases, in the same way it applies to contracts for the sale of goods. In the agreement between Ingersoll-Rand and Cole Energy, the disclaimer clearly mentions merchantability. The disclaimer is set out in large type and the section is clearly labeled “Warranties.” This passes the UCC test for conspicuousness. Because Ingersoll-Rand had properly disclaimed the implied warranty of merchantability, Cole Energy was not

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able to recover.Cole Energy Development Company v. Ingersoll-Rand Company , 678 F.Supp. 208 (C.D.Ill. 1988).

V.

Answer to Policy Cases

19.9.

Senco was liable for a design defect. The reasonable juror could infer the existence of profit motives causing the design defect. Defendant knew of the possibility of a misfire.

It was foreseeable that serious injury could occur. Lakin v. Senco Products Inc., 144 One. App. 52, 925 P.2d 107, Web 1996 Ore. App. Lexis 1466 (Court of Appeals of Oregon)

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Johnson v. Chicago Pneumatic Tool Co. 607 So.2d 615 (1992) Court of Appeals of Louisiana 2. Key Facts A. The plaintiff, Johnson, was employed by McDermitt, Inc., as a pipe worker. One of the tools used by McDermott was a pipe jack device manufactured by the defendant.

B. In the course of implementing this tool, McDermott had modified a clutch safety device by welding it shut, thus compromising the effectiveness of the tool’s safety lock and brakes.

C. When a 50 gallon drum made contact with the pipe jack, it moved forward and injured plaintiff.

D. Plaintiff claims that the product, as modified, was unreasonably dangerous, thus entitling him to damages for product liability.

E. The lower court held in favor of plaintiff. The defendant appeals.

3. Issue Was the product, as modified, unreasonably dangerous so as to allow a determination of product liability?

4. Holding Yes. 5. Court’s Reasoning The Court of Appeals of Louisiana held that: A. The product as originally designed had reasonable safety devices.

B. The modifications created an unreasonably dangerous product.

C. This accident could have been prevented had the original safety device still been in place.

D. The finding of fact was deemed reasonable by the Court of Appeals. The lower court’s in favor of the plaintiff, Johnson, was upheld.

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Chapter 20 Creation and Transfer of Negotiable Instruments

How Do You Make A Piece Of Paper Into A Substitute For Money?

Learning Objectives: 1. Distinguish between negotiable and nonnegotiable instruments.

2. Describe drafts and checks and identify the parties to these instruments.

3. Describe promissory notes and certificate of deposits and identify the parties to these instruments.

4. Describe how negotiable instruments are indorsed and transferred.

5. Distinguish between blank, special, qualified, and restrictive indorsements.

I.

Teacher-to-Teacher Dialogue

Many first-time students of law find this group of materials on negotiable instruments to be the most difficult part of the course. If students understand, at the beginning, that this material is frustrating to all, yet undeniably essential to the conduct of both personal and business affairs, then you have gotten them off to the right start.

Using the check process as the focal illustration throughout the entire set of materials on negotiable instruments seems to help make the material a little easier to understand. There is far more to this than just checks but using the check helps the student relate this material to the one negotiable instrument he or she is most likely to have personal contact with. In addition, checks do remain the single most important form of money substitute.

Finally, encourage students to get into the habit of using key question checklists for each of the major subjects covered in these chapters. These mini-outlines on the elements of negotiable instruments, indorsements, HDC, and so on helps make the material more manageable. In addition, strongly encourage them to diagram the negotiation process for each case. This visualization helps them to spot the point in the process where things may have gone wrong and who may be responsible.

Because this area of the law is so complex, the study of commercial paper is best begun with an introduction to key terms, the players who use those terms, and the mechanics of the negotiation process. Remember, that special sets of formalized contracts are being used as a substitute for money, extension of credit, and recordkeeping.

Out of this process, one can readily see that use of cash, as a form of payment, is not always practical or wise. An entire financial services industry, the traveler’s check, is premised on the risks inherent in the use of large amounts of cash for travel. Those same concerns apply to the commercial marketplace. Money simply does not work as well as negotiable instruments for .

Creation and Transfer of Negotiable Instruments 173

purposes of convenience, safety, recordkeeping, and extension of credit. Negotiable instruments are important money substitutes, and as such, it is critical that the elements of negotiability be identified and in place before these documents are passed to third parties.

Another problematic misconception held by first-time students of negotiable instruments is the difference between negotiability and legality. Many students proceed to duly memorize the elements of negotiability and learn how to identify them in an instrument. Having done that, they proceed to declare an instrument that lacks a missing critical element of negotiability as legally null and void. Nonnegotiability does not ipso facto preclude legality. Even though an instrument may fail to meet the requirements proscribed by the UCC for negotiability, that fact does not render it illegal. Nor is it necessarily barred from being enforced as a contract.

The following might help: Negotiable Instruments (In Reverse*) 1. Substitute for money 2. None or very few defenses to acceptance as a substitute for money 3. Special holder (HDC) 4. Holder 5. Transfer 6. Elements of negotiability 7. Paper *Start by asking questions in reverse (per diagram above) and when done reverse order to see what has been done. Refer students to spot in diagram under study.

II.

Text Materials

Negotiable Instruments: • To qualify as negotiable instrument (commercial place), the document must meet certain Revised Article 3 (Negotiable Instruments) of the Uniform requirement established by Commercial Code (UCC) .

• If the requirements of Article 3 are met, a transferee who qualifiesholder as a in due coursetakes the instrument free of many defenses that can be asserted against the original payee.

• In addition, the document is considered an ordinary contract that is subject to contract law.

Important Definitions: 1. The maker is one who makes a note.

2. The drawer is one who draws a draft.

3. The draweeis one ordered to pay a draft.

4. The payeeis one to be paid in either a note, draft, or check.

5. The indorser is one who makes an indorsement on an instrument.

6. The indorseeis one to whom indorsement is addressed, if at all.

7. The bearer is one in possession of bearer paper.

8. The holder is one in possession of paper payable to that person as payee or indorsee or one in possession of bearer paper.

Functions of Negotiable Instruments: • Negotiable instruments serve the following functions: .

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•

o Substitute for money o Credit device o Record-keeping device Most purchases by businesses and many individuals are made by negotiable instruments instead of cash.

Contemporary Environment: Revised Article 3 (Negotiable Instruments) of the UCC. In 1990 Article 3 was replaced with Revised Article 3. This was a comprehensive revision.

Types of Negotiable Instruments: • Instrument • o Term that means negotiable instrument. [UCC 3-104(b)] Revised Article 3 recognizes four kinds of instruments o Drafts o Checks o Promissory notes o Certificates of deposit Drafts: • A draft is a three-party instrument that is an unconditional written order by one party that orders the second party to pay money to a third party. o Drawer of a draft o Drawee of a draft o Payee of a draft Time Draft • A draft payable at a designated future date.

Time Draft • A draft payable on sight • Also called a demand draft • Trade acceptances—a sight draft that arises when credit is extended with the sale of goods Checks: • A distinct form of draft drawn on a financial institution and payable on demand. o Drawer of a check o Drawee of a check o Payee of a check Promissory Notes: • A two-party negotiable instrument that is an unconditional written promise by one party to pay money to another party. o Make of a note o Payee of a note • Types of notes: o Time note o Demand note • Collateral

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Creation and Transfer of Negotiable Instruments 175

Certificates of Deposit (CD): • A two-party negotiable instrument that is a special form of note created when a depositor deposits money at a financial institution in exchange for the institution’s promise to pay back the amount of the deposit plus an agreed-upon rate of interest upon the expiration of a set time period agreed upon by the parties. o Maker of the CD o Payer of the CD According to UCC 3-104(a), a negotiable instrument must: • Be in writing • Be signed by the maker or drawer • Be an unconditional promise or order to pay • State a fixed amount of money • Not require any undertaking in addition to the payment of money • Be payable on demand or at a definite time • Be payable in order or to bearer Note: The inclusion of prepayment, acceleration, or extension clauses does not affect negotiability.

Formal Requirements for a Negotiable Instrument 1. Writing—Writing must be permanent and portable. Oral instruments are nonnegotiable.

[UCC 3-104(d)] 2. Signed by Maker or Drawer—Signature must appear on the face of the instrument. It may be any mark intended by the signer to be his or her signature. Signature may be by an authorized representative. [UCC 3-104(a)] 3. Unconditional Promise or Order to Pay—Instrument must be an unconditional promise or order to pay. [UCC 3-104(a)] Permissible notions listed in UCC 3-106(a) do not affect instrument’s negotiability. If payment is conditional on the performance of another agreement, the instrument is nonnegotiable.

4. Fixed Amount of Money—Fixed amount: Amount required to discharge the instrument must be on the face of the instrument. [UCC 3-104(a)] Amount may include payment of interest, discount, and costs of collection. Revised Article 3 provides that variable interest rate notes are negotiable instruments.

5. Cannot Require any Undertaking in Addition to the Payment of Money—A promise or order to pay cannot state any other undertaking to do an act in addition to the payment of money. [UCC 3-104(a)(3)]. A promise or order to pay may include authorization or power to protect collateral, dispose of collateral, waive any law intended to protect the obligee, and the like.

6. Payable on Demand or at a Definite Time—Payable on demand: Payable at sight, upon presentation, or when no time for payment is stated. [UCC 3-108(a)] Payable at a definite time: Payable at a definite date, or before a stated date, a fixed period after a stated date, or at a fixed period after sight. [UCC 3-108(b)(c)] Instrument payable only upon the occurrence of an uncertain act or event is nonnegotiable.

Nonnegotiable Contract: • A promise or order to pay that does not meet the requirements of a negotiable instrument. .

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• •

It is not subject to the provisions of UCC Article 3.

A nonnegotiable contract can be enforced under normal contract law.

Contemporary Environment: Authorized Representatives Can Sign Negotiable Instruments A maker or drawer is liable on a negotiable instrument signed by an authorized agent.

Contemporary Environment: Order Instruments and Bearer Instruments If an instrument is not either payable to order or bearer or it is not negotiable but may be assignable under contract law. Order payable is payable to either the order of a person or the person and bearer paper is payable to the possessor or possessed, who presents it for payment.

Case 20.1. The Court Speaks. Gerber and Gerber, P.C. v. Regions Bank, 266 Ga. App. 8, 596 S.E. 2d 174, Web 2004 Ga. App. Lexis 206 (2004) Court of Appeals of Georgia Facts: Stafford stole some of the blank indorsed cashier’s checks before being deposited in the law firm’s trust account (as was the practice). She personally indorsed to the checks and deposited them in her personal bank account. The blank indorsement had created bearer paper.

Issue: Did Regions Bank property accept the blank-indorsed bearer checks from Stafford?

Decision: Regions Bank was not negligent in accepting the check and placing the money in Stafford’s personal account.

Reason: The holder of an instrument (even the wrongful) is entitled to enforce the instrument. A holder could be the possessor of an instrument indorsed in blank. This makes the check bearer paper which merely needs transfers.

Transfer by Assignment or Negotiation: Transfer by Assignment • The transfer of rights under a contract • It transfers the rights of the transferor (assignor) to the transferee (assignee) Transfer by Negotiation • The transfer of a negotiable instrument by a person other than the issuer • The person to whom the instrument is transferred becomes the holder • Negotiating order paper • Negotiating bearer paper Note: Assignee acquires only the rights that the assigner possessed.

Order or Bearer 1. Order—Payable to order of a person or to a person or orders.

2. Bearer—Payable to person in possession.

Indorsement: • The signature (and other directions) written by or on behalf of the holder somewhere on the instrument .

Creation and Transfer of Negotiable Instruments 177

•

The signature may: o Appear alone o Name an individual to whom the instrument is to be paid; or o Be accompanied by other words

Contemporary Environment: Converting Order and Bearer Paper An instrument can be converted from order paper to bearer paper and vice versa.The deciding factor in converting order paper to bearer paper is the type of indorsement placed on the instrument. See “Types of Indorsements” below.

Types of Indorsement 1. Blank—Does not specify a particular indorsee. This indorsement creates bearer paper.

2. Special—Specifies the person to whom the indorser intends the instrument to be payable.

This indorsement creates order paper. A blank indorsement can be converted to a special indorsement by using words such as “pay to” above the indorser’s signature.

3. Unqualified—Does not disclaim or limit liability. The indorsee is liable on the instrument if it is not paid by the maker, acceptor, or drawer.

4. Qualified—Disclaims or limits the liability of the indorsee. There are two types: a. Special qualified indorsement b. Blank qualified indorsement 5. Nonrestrictive—No instructions or conditions attached to the payment of funds.

6. Restrictive—Conditions or instructions restrict the indorsee’s rights. There are four types: a. Conditional indorsement b. Indoresment prohibiting further indorsement. c. Indorsement for deposit or collection d. Indorsement in trust Note: Words of negotiation are not requires for a special indorsement.

Imposter or Fictitious Payee 1. One who impersonates a payee and induces issuance in payee’s name 2. Person signing intends no interest for the named payee International Law: Negotiable Instruments Payable in Foreign Currency Special Situations: • Misspelled or wrong name can be indorsed correctly, as misspelled or both • Multiple payees • Joint; sign • Alternative or either signs The Fictitious Payee and Imposter Rule s.

Forged indorsements are usually wholly inoperative:

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The fictitious payee rule says that a drawer or maker is liable on a forged or unauthorized indorsement of a fictitious payee. The Imposter Rule says the named payee, drawer, or maker is liable to anyone who, in good faith, pays the instrument or takes it for value or for collection.

III.

Answers to Critical Thinking Cases

Type of Negotiable Instrument Negotiable Instrument 20.1.

Yes, the note executed by Dr. Bailey was a negotiable instrument. To be a negotiable instrument, a writing must contain either an unconditional promise or order to pay. To be negotiable, a promise to pay must be an affirmative undertaking. The mere acknowledgment of a debt or an implied promise to pay is not sufficient. Negotiable instruments must also be payable either to order or to bearer. An instrument is an order instrument if it is payable to the order or assigns of any person specified with reasonable certainty. The use of the words “order” or “assigns” usually indicates that a note is an order instrument. The note in this was an order instrument with an unconditional promise to pay. The language in Dr. Bailey’s note was unambiguous in stating that he “promises to pay.” The note also states that the promise to pay is made “to the order to CALIFORNIA DREAMSTREET.” Although this language is somewhat unusual in that most order instruments are made payable “to the order of,” the court determined that the note should still be classified as an order instrument. Therefore, Dr. Bailey’s note was both a promise to pay and an order instrument. Cooperative Centrale RaiffeisenBoerenleenbank B.A. v. Bailey, 9 UCC Rep Serv 2d 145 (C.D.Cal. 1989).

Formal Requirements 20.2.

Yes, a check printed on an envelope meets the requirements of the UCC for classification as a negotiable instrument. Three requirements are necessary for a negotiable instrument: (1) the instrument be in writing, (2) be permanent, and (3) be portable. The requisite writing is often on a preprinted form. Most writings on paper meet the permanency requirement. The portability requirement is intended to insure free transfer of the instrument. Any writing that is placed on an object that is small enough to be easily handled qualifies as portable. The check that Holsonback used to pay for the Corvette was a negotiable instrument. The check was a writing on a paper object, an envelope that was standard sized making the check easily portable. Thus, because the check was in writing, permanent, and portable, it met the requirements of the UCC for a negotiable instrument. Holsonback v. First State Bank of Albertville, 30 UCC Rep. Serv. 222 (Ala. 1980).

Demand Instrument 20.3.

Yes, the promissory note signed by Blanchard was a demand instrument. The UCC requires that an instrument be payable either on demand or at a definite time. Demand notes include those instruments that are payable on demand, payable at sight, payable upon presentation, and those instruments that have no specified payment date. The court in this case held that the note was payable on demand, and that the language which indicated the note was a demand note was controlling. It found that the note was payable on demand and that the language which referred to monthly payments was an additional .

Creation and Transfer of Negotiable Instruments 179

agreement. The Court stated: “The notation [about monthly payments] was indicative of a collateral agreement made by the parties to provide for monthly installments but did not destroy the demand nature of the note.” Because the monthly installments provided for in the note did not destroy the demand nature of the instrument, the note was a demand instrument. Blanchard v. Progressive Bank & Trust Co., 413 So.2d 589 (La.App. 1982).

Order to Pay 20.4

The purpose stated on the check does not limit its negotiability. This is a negotiable instrument.

Reference to Another Document 20.5. Because the mortgage does not, in itself, set obligations but instead describes the security, the note is not conditional and is negotiable.

Indorsement 20.6.

Because there was no restriction in the indorsement, the bank could cash them. The bank is not liable.

IV.

Answer to Ethics Questions

Order or Bearer Paper 20.7.

20.8.

The check was order paper at the time CM National Bank accepted it. The UCC states that an instrument is payable to the bearer when the only or last indorsement is in blank.

A specifically indorsed instrument must be indorsed by the one to whom it is payable before it becomes negotiable. In this case, the court established that St. Mary’s indorsement was in blank. This converted the original order paper into bearer paper.

Subsequently, St. Mary successfully negotiated this bearer instrument when he delivered the check to Coltharp. Thus, when Coltharp specifically indorsed the check making it payable only to the City Savings Bank, this special indorsement converted the check back to order paper. Under the UCC, this special indorsement converted the check back to order paper and the check became payable only upon indorsement of City Savings Bank. Coltharp’s intention that the check be converted into order paper was evident by his use of the words “pay to the order of” in his indorsement. Therefore, the check was order paper at the time it was accepted by the CM National Bank. Coltharp v. CalcasieuMarine National Bank of Lake Charles, Inc., 199 So.2d 568 (La.App. 1967).

No, Johnson’s signature alone was not sufficient to negotiate the check to Midland. An instrument can be payable to two or more persons either jointly or alternatively. If an instrument is payable jointly, then each person’s indorsement is necessary to negotiate the instrument. The use of the word “and” between two named payees creates an instrument which is payable jointly. An instrument which is payable in the alternative is payable if either party indorses it. The use of the word “or” effectively creates an instrument payable in the alternative. In this case, Murray clearly intended for his check to be made payable jointly to GE and Johnson. Murray indicated this intent on the check by using the word “and.” Johnson’s indorsement alone was not sufficient to negotiate the

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check to Midland because the check was made payable to two parties jointly.

Murray Walter, Inc. v. Marine Midland Bank, 39 UCC Rep Serv 972 (N.Y.Sup.Ct. 1984).

V.

Answer to Policy Cases

20.9.

The 31 promissory notes were not negotiable instruments because they were conditional on obligation contained in other documents and the UCC thus did not apply. Under the Texas version of the UCC, it applies only if the promissory note is a negotiable instrument—written, unconditional promise to pay a sum of certain money upon demand or at a definite time to order a bearer. Here the sum certain is not with the document.

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Federal Deposit Insurance Corp. v. Woodside Construction, Inc. 979 F.2d 172 (1992) United States Court of Appeals for the Ninth Circuit 2. Key Facts A. Donald Galt was an officer of the Woodside Construction Company. That company obtained a loan in the amount of $912,000 from Alaska Mutual Bank that was evidenced by a promissory note, a deed of trust, a loan agreement, and a contract of guaranty.

B. Subsequently, Alaska National Bank merged into Alliance Bank, which was closed by the state of Alaska. The Federal Deposit Insurance Corporation was named the receiver.

C. As the receiver, the FDIC now seeks to collect the loan from both Woodside and Galt personally.

D. Galt alleges that he signed only in his agency capacity and is not personally liable for the note.

E. The lower court held in favor of Galt; the FDIC appeals.

3. Issue Did Galt’s signatures on the documents constitute his personal signatures or only his fully disclosed agency capacity?

4. Holding Galt signed in his personal capacity and is personally liable for the loan.

5. Court’s Reasoning The United States Court of Appeals for the Ninth District held that: A. In order for an agent to be not held liable personally for his or her principal’s instrument, that agency capacity must be clearly designated on the instrument.

B. The order and placement of Galt’s signatures did not clearly designate him as signing only in an agency capacity; thus, his signatures constituted his own personal signature, and as such, he is personally liable for the loan contract.

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Holder in Due Course and Liability of Parties 181

Chapter 21 Holder in Due Course and Liability of Parties

Is The Paper Always A Substitute For Money?

Learning Objectives: 1. Define a holder in due course and describe the requirements for becoming a holder in due course.

2. Identify the universal defenses that can be asserted against a holder in due course.

3. Describe the signature liability of makers, drawees, drawers, acceptors, and accommodation parties.

4. List the transfer and presentment warranties and describe the liability of parties for breaching them.

5. Describe how parties are discharged from liability on negotiable instruments.

I.

Teacher-to-Teacher Dialogue

Because negotiable instruments are meant to be a substitute for money, a comparison to money is useful. If someone hands the student an obviously fake dollar bill, should the law protect the taker? What if, however, the taker had no realistic way of knowing the history of who had prior ownership and involvement with that instrument before him or herself. Should there be a little more, but not total, protection for the taker in this second scenario? When put in this light, students start to appreciate the practical reliance element of the rule. That element is designed to say this: if the law wants instruments to be relied on as money substitutes, the law must protect innocent takers of those instruments in as many ways as possible. Conversely, without this reliance factor, the entire system would simply collapse like a house of cards.

A portion of this chapter revolves around the life cycle of a negotiable instrument and how that cycle comes to an end. Try to reach back into the student’s recent exposure to contract law.

Back in contracts, we talked about how most contracts came to an end by way of the parties living up to their respective performance obligations. Where there were problems with performance, the law would step in to adjudicate the rights, duties, and obligations in light of the changed circumstances.

So too does the law of negotiable instruments create obligations which are subject to the purview of the courts in case of problems. These obligations are created out of the signatures of the parties and the warranties imposed on them by the UCC. Remind the students that negotiable .

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instruments are, in reality, special forms of transferable contracts. As such, the rules of transfer are overlaid and interwoven with the laws of contract breach and the like.

As part of the learning objectives it might be helpful if we: first, introduce the student to the unique UCC concept of holder in due course (HDC) and second, illustrate the basic liabilities and defenses which arise out of the use of negotiable instruments. The focus of these two objectives, therefore, now turns to the third party who becomes involved with a negotiable instrument. How, when, and where will the UCC protect that third party, and when will it not? Because any discussion of negotiable instruments is interwoven with their role as a substitute for money, a comparison with money may be useful. If someone hands you a dollar that is clearly a photocopy of currency, should you accept it in lieu of currency? Or should you be put on notice that there is a problem and act accordingly? The doctrine of holder in due course (HDC) is designed to protect good faith third party takers of money substitutes. It is designed to create justifiable reliance on instruments where the elements of HDC are in place. It is not designed to protect those who think play money is real and do not bother to learn the rules.

The degrees of protection afforded to third party takers of instruments begin with a comparison between the common law of contract and the UCC. Under the common law, an assignee steps into the shoes of the assignor. Generally, he or she undertakes the assignor’s obligations and benefits from their rights. The problem with this “what you see is what you get” philosophy is that it may not provide enough protection for third parties who may not be aware of the history behind the document. As a buyer of commercial paper, you want to buy only what you see and not get ambushed by potential lawsuits lurking in the bushes. The law of assignment simply does not cut off enough history and often allows third party takers of documents to be struck with legal entanglements that were not of their making.

The HDC concept allows for a fundamental shift in the law in that, where its elements are in place, the taker will be free of all claims and most of the defenses which could otherwise be asserted by other parties having contact with the instrument. These elements will be set in the chapter summary. Remember, as radical as this shift is from the common law of contract assignment, the metamorphosis is not complete. The HDC still takes the instrument subject to a number of defenses called real defenses. In addition, past abuses of HDC principles have led to some statutory overlay on the part of Congress through its delegation of regulatory authority to the Federal Trade Commission (FTC). In the area of consumer credit transactions, the FTC has stepped in by preempting the HDC rule. The law of contract under this rule subjects the HDC of consumer credit paper to all the defenses and claims of the consumer. Various states have also promulgated similar rules as outlined in the Uniform Consumer Credit Code or by case law.

As to this point, it might be helpful to review the liability, defense, and discharge aspects of negotiable instruments. No contract is forever. It may last a long time, but it will end. Negotiable instruments are a highly formalized and technically complex set of contracts used primarily as money substitutes. Paper money eventually wears out and needs to be taken out of circulation. So too does a negotiable instrument ultimately run its course. That course may be just a matter of days in the case of a check, or many years as seen in long term notes.

There are two main theories for attaching liability in negotiable instruments. The first is found in the rights and duties arising out of the signatures of parties to the instrument. These rights and duties are essentially derived from contract law as modified by the UCC. The second source of liability is found in a set of warranties imposed by the UCC. Warranties are promises imposed by the statute upon those who want to be players in this game. These promises are not always actually expressed by the party against whom the warranties are imposed, but the responsibility to live up to them is there, nonetheless. Think of them as duties that arise out of using the road of negotiation: if you go down this road, you must follow the rules of the road.

In addition, remember that by their very nature, negotiable instruments are meant to be handled by many people. The adjudication of the rights and duties of numerous takers of these .

Holder in Due Course and Liability of Parties 183

instruments vis-à-vis each other is of critical importance through the entire spectrum of UCC studies. How those respective rights and duties finally fall into place at the point of discharge of a negotiable instrument is the second major objective of this chapter. In the end, the law must provide some form of resolution. The rules on discharge help make a judge’s job a little easier.

II.

Text Materials

Holder vs. Holder in Due Course: Holder • A person who is in possession of a negotiable instrument that is drawn, issued, or indorsed to his or her order, or to bearer, or in blank Holder in Due Course (HDC) • A person who takes a negotiable instrument for value, in good faith, and without notice that it is defective or is overdue Note: Under the shelter principle, a holder who does not qualify as a holder in due course in his or her own right becomes a holder in due course if he or she acquires the instrument through a holder in due course.

Explanation of HDC Requirements 1. Value—similar to consideration but includes past consideration; does not include executory promise.

2. In Good Faith—honesty in fact; case-by-case analysis; knowledge of suspicious circumstances can be bad faith.

3. Without Notice of Defect—normally notice of defect is present if the instrument is overdue, has been dishonored, contains an unauthorized signature, has been altered, has a claim to it by another person or has a defense against it.

4. No Evidence of Forgery, Alteration, or Irregularity—includes being irregular or incomplete enough to call authenticity into question.

Signature Liability of Parties: • A person cannot be held contractually liable on a negotiable instrument unless his or her • • signature appears on the instrument.

The signatures on a negotiable instrument identify those who are obligated to pay it.

If it is unclear who the signer is, parol evidence can identify the signer.

Signer can be: 1. Maker 2. Drawer 3. Accepting or certifying drawee 4. Indorser 5. Agent 6. Accommodation party Note: Signature can be any name, word, or mark used in lieu of a written signature. This could include trade names and other assumed names. .

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Signature Liability: Primary Liability • Makers of promissory notes and certificates of deposit have primary liability of the • instrument.

• Upon signing a promissory note, the maker unconditionally promises to pay the amount stipulated in the note when it is due.

Makers are absolutely liable to pay the instrument, subject only to certain real defenses.

Signature Liability: Secondary Liability • Drawers of check and drafts and unqualified indorsers of negotiable instruments have • • secondary liability on the instrument.

This liability is similar to that of a guarantor of a simple contract.

It arises when the party primarily liable on the instrument defaults and fails to pay the instrument when due.

Primary vs. Secondary 1. Makers—Acceptors 2. Drawers—Unqualified indorsers. Needs: a. Presentment b. Dishonor c. Timely notice of dishonor i. Bank—Before next banking day midnight ii. Others—Within 30 days of notice Note: Accommodation party signs an instrument lending their name and credit to another party: 1. Guarantee payments—primary liability 2. Guarantee collection—secondary liability Agent’s Signatures: 1. If signature is authorized, principal is bound, its signature is not unauthorized.

2. Agent’s liability depends on information disclosed a. If representative capacity is not clear, agent is liable to an HDC b. If payable from principal’s account, agent is not liable Forged Indorsement: • Loss falls on the party who first takes after the forgery o Exceptions: ▪ Imposter rule—if the imposter forges the indorsement of the named payee, the drawer or maker is liable on the instrument to any person who, in good faith, pays the instrument or takes it for value or for collection.

▪ Fictitious payee rule—a drawer or maker is liable on a forged or unauthorized indorsement under this rule. It applies when a person signing as or on behalf of a drawer or maker intends the named payee to have no interest in the instrument or when the person identified as the payee is a fictitious person.

.

Holder in Due Course and Liability of Parties 185

Ethics: Imposter Rule Ethics: Fictitious Payee Rule

• The Warranty Liability of Parties: law implies certain warranties on transferors of negotiable instruments.

• Warranty liability is imposed whether or not the transferor signed the instrument.

• There are two types of implied warranties: o Transfer warranties o Presentment warranties Warranties 1. Transfer a. Good title b. Good signatures c. No material alteration d. No defenses e. No knowledge of insolvency 2. Presentment a. Good title b. No material attention c. No knowledge of unauthorized signature Defenses: Reasons for not accepting the paper as a substitute of money • The creation of negotiable instruments may give rise to a defense against its payment.

• There are two general types of defenses: o Real defenses o Personal defenses • A holder in due course (HDC) takes the instrument free from personal defenses but not real defenses.

Real Defenses: 1. Minority 2. Extreme duress 3. Mental incapacity 4. Illegality 5. Discharge in bankruptcy 6. Fraud in the inception 7. Forgery 8. Material alteration Effect: Real defenses can be raised against both holders and holders in due course.

Selected Defense Explanations 1. Forgery—Consider imposter and fictitious payee rules.

2. Material Alteration—HDC can enforce original unaltered amount. .

186 Chapter 21

Personal Defenses 1. Breach of contract 2. Fraud in the inducement 3. Mental illness that makes a contract voidable instead of void 4. Illegality of a contract that makes the contract voidable instead of void 5. Ordinary duress or undue influence 6. Discharge of an instrument by payment or cancellation Effect: Personal defenses cannot be raised against a holder in due course.

Ethics: FTC Rule Limits HDC Status in Consumer Transactions This serves a number of useful purposes. First, it can be used as a reminder that the UCC is not a federal but rather a state law and as such, it may be preempted by the exercise of federal authority. Secondly, it can be used to remind students that many solid public policy reasons for any statute can be undermined by an abuse of the same. The old law about the Statute of Frauds being used to perpetrate frauds comes to mind. Here, in spite of all the good reliance factors favoring the creation of the HDC status, abuses can and did occur in the consumer area. Thus the FTC acted and eliminated HDC status in certain consumer credit transactions.

Discharge: • Actions or events that relieve certain parties from liability on negotiable instruments.

• There are three methods of discharge: 1. Payment of the instrument 2. Cancellation 3. Impairment of the right of recourse III.

Answers to Critical Thinking Cases

Holder in Due Course 21.1

M&I took the check for value, without notice of defect or other irregularities and in good faith. M&I is therefore an HDC and should win.

Principal’s Liability 21.2.

Carriage House is liable on the checks as a principal. An authorized agent can sign a negotiable instrument on behalf of a principal and bind the principal to the instrument.

Generally, a principal is bound to a negotiable instrument if the agent’s signature includes the principal’s name or if the agent’s name appears with an indication of the agency status of the signature. The agent is not personally liable on the instrument, when an agent’s signature properly indicates his agency status, and the identity of the principal.

In this case, the court found that Smith, signing in his capacity as corporate secretary, was an authorized agent for Carriage Homes. Smith’s signature included the name of the principal and then the word “by.” The court held that the use of the word “by” indicated Smith’s agency status. The use of the word “by” to indicate agency status is clear when signing for a corporation because corporations can only sign negotiable instruments through its agents. Because the checks were signed by an authorized agent of Carriage .

Holder in Due Course and Liability of Parties 187

Homes, who properly indicated his agency status, Carriage Homes was a principal and solely liable for the checks. Southeastern Financial Corporation. v. Smith, 397 F.Supp.

649, 1975 U.S. Dist. Lexis 12624 (N.D.Ala 1975).

Accommodation Party 21.3

The Banks wins. As an accommodation maker, Paul is primarily liable.

Transfer Warranties 21.4.

Because the indorsement is authorized, Matco loses. Pontiac was authorized to accept a check based on the letter sent.

Presentment Warranties 21.5.

Yes, the First National Bank of Azle breached its presentment warranty of good title. A presenter of a negotiable instrument for payment warrants three things to the party to whom he presents the instrument. The presenter warrants that he has good title to the instrument, that he has no knowledge that the signatures on the instrument are unauthorized, and that the instrument has not been materially altered. In this case, the court held that the Bank of Azle had breached the warranty of good title when it presented Waddell’s check for payment to Longview. A presentment warranty is “an assurance that no one has better title to the check than the warrantor.” The Bank of Azle did not have better title to the check than the E.G. Smith Corporation, because E.G. Smith had not indorsed the check. Thus, the bank breached the presentment of good title because the company still had good title to it when the Bank of Azle presented the check for payment without E.G. Smith’s indorsement. Longview Bank & Trust Company v.

First National Bank of Azle, 750 S.W.2d 297, 1988 Tex. App. Lexis 3377 (Tex.App. 1988).

Imposter Rule 21.6.

Generally, a drawer is not liable for forged checks paid against the drawee. The exception is the imposter rule where the drawer fails to control the check writing process to allow a check made out to an imposter. In that case the drawer is liable. Therefore, in this case, the law firm is liable. McCarthy, Knney & Reidy, P.C. v. Firsy National Ban of Boston, 2UCC Rep. Serv. 2d 977 (Ma.Sup.Ct. 1986).

IV.

Answers to Ethics Cases

21.7.

Angelini wins because General does not qualify as an HDC because it failed to take the Angelinis’ note in good faith. A holder must take an instrument in good faith to qualify as an HDC. “Good faith” means honesty in fact in the conduct of the transaction. Honesty in fact is a subjective test that examines the holder’s actual belief. Courts look to the circumstances of a transaction to determine whether a holder acted in good faith. In this case, the Court found that General knew that the note signed by the Angelinis did not mature until after installation of the siding.

General was also aware that Lustro’s impending insolvency might interfere with their completion of the contract. Finally, General knew that Lustro had a poor record of completing installations they had contracted for. Given that General knew that the note did not mature until completion of .

188 Chapter 21

21.8.

V. 21.9.

VI.

the work and that there existed a strong possibility that the work would never be completed, General did not take the note in good faith. Because the note was not taken in good faith, General was not an HDC, and therefore was subject to both real and personal defenses to payment of the note. General Investment Corp. v. Angelini, 278 A.2d 193, 1971 N.J. Lexis 263 (N.J. 1971).

The Bank did not act ethically in failing to make sure that the Rose’s understood what they were signing. Because, however, they could have read the document but didn’t, the Rose’s will probably lose.

Answers to Ethics Cases Mrs. Humphrey was a co-maker on the line of credit promissory note and was therefore primarily liable. The relief of Mrs. Humphrey of this obligation would be between husband and wife and not be binding upon Grand Island. The divorce was irrelevant.

Grand Island Production Credit Association v. Humphrey, 388 N.W. 2d 807, Web 1986 Neb. Lexis 1185 (Supreme Court of Nebraska) Answer to “Briefing the Case” Writing Assignment:

Case Name, Citation, and Court 1. Kedzie & 103rd Currency Exchange Inc. v. Hodge 601 N.E.2d 803 (Ill. App. 1 Dist. 1992) Appellate Court of Illinois 2. Key Facts A. Plaintiff is engaged in the business of cashing checks for a fee.

B. Defendant had written a $500 check to Fred Fentress as partial payment for future plumbing services.

C. The plumbing services were not provided, and it was discovered that Mr. Fentress had none of the city or state licenses required to engage in the profession of plumbing.

D. The defendant ordered a “stop payment” on the check and claims a real defense of illegality under the UCC. E. The plaintiff alleges that he is a holder in due course and the defense does not apply.

F. The lower court held in favor of Fentress, and the Currency Exchange appeals.

Issue 3.

Does the underlying illegality of the contract create a real defense against a holder in due course of this negotiable instrument?

4. Holding Yes. 5. Court’s Reasoning The Illinois Court of Appeals held: A. State and local licensing laws are created to protect the public’s health, safety, and welfare.

B. Contracts entered into in violation of those laws are illegal and have civil and criminal sanctions.

C. This illegal contract gave rise to a negotiable instrument, which, under the UCC, had a real defense of illegality. .

Holder in Due Course and Liability of Parties 189

D. Holders in due course take negotiable instruments free of personal defenses, but they are subject to real defenses. The lower court ruling in favor of the defendant stands.

.

190 Chapter 22

Chapter 22 Banking System, E-Money, And Financial Reform

Why Are Checks Important To Our Society?

Learning Objectives:

1. Describe the difference between certified and cashier’s checks.

2. Describe the system of processing and collecting checks through the banking system.

3. Describe electronic banking and e-money.

4. Define commercial wire transfer and describe the use of wire transfers in commerce.

5. Describe the banking reform provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

I.

Teacher-to-Teacher Dialogue

Students relate to materials on the law of checks due to their own involvement with them.

This chapter proceeds to concentrate on that body of UCC rules and the banking system within which these transfers of money substitutes take place. Wherever possible, try to illustrate any given rule with examples to help bridge the gap between the theoretical and the practical.

In addition to the technical aspects of this material, spend a fair amount of time talking about the future direction of technology in the area of money substitutes and some of the practical problems the law is having while trying to keep up with emerging technologies. This area is particularly ripe for debate when it comes to issues of law enforcement and privacy. Financial institutions have many more duties today to report patterns of certain types of “suspicious” activities to the government. If these activities appear to be involved in money laundering or the like, the institution is required to report that to the government. But what about the customers’ privacy? As can be readily seen, new technology brings with it new legal issues which will ultimately challenge all who use the electronic highway.

The transfer of money substitutes is more complicated than ever because it is, at least in part, more efficient than ever. Money sitting in Tokyo can be transferred to New York City in seconds.

The rules of rights and duties involving checks are really not all that new to the layperson. Most students have an ongoing contractual relationship with a bank and are already familiar with the basic rules involving negotiable instruments. The best way to approach issues involving checks is to first examine the underlying contractual obligations between the respective parties. Then .

Banking System, E-Money, and Financial Reform 191

determine what public policy based limitations are imposed on the parties by the UCC and the courts. The duties imposed on banks can be very strict and difficult to avoid. Finally, look to see if the transaction falls into the sphere of hi-tech transfers of money substitutes.

It should be noted that in 2010, we have the Dodd-Frank Wall Street Reform and Consumer Protection Act that was designed to cover abuses in the banking system and provide increased protection for consumer in financial transactions.

II.

Text Materials

Contemporary Environment: UCC Governs Checks and Banking • Article 3—Commercial Paper • Revised Article 3—Negotiable Instruments • Article 4—Bank Deposits and Collections • Article 4A—Fund Transfers Parties to a Check: • Drawer—the customer who maintains the checking account and writes (draws) checks against the account.

• Drawee—the bank on which the check is drawn.

• Payee—the party to whom the check is written.

Note: A check is an order by drawer on drawee bank to pay a specified sum of money from drawers account to the named payee (or holder).

Normal relationship involves creditor-debtor: Customer—Debtor, Bank—Debtor

Note: Payee can either demand payment or indorse it to another party: Payee—Indorser Person to whom indorsed—Indorsee: Demand payment or indorse.

Special Types of Checks: • Bank Checks—check for which the bank is solely or primarily liable.

o Certified check—bank agrees to accept in advance (usually customer’s check), bank is now liable. o Cashier’s check—bank guarantees payment after customer pays bank (usually bank’s check). o Traveler’s check—sold by bank and others without named payee (to be filled in by purchaser).

Honoring Checks: • Honor—when a drawee bank receives a properly drawn check and there are sufficient funds in the drawer’s account to pay the check, the bank must honor the check and pay it.

• Issues related to honoring check include: o Stale checks—No obligation to pay stale checks .

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o Incomplete checks—Can pay a good faith completed incomplete check o Death or incompetence of a drawer—Can pay after death until notice and time to act (10 day rule) o Stop-payment orders—Oral stops good for 14 days, written good for 6 months o Overdrafts o Postdated checks—If the drawer postdates a check to some future date and gives separate notice to the bank, a bank can be liable for losses if the bank pays before its date o Wrongful dishonor Contemporary Environment: Federal Currency Reporting Law Federal currency reporting laws require financial institutions and other entities to file a Currency Transaction Report with the IRS. Forged Signature of the Drawer: • Forged Instrument—a check with a forged drawer’s signature on it.

• The ultimate loss for the payment of a check over the forged signature of the drawer • usually falls on the bank that paid the check.

The payor bank may recover from the forger, if he or she can be found.

Altered Checks: • A check that has been altered without authorization that modifies the legal obligation of a party o Original tender o Presentment warranty • If the payor bank pays the altered check, it can charge the drawer’s account the original tender (amount) of the check but not the altered amount.

Special Issue: One Year Rule Drawer’s failure to report a forged or altered check to the bank within 1 year of receiving the bank statement relieves bank of any liability.

Special Issue: Series of Forgeries Must report to the bank within a reasonable period (not more than 30 days from statement date) Case 22.1. The Court Speaks. Spacemakers of America, Inc. v. SunTrust Bank, 271 Ga. App. 335, 609 S.E. 2d 683, Web 2005 Ga. App. Lexis 43 (2005) Court of Appeals of Georgia.

Facts: Jenny was hired by Spacemakers as its bookkeeper. Because of the failure to investigate, Jenny’s criminal background including forging checks of previous employers, was not discovered. Jenny basically was in control of the entire accounting cycle. Dennis Rose had authority to sign checks. Jenny forged 59 checks ($475,000) over the first 10 months. Eventually, SunTrust became suspicious and called Rose. When he discovered a forged check made out to Jenny’s husband’s company (not a Spacemakers’ vendor), Jenny was arrested. Spacemakers demanded that SunTrust credit its account for $523,106 but they refused, contending Spacemakers’ failure to give timely notice of the forgeries. Spacemakers sued for negligence and

.

Banking System, E-Money, and Financial Reform 193

unauthorized payment of forged items. SunTrust’s motion for summary judgment was granted and Spacemakers appealed.

Issue: Did Spacemakers’ failure to uncover the forgeries and to give SunTrust timely notice bar its claim?

Decision: Yes. Grant of summary judgment was affirmed.

Reason: Under the GA commercial code, recovery for forgery is precluded without notice within 30 days of the first forgery. Spacemakers was negligent in its hiring of Jenny. No one but Jenny reviewed the bank statements. Thus, with lack of notice and review, the recovery by Spacemakers is barred.

Contemporary Environment: Federal Reserve System This assists banks in check collection for a fee.

Special Issues: • Deferred Posting: banks can fix cut off hours for daily processing • Provisional Credits: credit is given to a check prior to final settlement • Final Settlement: bank pays a check, settles or fails to dishonor • On Us Item: depository bank is payer banker can dishonor by second day • On Them Item: depository bank is not the payer bank—take action before midnight • Deposit of cash: available by next day • Failure to Examine Statements in a Timely Manner: customer must promptly notify of problems.

Contemporary Environment: FDIC Insurance of Bank Deposits Electronic Fund Transfer Systems: • Electronic fund transfer systems (EFTS) are supported by contracts among and • between customers, banks, private clearinghouses, and other third parties.

The most common forms of EFTS are: 1. Automated teller machines 2. Point-of-sale terminals 3. Direct deposits and withdrawals 4. Pay-by-Internet Cyber Law: Consumer Electronic Funds Transfers The most common electronic fund transfer systems are discussed. These are regulated by the FFTA and Regulation E. • Unsolicited cases: need to validated • Lost or stolen cards: notification within 2 days limits customer liability • Bank statements required • Evidence of transaction: computer receipt required Cyber Law: Commercial Wire Transfers (governed by UCC Article 4A): 1. Electronic transfers of funds from a bank to another party .

194 Chapter 22

2 Two principal systems are the Fedwire and CHIPS . Speed and low cost are among the benefits 3 Commercially reasonable security procedures under UCC 4A .

4 .

Landmark Law: Dodd-Frank Wall Street Reform and Consumer Protection Act • Banks can be chartered by the federal government or the state.

• Regulators have greater regulatory oversight.

• Mortgage lenders must make a good faith effort to determine eligibility.

• New liquidation procedure for bank and nonbank financial companies is established.

• Financial Stability Oversight Council was created to monitor system risk.

• Bureau of Consumer Financial Protection regulates consumer financial products and • services.

Federal Insurance Office monitors potential financial crisis by monitoring the insurance industry.

International Law: Holding Money in Offshore Bank The Bahamas offers bank secrecy laws and tax shelter laws, other countries are similar.

III.

Answers to Critical Thinking Cases

Cashier’s Check 22.1.

Wood wins, because Wood’s stop payment order should not have been effective. A cashier’s check, which is drawn on the issuing bank itself, is a debt of the bank. The bank, which has been paid for the check, guarantees payment of the check. When the check is presented for payment, the bank debits its own account. Neither the purchaser nor the issuer of a cashier’s check can stop payment of the check. In this case, Wood had paid the Bank $6,000 to issue a cashier’s check payable to Walker. The check became negotiable upon issue and should not have been subject to a stop payment order. As the court stated: “A cashier’s check is the obligation of the bank which issues it; it is not an item payable from a customer’s account. A cashier’s check is accepted in advance by the act of its issuance and is not subject to a stop payment order. Such a rule is necessary to insure the public’s confidence in and reliance upon our banking system.” Because a stop payment order is not effective against a cashier’s check, Bank should not have honored Wood’s request. Wood v. Central Bank of the South, 435 So.2d 1287, 1982 Ala. Civ. App. Lexis 1362 (Ala. App. 1982).

Overdraft 22.2.

The Pulaski State Bank wins because it had the legal right to create the overdraft in Kalbe’s account. When there are insufficient funds in a customer’s checking account to pay a check that is presented for payment, the payor bank can either dishonor the check, or honor the check and create an overdraft in the customer’s account. The payor bank can create the overdraft because there is an implied promise between the customer and the bank that the customer will reimburse the bank for paying checks he or she has written.

The bank can sue the customer to recover this amount, if the customer does not subsequently place sufficient funds in the checking account to cover the amount of the .

Banking System, E-Money, and Financial Reform 195

overdraft. In this case, Kalbe had a checking account with Pulaski State Bank. She drafted a check for $7,260 made payable to cash, drawn against her checking account. Therefore, when the check was presented for payment, Pulaski, as the payor bank, had a duty to honor it, because the last check was never reported to the bank. Subsequently, Pulaski was relieved of this duty, when the bank discovered that there were insufficient funds in Kalbe’s account to pay the check.

However, because of the provisions of UCC 4-401(1), the Pulaski State Bank had the option to create an overdraft in Kalbe’s account rather than dishonor the check.

Pulaski State Bank v. Kalbe, 364 N.W. 2d 162, 1985 Wisc. App. Lexis 3034 (Wis. App. 1985).

Wrongful Dishonor 22.3.

City National Bank of Fort Smith (CNB) wins. The court held that punitive damages are not recoverable in a conversion action simply because CNB intentionally exercised control or dominion over the Goodwin’s account. In general, the act of conversion alone will not support an award of punitive damages. Such an award would require that CNB had intentionally exercised control or dominion over the Goodwin’s account for the purpose of violating their right to the money or for the purpose of causing damages such as returned checks. In the present case, there was no evidence that CNB converted the Goodwin’s money for the purpose of violating their rights to the money or for the purpose of causing damages. It is only apparent that CNB mistakenly confused the identity of Larry K. Goodwin and Larry J. Goodwin, whereby CNB accidentally exercised dominion over the wrong Goodwin’s funds. Similarly, in order to receive consequential damages, the Goodwins must show that CNB acted in bad faith or that it deliberately or willfully dishonored the checks. Thus, because the bank mistakenly confused the identities of the Goodwins and acted in good faith, the court held that punitive and consequential damages were not allowable. City Nat. Bank of Fort Smith v.

Goodwin, 783 S.W.2d 335, 1990 Ark. Lexis 49 (Ark. 1990).

Stale Check 22.4.

Ragusa wins because Community Bank is liable for the $5,000 because the bank had paid a stale check. A check that has been outstanding for more than six months is considered stale. A bank is under no obligation to pay a check that is presented for payment more than six months after its date. Most states hold a bank liable for paying a stale check without the drawer’s permission. In this case, the Community Bank had paid a check that was more than three years old. The court found that Ragusa’s oral stop payment had expired, but this was of no importance in relation to the payment of the check. Ragusa should not have needed a stop payment order to prevent the Community Bank from paying on a three year old check. The fact that the check was stale should have been sufficient to keep the check from being paid. Thus, the court ordered the bank to recredit Ragusa’s account for $5,000. Charles Ragusa & Son v. Community State Bank, 360 So.2d 231, 1978 La. App. Lexis 3435 (La. App. 1978).

Postdated Check 22.5.

Yes, the New England Bank will have to recredit Siegel’s account for the $20,000.

However, because the New England Bank is subrogated to the rights of the payee, Peter Peters, the bank can collect this money from Siegel on the date of the check. A postdated check is created when a drawer writes a check and dates it for a time in the future. If a payor bank pays on a postdated check prior to its date, the bank is liable for any damages .

196 Chapter 22

incurred by the drawer. The drawer can also sue the bank to recredit the account for the improperly paid check. Because the payor bank is subrogated to the rights of the payee, and may later collect the amount of the check, the drawer usually suffers little or no loss when a postdated check is paid early. In this case, the court ordered the New England Bank to recredit Siegel’s account $20,000 because the bank had improperly paid a postdated check. The court also remanded the case back to the trial court to allow the New England Bank to assert its rights as a subrogor and recover the $20,000. Siegel v. New England Merchants National Bank, 437 N.E.2d 218, 1982 Mass. Lexis 1559 (Mass. Supp. 1982).

Stop Payment 22.6.

Dynamite Enterprises wins the suit because Eagle National had paid after a valid stop payment order request. A stop payment order is an order by a drawer of a check to the payor bank to not pay or certify a check. A written stop payment is valid for six months.

The bank must receive a stop payment order within a reasonable time, and in a reasonable manner, to afford the bank an opportunity to act on it. In this case, Dynamite Enterprises was the drawer of a check, and informed the payor bank of this check, Eagle National, that Dynamite wanted a stop payment order placed on the check. This written request was made before the check had been cashed or deposited. Although the bank stated that this request was not valid because Dynamite did not have sufficient funds to pay the check when the request was made, the court held a check written against an account with insufficient funds to be irrelevant. The court stated that “a bank customer has a right to stop payment on an overdrawn check.” Thus, the bank was found liable for the amount of the check, because Eagle National violated this right. Dynamite Enterprises, Inc. v. Eagle National Bank of Miami, 517 So.2d 112, 1987 Fla. App. Lexis 11791 (Fla. App. 1987).

IV.

Answers to Ethics Cases

22.7.

Peoples National Bank & Trust Co. wins. Peoples Bank is not liable for paying on the 25 forged checks because Gennone failed to promptly examine his bank statements, and the losses were the result of a series of forgeries. A customer has a duty to examine bank statements and canceled checks and promptly report any forged signatures to the bank. The customer is liable if the bank suffers a loss because of the customer’s failure to promptly examine bank statements and report forgeries. In this case, it was proven that Gennone had an opportunity to examine his bank statement because the People’s Bank held them for his personal receipt.

Because Gennone simply failed to examine these records for more than three years, Peoples Bank was relieved of any liability for the forgeries. The Bank was also relieved of liability because the losses were the result of a series of forgeries by the same wrongdoer. When a series of forgeries occurs, the customer has only fourteen calendar days after receipt of his or her statement to report any such forgeries. The failure of Gennone to report a series of forgeries by his wife was an alternative basis to relieve the Peoples Bank of any liability. Gennone v. Peoples National Bank & Trust Co., 9 UCC Rep. Serv. 707, 1971 Pa. D & C. Lexis 160 (Pa. 1971).

22.8.

Decision for AmSouth affirmed. Mere availability of the funds does not mean the check has been paid. Banks allow customers to make use of funds while awaiting final payments.

Nothing here indicates any more than a provisional settlement by .

AmSouth

Banking System, E-Money, and Financial Reform 197

that it was free to retract if the item was not paid. Therefore, AmSouth acted properly in creating the overdraft, and Golden Gulf is liable. Golden Gulf, Inc. v. AmSouth Bank, N.A., 565 So.2d 114, 1990 Ala. Lexis 436 (1990).

V.

Answers to Policy Cases

22.9.

The Bank of New York wins because it is not liable for paying on the forged checks, which were the result of Actors Equity’s own negligence. A bank is not liable for paying on a forged signature of the drawer, or on an altered check if the drawer’s negligence “substantially contributed” to the forgery. In this case, Scotti’s forging of four checks was the direct result of Actor’s negligence in failing to check Scotti’s background before hiring him as the union’s comptroller. As the court stated: “The fact remains that the conduct of the union in retaining someone to manage many millions of dollars in funds without conducting, or insisting upon, a reasonable and trustworthy background investigation constitutes negligence substantially contributing to the making of the unauthorized signatures involved here. Certainly, Actor’s Equity cannot avoid the consequences of its own omissions.” Thus, the Bank of New York was not liable for the missing $100,000, because the union’s negligence substantially contributed to Scotti’s forgery. Firemen’s Fund Insurance Co. v. The Bank of New York, 539 N.Y.S.2d 339, 1989 N.Y. App.Div.Lexis 4172 (N.Y. Sup. 1989).

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation and Court First American Bank and Trust v. Rishoi 553 So. 2d 1387 (Fla. App. S. Dist. 1990) District Court of Appeals of Florida 2. Key Facts A. The plaintiff is a receiver for Clara Lamstein and the business she operated as Interamerican Business Consultants and Associates, Inc. (IBCA).

B. IBCA was shut down by the state of Florida for having operated an illegal pyramid scheme.

C. Among the assets of IBCA payable to the plaintiff as receiver was $80,000 worth of cashier’s checks issued by the defendant and paid for by Crosbys, who were investors in IBCA. D. The defendant refused to cash the checks based on a claim of underlying illegality.

E. The lower court held that the bank had no right to refuse payment on the checks; the bank appeals.

3. Issue Could the bank use the check payor’s claim of illegality to prevent payment of its own cashier’s check?

4. Holding No. 5. Court’s Reasoning The District Court of Appeals of Florida held that: .

198 Chapter 22

A. Banks that issue casher’s checks are primarily responsible to a proper holder of the check.

B. Cashier’s checks are intended to be the next best thing to cash, and any defenses to payment must be narrowly limited.

C. The bank must only use its own defenses and not those of a third party.

D. Because it could not show any of its own real defenses, the bank was wrong when it refused to cash its cashier’s check. The holding of the lower court was affirmed.

.

Credit and Secured Transactions 199

Chapter 23 Credit and Secured Transactions

How Can I Make Sure The Debt Is Paid?

Learning Objectives 1.

2.

3.

4.

5.

I.

Distinguish between unsecured and secured credit.

Describe security interests in real property, such as mortgages and deeds of trust.

Define a secured transaction and describe the scope of Revised Article 9 of the UCC. Describe surety and guaranty arrangements.

List and describe collection remedies.

Teacher-to-Teacher Dialogue

Credit One of the difficulties in teaching these materials is trying to steer students clear of a certain statutory myopia. They read these materials and often come to the conclusion that Article 9 and mortgages must be the main ways credit is extended in our economic system. Obviously, this view is far from true. Secured credit on sales of personal goods and real estate represent important pieces of a much bigger puzzle. Consider the entire realm of personal credit, corporate bonds, credit cards, letters of credit, and on and on. The list is virtually endless. Thus it is incumbent upon us, as instructors, to put this material in perspective at the outset by reminding students of this larger universe.

In addition to creating a sense of relative proportion, this universal perspective allows us to impart another important point—that few credit problems are isolated. Most people who find themselves in credit difficulties feel like they are being compacted by a four-sided vice. When things go wrong, all sorts of collection actions are likely to occur from both secured and unsecured creditors. Raising awareness at this point helps prepare students for the materials that follow on both bankruptcy and other related areas such as real property.

Secured Transactions The study of secured transactions allows teachers to focus on two sides of the same coin. One involves the rights, duties, and obligations of the debtor and creditor. The statutory materials covered in Article 9 of the UCC are extensive, and there is a lot of latitude on how to present them.

.

200 Chapter 23

The second side of the coin involves trying to ascertain rights, duties, and obligations after someone (usually the debtor) has had a problem. So much of the law of credit really concerns the establishment of an order of priorities between competing creditors.

Article 9 of the UCC is a particularly good example of the interaction between the old and new. The original sources of the law of secured transactions involving personal property can be found in a combination of common law contracts, real property law, debtor and creditor law, and the law of liens. The UCC has sought to interpolate the best elements of all these areas into a cogent and organized structured system of facilitating secured credit transactions for the sale of personal property.

This system is premised on the legal realism that merchants doing business with each other are expected to live up to a higher standard of both behavior and knowledge of the law. In addition, that same realism attempts to protect the innocent third parties’ good faith reliance on the legitimacy of the marketplace whenever possible. These ends are mainly sought through the use of the recording principles long established in real property law transactions. These rules are designed to give creditors notice not only of the debtor’s obligation, but even more important, to give notice to other creditors that this securitybased transaction hasfactors taken make place.the law of secured transactions in personal property particular Several practical troublesome. First, compared to real estate, personal property is portable. Being more moveable, the role of making sure that the security interest attaches and stays with the goods is of critical importance. Second, in a society based on credit, there is a strong likelihood that most large personal goods, such as automobiles and the like, may have more than one creditor looking to that good as security. This reliance on that good may come from either the original acquisition of the good or from subsequent transactions after the good is acquired. The ordering of priorities between multiple creditors having claims to the same goods becomes a critical issue.

Finally, just as there are likely to be multiple creditors, so are there likely to be multiple users. The vertical chain of distribution starts with supplies of raw materials to manufacturers, distributors, and retailers. On the horizontal level, the users start with the consumer, his or her family, and go on to third party users or acquirers. With each shift, there lies the probability of having to recognize new duties and obligations with respect to all parties having a legal relationship to those goods. All in all, it can very quickly become complicated, but the UCC and the common law rules with regard to liens, surety, guaranty, and collection provide some very good rules for both debtor and creditor.

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

In an examination of credit relationships, remember that most disputes have more than one level of controversy. On the surface, the most apparent problem revolves around resolution of the differences between the debtor and creditor. A second dispute can often be found in competing creditors fighting over priority rights to the debtor’s property. A proper examination of any credit case answers both aspects. Although there are many sorts of credit relationships, the main focus

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Credit and Secured Transactions 201

of this chapter is on Article 9 of the UCC. That chapter covers the sale of personal property coupled with a security interest in the debtor’s property.

II.

Text Materials

Introduction: • The American economy is a credit economy.

• Businesses and individuals use credit to purchase many goods and services • Debtor—the borrower in a credit transaction • Creditor—the lender in a credit transaction Unsecured Credit: • Credit that does not require any security (collateral) to protect the payment of the debt.

• The creditor relies on the debtor’s promise to repay the principal (plus an interest) when • it is due.

The creditor may bring legal action if the debtor fails to make the payments.

Secured Credit: • Credit that requires security (collateral) that secures payment of the loan.

• Security interests may be taken in real, personal, intangible, and other property.

• The collateral may be repossessed to recover the outstanding amount if the debtor fails to make payment.

Security Interests in Real Property: Mortgage • A collateral arrangement where a property owner borrows money from a creditor who uses a deed as collateral for repayment of the loan • Mortgagor—the owner-debtor in a mortgage transaction • Mortgagee—the creditor in a mortgage transaction Notes and Deeds of Trust: • Note—an instrument that evidences the borrower’s debt to the lender.

• Deed of Trust—an instrument that gives the creditor a security interest in the debtor’s property that is pledged as collateral Recording Statute: • A statute that requires the mortgage or deed of trust to be recorded in the county • recorder’s office of the county in which the real property is located.

This record gives potential lenders or purchasers of real property the ability to determine whether there are any existing liens (mortgages) on the property.

Foreclosure Sale: • Legal procedure by which a secured creditor causes the judicial sale of the secured real • • estate to pay a defaulted loan.

All states permit foreclosure sales.

Most states permit foreclosures by power of sale.

Deficiency Judgment: .

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• •

Some states permit the mortgagee to bring a separate legal action to recover a deficiency from the mortgagor.

If the mortgagee is successful, o The court will award a deficiency judgment. o Entitles the mortgagee to recover the amount of the judgment from the mortgagor’s property.

Right of Redemption: • Some states permit the mortgagee to bring a separate legal action to recover a deficiency • from the mortgagor.

If the mortgagee is successful, o The court will award a deficiency judgment. o Entitles the mortgagee to recover the amount of the judgment from the mortgagor’s property.

Note: A land sales contract is permitted in most states as a means of transfer and sale of real property.

Contemporary Environment: Mechanic’s Liens on Real Property

A contractor’s and laborer’s lien that makes the real property to which improvements are being made become security for the payment of the services and materials for those improvements.

To Obtain a Material Person’s Lien: 1. Lien holder must file “notice of lien” 2. Notice must have all details 3. Follow time requirements 4. Notice to owner of real property “Release of lien” is often used after payment.

•

Secured Transactions in Personal Property: Article 9 of the UCC—Security Interests in Personal Property • An article of the Uniform Commercial Code (UCC) that governs secured transactions in • personal property.

Article 9 has been adopted by all states except Louisiana.

• Although there may be some variance among states, most of the basics of Article 9 are the same.

Landmark Law: Revised Article 9—Secured Transactions Terms and Definitions used in Secured Transactions: 1. Debtor—has an interest in collateral and uses payment of a secured obligations 2. Secured Party—person in whose favor a security interest is created and provided under a security agreement 3. Security Interest—interest in collateral securing payment and performance of an obligation .

Credit and Secured Transactions 203

4. Security Agreement—agreement that creates or provides for a security interest 5. Collateral—property subject to a security agreement 6. Financing Statement—usually filed to give public notice of the secured party’s security interest in the collateral Note: Attachment—secured part beats debtor; occurs at later of: 1. Value given 2.

Rights in collateral 3.

Security agreement Perfection—secured party beats other creditors or people with an interest in collateral; occurs at later of: 1. Attachment 2. Perfecting step 3. Filing a financing statement 4. Possession 5. PMSI in consumer goods Case 23.1. The Court Speaks: In re FV Steel and Wine Company, 310 B.R. 390, Web 2004 Bankr. Lexis 748 (2004) U.S. Bankruptcy Court Facts: PSC filed a financing statement for a security interest in personal property on a loan extended to Keystone. The debtor’s named listed its trade name, not its corporate name.

Issue: Was the financing statement filed in the debtor’s trade name, not to them in its corporate name, effective?

Decision: No. The bankruptcy trustee could avoid PSC’s unperfected security interest. PSC becomes unsecured.

Rationale: Under Revised Article 9, a financing statement showing only the debtor’s trade name is not sufficient. The correct legal named must be used. PSC knew the correct legal name but ignored it.

Security Agreement—creates security interest 1. Description 2. Promise 3. Rights upon default 4. Debtor’s signature More Definitions: Personal Property Subject to a Security Agreement Goods 1. Consumer goods—personal or household 2. Equipment—business use (or default category) 3. Farm products—farming use 4. Inventory—sell or lease 5. Fixtures—affixed to real estate Instruments 1. Checks, notes, stocks, bonds, and so on 2. Chattel paper—note plus security agreement 3. Documents of title—bills of lading, warehouse receipts, and so on 4. Accounts—accounts receivable .

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5. General intangibles—patents, copyrights, and so on Note: PMSI—Creditor extends credit to buy goods or sells on credit and takes interest in goods.

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

Priorities—General Rules 1. Order of perfection 2. Order of filing if filing is perfecting step 3. Liens over prior unperfected security interest 4. Buyer of goods in ordinary course of business (BGOCB) usually wins 5. Purchasers of collateral a. Beat unperfected if value and no notice—if inventory (BGOCB) win even if knowledge b. Beat perfected if authorized sale or (BGOCB) or buyer of consumer goods for consumer use with value and without notice 6. PMSI’s a. Collateral not inventory wins for 10 days and if filed then wins b. Inventory wins with notice and perfection before possession 7. Order of attachment if no perfection Default and Remedies: Keep—notice; no written objection; not for 60 percent paid consumer goods Take possession or Sell—costs; satisfy debt; second, (etc.) debts;—need notice of reasonable sale Deficiency is still owed Can redeem by payment Cyber Law: Revised Article (Securities Transactions) Recognizes Electronic Financing Statements and Records Recognized electronic financing statements and records. Revised Article 9 recognizes the importance of electronic transactions and records.

Contemporary Environment: Artisan’s Lien and Personal Property This discusses how these types of liens usually prevail over other interests.

Surety and Guaranty Agreement: Surety: • An arrangement where a third party promises to primarily liable with the borrower for the payment of the borrower’s debt.

• Surety—the third person who agrees to be liable in a surety arrangement.

Guaranty: • An arrangement where a third party promises to be secondarily liable for the payment of another’s debt.

• Guarantor—the third person who agrees to be liable in a guaranty arrangement. .

Credit and Secured Transactions 205

Summary: Liability of Sureties and Guarantors Compared: 1. Surety Contract—Primarily liable. The surety is a co-debtor who is liable to pay the debt when it is due.

2. Guaranty Contract—Secondary liable. The guarantor is liable to pay the debt if the debtor defaults and does not pay the debt when it is due.

Collection Remedies: • When a debt is past due, the creditor may bring a legal action against the debtor.

• If the creditor is successful, the court will award a judgment against the debtor.

• The judgment will state that the debtor owes the creditor a specific sum of money: o Principal and interest past due on the debt, o Other cost resulting from the debtor’s default, and o Court costs The most common collection remedies are: 1. Attachment 2. Execution 3. Garnishment Surety vs. Guarantor Surety 1. Concurrent liability 2. “If he doesn’t” 3. Same instrument 4. No new consideration 5. No demand from debtor Guarantor 1. Nonconcurrent liability 2. “If he can’t” 3. Different instrument 4. New consideration 5. Needs demand from debtor Rights and duties are basically the same Defense of Debtor 1. Discharge 2. Minority of debtor 3. Nonpersonal a. Performance b. Breach Defenses of Surety 1. All nonpersonal defenses 2. Minority of surety 3. Creditor’s fraud or nondisclosure 4. Modification of debtor’s contract 5. Release of security or debtor

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III.

Answers to Critical Legal Thinking Cases

Material Person’s Lien 23.1.

Ivonwood should win. Lantz could have had a material person’s lien but Ivonwood paid Lantz. Graco’s claim is against Lantz only.

Foreclosure 23.2.

The mortgagor can recover any surplus from a foreclosure sale. Atlantic should be paid the surplus in this case.

Financing Statement 23.3.

No, S&D does not have a security interest in the Mack truck. A lender can take a security interest in the property of a debtor to serve as collateral when credit is being extended.

One way to create such a security interest is for the creditor to file a financing statement.

The purpose of the financing statement is to notify others who are contemplating extending credit to the debtor that certain property of the debtor is already subject to a security interest. The financing statement must contain such information as the names and addresses of the parties involved in the transaction and the type of collateral secured.

In order to perfect, that is, make valid the security agreement, the financing statement must be filed with the proper government entity, such as the Secretary of State, or County Clerk.

In this case, S&D did not have a security interest in C&H’s Mack truck because a financing statement regarding the truck had not been filed as required by state law. Thus, S&D had no interest in the truck, because the security agreement was not perfected.

However, S&D is able to recover from its attorney, Clifton Tamsett, for malpractice.

Tamsett was liable for malpractice for failing to properly file a financial statement securing an interest in the truck as collateral for the loan to C&H. S&D Petroleum Company, Inc. v. Tamsett, 534 N.Y.S 2d 800, 1988 N.Y. App. Div. 11258 (N.Y.Sup.Ct.App. 1988).

Floating Lien 23.4.

Columbus Junction State Bank wins the case. The Bank is a secured creditor of Joseph Jones based upon a properly filed security agreement. Once filed, a perfected security interest is valid for five years. The creditor may continue his perfected interest for another five years by filing a continuation statement. A continuation statement may be filed up to six months prior to the expiration of the financing statement’s five-year term.

Once filed, they are effective for another five years and may be refilled. Subsequently, when a creditor has obtained a security interest and the debtor goes bankrupt, the secured party’s interest is satisfied out of the specific property given as collateral for the loan.

Secured creditors have priority over other creditors. In this case, Columbus Bank was a secured creditor because it had properly purchased a security interest in Jones’ property by filing a financing statement. The Bank subsequently filed a valid continuation statement six weeks prior to the expiration of the perfected security interest. Thus, Columbus Bank, a secured creditor, had first priority in obtaining the property of the bankrupt Jones. The Court awarded the Bank $10,075 and Jones’ soybeans. In Re Jones, 79 B.R. 839, 1987 Bank v. Lexis 1825(Bk.N.D. Iowa 1987). .

Credit and Secured Transactions 207

Purchase Money Security Interest 23.5.

Yes, International Harvester’s (IH) security interest in the tractor takes priority over the Bank of California’s security interest in the same collateral. This is because IH had a purchase money security interest in the tractor that takes priority over any general security interest in the same property. A perfected purchase money security interest prevails over a perfected nonpurchase money security interest in after acquired property.

If the collateral in question is not inventory, the purchase money security interest must be perfected within ten days of the debtor receiving the collateral to take priority over a perfected nonpurchase money security interest. In this case, both parties had an interest in the Prior Brothers’ after acquired property, the model 1066 tractor. IH’s interest was a purchase money security interest because IH had extended credit to the Prior Brothers to purchase the collateral. IH perfected its security interest in the tractor within ten days of the Prior Brothers accepting the tractor. The Court held that such acceptance acts as the starting point for the ten-day deadline for perfecting the interest in a sale on approval.

Because IH had a perfected purchase money security interest, their claim took priority over the Bank’s. In the Matter of Prior Brothers, Inc., 632 P.2d 522, 1981 Wash. App. Lexis 2507 (Wash.App. 1981).

Buyer in the Ordinary Course of Business 23.6.

Ford Motor Credit Corporation (FMCC) wins because its purchase money security interest in the two automobiles has priority over the security interest of First National Bank and Trust Company of El Dorado. First National’s security interest would have taken priority if the two officers of Heritage Ford who financed the cars had been buyers in the ordinary course of business. A buyer in the ordinary course of business who purchases goods from a merchant takes the goods free of any security interest of a creditor in the merchant’s inventory, even if that security interest is perfected. This rule is necessary because buyers would be reluctant to purchase goods from merchants if the merchants’ creditors could recover the goods from the buyer when the merchant defaulted on loans owed to second creditors. In this case, the Court held that the two officers who financed the cars were not buyers in the ordinary course of business.

However, both men worked for the merchant offering the goods for sale, Heritage Ford, and were using the financing as a way to raise funds for the dealership. FMCC’s perfected security interest had priority because the two men were not buyers in the ordinary course of business. First National Bank and Trust Company of El Dorado v.

Ford Motor Credit Company, 646 P.2d 1057, 1982 Kan. Lexis 280 (Kan. 1982).

IV.

Answers to Ethics Cases

23.7.

Yes, Mrs. Sales is liable as a guarantor for the payment of the medical services provided to her sister, Mrs. Lynch, by the Forsyth County Hospital. A guaranty is a promise to answer for the payment of some debt in the case of the failure of the person who is primarily liable to pay the debt. A guaranty is a collateral and independent undertaking creating secondary liability, and the creditor’s cause of action against the guarantor ripens immediately upon the failure of the principal debtor to pay the debt at maturity.

The court held that Mrs. Sales personally guaranteed the payment of Mrs. Lynch’s medical costs when she signed the form admitting Mrs. Lynch to the hospital. Thus, Mrs. Sales is personally liable for the moneys owed by Mrs. Lynch to the hospital. Forsyth .

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County Hospital Authority, Inc. v. Sales, 346 S.E.2d 212, 1986 N.C. App. Lexis 2432 (N.C.App. 1986).

Artisan’s Lien 23.8.

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

Here, when Pete & Sons performed the repair services for the Turners, a common law lien attached to the truck to secure payment for these services. However, a common law lien is a possessory lien, that is, the lien only lasts as long as the lien holder has possession of the goods. The court held that when Pete & Sons released the truck to the Turners, its common law lien terminated. Because there was no common law lien on the truck, Ozark could foreclose on its perfected security interest in the truck.

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

V.

Answer to Policy Cases:

23.9.

Buffalo should win because of a deficiency judgment unless this is a state that prohibits deficient judgments.

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Davenport v. Chrysler Credit Corp. (CCC) 818 S.W. 2d 23 (1991) Court of Appeals of TN 2. Key Facts A. Davenport purchased a car from Matthews Motors using financing from CCC. B. Before driving off the lot the car developed mechanical problems and was returned 7 times for repair before the first payment was made.

C. They withheld payments and CCC sent a standard delinquency notice after the first payment was 10 days late. When the Davenports did not respond, CCC called and told them that they would repossess if no payment was made.

D. Repossession was attempted but to no avail at first. The car was taken from an enclosed garage after a padlock was cut. CCC held one car for more than a year due to the Davenports’ allegations. Eventually they sold it and CCC requested a deficiency payment.

E. The trial court held that CCC had a legal right to repossess.

3. Issue Can repossession be affected by breach of peace?

4. Holding No. 5. Court’s Reasoning .

Credit and Secured Transactions 209

A. The Davenports’ dissatisfaction did not allow a unilateral refusal to pay on an installment contract.

B. Repossession must be accomplished without breach of the peace.

C. The Davenports could only recover damages for the manner of repossession.

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Chapter 24 Bankruptcy and Reorganization

Bankruptcy Is Not The Easy Way Out Learning Objectives:

1. Identify and describe the major changes to federal bankruptcy law made by the Bankruptcy Abuse Prevention and Consumer Protection of 2005.

2. Describe a Chapter 7 liquidation bankruptcy and the means test for filing for Chapter 7 bankruptcy.

3. Describe a Chapter 13 adjustment of debts of an individual with regular income.

4. Describe how businesses are reorganized in Chapter 11 bankruptcy.

I.

Teacher-to-Teacher Dialogue

The bankruptcy material presents an excellent opportunity to illustrate how law works as the end product of social philosophies and value judgments. The best place to start is with the “preenlightened” era of debtor’s prisons and the like. History shows us that earlier societies in Western Europe held debtors not only in low regard but sought to criminally punish those who could not repay their obligations. These views eventually gave way to the more liberal view that allows for a fresh start after proper procedures for debt discharge are used.

Debtor’s prisons were holding cells for economic hostages whose ability to get out was directly proportional to the debtor’s ability to get others to pay his debt for him. Many of those dungeons became so crowded that the New World became a dumping ground for detainees. As fate would have it, that migration was most fortuitous for our nation. Very often the same people who were in prison for debt were also the innovators, risk takers, and entrepreneurs who helped build a new economic system less encumbered by class mentalities.

The basic underlying premise of bankruptcy law is founded on a simple reality: bad things happen to good people. How many of us can really provide ourselves with a safe haven from financial disasters brought on by bad health, economic downturns, financial institution failures, and the like? The early bankruptcy laws of England first recognized that businesses can and do fail in spite of the best good faith efforts of their proprietors. That failure should not, in effect, act as a life sentence in keeping that business or its proprietor from reentering the marketplace.

Bankruptcy is really one of the earliest forms of recycling, a recycling of economic opportunity for good faith debtors who deserve a second chance.

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Bankruptcy and Reorganization 211

As with any legal favor, there are people and business entities that get too greedy when asking for the benefit of the law. Bankruptcy is built on a cornerstone of good faith. Where debtors’ actions are motivated by bad faith attempts to avoid legitimate obligations, both the law and the larger societal public policy is subverted. The history of the law of bankruptcy is riddled with cases of clear abuse and creditor victimization that have created a dilemma for legislators who must draft bankruptcy statutes.

The recent history of federal reforms in the United States illustrates Congress’s attempts to deal with the dilemma of trying to make the law more humane while trying to curb abuses.

The Bankruptcy Act of 1978 provided for sweeping reforms that sought to destigmatize bankruptcy in an economy that had grown too dependent on credit. Unfortunately, with this liberalization came a number of abuses of the law. Graduates of long and expensive professional studies began their lucrative careers with a bankruptcy discharge of school loans. Many consumers loaded up on all sorts of items on credit and kept them debt free after bankruptcy. Corporations began to use the reorganization provisions of the law as a management wedge to get out from under otherwise binding executory contracts, or even worse, tort judgments. Congress responded with the Bankruptcy Amendments and other legislation and subsequent revisions. This legislation sought to pull in the reins on many of these abuses.

II.

Text Materials

Federal Bankruptcy Code: • Article I, section 8, clause 4 of the U.S. Constitution provides that “The Congress shall have the power . . . To establish . . . Uniform laws on the subject of bankruptcies throughout the United States.”

• Bankruptcy law is exclusively federal law.

• There are no state bankruptcy laws.

Landmark Law: Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 Federal Bankruptcy Code: 1. Bankruptcy reform Act of 1978 2. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 a. Substantially amended federal bankruptcy law making it much more difficult to debtors to escape unwanted debt through bankruptcy Types of Bankruptcy: • The Bankruptcy Code is divided into chapters • The most common forms of bankruptcy are provided by the following chapters: o Chapter 7—Liquidation Bankruptcy o Chapter 11—Reorganization Bankruptcy o Chapter 13—Consumer Debt Adjustment o Chapter 12—Family Farmer Bankruptcy Bankruptcy Courts: • Help with congress • One Bankruptcy court for each district • Judges appointed for 14 year terms .

212 Chapter 24

Fresh Start: • The primary purpose of federal bankruptcy law is to discharge the debtor from • burdensome debts The law gives debtors a fresh start by freeing them from legal responsibility for past debts Bankruptcy Procedure: 1. Prepetition and post petition counseling 2. Filing a petition a. Voluntary: Chapters 7,11,12,13 b. Involuntary: Chapters 7,11 i.

Fewer than 12 creditors—1 creditor ii.

12 or more creditors—3 creditors iii. $12,300 unsecured claims 3. Submit schedules 4. Attorney certification 5. Order of relief 6. First creditors meeting—10 to 20 days 7. Creditor files proof of claim 8. Trustee is appointed a. Mandatory: Chapters 7,12,13 b. May be appointed: Chapter 11 9. Trustee: a. Takes possession of property b. Investigates c. Distributes 10. Automatic stay 11. Discharge—if requirements are met Contemporary Environment: Automatic Stay Prevent Creditors Scramble for Debtor’s Assets • Petition filing automatically stays (suspends) certain legal actions by credits vs. debtors • or debtors property Stays include: o Legal actions o Judgment enforcement o Liens o Nonjudicial collection Exceptions from Discharge: 1. Taxes accrued within 3 years prior to filing the petition 2. Fines and penalties to the government 3. Willful or malicious injury to a person or property 4. Fraud, larceny, or embezzlement while a fiduciary 5. Alimony, maintenance, and child support 6. Unscheduled claims

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Bankruptcy and Reorganization 213

7.

8.

9.

10.

11.

Purchase of luxury goods more than $600 from a single creditor within 90 days of the order of relief Cash advances of more than $875 by a consumer-debtor with revolving line of credit or credit cards within 70 days of the order of relief Judgment from DUI Hurt spouse or child Amount owed to pension plan, and so on

Debtor and Creditor can enter into reaffirmation agreement: Bankruptcy Estate: 1. Created upon commencement of a bankruptcy estate 2. Includes all debtors legal and equitable interests in real, personal, tangible, and intangible property unless exempt 3. List put in exhibit 24.1 from text of exempt property Ethics: Fraudulent Transfer of Property by a Debtor Prior to Bankruptcy Can Be Voided • Can void if made by debtor within 2 years prior to filing if intent to hurt creditor or debtor who received less than a reasonable equipment in value Preferential and Fraudulent Transfers: 1. Preferential: a. To or with any party on or within 90 days of filing b. To or with any insider between 90 days and one year of filing c. For benefit of creditor d. Antecedent debt e. Creditor receives more than the Chapter 7 amount f. Insolvent debtor g. Exceptions 2. Fraudulent: a. Intent to defraud b. Debtor receives less than reasonable value c. Insolvent debtor or can’t pay Ethics: Limit on Abusive State Homestead Exemptions The bankruptcy Code’s federal homestead exemption is $21,605. Abusive exemptions are limited. The 2005 Act says no more than $146,450 may not be exempt if property was acquired within 1,215 days before filing.

Chapter 7 Liquidation Special Applications: 1. Chapter 7—new simple abuse rules and means testing to determine if relief should be granted Median Income Test and Means Test: .

214 Chapter 24

1. If debtor’s family income (last 6 months times 12 /6) is less than or equal to state’s median income—no presumption of abuse 2. If debtor’s family income greater than state’s median income—look to mean’s test a. Debtor’s Monthly Income (DMI) = last 6 month’s income/6 (certain deductions are available) b. State’s Median Income for 5 yrs. X (DMI X 60) = Total c. If total < 7,025—no presumption of abuse d. If total between 7,025 and 11,705 i.

Deny relief if total can pay 25 percent of unsecured debt ii. Relief if total can’t pay 25 percent of unsecured debt 3. If total is greater than or equal to 11,725—abuse is presumed—not eligible for Chapter 7 relief Chapter 7: Distribution of Property • Nonexempt property of the bankruptcy estate must be distributed to the debtor’s secured and unsecured creditors pursuant to the statutory priority established by the Bankruptcy Code.

• A secured creditor’s claim to the debtor’s property has priority over the claims of unsecured creditors.

• If collateral value is greater than security over secured property sold excess goes to secured.

• If collateral values equals under secured—given to secured.

Chapter 7: Discharge • • •

The termination of the legal duty of a debtor to pay debts that remain unpaid upon the completion of a bankruptcy proceeding.

Only individuals may be granted a discharge o Not all debts are dischargeable in bankruptcy Discharge is not available to partnerships and corporations

Unsecured Creditors Priority: 1. Fees and expenses 2. Gap claims 3. Wages, and so on 4. Employee benefit claims 5. Farmers and fishermen 6. Deposits 7. Taxes 8. Banks 9. Claims from NI Case 24.1. The Supreme Court Speaks: Kawaauhau v. Geiger, 523 U.S. 57, 118 S.Ct. 974, 140 L.Ed. 2d 96, Web 1998 U.S. Lexis 1995 (U.S. Supreme Court) Facts: Margaret Kawaahau sought treatment from Dr. Geiger for a foot injury. Geiger prescribed an ineffective drug because he wanted to minimize treatment cost. Eventually her condition deteriorated, and she had to have her leg amputated at the knee. Kawaahau and her husband sued Geiger for malpractice. Geiger, who did not have malpractice insurance, filed for bankruptcy. The

.

Bankruptcy and Reorganization 215

bankruptcy court denied the discharge; the court of appeals reversed; and the Kawaahaus appealed to the US Supreme Court.

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

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

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

Chapter 7: Acts That Bar Discharge: Certain acts by the debtor may bar discharge: • Making false representations about his or her financial position when he or she obtained • an extension of credit Transferring, concealing, or removing property from the estate with the intent to hinder, • delay, or defraud creditors • Falsifying, destroying, or concealing records of his or her financial condition • Failure to account for any assets Failure to submit to questioning at the meeting of the creditors (unless excused) Chapter 13 Consumer Debt Adjustment: Applies to Natural Persons • A rehabilitation form of bankruptcy that permits the courts to supervise the debtor’s plan • • for the payment of unpaid debts by installments Debtor avoids the stigma of Chapter 7 liquidation Creditors may recover a greater percentage of the debts owed them than they would under a Chapter 7 proceeding Limitations on Filing: 1. Need unsecured debts less than $360,475 and secured debts less than $1,081,400.

2. Trustee is appointed.

3. Plan of payment must be filed no later than 90 days after order of relief. It can be up to 3 or 5 years.

Chapter 13: Confirmation of the Plan: • The plan may modify the rights of unsecured creditors and some secured creditors.

• The plan must: o Be proposed in good faith o Pass the feasibility test o Be in the interest of the creditors • Meet certain requirements: o Good faith o Feasible o Creditors’ best interest o All domestic support paid o All taxes filed Chapter 11: Reorganization Bankruptcy .

216 Chapter 24

• • •

A bankruptcy method that allows reorganization of the debtor’s financial affairs under the supervision of the Bankruptcy Court.

Chapter 11 is used primarily by businesses to reorganize their finances under the protection of the Bankruptcy Court.

The debtor usually emerges from bankruptcy a “leaner” business, having restructured and discharged some its debts.

Note: Debtor-in-possession is left in place to operate the business during the reorganization proceeding.

Chapter 11: Creditors’ Committee • The creditors holding the seven largest unsecured claims are usually appointed to the • creditors’ committee.

• Representatives of the committee appear at Bankruptcy Court hearings, participate in the • negotiation of a plan of reorganization, assert objections to the plan, and so on.

Chapter 11: automatic stay upon filing Chapter 11: executory contracts and unexpired lease • Debtors may reject Chapter 11: Plan of Reorganization • A plan that sets forth a proposed new capital structure for the debtor to have when it • • emerges from reorganization bankruptcy.

The debtor has the exclusive right to file the first plan of reorganization.

Any party of interest may file a plan thereafter.

Chapter 11: Rejection of Collective Bargaining Agreements • A collective bargaining agreement may be rejected or modified as an executory contract if: 1. It is necessary to the reorganization.

2. The debtor acted in good faith.

3. The balance of the equities favors rejection or modification of the agreement.

Chapter 11: Confirmation of a Plan of Reorganization: • The final step is the confirmation of the plan of reorganization by the court.

• A plan of reorganization must be confirmed by the court before it becomes effective.

• Confirmation is either by: o The acceptance method; or o The cram-down method Note: Under cram-down method—Plan must be fair to impaired class.

Chapter 11:Discharge • Upon confirmation of a plan of reorganization, the debtor is granted discharge of all a • claims not included in the plan.

The plan is binding on all parties once it is confirmed. .

Bankruptcy and Reorganization 217

Contemporary Environment: Bankruptcy of General Motors Corporation This is an example of a “pre-packaged” bankruptcy.

International Law: Cross-Border Bankruptcies The UN Commission on International Trade Law adopted a model case for cross-border bankruptcies.

Chapter 13: Discharge • A discharge is granted to a debtor in a Chapter 13 consumer debt adjustment bankruptcy • only after all payments under the plan are completed by the debtor.

Debtor cannot be granted discharge if they receive discharge under Chapter 7,11, or 12 within prior 4 years or Chapter 13 within prior 2 years.

III.

Answers to Critical Thinking Cases

Petition 24.1.

Yes, the involuntary petition to place Walnut Street Four, a general partnership, into bankruptcy should be granted. The Bankruptcy Code provides that the Bankruptcy Court shall grant an involuntary petition if the debtor is not paying its debts as they become due. The court heard evidence from creditors that the partnership was not paying its debts as they became due. Based upon this evidence, the Bankruptcy Court granted an order for relief under Chapter 7 of the Bankruptcy Code. In re Walnut Street Four, 106 B.R. 56, 1989 Bank v. Lexis 1806 (Bk.M.D.Pa. 1989).

Automatic Stay 24.2.

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

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

Student Loan

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24.3.

No, the debtor’s student loan should not be discharged in bankruptcy. Congress, which was concerned about debtors who incurred student loans and then filed bankruptcy after leaving school, enacted Section 523(a)(8)(B) of the Bankruptcy Code to make it more difficult for student loans to be discharged in bankruptcy. This section provides that during the first five years after a student loan becomes due and payable, it is not dischargeable in bankruptcy unless payment would cause “undue hardship” on the debtor and his dependents. After this five-year period has run, student loans are dischargeable in the same manner as other loans. Section 523(a)(8)(B) is strictly construed by the courts, and the debtor bears the burden of proof as to undue hardship.

The Bankruptcy Court held that because the debtor’s student loan became due and payable one month before he declared bankruptcy, it falls within the five-year period and is subject to the “undue burden” standard of dischargeability. The court held that the debtor’s two children were reasonably well shielded from the effects of the debtor’s liability for the student loan by virtue of the state court’s order that he pay $300 per month for the support of the children. In addition, the court found that the debtor’s former wife was not dependent on the debtor. Therefore, the only question was whether the liability for the student loan would impose an undue hardship on the debtor. The court, recognizing that this was a “close case,” held that the monthly payment of $50 per month toward paying off the student loan would not cause an undue burden on the debtor. The court held that the debtor’s liability for the student loan was not dischargeable in bankruptcy. In re Doyle, 106 B.R. 272, 1989 Bank v. Lexis 1772 (Bk.N.D.Ala. 1989).

Executory Contracts 24.4.

Yes, The Record Company may reject the purchase agreement to buy the record stores from Bummbusiness. The Bankruptcy Code permits a debtor in a Chapter 11 case to reject executory contracts. An executory contract is defined as one under which the obligations of both the debtor and the other party are so far unperformed that the failure of either party to complete performance would constitute a material breach. The Bankruptcy Court held that the purchase agreement in the instant case fit this definition.

The Record Company still owed Bummbusiness $10,000 and was obligated to keep paying on the $380,000 trade debt. The performance outstanding of Bummbusiness included not competing with the buyer and using its efforts to obtain extensions of the due dates for the trade debt. The court held that the sum total of the performance outstanding by both parties made the purchase agreement an executory contract. As such, the court permitted The Record Company to reject the purchase agreement. In re The Record Company, 8 B.R. 57, 1981 Bank v. Lexis 5157 (Bk.S.D.Ind. 1981).

Plan of Reorganization 24.5.

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

Under the Bankruptcy Code, a class of creditors is impaired if (1) the plan alters the legal, equitable, and contractual rights of the class of creditor and (2) the class does not vote to accept the plan. In this case, the Bankruptcy Court held that the debtor’s proposed plan of reorganization alters the legal, equitable, and contractual rights of Class 2 because it reduced the class’ claims by 50 percent. Therefore, in order for the plan to be confirmed without use of the cram-down provisions, these creditors must vote for the plan, which they have not. Because Class 2 is impaired and has not accepted the plan, the requirements for confirmation under Section 1129(a) of the Bankruptcy Code have not been met. .

Bankruptcy and Reorganization 219

In addition, the plan cannot be confirmed under the “cram-down” provisions of Section 1129(b). In order for the court to confirm a plan under the cram-down provisions, the Bankruptcy Code requires that at least one class of creditors must vote to accept the plan. Here, the court found that no class of creditors has voted for the plan.

Therefore, the court held that the debtor’s proposed plan cannot be crammed down on the impaired Class 2 creditors. The Bankruptcy Court denied confirmation of the debtor’s proposed plan of reorganization. In re Friese, 103 B.R. 90, 1989 Bank v. Lexis 1309 (Bk.S.D.N.Y. 1989).

24.6.

IV. 24.7.

24.8.

V.

No. The jewelry does not qualify as necessary and proper wearing approval. Under Tennessee law, the debtor cannot claim because the jewelry items are neither necessary nor proper wearing approval. They are luxury items. They are property and must be included in the estate. In re Lebovitz, 344 B.R. 556, Web 2006 Bank Leis 1044 (U.S. Bankruptcy Court of the Western District of Tennessee) Answers to Ethics Cases The bankruptcy trustee wins, and the debtors’ transfer of their home to their daughters may be set aside as a fraudulent transfer. The court held that the bankruptcy trustee could not employ the one-year fraudulent transfer provision of the Bankruptcy Code because the debtors’ transfer of their residence to their daughters took place approximately 1 1/2 years prior to the filing of their bankruptcy petition. However, the trustee can use the sixyear limitation period of the New York fraudulent transfer statute because it was made for no consideration, which raised a presumption of insolvency that the debtors did not overcome. The court held that the transfer could therefore be avoided as a fraudulent transfer and that the residence became part of the bankruptcy estate. In re Tabala, 11 B.R. 405, 1981 Bank v. Lexis 3663 (Bk.S.D. N.Y. 1981).

Yes, the debtor’s petition for Chapter 7 bankruptcy should be dismissed because the debtor acted in bad faith. One of the primary purposes of the Bankruptcy Code is to relieve the honest debtor from the weight of oppressive indebtedness and permit him to start afresh free from his prepetition obligations. However, Congress never intended that bankruptcy be a refuge for the unscrupulous and cunning individual. The Bankruptcy Code provides that a bankruptcy petition may be dismissed if the debtor filed the petition in bad faith. The Bankruptcy Court found that the debtor quit his job rather than attempting to work out a repayment plan with his creditors, did not try his best to pay his debts and made every effort to avoid paying them, and did not adjust his affluent lifestyle. Based upon this evidence, the Bankruptcy Court held that the debtor acted in bad faith and dismissed his bankruptcy petition. In re Scott Keebler, 106 B.R. 662, 1989 Bank v. Lexis 1919 (Bk.D. Hawaii 1989).

Answer to Public Policy Case

24.9. The goal of Chapter 11 is to reorganize allowing the debtor to have a new capital structure and emerge as a viable company. Inevitably same stakeholders will be hurt but the overall result is better to them then an alternative.

Answer to “Briefing the Case” Writing Assignment VI.

Case Name, Citation, and Court 1. Dewsnup v. Timm .

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116 L. Ed. 2d 903 (1992) United States Supreme Court 2. Key Facts A. On June 1, 1978, Aletha Dewsnup and her husband, T. LaMar Dewsnup borrowed $119,000 from Timm. The loan was secured by a deed of trust lien on two parcels of farmland located in Utah.

B. In 1981, the Dewsnups tried to file for Chapter 11 bankruptcy. Subsequently, they filed for Chapter 7 liquidation.

C. C. Timm sought foreclosure of the lien, and the debtor sought to limit the lien amount to the judicially determined value of the real property.

D. The lower court held that the value of the lien stays with the property until such time as the foreclosure and any increase in value during the bankruptcy inured to the creditor.

Dewsnups appealed.

3. Issue Does the Bankruptcy Code allow for the increase in value during the proceeding to inure to the creditor?

4. Holding Yes. 5. Court’s Reasoning The U.S. Supreme Court held that: A. Sections 506(a) and 502 of the Bankruptcy Code are not required to be read together thus allowing 502 to operate independently.

B. The underlying agreement, signed by both parties, allows for this outcome.

C. The holding of the lower court for the creditor was affirmed.

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Chapter 25 Agency Law

What Can An Agent Do? Learning Objectives: 1.

2.

3.

4.

5.

I.

Define agency and the parties to an agency.

Identify and define a principal-independent contractor relationship.

List and define the agent’s duties to the principal and the principal’s duties to the agent.

Describe the principal’s and agent’s liability on third-party contracts.

Describe the principal’s, agent’s, and independent contractor’s liability for tortuous conduct.

Teacher-to-Teacher Dialogue

Agency law is very important in a basic undergraduate law course in that it represents a synergy of two otherwise distinctive bodies of law: contracts and torts. It is useful to remind students of the interplay between these two areas of law. For example, go through the creation of the agency relationship (which highlights contract elements), involve a third party (by way of tort), and decide whether any defenses may apply (possibilities from both the law of contracts and torts). Invariably, certain patterns of behavior can be identified that can be used to help students ask key questions about agency-based issues.

Agency is defined by Section 1 of the Second Restatement of Agency as: The fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act.

Agency is a legally recognized relationship that allows an attribution of one person’s behavior to another. This carryover process is two-sided in that both benefit and burden inure to the parties involved in the agency relationship.

Under the basic doctrine of agency, the principal is allowed to reap the beneficial harvest of the agent’s actions made on his or her behalf. For example, assume an agent has agreed to be paid a set salary of $100 for selling certain kinds of goods. The principal gets to keep the net profits from that agent’s selling activities, be they $100 or $1,000,000. This net gain is what allows the use of agency theory to maximize one’s efficiency through the actions of others. There, are, however, some limits on the ability to designate others to act on one’s behalf based on uniqueness of personal services or on public policy grounds that forbid use of agents, such as voting or serving a criminal sentence. As a practical matter, business as we know it today simply could not

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be conducted on any scale beyond sole proprietorship without extensive use of agency relationships.

The benefits of agency are not without counterbalancing problems. The Latin maxim respondeat superior may be familiar to your students. In certain instances, a principal is liable to third parties for the acts of his or her agent. Just as the benefits of agency can be great, so can the burdens. One of the fastest growing areas of management specialization in today’s business environment is risk management. This area generally concerns business financial responsibility for exposures to specified contingencies or perils. Included in these perils are the acts of the agents for which the principal may be liable. The ironic aspect of all this is that the very same people who help a business grow can lead that same enterprise to financial ruin. *Every agency liability question having an involvement with third parties has three subquestions that must be answered in order to come to a final resolution of the issues at hand.

They are: 1. What are the responsibilities of the principal and agent vis-à-vis each other?

2. What are the responsibilities of the agent vis-à-vis the third party?

3. What are the responsibilities of the principal vis-à-vis the third party?

Invariably, a certain fact pattern emerges. First there is some sort of principal–agent relationship established. This relationship may be based on actual, implied, apparent, or ratified authority. In all events, once that authority line has been drawn, the question of the legal consequences to the principal and agent vis-à-vis each other must be answered. These consequences include their respective rights and duties to each other.

Once the first subquestion is resolved, the rights, duties, and obligations of the agent and principal, respectively, must then be examined vis-à-vis the third party. Often there will be some sort of wrongful and unauthorized act committed by the agent. That act will result in probable liability for both the agent and the principal to the third party who was harmed by the act. Think of the three subquestions as a loop that must be closed in order for the whole case to be resolved.

An agency issue starts with the establishment of the agency relationship. It goes through the rights and duties of third parties. It terminates where it began, with a determination of the ultimate responsibilities of the principal and agent vis-à-vis each other.

II. Text Materials Agency: • Agency relationships are formed by the mutual consent of a principal and an agent.

• Agency is the fiduciary relationship “which results from the manifestation of consent by one person to another that the other shall act in his behalf and subject to his control, and consent by the other so to act.”

Note: Usually need contractual capacity to appoint an agent.

Summary—Kinds of Employment Relationships: 1. Employer–Employee—The employer has the right to control the physical conduct of the employee.

2. Principal–Agent—The agent has the authority to act on behalf of the principal as authorized by the principal and implied from the agency. An employee is often the agent of his employer. .

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Formation of an Agency Relationship: • An agency and the resulting authority of an agent can arise in any of these four ways: 1. Express agency 2. Implied agency 3. Apparent agency 4. Agency by ratification a. Often formed by contract Case 25.1. The Court Speaks: Bosse v. Brinker Restaurant Corporation,,d.b.a. Chili’s Grill and Bar, Web 2005 Mass Super. Lexis 372 (2005) Superior Court of Massachusetts Facts: Bosse and Griffin and others ate a $56 meal at Chili’s. They left without paying. An unidentified patron chased them and called the Chili’s manager who called the police. Bosse’s car hit a wall and Bosse and Grifin were seriously injured. They sued Chili’s for compensatory damages arguing an agency relationship between Chili’s and the patron making him liable under respondeat superior. Chili’s files a motion for summary judgment.

Issue: Was the patron an agent of Chili’s?

Decision: No. Summary judgment was granted.

Reason: To be an agent, there must be consent by Chili’s, retaining of control, and action to benefit Chili’s. Here there was no preliminary communication so any consent is tenuous at best.

By using the phone intervention, Chili’s was merely reporting a petty crime that the patron was pursuing. Agency need not exist in this case and it did not.

Contemporary Environment: Power of Attorney This is an agency agreement often used to give an agent the power to sign legal documents. It can be “general” or “special”.

Summary: Formation of Agency Relationships: 1. Express—Authority is expressly given to the agent by the principal. Principal and third party are bound to the contract.

2. Implied—Authority is implied from the conduct of the parties, custom, and usage of trade or act. Principal and third party acts are bound to contract.

3. Apparent—Authority created when the principal leads a third party into believing that the agent has authority. Principal and third party are bound to the contract.

4. Implied—Acts of the agent committed outside the scope of his authority. Principal and third party are not bound to the contract unless the principal ratifies the contract.

Note: Implied authority to act on contingencies is called incidental authority.

Principal’s Duties: • Duty to compensate o A duty that a principal owes to pay an agreed-upon amount to the agent either upon the completion of the agency or at some other mutually agreeable time. .

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•

•

•

Duty of reimburse o A duty that a principal owes to repay money to an agent if the agent spends his or her own money during the agency on the principal’s behalf.

Duty to indemnify o A duty that a principal owes to protect the agent for losses the agent suffered during the agency because of the principal’s misconduct.

Duty to cooperate o A duty that a principal owes to cooperate with and assist the agent in the performance of the agent’s duties and accomplishment of the agency.

Agent’s Duties: • Duty of performance An agent’s duty to a principal that includes: 1. Performing the lawful duties expressed in the contract; and 2. Meeting the standards of reasonable care, skill, and diligence implicit in all contracts.

• Duty of notification o An agent’s duty to notify the principal of information he or she learns from a third party or other source that is important to the principal. o Imputed Knowledge—most information learned by an agent in the course of the agency is imputed to the principal.

• Duty of accountability o A duty that an agent owes to maintain an accurate accounting of all transactions undertaken on the principal’s behalf.

• Duty of loyalty o An agent owes a fiduciary duty not to act adversely to the interests of the o principal.

If this duty is breached, the agent is liable to the principal.

Ethics: Agent’s Breach the Duty of Loyalty: The most common types of breaches of loyalty by an agent are: 1. Self-dealing 2. Usurping an opportunity 3. Competing with the principal 4. Misuse of confidential information 5. Dual agency Tort Liability to Third Parties: • The principal and the agent are each personally responsible for their own tortious • conduct.

• The principal is liable for the tortious conduct of an agent who is acting within the scope of his or her authority (respondent superior).

The agent is liable for the tortious conduct of the principal if he or she directly or indirectly participates in or aids and abets the principal’s conduct.

Sources of Tort Liability for Principles and Agents: • Misrepresentation o Intentional misrepresentation o Innocent misrepresentation .

Agency Law225

•

•

Negligence o Respondent superior o Frolic and detour—case by case basics o “Coming and going” rule—not while on way to or from work o Dual-purpose rule—but not usually liable Intentional Torts

Case 25.2. The Court Speaks: Keating v. Goldrick and Lapp Roofing and Sheet Metal Company, Inc., Web 2004 Del. Super Lexis 102 (2004) Superior Court of Delaware Facts: Lapp, an Ohio company, sent Goldrick and others to do a roofing job in Wilmington.

Company policy prohibits use of company vehicles for personal uses. Goldrick was given a company van for transportation of workers to the site and for necessities while in Wilmington.

Goldrick and McNeese (both Lapp employees) went to eat and drink and were ejected. Goldrick drove onto a curb and struck people in various places. He was charged and pleaded guilty to criminal assault. Keating and others injured filed this personal injury suit. Lapp says they were not liable because Goldrick was outside the scope of his employment.

Issue : Was Goldrick’s negligence within the scope of his employment at Lapp?

Decision: No. Summary judgment was granted.

Reason: A reasonable person would not assign liability to a company based on an employee using a company van to drink at night. If the accident occurred after using the van for a necessity, there would probably be a different result. This conduct, however, was completely unrelated to Lapp’s business, outside of working hours and does not benefit Lapp in any way. This was a purely personal activity.

Intentional Tort 1. Motivaiton Test—Principal liable if agent was promoting principal’s business.

2. Work-Related Test—Principal liable if agent was within work-related time and space.

Case 25.3. The Court Speaks: Massey v. Starbucks Corporation, Web 2004, U.S. Dist. Lexis 12993 (2004) U.S. District Court.

Facts: Massey and Rodriguez ordered drinks at Starbucks and paid for them. After being told the store was closing by Morales, the manager, he refunded their money and told them to leave. After a verbal battle, Polanco, Morales, and Wilson (all employees) held the door open for Massey and Rodriguez, Polanco had told Massey they “…can go outside”. After closing, Polanco ran after Massey and pushed her and a fight ensued. Morales and Polanco each pleaded guilty to criminal assault. The three employees were fired. Massey sued Starbucks for her injuries. Starbucks moved for summary judgment alleging actions outside the scope of employment.

Issue: Were the employees within the scope of employment during the assault?

Decision: No. The motion for summary judgment was granted.

Reason: The question to be answered was whether the assault (causing injury) not the dispute was within the scope of employment. They were two separate events. First, the store was closed.

Second, the statement to go outside mentioned it would be after closing. Third, the assault happened outside of the store. They had held the door open for them to leave. Vicarious liability only applies where the actions were intended to benefit the employer. This was not the case here.

The assault had purely personal motives.

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Note: A principal is not liable on a contract that exceeds the agent’s authority unless the principal ratifies it.

Misrepresentation: • Intentional is fraud • Innocent could be negligence • Principal liable agent is within the scope of employment Contract Liability of Principals and Agents to Third Parties: Fully Disclosed Agency • The principal is liable to the third party.

• The agent is not liable.

• An agent is liable on the contract if he or she guarantees that the principal will perform the contract.

Partially Disclosed Agency • Both the principal and the agent are liable to the third party if the principal fails to • perform the contract.

This is because the third party must rely on the agent’s reputation, integrity, and credit because the principal is unidentified.

Undisclosed Agency • The third party is unaware of either the existence of an agency or the principal’s • identity.

Both the principal and the agent are liable to the third party if the principal fails to perform the contract.

Agent Exceeding the Scope of Authority • Normally, agent acting on behalf of another causes an implied warranty of authority • to use.

• Agent can be liable to principal.

For third party transactions reliance and ignorance must be shown.

Liability for Independent Contractor’s Torts • Principal employs a person who is not an employee of the principal.

• The independent contractor has authority only to enter into contracts authorized by the • principal.

Generally, principals are not liable for the tortious conduct of independent contractors.

• Independent contractors are personally liable for their own torts.

Note: The critical factor in determining an independent contractor is the degree of control.

Generally, a principal is not liable for the torts of independent contractors. Exceptions include nondeligable duties, special risks, inherently dangerous activities, and negligence in the selection of an independent contractor. Principal save bound on contracts made on their behalf by an independent contractor.

Ethics: Bank Liable for a Repo Man’s Tort This discusses liability by a principal for the tortious conduct of an independent contractor amount to breaching the peace.

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Termination of an Agency: An agency may be terminated by the following acts of the parties: 1. Mutual agreement 2. Lapse of time 3. Purpose achieved 4. Occurrence of a specified event Notification Required at the Termination of an Agency The principal is under a duty to give certain third parties notification of the termination of an agency.

Direct notice—prior dealings.

Constructive notice—any with knowledge of agency.

Termination by Impossibility: 1. Loss or destruction of the subject matter of the agency 2. Loss of a required qualification 3. Change in the law Contemporary Issue: Irrevocable Agency An agency coupled with an interest, created for the agent’s benefit, is irrevocable.

Termination by Operation of Law: An agency is terminated by operation of law, including: 1. Death of the principal or agent 2. Insanity of the principal or agent 3. Bankruptcy of the principal 4. War between the principal’s and agent’s countries Termination by Impossibility of Performance: Termination Could Occur Through: 1. Impossibility of performance 2. Changed circumstances III.

Answers to Critical Thinking Cases

Agent of Independent Contractor 25.1.

Independent Contractor. The evidence was: 1. Torres performed services for the person as part of a independent business.

2. Torres supplied the equipment.

3. Torres was not hired by day or hour but by the job or contract.

4. The work was maintenance work at their house and not part of the person’s business.

5. Torres had substantial investment in his business.

6. Torres had employees.

The persons were not liable to Torres. Torres v. Rearden, 3 Cal. App. 459 831, 5 Cal. Rptu. 2d 52, Web 1992 Cal. App. Lexis 198 (Court of Appeal of California)

Fiduciary Duty .

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25.2.

Yes, E.F. Hutton is liable for the fraudulent activities of its employee, Johnson. A principal can be held liable for an agent’s tortious conduct even if such conduct falls outside the scope of the agent’s employment if the principal ratifies such conduct. The court held that because the manager of E.F. Hutton had knowledge of Johnson’s activities and took no action to prevent this conduct, E.F. Hutton ratified the agent’s tortious acts. The court held E.F. Hutton liable to Pusateri for $120,000 compensatory damages and $160,000 punitive damages. Punitive damages can be awarded against a principal for an act of an agent if the employer ratifies his tortious activity. Pusateri v.

E.F. Hutton & Co., Inc., 225 C.R. 526, 1986 Cal. App. Lexis 1502 (Cal.App. 1986).

Imputed Knowledge 25.3.

Yes, Boulevard Investment Company (Boulevard) is liable to Iota Management Corporation (Iota) for breach of contract. The knowledge of an agent of corporate principal regarding matters within the agent’s scope of employment and authority is imputed to the principal. The court held that Cecil Lillibridge, who was Boulevard’s maintenance supervisor, had acquired knowledge of the condition of the pipes through his work at the hotel, clearly within the scope of his employment and authority. The court held that this knowledge was imputed to the corporate principal, Boulevard. The appellate court affirmed the trial court’s decision that permitted Iota to rescind the contract. Iota Management Corporation v. Boulevard Investment Company, 731 S.W.2d 399, 1987 Mo. App. Lexis 4026 (Mo.App. 1987).

Duty of Loyalty 25.4.

Yes, Shields breached his fiduciary duty of loyalty to his principal, Production Finishing, by usurping a corporate business opportunity. Shields, as president and a member of the board of directors of Production Finishing, was an agent of the corporation. A corporate officer or director is an agent of the corporation and under a fiduciary duty not to divert a corporate business opportunity for his own personal gain. If an agent acquires any pecuniary advantage to himself from third parties by breaching his fiduciary duties, he is accountable to his employer for the profit made. The court held that Shields breached his fiduciary duty of loyalty and honesty to his principal by diverting the Ford contract to him. The Court of Appeals affirmed the trial court’s granting of summary judgment in favor of Production Finishing and remanded the case for a determination of damages.

Production Finishing Corporation v. Shields, 405 N.W.2d 171, 1987 Mich. App. Lexis 2379 (Mich.App. 1987).

Contract Liability 25.5.

Both Elvin Grinder personally and G. Elvin Grinder Construction, Inc., are liable to Bryans Road Building & Supply Co., Inc. This is a situation of an undisclosed principal.

An agent who makes a contract in his own name without disclosing his agency and the identity of the principal is liable on the contract to the other party. The principal is liable because the contract was made for his benefit. The court held that a creditor who contracts with the agent for an undisclosed principal does not obtain alternative liability, but that he may proceed to judgment against both, and that he is limited to one satisfaction. The court held that Grinder was the agent for an undisclosed principal, and that Bryans is entitled to take judgment against Grinder personally in addition to its unsatisfied judgment against the corporation. Grinder v. Bryans Road Building & Supply Co., Inc., 432 A.2d 453, 1981 Md. Lexis 246 (Md.App. 1981). .

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Tort Liability 25.6.

Because Rogers was basically on the job and the accident occurred during work time, the principal is liable for the intentional tort of the agent. NAC is liable. Johnson v. Rogers, 763 P. 2d, 771, 90 Utah HDV. Dep13, Web 1988 Utah Lexis 81 (Supreme Court of Utah)

IV.

Answers to Ethics Cases

25.7.

Desert Cab is liable for the intentional tort of its employee Edward. Under the workrelated test, its agent commits an intentional tort within work-related time or space, principal is liable. Here the incident occurred while Edwards was working. Desert Cab v.

Mains., 823 P.2d 898, Web 1992 Nev. Lexis (Supreme Court of Nevada)

25.8.

Yes, the agency agreement was terminated when the Hagues sent the termination letter to Hilgendorf on August 13, 1976. Because an agency is a consensual relationship, a principal has the power to terminate an agency, except those coupled with an interest, although the contract is for a period that has not yet expired. The agent’s authority to bind the principal ceases. Thus, the Hagues had the power to terminate the exclusive listing agreement with Hilgendorf.

However, absent some legal ground, the principal does not have the right to terminate an unexpired agency contract, and may subject himself to damages by doing so. The court held that the Hagues had no legal ground for terminating their agency agreement with Hilgendorf and are, therefore, liable for wrongful termination of the agreement. Where the principal terminates an exclusive agency listing within the term, the agent may show that he would, but for the termination, have sold the property within the unexpired period at the listing price, and then recover his lost profits as ordinarily measured by the commission he would have earned. The appellate court affirmed the trial court’s award of the commission to Hilgendorf. Hilgendorf v. Hague, 293 N.W.2d 272, 1980 Iowa Sup. Lexis 882 (Iowa 1980).

V.

Answers to Policy Cases

25.9.

Spire was not acting within the scope of employment. This does not include going to a friend’s house. Siegenthaler v. Johnson Welded Products, Inc., 2006 Ohio 5588, Web 2006 Ohio App. Lexis 5616 (Court of Appeals of Ohio)

V.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court District of Columbia v. Howell 607 A.2d 501 (D.C. App. 1992) District of Columbia Court of Appeals 2. Key Facts

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230 Chapter 25

A. A school principal, working for the District of Columbia school system (DC) hired a chemistry teacher as an independent contractor for a summer program sponsored by the DC school system.

B. The chemistry teacher conducted a classroom experiment involving the use of controlled explosions, which resulted in harm to Howell, a student enrolled in the summer program.

C. The school system argued it is not responsible for the acts of an independent contractor.

D. The lower court held in favor of the student claiming that this case is an exception to the general rule of nonresponsibility for acts of independent contractors because of the dangerous nature of the activities involved.

3. Issue Does the exception to the general rule of nonresponsibility for the acts of an independent contractor apply in this case?

4. Holding Yes. 5. Court’s Reasoning The District of Columbia Court of Appeals held that: A. The general rule holds that a principal will not be liable for the acts of an independent contractor.

B. An exception to that rule applies where the activities involved includes special dangers and risks.

C. The nature of the materials used and the age of the students involved created a special danger. Thus, the holding of the lower court in favor of the student plaintiff, Howell, was upheld.

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Chapter 26 Small Business, Entrepreneurship and Partnerships

How Do I Form My Business?

Learning Objectives: 1. Define entrepreneurship and describe the types of businesses that an entrepreneur can use to operate a business.

2. Define sole proprietorship and describe the liability of a sole proprietor.

3. Define general partnership and describe how general partnerships are formed and operated.

4. Define limited partnership and describe how limited partnerships are formed and operated.

5. Explain the contract and tort liability of partners.

I.

Teacher-to-Teacher Dialogue

One of the key roles of attorneys engaged in the practice of modern business law is advising their clients on the selection of the best venue for doing business. What seems like a relatively limited number of options is, in fact, quite extensive. The choices run the gamut from the simplest lemonade stands to a multinational publicly traded corporation.

With each choice comes a list of pros and cons in the eyes of the law. For example, if a person seeks maximum privacy in his or her financial affairs along with the least possible accountability to others, a private form of sole proprietorship may be best. Compare, however, the businessperson who wants to leverage the maximum utilization of other people’s money while limiting her personal financial exposure. That person may find the corporate form best suited for her needs.

The law has something for everyone. The real issue is first finding out what options are legally available and then choosing the best fit. That fit should be tailored by sound advice from a number of quarters including law, accounting, finance, and business management strategy. It is this interdependent equation that makes the practice of business law so difficult yet so interesting.

The vast majority of the users of Professor Cheeseman’s book will never go to law school. Yet that same majority will be influenced every working day by the legal business entity choices made in whatever business pursuits they chose.

Sole proprietorship is still the most widely used form of business entity even though it may not be the most important in sheer economic terms. With the advent of the information highway and more emphasis on entrepreneurial niche marketing of goods and services, this form of business may enjoy a renaissance in the twenty-first century. The law of sole proprietorship is, in .

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fact, derived from a combination of property, contract, agency, and tort law doctrines. The practice of law for sole proprietorships is akin to the medical family doctor. Every sort of business issue ranging from taxes to zoning may confront this businessperson. Yet in spite of the high risk and sometimes-marginal rewards, few sole proprietors would willingly give up their personal control over their fate.

The operation of a partnership is one of the oldest recognized methods of cooperative business conduct. Many of its antecedents go back to the age of chivalry where the duties of loyalty were paramount. “All for one and one for all” was more than just a rallying cry before battle. The phrase connoted an expectation that made your acts the acts of your colleague and vice versa. A legal oneness came to be recognized between partners and the third parties with whom they dealt. Subsequent evolution of partnership law has carried forth this unity.

Modern contract law, tort law, and especially agency law all reflect this commonality when it comes to partnerships. Partners are expected to be responsible for each other’s acts in the eyes of the law. These responsibilities may not always seem fair to the layperson. Remember, however, the benefit-burden dichotomy illustrated in the law of the agency. The principal stands to gain much from the efforts of his or her agent. That gain may be offset by the costs incurred for the agent’s acts. We also see that the pendulum can swing both ways in partnership law. A partner is an agent of the partnership and yet is also a principal. Agency law dominates as the foundation of partnership law.

Given the long and sometimes tortuous entanglements that people find themselves in, maybe they should think long and hard before partnering with someone legally. Remember, both partners have a lot of latitude in contracting rights and duties between themselves, but less so visà-vis third parties under the Uniform Partnership Act. Limited partnerships remain, in many ways, the best of both worlds. They can provide the flexibility of partnership while affording limited liability exposure to investors. But as with all deals that seem too good to be true, there is no free lunch. The rules of the legal road must be strictly complied with and failure to do so leads to often severe consequences.

Investment is the key to the original notion of limited partnership. The idea was to create a middle ground between pure partnership and an entity with a totally autonomous existence.

Today’s modern laws of limited partnerships are found in two key statutes: the original 1916 Uniform Limited Partnership Act and its heir apparent, the Revised Uniform Limited Partnership Act first promulgated in 1976. Even though there are substantial differences between the two versions, they remain the same with regard to several key provisions: 1. Both call for statutory creation (as opposed to just contract creation) of limited partnerships, including the use of a certificate of limited partnership.

2. Both call for two key classes of partners to be in place: at least one general partner with unlimited traditional partner’s liability and a class of limited partners who normally can be held liable only to the extent of their capital contribution.

3. Both statutes generally limit the amount of activity a limited partner may engage in regarding the business as a price of having limited liability protections.

4. Both use the general partnership principles of the Uniform Partnership Act as a fallback position if their respective statutory requirements are not complied with.

Among other things, this chapter is designed to introduce students to four key issues in partnership law. They are the formation of a partnership, the operation of a partnership, the dissolution of a partnership, and an overview of limited partnerships. Persons entering into a partnership arrangement must do so voluntarily and with their legal eyes open to the ramifications of their bonding.

As for the dissolution of a partnership, compare its existence with that of a corporation. One of the key distinctions between the partnership form of doing business and corporate format is the corporation’s ability to have an indefinite or perpetual existence. Under state laws of incorporation, a corporation is allowed to continue its juristic existence in spite of the death of its .

Small Business, Entrepreneurship, and Partnerships 233

key players. This is not so with partnerships. Partnerships are much more personal. When the partner is gone, so is the partnership. One of the questions students frequently ask is: How is it that multinational business organizations such as large accounting or law firms stay in business as partnerships when they frequently lose partners through death or changes in partnership associations? Technically, with each of these changes, the partnership is ended, and a new one is created. A well-crafted partnership agreement should have, as one of its key components, an orderly process of succession in case of death or termination. Where these circumstances are properly planned for, the transition is seamless, and the life of the new partnership goes on where the old one left off.

Most partnerships are not, however, large and multinational in scale. Most are created and operated by individuals who have sought to capitalize on their respective economic or talent contributions by acting together in the legal sense. These business ventures could be set for a short-term, specific goal, such as erecting a building, or extend to a full professional career as a licensed practitioner of law, medicine, or accounting. We must keep in mind, however, that sometimes the best intentions involved in forming a partnership do not always work out in the strain of working with someone else.

II.

Text Materials

Entrepreneurial Forms of Conducting Business: • Sole proprietorship • General partnership • Limited partnership • Limited liability partnership • Limited liability corporation • Corporation An Entrepreneur is a person who forms and operates a new business.

Law for Business Organizations Types of Organization

Common Law

Statutory Law

Partnership

Contracts and Agency

Uniform Partnership Act (UPA)

Corporation

Contracts and Agency

Model Business Corp. Act (MBCA)

Contemporary Environment: Entrepreneurship:The Founding of Facebook Facebook was launched from a dorm room at Harvard University. It was one of the most lucrative venues for advertising on the Internet.

Advantages of a Sole Proprietorship: • The ease and low cost of formation • The owner’s right to make all management decisions concerning the business o Including those involving hiring and firing employees .

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• •

•

The sole proprietor owns all of the business and has the right to receive all of the business’s profits.

A sole proprietorship can be easily transferred or sold if and when the owner desires to do so. o No other approval (such as from partners or shareholders) is necessary There are no formalities involved in creation

Contemporary Environment: Using a “d.b.a.” to Conduct Business A sole proprietorship can operate under the names of the sole proprietor or a trade name. For the latter, most states require the filing of a fictitious name statement.

Personal Liability of a Sole Proprietor: • The sole proprietor bears the risk of loss of the business.

• The owner will lose his or her entire capital contribution if the business fails.

• The sole proprietor has unlimited personal liability.

• Creditors may recover claims against the business from the sole proprietor’s personal • assets.

The law holds that a sole proprietorship is not a distinct legal entity.

• • The sole proprietorship and the sole proprietor are one and the same.

Sole proprietorship does not pay taxes. Schedule C is used to report income/loss on owner’s income tax return Case 26.1. The Court Speaks: Vernon v. Schuster, d/b/a Diversity Heating and Plumbing, 179 Ill.2d 338, 688 N.E. 2d 1172, Web 1997 Ill. Lexis 482 (Supreme Court of Illinois) The Facts: Vernon hired Diversity to install a new boiler, which was done along with a 10-year warranty. Schuster, a sole proprietor owner of Diversity died within the 10-year warranty period.

Jerry inherited the business and ran it as a sole proprietorship. The boiler broke (without possible repair) within the warranty period. Jerry refused to honor the warranty. Upon suit by Vernon for replacement costs, the trial court dismissed but the appellate court reinstated.

Issue: Is Jerry liable for the warranty made by his father?

Decision/Remedy: No. Supreme Court of Illinois reversed the decision of the appellant court.

Reason: There is generally no continuity of existence because of the death of a sole proprietor.

Additionally, a sole proprietorship has no legal identity separate from the owner even if it is doing business under a fictitious name. Jerry’s business was basically a new sole proprietorship.

General Partnership: • A voluntary association of two or more persons for carrying on a business as co-owners • for profit.

• May be formed orally or in writing but should always have a written partnership • agreement. UPA takes over where agreement has gaps.

• Also called a partnership.

General partners or partners are personally liable for the debts and obligations of the partnership.

Sharing in profits is prima facie evidence of existence unless for some other purposes such as rent. Participation in management is important but not conclusive. .

Small Business, Entrepreneurship, and Partnerships 235

•

Partnerships do not pay taxes. Income/loss flows through to partners.

Uniform Partnership Act (UPA): • Model act that codifies partnership law.

• Most states have adopted the UPA in whole or part.

• The UPA covers most problems that arise in the formation, operation, and dissolution of ordinary partnerships.

Partner Rights: 1. Participate in management 2. Share profits (equally unless stated) 3. Not compensation but reasonable reimbursement 4. Accounting Partner Duties: 1. Loyalty a. No self-dealing b. Usurping opportunity c. Secret profits d. Breach of confidentiality e. Misuse of partnership property 2. Care 3. Inform 4. Obedience Right to Participate in Management: • Unless otherwise agreed, each partner: o Has a right to participate in the management of the partnership. o Has equal vote on partnership matters. o Under the UPA, a simple majority decides most ordinary partnership matters Tort Liability of Partnerships and Partners: • The partnership is liable if the tortious act of a partner, or employee, or agent of the partnership is committed while the person is acting within the ordinary course of partnership business or with the authority of his or her co-partners.

• Partners are jointly and severally liable for tort liability of the partnership. o That is, the plaintiff can sue one or more of the partners separately. o If successful, the plaintiff can recover the entire amount of the judgment from any or all of the defendant-partners.

Case 26.2. The Court Speaks: Zuckerman v. Antenucci, 124 Misc. 2d 976, 478 N.Y.S. 2d 578, Web 1984 N.Y. Misc. Lexis 3283 (Supreme Court of NY) The Facts: Pena and Antenucci were doctors and partners in a medical practice who both treated Zuckerman during her pregnancy. Son was born with severe physical problems. In a malpractice suit against both doctors, the jury found only Pena guilty with a $4 million verdict and a corresponding judgment was entered. The plaintiffs filed a post trial motion for judgment against both defendants.

Issue: Is Antenucci jointly and severally liable for the medical malpractice of his partner? .

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Decision/Remedy: Yes. The Supreme Court reversed the decision of the trial courts and held Antenucci jointly liable.

Reason: When a partner commits a tort, the partnership is liable, and the wrong is imputable to all the partners jointly and severally.

Liability of Incoming Partners: • A new partner who is admitted to the partnership is liable for the existing debts and obligations (antecedent debts) of the partnership only to the extent of his or her capital contribution.

• The new partner is personally liable for debts and obligations incurred by the partnership after becoming a partner.

Dissolution of Partnership: • Partnership for a term • o A partnership for fixed duration Partnership at will o A partnership with no fixed duration o A partner has the power to withdraw and dissolve the partnership at any time, but he or she may not have the right to do so.

• Wrongful Dissolution o When a partner withdraws from a partnership without having the right to do so at the time the partner is liable for damages caused by the wrongful dissolution of the partnership.

• Notice of dissolution o Notice of dissolution must be given to certain third parties. o The degree of notice depends on the relationship of the third person with the partnership.

• Winding Up o Follows dissolution unless partnership is continued.

• Continuation of a partnership after dissolution o The surviving or remaining partners have the right to continue the partnership after dissolution.

• Liability of outgoing partners o The dissolution of a partnership does not itself discharge the liability of outgoing partners for existing partnership debts and obligations.

Dissolution of Partnership: 1. By agreement 2. In breach of contract 3. By lay Notice 1. Actual—prior dealings 2. Constructive—all others Distribution of Partnership Assets: 1. Nonpartner creditors 2. Partner creditors .

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3. Capital 4. Profits Limited Partnership: Under RULPA, a certificate of limited partnership is needed.

• A type of partnership that has two types of partners: o General Partners—who invest capital, manage the business, and are personally liable for partnership debts o Limited Partner—who invest capital but do not participate in management and are not personally liable for partnership debts beyond their capital contribution • The Revised Uniform Limited Partnership: The RULPA was promulgated in 1976.

• Formation requires a certificate be filed with the state.

• The name of the Limited Partnership may normally not include the surname of a limited partner. Limited partners cannot participate in management or they will be liable as general partners.

• Can share in profits and have right to information.

• Limited partners generally have limited liability for partnership debts.

• Limited partners cannot be managers.

• Limited partners can: o Act as an agent or consultant or surety o Vote on dissolution, sale of substantially all assets, change in name, removal of general partner, enforcing the debt Summary: Liability of Limited Partners General Rule—Limited partners are not individually liable for obligations or conduct of the partnership beyond the amount of their capital contribution.

Exceptions to the General Rule—Limited partners are individually liable for debt, obligations, and tortuous acts of the partnership in three situations: 1. Defective Formation 2. Participation in Management 3. Personal Guarantee Defective Formation: Occurs when: 1. A certificate of limited partnership is not property filed, 2. There are defects in a certificate that is filed, or 3. Some other statutory requirement for the creation of a limited partnership is not met Contemporary Environment: Limited Partners Permitted to Participate in Management The RULPA permits some management. State may adopt.

Note: If there is nothing in the limited partnership agreement about how to share profits, RULPA says they are shared on the basis of the value of the partner’s capital contribution. This is also the maximum liability for a limited partner.

Contemporary Environment: Right of Survivorship of a General Partner As a tenant in partnership, they have the right of survivorship.

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Distribution of Assets of an LLP: 1. All creditors 2. Partners a. Unpaid distributions b. Capital c. Remainder Limited Liability Partnership • Has both general and limited partners • Both have limited liability (LLLP’s debt belong to the LLLP) • See state certificate of LLLP • Certificate of LLLP III.

Answers to Critical Thinking Cases

General Partnership 26.1.

Yes, a partnership was created between Smithson and the four defendants—White, Devrow, Ennis, and Morgan. The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as co-owners of a business for profit. It is not necessary that a partnership be designated as such to be created. The court held that the preponderance of the evidence showed the existence of a joint venture between Smithson and the four defendants to develop the property on Boyd Mill Pike; that they would share in the profits equally; and that Smithson would not be required to put any money into the venture. The court entered judgment for Smithson against the four defendants for $36,800, which was one-fifth of the $184,000 profit made on the sale of the property.

Note: Morgan had previously agreed to indemnify the other three partners from any claims by Smithson; the court enforced this agreement against Morgan on a counterclaim by the other partners. Smithson v. White, 1988 Tenn.App. Lexis 221 (Tenn.App. 1988).

Right to an Accounting 26.2.

A final accounting should be available and Fial apparently breached his duty to the partnership by establishing one new business with former clients without Steeby’s agreement. Steeby should win. Steeby v. Fial, 765 P.2d 1081, Web 1988 Colo. App. Lexis 409 (Court of Appeals of Colorado)

Tort Liability 26.3.

McGrath is liable. The law firm and the other partners are not liable for McGrath’s tortious conduct in shooting Hayes. The court noted that a master is responsible for the servant’s acts under the doctrine of respondeat superior when the servant acts within the scope of his employment and in the furtherance of the master’s business. Where a servant steps aside from the master’s business in order to affect some purpose of his own, the master is not liable. The court found no evidence to indicate, either directly or by inference that McGrath was acting in the scope of his employment when he shot Hayes.

There was no evidence that McGrath transacted law firm business or engaged in any .

Small Business, Entrepreneurship, and Partnerships 239

promotional activities on behalf of the law firm, and its other partners were not liable for McGrath’s tortious conduct. Hayes v. Torbenson, Thatcher, McGrath, Treadwell & Schoonmaker, 749 P.2d 178 (Wash.App. 1988) Limited Partnership 26.4.

No, the limited partners of USANL are not individually liable for the alleged breach of contract by the limited partnership. Partnership law stipulates that only general partners are individually liable for the debts of a limited partnership. Limited partners are not individually liable unless they take part in the management of the partnership or personally guarantee the performance of the partnership. The court held that in this case the limited partners did not take part in the management or control of the limited partnership, nor had they personally guaranteed the performance of the lease with the NRPA. Only the limited partnership and its general partners may be held liable to the NRPA. Note, however, that the limited partners may lose their capital contribution that they have made to the limited partnership. National Railroad Passenger Association v.

Union Station Associates of New London, 643 F.Supp. 192, 1986 U.S. Dist. Lexis 22190 (D.D.C. 1986).

Limited Partners 26.5.

No, the limited partners are not individually liable to Day. Under KY law a foreign (organized outside KY) limited partnership must register in the state. If it doesn’t, it can’t initiate litigation in KY. No other right is affected. The limited partners had no liability to Day. Virginia Partners, the limited partnership, and its general partners could be held liable to Day. Virginia Partners Ltd. v. Day 738 S.W.2d 87 (KY App.).

Limited Partnership 26.6.

Molander can only recover against the assets of the limited partnership and its corporate general and limited partners; not against Raugust personally. Here the LP was defectively formed and there was liability also on Molander’s contract. Because they are corporations, however, recovery is only against the shareholders. A personal guarantee of Raugust might have helped. Molander v. Raugust-Mathwig, Inc. 722 P.2d 103 (Wash App.)

IV.

Answers to Ethics Cases

26.7.

26.8.

There was a breach of duty and the court should appoint a receiver. After six years of management the winding-up partners had failed to liquidate the partnership. Although time alone would not necessarily establish mismanagement when combined with evidence that Moe Hankin, one of the winding-up partners, desired to buy certain partnership property at a premium, it seems reasonable to find a breach of fiduciary duty on behalf of that partner and to appoint a receiver so as to expedite the liquidation. The trial findings and decision were upheld; the superior court decision was reversed. Hankin v. Hankin, 493 A.2d 675, 1985 Pa. Lexis 337 (Pa. 1985).

The limited partners of Cosmopolitan are individually liable on the contract between the partnership and Dwinell’s Central Neon. Partnership law provides that if a limited partnership “substantially complies” with the legal requirements for organizing a limited partnership, the limited partners are not individually liable for the debts of the .

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partnership, and are only liable up to the extent of their capital contribution to the limited partnership. However, if substantial compliance is not met, the partnership is a general partnership, and the purported limited partners are individually liable as general partners.

The court held that Cosmopolitan had not substantially complied with the legal requirements for the organization of a limited partnership at the time it had entered into the contract with Dwinell’s. This was because the certificate of limited partnership had not been filed with the state until several months after the contract was signed. Obviously, the purpose of the filing requirement is to acquaint third persons, such as Dwinell’s, of the existence of the limited partnership and the limited liability of the limited partners. In this case, no filing was made at the time Dwinell’s entered into the contract, so it had no way of apprising itself of the asserted limited liability. Further, the contract only identified Cosmopolitan as a “partnership,” not as a limited partnership. The court held that there was a defective formation of Cosmopolitan as a limited partnership, and that it was a general partnership at the time the contract was signed with Dwinell’s. Therefore, the court held the purported limited partners individually liable as general partners on the debt due Dwinell’s. The limited partners did not act ethically in denying liability on the contract. They lead Dwinell’s to believe they were acting as a partnership causing the transaction to occur. Dwinell’s Central Neon v.

Cosmopolitan Chinook Hotel, 587 P.2d 191 (Wash.App. 1978).

V.

Answer to Policy Cases

26.9.

Leonard Sumter, Sr. is liable for the debt owed Thermal Supply by Michael. Under partnership law, if a partnership is dissolved, actual notice of dissolution must be given to third parties who actually dealt with the partnership. The court found that Leonard and Michael had failed to notify Thermal of the dissolution of the partnership, and that Thermal did not receive notice of this fact from any other source. The court further held that passage of one year between purchases at Thermal was not unusual in the plumbing trade because plumbers often use several sources of supplies. The court held that a creditor is not obligated to investigate or ask if a partnership is still in operation. Instead, the burden is on the partners to notify creditors with whom they have dealt that their partnership has been dissolved. The court held that Sumter’s failure to give such a notice to Thermal made Leonard liable for Michael’s debts to Thermal. Thermal Supply of Louisana, Inc. v. Sumter, 452 So. 2d 312, 1984 La. App. 8975 (La. App. 1984)

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Catalina Mortgage Co. Inc. v. Monier 166 Ariz. 71, 800 P.2d 574 (1990) Supreme Court of Arizona 2. Key Facts A. Defendant was a general partner in an organization called Coronado Industrial Investors Limited Partnership (Coronado).

B. Coronado had refinanced its property located in Tucson, AZ with plaintiff, Catalina Mortgage Co. Inc., in 1986.

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Small Business, Entrepreneurship, and Partnerships 241

C. In 1989, the plaintiff brought a collection action on the note against the defendant and claimed personal liability on the part of the defendant.

D. Defendant argued that, under the prevailing view of the Uniform Partnership Act, the plaintiff must first go against partnership property before it can go after personal assets.

E. Plaintiff claimed that Arizona law allows for an exception to that general common law rule.

3. Issue Does Arizona law create an exception to the general common law rule and allow the plaintiff to sue against the partner’s personal assets before the assets of the partnership are exhausted?

4. Holding Yes. 5. Court’s Reasoning A. Several liability rules the plaintiff go after the partner’s personal assets independently from any other joint and several partnership liability.

B. Because Arizona law created an exception to the general common law rule, this action was allowed to go forward against the partner’s personal assets without prior exhaustion of partnership assets.

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Chapter 27 Corporate Formation and Financing

Is A Corporation A Real Person?

Learning Objectives: 1. Define corporation and list the major characteristics of a corporation.

2. Describe the process of forming a corporation.

3. Describe promoters’ liability.

4. Define common stock and preferred stock.

5. Define S corporation and describe the tax benefits of this form of corporation.

I.

Teacher-to-Teacher Dialogue

Corporations can provide many advantages for business including perpetual existence, limited liability, and numerous tax and other legal opportunities to massage the system. These advantages are not free, nor are they always easily obtained. Corporate law has always been more technically intricate and demanding of legal practitioners. It can also be more unforgiving to its users than sole proprietorships or partnerships if mistakes are made in its formation and financing. The stakes are simply greater because more than 85 percent of business done in the United States uses the corporate format. This chapter has several objectives: to illustrate how the corporate form is established legally and how it is infused with funds. In addition, the process of establishing the basic ground rules for the key players will be examined.

The formation of a corporation starts with a contracting process initiated by a person called a promoter. A promoter of a new corporation is really the catalyst that brings together the diverse elements of law, finance, entrepreneurial talent, and technical competence that will eventually drive the fortunes of the new business entity. The role of promoter is also tied to the laws of contract, fiduciaries, and agency. He or she is expected to act for the benefit of the eventual corporation and can be expected to be personally liable for contracts entered into on its behalf in the interim.

The promoter’s main duties are bifurcated toward two main audiences—the state and potential investors. He or she will be involved in contracts with both of these constituencies. With regard to the state, the actual creation of the new corporate entity is the outgrowth of a document called the charter. This document is the foundation contract between the promoter and the state.

The charter takes the form of a certificate of incorporation. This certificate provides the official .

Corporate Formation and Financing 243

state-sanctioned ground rules under which the new corporate entity will be allowed to do business. Violation of these ground rules can lead to an eventual corporate death penalty, the revocation of the charter. The second critical task of the promoter is to find legal methods for the start up of the corporation so that it may be infused with funds. The corporate form is unparalleled in its ability to be a fundraiser. These funds are generated by two basic methods— debt and equity financing.

Once the proper procedures for the establishment of the corporation have been complied with and adequate financing has been secured, the next step is to see what the basic ground rules will be for key players in this arena. The leading protagonists will be the board of directors, shareholders, and managers of the corporation. The distinctions among these roles are sometimes blurred when it comes to the formation and management of corporations. Yet failure to honor these distinctions can lead to disastrous consequences.

When most people are asked about the associations they have with the word “corporation,” they think of the large companies mentioned in the financial news of the day. Usually, this group of companies will encompass those entities listed in the Fortune 500, the Dow Jones Industrial, or companies publicly traded on the New York or American Stock Exchanges. In terms of financial importance, these companies certainly do dominate the corporate landscape. The world of corporations has, however, a much less public face—the face of the closely held corporation.

Blacks Law Dictionary defines a close corporation as one where the shares are held by a single or closely knit group of shareholders. Generally there are no public investors and its shareholders are active in the conduct of the business. The vast majority of for-profit business entities using the corporate form are, in fact, closely held. Only 5 percent of all corporations are publicly traded. In the world of closely held corporations, stock ownership is not widely dispersed, and control is held in virtual perpetuity through proxies and other mechanisms within the “closed” group.

What is interesting about this two-sided (public vs. closed) corporate landscape is that, except for some special rules set out in individual state closed corporation statutes, the rules of corporate formation are virtually the same for both. The basic rights, duties, and expectations of shareholders, directors, and corporate officers are the same on paper for both large and small corporations. The reality is far different. The hows, whys, and wherefores of control over, for example G.M., are completely different from a small family business. Both entities must comply with the rules, however. Once these rules have been established in the formation process, subsequent chapters will proceed to examine the rights, duties, and liabilities of these persons not only vis-à-vis each other, but also with respect to third parties who deal with them.

Remember, most people who get in trouble with corporate law do so not because they are bad managers, directors, or shareholders. They get into trouble because they sometimes do not follow the rules of corporate formation and operation.

This chapter lends itself to the old “black letter” law approach because of the sheer volume of rules, definitions, and procedures set out in these materials. One of the most important aspects of this entire body of law is to constantly remind students that the use of the corporate form constitutes a favor, not an entitlement, in the eyes of the law. The law allows for many distinct advantages to the corporate entity; but what the law gives with one hand, it can take away with the other. How to protect those corporation-based prerequisites is really what this chapter is all about. Where the rules of the corporate law road are honored, safe passage and a restful reward are assured. Where they are not, personal liability looms near. Thus as a matter of teaching technique, it might be helpful to present this material in the following order: 1. A diagram of the corporate lines of authority.

2. The respective rights and duties of the various parties in that line of authority.

3. A listing of responsibilities and liabilities of these parties not only to each other, but also to key third parties such as shareholders and parties having a contract or tort nexus with the corporation. .

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In all three scenarios try to give case examples that illustrate the rule of law being discussed.

II.

Text Materials Characteristics of Corporations: 1. Limited liability of shareholders 2. Free transferability of shares 3. Perpetual existence 4. Centralized management

Landmark Law: Revised Model Business Corporation Act (RMBCA) The MBCA was revised in 1984.

Classifications of Corporations: Corporations are fictitious legal entities that are created according to statutory requirements. The owners are called shareholders.

• Profit Corporation o A corporation created to conduct a business for profit. o Can distribute profits to shareholders in the form of dividends.

• Nonprofit Corporation o A corporation that is formed to operate charitable institutions, colleges, universities, and other not-for-profit entities.

• Public Corporation • o A corporation formed to meet a specific governmental or political purpose.

Private Corporation • o A corporation formed to conduct privately owner business.

• Professional Corporation o A corporation formed by lawyers, doctors, or other professionals.

Publicly Held Corporation o A corporation that has many shareholders. o It’s securities are often traded on national stock exchanges.

• Closely Held Corporations o A corporation owned by one or few shareholders.

Types of Corporations: 1. Domestic—A corporation is a domestic corporation in the state in which it is incorporated.

2. Foreign—A corporation is a foreign corporation in states other than the one in which it is incorporated.

3. Alien—A corporation is an alien corporation in the United States if it is incorporated in another country.

Special People in the Corporation Life Cycle: Promoter—Organizes, negotiates and enters into advance contracts, finds initial invesors, and is liable.

Incorporators—Incorporates, registered agent, and accepts ser vice of process.

Corporate Formation and Financing 245

Selecting a State for Incorporating a Corporation A corporation can be incorporated in only one state even though it can do business in all other states in which it qualifies to do business. Most corporations choose the state in which the corporation will be doing most of its business as the state for incorporation.

Selecting a Corporate Name This explains what the organizers should do to ensure that the name selected for a corporation has not already being used by another business.

Cyber Law: Choosing a Domain Name for a Corporation Corporate name often used.

Contemporary Environment: Close Corporation Election Formed by entrepreneurs with few shareholders who often work for the corporations and manage its day-to-day operations. Many formalities are dispersed with. The model statutory close corporation supplement was added to the RMBCA. Contemporary Environment: S Corporation Election for Federal Tax Purposes This sets out the basic parameters under which the Sub-S rules of the Internal Revenue Code can be used to avoid double taxation by relatively small closely held corporations. This format does have its advantages but is limited in its utilization for small companies who hope to attract venture capital. When a company decides that it wants to grow by “going public,” this format no longer works.

Financing the Corporation: • A corporation needs to finance the operation of its business: o Equity securities (or stocks)—represent ownership rights in the corporation o Stock can be common or preferred ▪ Authorized ▪ Issued Outstanding ▪ o Debt securities—establishes a debtor–creditor relationship in which the corporation borrows money from the investor to whom the debt security is issued.

Note: Shares may be issued in exchange for cash, property, notes, services, and so on (benefit to the corporation).

Common Stock: • A type of equity security that represents the residual value of the corporation: o Common stock has no preferences. o Common stock does not have a fixed maturity date.

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o Corporations may issue different classes of common stock. o Common shareholders have limited liability.

Preferred Stock: • A type of equity security that is given certain preferences and rights over common stock: o Preferred stock can be issued in classes or series. o One class of preferred stock can be given preferences over another class of preferred stock. o Preferred shareholders have limited liability.

• Preferences/Characteristics: o Dividends o Liquidation o Cumulative o Profits o Conversion o Participating o Redeemable Types of Shares: 1. Authorized—Shares authorized in the corporation’s articles of incorporation.

2. Issued—Shares sold by the corporation.

3. Treasury—Shares repurchased by the corporation. They do not have the right to vote.

4. Outstanding—Shares of stock that are in the shareholder hands. These shares have the right to vote.

Debt Securities: • Debenture—a long-term unsecured debt instrument that is based on the corporation’s general credit standing • Bond—a long-term debt security that is secured by some form of collateral • Note—a debt security with a maturity of 5 years or less Express Powers of a Corporation: • A corporation has the same basic rights to perform acts and enter into contracts as a • physical person.

A corporation’s express powers are found in: 1. The U.S. Constitution 2. State constitutions 3. Federal statues 4. State statutes 5. Articles of incorporation 6. Bylaws 7. Resolutions of the board of directors • Generally, a corporation has the power to: o Purchase, own, lease, sell, mortgage, or otherwise deal in real and personal property o Make contacts o Lend and borrow money o Incur liabilities o Issue notes, bonds, and other obligations o Invest and reinvest funds

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o Sue and be sued in its corporate name Implied Power of a Corporation: • Powers beyond express powers that allow a corporation to accomplish its corporate purpose: o That is, a corporation has the implied power to open a bank account. o That is, a corporation has the implied power to reimburse its employees for expenses.

Ultra Vires Act: • An act by a corporation that is beyond its express or implied powers.

• Shareholders can sue for an injunction to prevent the corporation from engaging in the • act.

The corporation can sue the officers or directors who caused the act for damages.

• The attorney general of the state of incorporation can sue to enjoin the act.

Contemporary Environment: Delaware and Nevada Attract Corporate Formation More than 50 percent of publicly held corporations are incorporated in Delaware: 1. Anti-takeover statutes 2. Nevada has favorable tax laws Dissolution and Termination of Corporations: • The methods for dissolving and terminating corporations include: o Voluntary dissolution o Administrative dissolution o Judicial dissolution Winding-Up and Liquidation: • The process by which a dissolved corporation’s assets are collected, liquidated, and distributed to: o Creditors o Shareholders o Other claimants Termination: • The ending of a corporation that occurs only after the: o Winding-up of the corporation’s affairs o Liquidation of its assets o Distribution of the proceeds to the claimants International Law: Outsourcing of U.S. Jobs Many jobs are outsourced by U.S. companies to other countries, whose workers work for less than Americans. Laws and benefits are also different.

III.

Answers to Critical Thinking Cases

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Legal Entity 27.1.

Yes, Deister Corporation can be sued. Corporations are the most dominant form of business organization today. When a corporation is properly incorporated pursuant to the laws of the state of incorporation, the corporation becomes a separate legal entity for most purposes. Corporations are treated, in effect, as artificial persons created by the state that can sue or be sued in their own names. Deister was a business properly incorporated under the laws of the state of Pennsylvania. When the corporation became involved in a dispute with Sammak, Sammak decided to sue. Because the law views the corporation as a legal person for most purposes, Sammak was able to bring suit directly against the Deister Corporation. Blackwood Coal v. Deister Co., Inc., 626 F.Supp. 727, 1985 U.S. Dist. Lexis 12767 (E.D.Pa. 1985).

Corporation 27.2.

Hutchinson Baseball Enterprises, Inc., is a private, nonprofit corporation. Nonprofit corporations are formed for charitable, educational, religious, or scientific purposes.

Although nonprofit corporations may make a profit, they are prohibited by law from distributing this profit to their members, directors, or officers. Hutchinson Baseball Enterprises was formed for a charitable purpose, to promote Little League and other amateur baseball teams in Hutchinson, Kansas. Although the corporation does generate revenue from ticket sales and concession stands, this money is never distributed to Hutchinson’s officers or directors. All revenue that the corporation generates is used to fund the corporation’s activities. Because of the corporation’s nature, Hutchinson Baseball was incorporated under Kansas’s law as a nonprofit corporation. Hutchinson Baseball Enterprises, Inc. v. Commissioner of Internal Revenue, 696 F.2d 757, 1982 U.S. App. Lexis 23179 (10th Cir. 1982).

Corporation 27.3.

Florida Fashions was a domestic corporation in the state of Pennsylvania. This meant that Florida Fashions was a foreign corporation in the state of Florida, unlawfully doing business due to its failure to register. A corporation is a domestic corporation in the state in which it is incorporated. It is a foreign corporation in all other states and jurisdictions.

Foreign corporations have to qualify, that is, register, to conduct business in states other than their state of incorporation. Florida Fashions was illegally taking orders and doing business in Florida because the corporation had never qualified to conduct business in the state. Mysels v. Barry, 332 So.2d 38, 1976 Fla. App. Lexis 14341 (Fla.App. 1976).

Promoter’s Contracts 27.4.

Stern wins. Jacobson is incorrect, because a novation of the contract between the two parties did not occur. A corporation can become liable on a promoter’s contract by executing a novation. A novation is a three-party agreement whereby one party (the corporation) agrees to assume the contractual liability of another party (the promoter) with the consent of the original contracting party (the third party). When a novation is executed, the promoter is released from liability on the contract. In this case, Jacobson was the promoter who formed a contract for architectural services with Stern. Jacobson later formed a corporation, Lake Enterprises, to own and operate the new casino for which Stern was drawing plans. Although the corporation may have adopted this promoter’s contract, Stern, the third party, never gave his consent for a novation. Thus, .

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Jacobson remains liable for the contract with Stern, because a novation cannot occur without the consent of the third party. Jacobson v. Stern, 605 P.2d 198, 1980 Nev. Lexis 522 (Nev. 1980).

Preferred Stock 27.5.

The one million shares of preferred stock issued by Commonwealth Edison on June 24, 1970, were shares of redeemable preferred stock. Redeemable preferred stock (or callable preferred stock) permits the corporation to redeem, that is, buy back, the preferred stock at some future date. The terms of the redemption are established when the shares are issued. Corporations will usually redeem the shares when the current interest rate falls below the dividend rate of the preferred shares. Commonwealth Edison had set the dividend rate of the one million preferred shares higher than it wanted due to market conditions. Thus, when the market changed, Edison was able to buy back the stock for $110 a share, $10 a share more than it had to sell the shares for, because the preferred stock was redeemable. By issuing redeemable preferred stock, the corporation is able to protect itself from changing market conditions. The Franklin Life Insurance Company v.

Commonwealth Edison Company, 451 F.Supp. 602, 1978 U.S. Dist. Lexis 17604 (S.D.Ill. 1978).

Debt Security 27.6.

The most important difference between the stock issued by United Financial and the debenture bonds is that the stock represents an equity (ownership) interest in the corporation, whereas the debenture bonds do not. A debenture bond is a debt security, and as such, does not represent an ownership interest in the corporation. Instead, the corporation borrows money from an investor to whom the debt security is issued. A debenture bond is a long-term, unsecured debt instrument, which is based on the corporation’s general credit rating. Therefore, if the corporation becomes insolvent, debenture holders are paid only after the secured creditors claims are met. In this case, those investing in United Financial received both shares of stock in the company, representing an ownership interest, and a debenture bond. Although the debenture bonds paid a 5 percent interest rate, they did not represent an ownership interest in the company. Therefore, investors who bought one of the units offered by United Financial received both debt and equity securities. Jones v. H.F. Ahmanson & Company, 1 Cal.3d 93, 81 Cal.Rptr. 592, 1969 Cal. Lexis 195 (Cal. 1969).

IV.

Answers to Ethics Cases

27.7.

Yes, Goodman can be held personally liable for the renovation contract with DDS. A corporation becomes liable for a contract entered into by a promoter before the corporation was formed if it agrees to be bound by ratification, adoption, or novation.

Liability for the contract does not automatically transfer because the promoter was acting as the agent of a nonexistent principal when the contract was entered into. In this case, ratification of the promoter’s contracts was not allowed in the state of Washington, and no novation had occurred place. Therefore, if the newly formed corporation chose to be bound by the renovation contract, it would have to be by adoption. Upon adoption, the corporation becomes liable for the contract. However, the promoter remains personally liable on the contract, unless the third party agrees to release him. Because DDS did not agree to release Goodman from liability on the renovation contract, he remained .

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personally liable with the newly formed corporation. Goodman v. Darden, Doman & Stafford Associates, 670 P.2d 648, 1983 Wash. Lexis 1776 (Wash. 1983).

27.8.

V.

Neither Knoll nor Cogan owe a fiduciary duty to the debenture holders. The rights of the holder of a debt instrument are spelled out in the documents that accompany the debentures. Broad and abstract requirements of a fiduciary character ordinarily can be expected to have little or no role to play in the governance of a negotiated, commercial relationship. Simons v. Cogan, 542 A.2d 785, 1987 Del. Ch. Lexis 520 (Del. Ch. 1987).

Answer to Policy Cases

Limited Liability of Shareholders 27.9.

No, the shareholders of USM cannot be held personally liable for the suit against the corporation. One of the most important features of a corporation is the limited liability of its shareholders. As separate legal entities, corporations are liable for their own contracts, debts, and torts. In a publicly held corporation shareholders are normally not responsible for a corporation’s debts, torts, claims, or contracts. USM was a publicly held corporation. Billy was injured in the course of his employment with USM. Because USM is considered a separate legal entity, Billy’s widow must look directly to the corporation to satisfy any judgment she may seek in a torts suit against USM. Billy v. Consolidated Mach. Tool Corp., 412 N.E.2d 934, 51 N.Y.2d 152, 1980 N.Y. Lexis 2638 (N.Y.App. 1980).

V.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Johnson v. Dodgen 451 N.W. 2d 168 (1990) Supreme Court of Iowa 2. Key Facts A. The First National Bank of Humbolt, IA failed because of embezzlement.

B. Ben P. and Adeline St. John owned the bank’s controlling shares, and they were sold to Joe W. Dodgen in 1967.

C. Shortly after the sale, the sellers died, and the monthly payments were made to two trusts created to collect the payments.

D. The buyer assigned his contract to a company created after the time of the original agreement, Humboldt Realty Insurance Co., Inc., which subsequently was renamed Iowa Growthland Financial Corporation.

E. In 1982, the bank closed, but Growthland continued to make payments until 1984.

F. Subsequently, Growthland fell into default and the trusts sued Dodgen for collection.

G. Dodgen claims he is not liable based on a lack of consideration in the contract and that he had signed as an agent of Growthland.

3. Issue Did the contract have consideration, and did Dodgen assume personal liability for the contract?

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4. Holding The contract had consideration, and Dodgen is personally liable under the contract.

5. Court’s Reasoning A. There is a difference between lack of consideration and failure of consideration. In this case, there was lack of consideration, a risk of failure inherent in business contracts.

B. At the time the contract was entered into, Growthland was not in existence, so there was no agency in place. There was no evidence that the seller intended to rely on payment exclusively from a future nonexistent agent. Therefore, the promoter was personally liabile.

C. Dodgen’s counterclaim of unjust enrichment was also rejected.

D. The Iowa Supreme Court reversed the lower court holding by entering a judgment in favor of the seller-trustees for the amounts owned under the contract.

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Chapter 28 Corporate Governance and Sarbanes-Oxley Act

Who Are The People In A Corporation?

Learning Objectives: 1. Describe the functions of shareholders, directors, and officers in managing the affairs of a corporation.

2. Describe a director’s and an officer’s duty of care, and the business judgment rule.

3. Describe a director’s and an officer’s duty of loyalty and how this duty is breached.

4. Define piercing the corporate veil or alter ego doctrine.

5. Describe how the Sarbanes-Oxley Act affects corporate governance.

I.

Teacher-to-Teacher Dialogue

This chapter lends itself to the old “black letter” law approach because of the sheer volume of rules, definitions, and procedures set out in these materials. As mentioned in the overview, one of the most important aspects of this entire body of law is to constantly remind students that the use of the corporate form constitutes a favor, not an entitlement, in the eyes of the law. The law allows for many distinct advantages to the corporate entity; but what the law gives with one hand, it can take away with the other. How to protect those corporation-based prerequisites is really what this chapter is all about. Where the rules of the corporate law road are honored, safe passage and a restful reward are assured. Where they are not, personal liability looms near. Thus as a matter of teaching technique, possibly present this material in the following order: 1. A diagram of the corporate lines of authority.

2. The respective rights and duties of the various parties in that line of authority.

3. A listing of responsibilities and liabilities of these parties not only to each other, but also to key third parties such as shareholders and parties having a contract or tort nexus with the corporation.

In all three scenarios try to give case examples that illustrate the rule of law being discussed.

There are two basic theories under which most of the limitations to corporate entity and/or corporate participants’ liability are restricted or eliminated. First, public policy never has allowed the corporate form to act as a total shield from liability to third parties. From the very inception of corporate law, courts and legislators have clung to the back door option of holding someone

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personally liable where circumstances deemed it appropriate. Thus in the areas of crimes, tort, and generally undesirable behavior, a number of corporate shield-bursting mechanisms have always been in place. These have ranged from piercing the corporate veil to outright revocation of the continued existence of the corporation. In all these cases, the underlying premise is that the corporate form should not allow a person to do something that would otherwise be prohibited by public policy.

The second theory is found in the intracorporate workings of the organization itself. Just as the corporate form should not be allowed to defraud creditors and the like, so too should it not be allowed to be used by various members of corporate organizations to harm each other. The cornerstone of relationships among shareholders, directors, and officers is founded in the law of fiduciaries, loyalty, and mutual support. Even though not all aspects of these interdependent relationships could ever realistically be expected to be harmonious, some common good is expected to be interwoven into their behavior towards each other. Some of the most vociferous business battles are fought within the confines of the corporate boardrooms around the country.

Finally, congress acted quickly in 2002 when passing the Sarbanes-Oxley Act to help restore confidence in corporate governance and the market. From the PCAOB to the suggested code of ethics, many issues were addressed but it remains to be seen as to whether or not they help.

II. Text Materials Shareholders: • A corporation’s shareholders own the corporation.

• Shareholders are not agents of the corporation.

• They cannot bind the corporation to contracts.

• Shareholders have the right to vote on matters such as: o The election of directors o The approval of fundamental changes in the corporation Contemporary Environment: Cumulative Voting This explains electing directors by cumulative voting.

Shareholder’s Meetings • Annual Shareholder’s Meeting—meeting of the shareholders of a corporation that must be held annually by the corporation to elect directors and vote on other matters. o Shareholders do not have to attend the shareholders’ meeting to vote. o Shareholders may vote by proxy.

• Special Shareholder’s Meetings o Written notice of the place, day, and time of annual and special meetings is required.

Voting Requirements: • At least one class of shares of the corporation must have voting rights. o Record date o Quorum o Straight voting o Cumulative voting o Supramajoirty voting requirement

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Voting Agreements: Voting Trusts • The shareholders transfer their stock certificates to a trustee who is empower to vote the • shares.

• Agreement must be in writing and cannot exceed ten years.

Agreement must be filed with the corporation.

Shareholder Voting Agreements • Agreement between two or more shareholders agreeing on how they will vote their • shares.

These agreements are not limited in duration and do not have to be filed with the corporation.

Transfer of Shares: • Generally, shareholders have the right to transfer their shares. o Article 8 of the UCC governs transfer of securities. o Usually, shares are transferred by indorsement and delivery of the shares to the new owner.

Transfer Restrictions on Securities: • Shareholders may enter into agreements with one another to prevent unwanted persons from becoming owners of the corporation: o Right of First Refusal o Buy-and-Sell Agreement Preemptive Rights: • Rights that give existing shareholders the option of subscribing to new shares begin • issued in proportion to their current ownership interests.

Such a purchase can prevent a shareholder’s interest in the corporation from being diluted.

Right to Receive Information and Inspect Books and Records: • Shareholders have the right to be informed about the affairs of the corporation.

• A corporation must furnish its shareholders with an annual financial statement.

• Right of Inspection—a right that shareholders have to inspect the books and records of the corporation.

Dividends: • Dividends are not automatically paid to shareholders.

• Dividends are paid at the discretion of the board of directors.

• Record date—a date that determines whether a shareholder receives payment of a declared dividend.

• Stock dividend—additional shares of stock paid as a dividend.

Derivative Lawsuit: • A lawsuit a shareholder brings against an offending party when the corporation fails to • bring the lawsuit.

A derivative lawsuit will be dismissed by the court if either a majority of independent directors or a panel of independent persons appointed by the court determines that the lawsuit is not in the best interests of the corporation.

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Liability of Shareholders: • Shareholders of a corporation generally have limited liability. o Liability that shareholders have only to the extent of their capital o contributions. Shareholders are generally not personally liable for the debts and obligations of the corporation.

Piercing the Corporate Veil • A doctrine that says if a shareholder dominates a corporation and uses it for improper purposes, a court of equity can: o Disregard the corporate entity, and o Hold the shareholder personally liable for the corporation’s debts and obligations Piercing the Corporate Veil Alter Ego Doctrine 1. Thin capitalization 2. No separateness Case 28.1. The Court Speaks: Northeast Iowa Ethanol, LLC v, Drizin, Web 2006 U.S. Dist.

Lexis 4828 (2006) U.S. District Court Facts: Local farmers decided to build an Ethanol plant. They invested $2,365,000. They formed Northeast Iowa to hold the money and develop. William invested $1,000,000 and North Central invested $500,000. All money was placed in escrow and financing was needed for another $20,000,000.

Drizin formed GSI to raise the financing. He had $250 capital. Drizin got investors

but commingled funds with his own and orchestrated a process where all the funds were stolen (mostly worthless investments). Northeast sued Drizin for civil fraud. Drizin argued GSI was

liable but not him. Northeast argued that the corporate veil should be pierced.

Issue: Does the doctrine of piercing the corporate veil apply in this case?

Decision: Yes. Plaintiff was awarded $3,800,000 in compensatory damages and $7,600,000 in punitive damage against Drizin.

Reason: TheModern corporate veil mayCodes be pierced in exceptional circumstances. In Iowa this Cyber Law: Corporation Recognize Electronic Communications Most mightstates allow electronic communications to shareholders and among directors. include lack of separate books, commingling of funds, and promotion Board ofundercapitalization, Directors: of

fraud. there was undercapitalization and of separateness. The corporate veil • Here A panel of decision makers elected by thelack shareholders.

• beThe directors of a corporation are responsible for formulating the policy decision could pierced.

• affecting the corporation.

The board may initiate certain actions that require shareholders’ approval.

Selecting Directors: • Inside Director—a member of the board of directors who is also an officer of the corporation. .

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• Outside Director—a member of the board of directors who is not an officer of the corporation.

• Term of Office—the term of a director’s office expires at the next annual shareholders’ meeting following his or her election unless terms are staggered.

Meeting of the Board of Directors: • The directors can only act as a board.

• They cannot act individually on the corporation’s behalf.

• Every director has the right to participate in any meeting of the board of directors.

• Each director has one vote.

• Directors cannot vote by proxy • Regular Meeting o A meeting held by the board of directors at the time and place established by the bylaws.

• Special Meeting o A meeting convened by the board of directors to discuss new shares, merger proposals, and so on.

• Quorum o The number of directors necessary to hold a board of directors meeting or transact business of the board.

Committees of the Board of Directors: • The board of directors may create committees of the board and delegate certain powers to • • those committees.

All members of these committees must be directors.

An act of a committee pursuant to delegated authority is the act of the board of directors.

Ethics: Sarbanes-Oxley Act Imposes Responsibilities on the Audit Committee They must be members of the board and independent. They oversee accounting firms employed to audit the company. They supervise internal audit.

Business Ethics: Sarbanes-Oxley Act of 2002 Regulates accounting practices: 1. Audit committee a. Independent board members b. One financial expert 2. Public company accounting oversight board a. Five SEC appointed members b. Two CPAs c. Three Non–CPAs d. Public accounting firms must register 3. Separation of audit and nonaudit services 4. Internal control requirements 5. Disclosure of off-balance sheet items 6. Some prohibited employment Corporate Officers: .

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• Officers—employees of the corporation who are appointed by the board of directors to manage the day-to-day operations of the corporation.

• Agency Authority of Officers—officers and agents of the corporation have such authority as may be provided in the bylaws of the corporation or as determined by resolution of the board of directors. o Express authority o Implied authority o Apparent authority Duty of Obedience: • A duty that directors and officers of a corporation have to act within the authority conferred upon them by: o The state corporation statute o The articles of incorporation o The corporate bylaws o The resolutions adopted by the board of directors • Directors and officers who either intentionally or negligently act outside their authority are personally liable for any resultant damages caused to the corporation or its shareholders.

Duty of Care: • Duty of Care o A duty that corporate directors and officers have to use care and diligence when acting on behalf of the corporation.

• Negligence o Failure of a corporate director or officer to exercise the duty of care while conducting the corporation’s business.

• Business Judgment Rule o Directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment.

• Reliance on Others o Corporate directors and officers may rely on information and reports prepared by competent and reliable officers and employees, lawyers, accountants, other professionals, and committees of the board of directors.

Duty of Loyalty: • A duty that directors and officers have: o Not to act adversely to the interests of the corporation, and o To subordinate their personal interests to those of the corporation and its shareholders • Breach of the duty of loyalty usually occurs because of intentional conduct Breaches of the duty of loyalty include unauthorized: 1. Self-dealing with the corporation 2. Usurping of a corporate opportunity 3. Competing with the corporation 4. Making a secret profit that belongs to the corporation

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Case 28.2. The Court Speaks: Smith v. Van Gorkom, 488 A. 2d 858, Web 1985 Del. Lexis 421 (Supreme Court of Delaware) Facts: After a meeting with Jay A. Pritzker, Van Gorkom, acting as chairman of the board, proposed to his fellow directors that they accept a cash-out merger offer by Pritzker, and that they not solicit other offers. Although none of the directors including Van Gorkom had actually read the merger agreement, they voted to accept the Pritzker offer after listening to a twenty-minute presentation by Van Gorkom.

Issue: Did Trans Union’s directors breach their duty of care?

Decision: Yes. Reason: A corporate director is protected by the business judgment rule only if he acted (1) on an informed basis, (2) in good faith, and (3) in the honest belief that the action taken was in the best interest of the corporation. Here, all of the directors breached their duty of care by not acting on an informed basis, that is, by not reading the merger agreement they have neglected the shareholders’ interest. An ordinary person in the position of a director would have insisted upon a copy of the agreement and time to read it prior to voting.

Sarbanes-Oxley Act (2002): • Federal statute enacted by Congress to: o Improve corporate governance rules o Establish independence between public accounting firms and the public companies they audit o Eliminate conflicts of interest • Auditing and accounting rules • Corporate governance rules Ethics: Sarbanes-Oxley Act Regulates Corporate Governance Business Ethics: Sarbanes-Oxley Act of 2002 Improves Corporate Governance 1. Enron 2. Tyco 3. WorldCom Major Provisions 1. CEO and CFO Certification 2. Reimbursement of Bonus and Incentive Pay 3. No Personal Loans 4. Crime for Evidence Tampering 5. SEC Prohibition from Acting as an Officer or Director International Law: Foreign Corrupt Practices Act FCPA was enacted to prevent U.S. companies from bribing foreign officials if meant to influence.

It meant to be there for new business or the retention of continuing business.

III.

Answers to Critical Thinking Cases

Shareholders’ Meeting .

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28.1.

Yes, Ocilla can force the board of directors of Direct Action to hold the shareholders meeting at an earlier date. The purpose of an annual shareholders meeting is to elect directors, choose an independent auditor, and to take other actions. Under the MCBA, any shareholder may petition the court and obtain an order that such a meeting be held.

The last annual stockholders meeting held by Direct Action took place on September 19, 1986. The corporation did not plan for another shareholders meeting to be held until January 27, 1988, more than 16 months after the previous meeting. Under the MBCA, Ocilla, as a shareholder, can obtain a court order to compel Direct Action to hold the shareholders meeting at an earlier date. Because of the importance of shareholders meetings, the MBCA allows shareholders to force corporations to hold the meetings on an annual basis. Ocilla Industries, Inc. v. Katz, 677 F. Supp. 1291, 1987 U.S. Dist. Lexis 12741 (E.D.N.Y. 1987).

Special Shareholder Meetings 28.2.

Shoenholtz wins because the special shareholders meeting was properly called. Special shareholder’s meetings may be called by the board of directors, or by the holders of at least 20 percent of the voting shares of the corporation. Special meetings may be held to consider important or emergency issues, such as a corporate merger, or the removal of a director. The corporation is required to give the shareholders written notice of the place, day, and time of annual and special meetings. If the meeting is a special meeting, the purpose of the meeting must also be stated. Because Shoenholtz owned more than 10 percent of the voting shares of Rye Hospital, this gave him the right to request a special meeting. The notice given to Rye’s shareholders was adequate, in that it stated the time, date, and purpose of the meeting. Because the special shareholders meeting was requested by an authorized party and proper notice was given to the shareholders, the meeting was properly called. Rye Psychiatric Hospital Center, Inc. v. Shoenholtz, 476 N.Y.S.2d 339, 1984 N.Y. App. Div. Lexis 178 (A.D. 2 Dept. 1984).

Proxy 28.3.

No, Smith and Gibbons cannot reverse their proxy agreement with Zollar. A normal proxy, unless otherwise stated, is valid for 11 months. A proxy becomes irrevocable for a longer period if the proxy states that it is irrevocable, and it is coupled with an interest.

Smith and Gibbons had given Zollar a proxy that specifically stated that it was irrevocable for a period of ten years. The court held that the proxy was coupled with an interest in that Smith and Gibbons had given their proxies in exchange for Zollar’s contribution to the corporation. Smith and Gibbons were attempting to reverse their proxy after only one had passed. Because the proxy agreement was to last for ten years, and the proxy met the requirements for irrevocability, the court held that the proxies were still valid. Zollar v. Smith, 710 S.W.2d 155, 1986 Tex. App. Lexis 12900 (Tex. App. 1986).

Dividends 28.4.

Gay’s Super Markets wins the suit. The payment of dividends is at the discretion of the board of directors. The directors are responsible for determining when, where, how, and how much will be paid in dividends. Corporations often do not pay dividends, but retain profits in the corporation to be used for research expense, internal expansion, and other anticipated needs. Courts will only order a corporation to declare a dividend if the .

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directors have abused their discretion in not paying. Gay’s Super Markets’ board stated valid reasons, such as expansion, for not granting a dividend at their January, 1972 meeting. This decision was well within the board’s discretion. Because Gay’s had usually decided to retain earnings due to increased competition and planned expansion, the court did not interfere with their decision. Gay v. Gay’s Super Markets, Inc., 343 A.2d 577, 1975 M. Lexis 391 (Maine Sup. 1976).

Duty of Loyalty 28.5.

Hellenbrand wins because he can obtain an injunction to prevent Berk from leasing the club. Directors and officers of corporations owe the corporation a duty of loyalty. This duty requires that officers and directors subordinate their own personal interests to those of the corporation and its shareholders. The duty of loyalty prevents officers and directors from competing with the corporation and usurping corporate opportunities.

Berk was an officer of a corporation, and a vice-president of Comedy Cottage, Inc. Berk usurped a corporate opportunity when he arranged for the Comedy Cottage’s lease to be drawn in his own name. When this action was discovered, Berk used his former position to retain the lease and open his own Comedy Club. This new club was in direct competition with his old corporation. Because of these two actions, the court held that Berk had breached his duty of loyalty to the Comedy Cottage, and granted Hellenbrand the injunction he sought. Comedy Cottage, Inc. v. Berk, 495 N.E.2d 1006, 1986 Ill. App. Lexis 2486 (Ill.App. 1986).

Derivative Shareholder Lawsuit 28.6.

Yes, Sam Dotlich can file a shareholders derivative suit on behalf of the corporation. If someone harms a corporation, the directors of the corporation have the authority to bring an action on behalf of the corporation to recover damages or gain other relief. A shareholder may not bring a lawsuit that asserts a claim that belongs to the corporation unless: (1) the corporation has a claim against a director, officer, or some other person, (2) the shareholder has made a demand on the directors to pursue this claim, and (3) the directors have refused to pursue the claim. Sam Dotlich had the right to sue on behalf of Dotlich Brothers, Inc., because another director, Monnie Dotlich, had harmed the corporation. The harm was in the form of retaining property bought by the corporation in his own name. Sam had asked the corporation’s board of directors to take action in regards to this matter, but they had refused. The board’s refusal gave Sam the right to file a shareholders derivative suit. Dotlich v. Dotlich, 475 N.E.2d 331, 1985 Ind. App. Lexis 2233 (Ind. App. 1985).

IV.

Answers to Ethics Cases

Duty of Loyalty 28.7.

Chelsea wins and can recover from Gaffney and his partners. Directors and officers of a corporation owe a duty of loyalty to the corporation. Part of this duty is to not compete with the corporation, unless full disclosure of the competing activity is made, and a majority of the disinterested shareholders approve of the activity. Directors and officers cannot use the facilities, personnel, or funds of the corporation for their own benefit. The corporation can recover any profits made by the nonapproved competition and any other damages caused to the corporation. Gaffney and his partners were all officers of Ideal. .

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Gaffney and the others set up a competing business without informing the corporation or its shareholders. They also used Ideal’s assets and facilities to build their own business and recruit customers for it. These actions by Gaffney and the other officers constituted a breach of their duty of loyalty to Ideal, and the corporation was able to recover damages from them. Chelsea Industries, Inc. v. Gaffney, 449 N.E.2d 320, 1983 Mass. Lexis 1413 (Mass. Sup. 1983).

28.8.

V.

The District Court correctly found Farms to be the alter ego of Chemicals. First, Farms did not have a separate financial existence. The $10,000 investment created a thin corporation (diaphanous) that depended upon its parent Chemical for transfusions of working capital. Second, the nature of the loans to Farms from Chemicals reveals that whenever Farms could not pay its debts Chemicals wrote a check for payment. There were no corporate resolutions authorizing these extraordinary “loans.” Third, the use of Chemicals’ offices and computers justify the district court’s finding of joint use and ownership of property. Finally, regardless of whether the fraudulent papers were signed

by Thomas as Farms’ President or Thomas as Chemical’s the corporate entity was appropriately disregarded. Observance of corporate formalities is only one aspect of corporateness; by itself it does not create a separate existence for an entity. United States of America v. Jon-T Chemicals, Inc., 768 F.2d 686, 1985 U.S. App. Lexis 21255 (5th Cir. 1985).

Answers to Policy Cases

Piercing the Corporate Veil 28.9.

Yes, Watters can be held personally liable, because Wildhorn Ranch, Inc., was merely his alter ego. When a shareholder dominates a corporation and does not maintain any separation between himself and the corporation, that corporation is merely his alter ego.

When this occurs, the shareholder may be held personally liable for the corporation’s debts and obligations. A shareholder may be held liable if the corporation fails to follow the necessary formatting required by applicable statutes, such as holding shareholders meetings, and keeping minutes of these meetings. In this case, Watters dominated the affairs of Wildhorn Ranch, Inc., and ran the corporation without observing any of the necessary corporate formalities. Watters paid Wildhorn’s debts with money from his other corporations, kept no minutes of shareholders meetings, and held the meetings in his living room. Because Watters failed to separate himself from the corporation, he was found liable for the corporation’s torts and other debts. Geringer v, Wildhorn Ranch, Inc., 760 F.Supp. 1442, 1988 U.S. Dist. Lexis 1570 (D. Colo. 1988).

V.

Answer to “Briefing the Case” Writing Assignment:

1. Case name, Citation, and Court United States v. WRW Corp.

986 F2d 138 (1993) United States Court of Appeals for the Sixth Circuit 2. Key Facts A. Defendants were the sole owners of a coal-mine operation doing business as WRW Corporation, a Kentucky corporation.

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B. The WRW Corporation went out of business in 1985 after having been found in violation of safety standard set out in the Federal Mine Safety and Health Act. Those violations resulted in the deaths of two miners.

C. All three of the co-owners were found criminally liable and served prison sentences.

D. Additional civil penalties in the amount of $90,350 were imposed against WRW E. The defendants claim limited liability because of the corporate status of WRW. F. Plaintiff asked that the corporate veil be pierced and that the owners be held personally liable for the fines.

G. The lower court held for the plaintiffs.

3.

Issue Should the corporate veil be pierced and the owners of WRW Corporation be held personally liable?

4. Holding Yes. 5. Court’s Reasoning A. Using the factors of under capitalization and failure to follow corporate existence formalities, the lower court found that these factors could be used under Kentucky law to pierce the corporate veil.

B. There was no evidence of an “alter ego,” that is, there was a complete merger of ownership and control of WRW with the individual defendants.

C. The lower court’s holding, which pierced the corporate veil, was upheld.

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Chapter 29 Corporate Acquisitions and Multinational Corporations

How Can Corporations Combine?

Learning Objectives: 1. Describe the process of soliciting proxies from shareholders and engaging in proxy contests.

2. Define shareholder resolution and identify when a shareholder can include a resolution in proxy materials.

3. Describe the process for approving a merger or share exchange.

4. Define tender offer and describe poison pills, greenmail, and other defensive maneuvers to prevent hostile takeover.

5. Examine the use of multinational corporations in conducting international finance.

I.

Teacher-to-Teacher Dialogue

These materials lend themselves to two levels of presentation. The first is the law level that lays out the basic rules vis-à-vis mergers, acquisitions, and termination of corporations. Given the constant time management choices teachers of undergraduate business law courses have to make, reaching this first plateau should suffice. But opportunities abound when it comes to corporate combinations. The second level involves the much broader socioeconomic debate that gave birth to the Law and Economics Movement. Both of these great academic disciplines have had dramatic effects on the formulation of public policy. These debates have tended to look like the old cart-horse dilemma. Many economists argue that the laws of supply and demand are “natural,” and as such, should not be encumbered by a labyrinth of law that only imposes artificial barriers to that reality.

Traditional law views an unfettered economic drive as little more civilized than a mere law of the jungle where only the most vicious survive. This side argues that unrestricted business tends toward monopolies and economic subjugation. The possibilities for stimulating student debate on these issues are virtually endless. As Clarence Darrow once said: “The problem in business, and in life, has always been to preserve freedom without monopoly … we have solved it as we do most questions by taking both courses at the same time.”

The world of corporate combinations through mergers and the like has been turned upside down in recent history. Several factors have contributed to the frenzy of activity on the street, not all of it well motivated. As with so many of these sort of fundamental changes to how society

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orders its affairs, there is no one underlying motive or rhyme or reason to it, and arguments pro and con can be heard from the halls of academia to Wall Street.

The proponents for changes first argue mergers, takeovers, and consolidation are simply marketplace adjustments that reflect attempts to correct inefficiencies in the marketplace.

Where a company is poorly managed, running on “cruise control,” and is not sufficiently lean and mean, it should be swallowed up by more efficient competitors. This view literally adopts the law of the jungle where only the strong survive. The Law and Economics Movement proponents argue that the mechanisms of the law should not only allow this natural business evolution to take place, but that to stifle it would do harm to society in the end.On the other side of the coin, a number of commentators have argued that runaway activity in the areas of mergers, acquisitions, buyouts, and the like breed a whole new generation of unethical, short-term thinking, financial charlatans whose only real self-interest is their personal bank accounts. Critics of the merger phenomenon point to the endless game-playing going on in this arena. They argue that what has been created is a big time casino where the chips are bigger than ever. Out of that gaming mentality, the larger society has had to pay for numerous financial scandals because the original players were not really motivated by the long-term good of society.

In addition, long-term growth, research, and development of essential business fundamentals have been cast aside in the name of greenmail, corporate spin-offs, tax manipulation, and golden parachutes. The net result of this sort of short-term thinking is that although the financial market manipulators are playing high stakes poker, our industrial, financial, and transportation infrastructure has sunk into a quagmire of noncompetitiveness on the world marketplace.

The truth probably lies somewhere in between these poles when it comes to business combinations. Time will ultimately tell if recent history has reflected a transition cost to stay competitive as a nation, or if we are frittering away our industrial base at the gaming table.

However it all turns out, each and every one of us will ultimately share in the ultimate benefit or burden.

II.

Text Materials

Business Combinations 1. Merger: A + B = A a. Friendly combinations 2. Consolidation: A + B =C 3. Acquisition: A + B =A = B a. Hostile takeovers Proxy Solicitation: • Corporate shareholders have the right to vote on the election of directors, mergers, and • charter amendments.

They can exercise their power to vote either in person or by proxy.

• Proxy Card—a written document signed by a shareholder that authorizes another person to vote the shareholder’s shares.

The SEC has adopted certain rules that apply to proxy solicitations and proxy contests. Proxy Statements with all information must be filed with the SEC. Under the 1934 Act fraud is prohibited. A proxy contest involves a challenge by insurgent shareholders.

Shareholder Resolutions Submitted to other shareholders for consideration. .

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1. Need 1,000 shares 2. Less than or equal to 550 words 3. Business Concerns SEC Ethics: Coca-Cola says “No” to a Shareholder Resolution A sample shareholder resolution is displayed.

Merger and Acquisitions: • Occurs when one corporation is absorbed into another corporation and ceases to exist.

• The surviving corporation gains all the rights, privileges, powers, duties, obligations, and • liabilities of the merged corporation.

The shareholders of the merged corporation receive stock of securities of the surviving corporation as provided in the plan of merger.

Contemporary Environment: Google Acquires YouTube Google believes that YouTube’s video sharing site will provide a marketing opportunity.

Consolidation: • Occurs when two or more corporations combine to form an entirely new corporation.

• The new corporation is called the consolidated corporation.

• The article of incorporation of the new corporation replace the articles of incorporation of the component corporations.

Share Exchange: • When one corporation acquires all the share of another corporation.

• Both corporations retain their separate legal existence.

• After the exchange, one corporation (parent corporation) owns all the shares of the other • corporation (subsidiary corporation).

Often used to create holding companies.

Note: Need for consolidated financial statements Required Approvals for Combination 1. Board Recommendation 2. Affirmative Majority Shareholder Vote a. Dissenters b. Appraisal Right Tender Offer: • An offer that an acquirer makes directly to a target corporation’s shareholders in an effort • to acquire the target corporation.

The tender offeror’s board of directors must approve the offer. .

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•

o The shareholders do not have to approve.

The tendering corporation and the target corporation retain their separate legal status.

The Williams Act The Williams Act regulates tender offers.

Tender Offer Rules 1. Twenty days before closing the offer 2. Ten day extension if increase in number or money 3. Fair price rule to all 4. Pro rata rule 5. No fraud Defensive Strategies and Tactics Against Hostile Tender Offers: • Persuasion of Shareholders • Delaying Lawsuits • Selling a Crown Jewel • Adopting a Poison Pill • White Knight Merger • Pac-Man (or reverse) Tender Offer • Issuing Additional Stock • Creating an Employee Stock Ownership Plan (ESOP) • Flip-Over and Flip-In Rights Plans • Greenmail and Standstill Agreements Explanation of Defensive Strategies 1. Crown Jewel—Sell good assets 2. Poison Pill—Built-in contract provisions (e.g., mergers) 3. White Knight—Mergers with friendly parties 4. Pac-Man—Tender offer on tender offeror 5. Greenmail and Standstill—Payment for agreeing to abandon tender offer Business Judgment Rule: • A rule that protects the decisions of the board of directors, who act on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the corporation and the shareholders.

• In the context of a tender offer, the defensive measures chosen by the board must be reasonable in relation to the threat posed.

Ethics: Target Company Management’s Defensive Tactics Violate Their Fiduciary Duty QVC made a hostile takeover bid to Paramount (Viacom had originally made a friendly offer) Paramount : 1. Included a no-shop provision (unlawful) 2. Included a lock-up option (illegal) 3. Had certain poison pills (dishonorably) Viacom won the battle with QVC. .

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Paramount Communications, Inc. v. QVC Network, Inc. The Facts: Viacom and Paramount announced a friendly merger in September 1993. Five days later QVC made a $90 hostile bid for Paramount that topped Viacom’s merger offer. Paramount’s board adopted anti-takeover strategies including a no-shop provision, a lock-up option in favor of Viacom, and poison pill strategies. QVC sued alleging Paramount’s board had breached their fiduciary duties to the corporation and its shareholders. The court agreed with QVC. Issue: Do the defensive tactics adopted by Paramount’s board of directors violate their fiduciary duties?

Decision/Remedy: The court invalidated Paramount’s no-shop provision and lock-up option.

They held that once a Delaware corporation has put itself in plan, it must remove all poison pills as to all possible bidders and put itself up for auction to be purchased by the highest bidder.

State Anti-Takeover Statutes: • Statutes enact by state legislatures that are aimed at protecting corporations that are either • incorporated in or doing business with the state from hostile takeovers.

Many of these statues have been challenged as unconstitutional because they violate the Williams Act and the Commerce and Supremacy clauses of the U.S. Constitution.

Case 29.1. The Court Speaks: CTS Corporation v. Dynamics Corporation , 481 U.S. 69, 107 S.Ct. 1637, 95L. E9. 2d 67, Web 1987 U.S. Lexis 1811 (Supreme Court of the United States) Facts: Dynamics Corporation of America (Dynamics) announced a tender offer of one million shares of CTS that would give it 27.5 percent of CTS’s stock. Because the acquisition of more than 20 percent of the stock of an Indiana Corporation triggers the Indiana Control Share Acquisition Act and because Dynamics would lose its right to vote its shares, Dynamics challenged the Act in federal court alleging violation of the Williams Act and the Commerce Clause.

Issue: Does the Indiana Control Share Acquisition Chapter conflict with the Williams Act or violate the Commerce Clause by unduly burdening interstate commerce?

Decision: No, it does not violate the federal laws.

Reason: A basic purpose of the Williams Act was to place investors on an equal footing with the takeover bidders. The Indiana Act protects shareholders from coercive tender offers. The Williams Act does not preempt the Indiana Act because they are consistent and Congress did not indicate an intention to preempt state law.

Laws regulating corporate governance necessarily affect certain aspects of interstate commerce. However, states traditionally have been given the power to create corporations, to prescribe their powers, and to define the rights acquired by purchasing corporate shares. It is an accepted part of the business landscape and does not violate the Commerce Clause.

Multinational Corporations 1. Subcontracting with independent firms in host countries 2. Wholly-owned foreign branches and subsidiaries 3. International multinational firms International Law: India’s Multinational Corporations

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International Law: International Branch Office and Subsidiary Corporation These discuss the ways in which a corporation can conduct business in a foreign country.

International Law: Foreign Acquisitions of U.S. Companies That Would Impair National Security Are Prohibited Exxon-Florio Foreign Investment Provision prohibits investment by foreign investors that might threaten “national security”.

III.

Answers to Critical Thinking Cases

Proxy Contest 29.1.

The Gladwins win. The court held that Medfield Corporation’s proxy materials contained multiple instances of material misstatements and material omissions of fact in violation of Section 14(a) of the Securities Exchange Act of 1934 and the applicable proxy disclosure rules adopted by the Securities and Exchange Commission. The court held that Medfield had (1) failed to disclose the nature and extent of Medfield’s liabilities, (2) failed to disclose self-dealing by a director, and (3) unlawfully impugned the character, integrity, and personal reputation of a rival candidate for office. The court ordered a new election. It also directed that Medfield’s new proxy solicitation materials include corrections of all illegal misstatements and omissions, a statement that prior solicitations were in violation of Section 14(a) and SEC proxy rules, and an explanation that the resolicitation was the result of a lawsuit. Gladwin v. Medfield Corporation, 540 F.2d 1266, 1976 U.S. App. Lexis 6548 (5th Cir. 1976).

Merger 29.2.

Yes, the shareholders of Plant Industries, Inc., must be accorded dissenting shareholder appraisal rights regarding the sale of Plant National (Quebec) Ltd. Delaware state law requires that a sale of all or substantially all of a corporation’s property and assets requires not only the approval of the corporation’s board of directors but also a resolution adopted by a majority of the outstanding stockholders of the corporation. Whether a sale of assets constitutes a sale of substantial corporate assets is a question of fact. This is defined as a sale of assets that is quantitatively vital to the operation of the corporation and is out of the ordinary, and substantially affects the existence and purpose of the corporation. The court held that the proposed sale of Plant (Quebec) met this definition.

This was because this subsidiary constituted more than 50 percent of the assets, sales, and net income of Plant Industries, its parent corporation. Therefore, the vote of the shareholders of Plant Industries, required before the sale of this subsidiary could take place. The court issued an injunction preventing the sale of the subsidiary until it was approved by a majority of the outstanding shareholders.

Also, under Delaware law, where there is a sale of substantially all of the assets of a corporation, the shareholders are accorded dissenting shareholder appraisal rights.

Therefore, in this case, if a majority of the shareholders vote to approve the sale of the subsidiary, dissenting shareholders who properly object to the sale and timely require appraisal rights may require the court to appraise the value of their stock. Katz v.

Bregman, 431 A.2d 1274, 1981 Del. Ch. Lexis 449 (Del.Ch. 1981).

Dissenting Shareholder Appraisal Rights .

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29.3.

No, John Bershad may not obtain dissenting shareholder appraisal rights. To obtain appraisal rights, a dissenting shareholder must (1) file a written objection to the merger prior to the vote of shareholders, (2) not vote in favor of the proposed merger, and (3) make a written demand for payment of his shares. Failure to comply with these statutory procedures results in loss of appraisal rights.

In this case, Bershad failed to comply with the statutory requirements. He failed to make a written objection to the merger prior to the vote of shareholders, he tendered his shares for the merger and received payment for his shares, and he failed to make a written demand for payment of his shares. The court held that because Bershad did not meet the statutory procedure, he did not qualify to bring an action to recover dissenting shareholder appraisal rights or any other remedy. Bershad v. Curtiss-Wright Corporation, 535 A.2d 840, 1987 Del. Lexis 1313 (Del. 1987).

Tender Offer 29.4.

Mobil Corporation wins. The court held that Marathon Oil Company had violated Section 14(e) of the Williams Act. Section 14(e) prohibits fraudulent, deceptive, and manipulative practices in connection with tender offers. The court held that both the stock option and Yates Field option that Marathon granted to U.S. Steel was a fraudulent, deceptive, and manipulative practice in violation of Section 14(e).

First, the stock option was fraudulent in that it gave U.S. Steel the right to purchase 30 million shares of Marathon common stock for $90 per share. This was fraudulent because it was below the fair market value of the stock, which was currently around $125 per share. This stock option violated Section 14(e) because it subsidized U.S. Steel’s purchase of Marathon. No other suitor, particularly Mobil, was given this same right.

Second, the Yates Field option which gave U.S. Steel the irrevocable right to purchase Marathon’s interest in Yates Field for $2.8 billion if a third party gained control of Marathon violated Section 14(e). This was because the fair market value of Marathon’s interest in the Yates Field was worth up to $3.6 billion. This is called selling the “crown jewel” because Marathon was selling one of the most important assets that attracted Mobil to make the tender offer for Marathon’s share in the first place.

The court held that both the stock option and Yates Field option granted by Marathon to U.S. Steel violated Section 14(e) of the Williams Act. The court ordered that U.S. Steel’s $125 per share offer be kept open for a reasonable time but free of the inhibiting and unlawful impact of these two options. Note: U.S. Steel acquired Marathon Oil through a tender offer and follow-up merger. Mobil Corporation v. Marathon Oil Company, 669 F.2d 366, U.S. App. Lexis 14958 (6th Cir. 1981).

Poison Pill Defense 29.5.

Household International, Inc., wins. The court held that the “flip-over” Rights Plan adopted by the directors of Household did not violate the business judgment rule. The court cited the fact that the Plan was adopted to ward off future advances and was not adopted in reaction to a specific threat. Thus, the court held that such preplanning for the contingency of hostile takeover reduces the risk that, under the pressure of a takeover bid, management will fail to exercise reasonable judgment.

The court also held that the Plan was reasonable because it was not absolute. That is, the consequences of the Rights Plan can be avoided if the potential takeover company negotiates with the management of Household regarding the terms of a merger or other .

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form of acquisition. Further, the court held that the proxy contest was for control of Household. The court held that there was no showing of bad faith on the part of Household’s directors who receive the benefit of the business judgment rule in their adoption of the Rights Plan. In addition, the court held that Household demonstrated that the Rights Plan was reasonable in relation to the threat posed. Moran v. Household International, Inc., 500 A.2d 1346, 1985 Del. Lexis 557 (Del. 1985).

State Antitakeover Statute 29.6.

The court held that Wisconsin’s anti-takeover statute was lawful and did not conflict with the federal Williams Act or violate the Commerce Clause of the U.S. Constitution. The Court of Appeals reached this decision by applying the reasoning used by the U.S. Supreme Court in upholding a state antitakeover statute in CTS Corporation v. Dynamics Corporation of America, 481 U.S. 69, 107 S. Ct. 1637 (1987).

The court in the present case held that the Williams Act regulates the process of tender offers, that is, timing, disclosures, proration, best price rule, and such. None of these provisions are violated by the Wisconsin act; it does not alter any of the procedures governed by federal regulation. The court also held that the Wisconsin act does not unduly burden interstate commerce. It is an accepted part of the business landscape in this country for states to create corporations, prescribe their powers, and regulate their internal affairs. Wisconsin has done no more than that in this case. The court held that the Wisconsin anti-takeover statute did not conflict with the Williams Act or violate the Commerce Clause of the U.S. Constitution. Amanda Acquisition Corporation v.

Universal Foods, 877 F.2d 496, 1989 U.S. App. Lexis 9024 (7th Cir. 1989).

IV.

Answers to Ethics Cases

29.7.

Yes, the actions of Fruehauf’s management violated the business judgment rule.

The business judgment rule requires management of a company to act in good faith and in the best interests of the corporation’s shareholders. Management must not put their personal interests before those of the company’s shareholders. In this case, the court held that the management and directors of Fruehauf violated the business rule in the following respects: 1. The payment of a breakup fee to Merrill Lynch—which was payable even if the management-led MBO was not misuse of the corporation’s funds. This was really a payment by competing management-led MBO to Merrill Lynch out of the corporate treasury.

2. The “no shop” agreement violated Fruehauf management’s responsibility to shareholders to find the best and highest price for their shares. This can hardly be done when management has agreed not to look for a higher bidder to compete with their own bid for the company.

3. Fruehauf management’s continued preference for their own bid over that of the Edelman group by giving Merrill Lynch information not given to the Edelman group was a violation of their duty to give all suitors an equal opportunity to bid for the company.

4. Granting such lucrative “golden parachutes” to themselves, which would be triggered by their own bid for the company and used as their equity investment to purchase the company, violated their fiduciary duty to the shareholders.

The court held that all of the actions by Fruehauf’s management were a breach of their fiduciary duties to shareholders and a violation of the business judgment rule. The .

Corporate Acquisitions and Multinational Corporations 271

court enjoined Fruehauf management from instituting their actions. Edelman v. Fruehauf Corporation, 798 F.2d 882, 1986 U.S. App. Lexis 27911 (6th Cir. 1986).

29.8.

V.

Realist is not liable to Royal. The court of appeals held that although Section 14(a) gives a normal shareholder the right to sue incumbent management for alleged false and misleading statements in management’s proxy materials, a proxy contestant does not have this same right even though the contestant is a shareholder in the target corporation.

The court stated that giving a proxy contestant a private right of action for damages would not advance the underlying purpose of Section 14(a), that is, to protect normal shareholders from fraudulent conduct. The court also found no causal nexus between Royal’s alleged injury and Realist’s secret merger negotiations with Ammann. The court stated, “The only injury the plaintiffs suffered was caused by their involvement as combatants in an election they won—but one where, in retrospect, they would rather not have entered.” Royal Business Group, Inc. v. Realist, Inc., 933 F.2d 1056, 1991 U.S. App. Lexis 10389 (1st Cir. 1991).

Answer to Policy Cases

29.9. The committee wins. Yes, the Medical Committee’s proposed shareholder resolution could be stated in terms to meet the requirements of Section 14(a) to be included in Dow Chemical’s proxy materials. If a shareholder meets the ownership requirements of Section 14(a) (which the Committee met), he has a right to place a proposal in the proxy materials of the corporation if the proposal relates to the corporation’s business, concerns a policy issue and not the day-to-day operations of the corporation, and does not solely relate to a social or religious purpose.

In this case, Dow Chemical was manufacturing napalm, a chemical substance that was used as a defoliant in Vietnam during the Vietnam conflict. Napalm, which was often dropped from airplanes, caused damage to humans who were burned by it and those who were exposed to it. There was substantial public criticism and demonstration against Dow for making napalm. In addition, many young people of college age refused to work for Dow because of its manufacture of napalm.

These reasons—the bad publicity and inability to recruit young professionals— were sufficient to support the Committee’s request to include its shareholder proposal in Dow’s proxy materials. In addition, the Committee could have also asserted that Dow’s manufacture of napalm made it susceptible to product liability lawsuits by those injured by it. Each of these are reasons that the Committee could have asserted to support the inclusion of its shareholder proposal in Dow’s proxy materials. Merely stating that the making of napalm violated the Commission’s credo for the concern for human life would not be sufficient to require the proposal to be included in Dow’s proxy materials.

Medical Community for Human Rights v. Securities and Exchange Commission, 432 F.2d 659, 1970 U.S. App. Lexis 8284 (D.C.Cir. 1970).

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Neal v. Alabama By-Products Corp.

No. 8282, 1990 Del. Ch. Lexis 127 (1990) Court of Chancery of Delaware

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2. Key Facts A. The defendant (ABC), a Delaware corporation, was engaged in coal mining and related businesses in the 1970s and 1980s.

B. ABC had issued two classes of stock: “A” with voting rights, and “B” without voting rights.

C. Drummond, an Alabama corporation, made several attempts to acquire and merge with ABC starting in 1977 and culminating with a merger in 1985.

D. Minority shareholders of ABC were offered a price of $75.60/share, and they claimed that value was too low and sought to assert their appraisal rights under Sec. 262 of Title 8 of the Delaware Code.

E. Both sides presented their respective appraisals.

3.

Issue Under Delaware laws regarding corporate valuation methods, which of the two appraisals most fairly represents fair market value on August 13, 1985?

4. Holding The valuation preferred by the minority shareholders most closely approximated the fair market value on August 13, 1985.

5. Court’s Reasoning A. Both sides used appropriate valuation techniques, but differed substantially regarding the underlying assumptions related to the valuations.

B. Both sides agreed on the use of the discounted future returns model and a net asset model.

C. Based on the use of the common techniques coupled with the court’s acceptance of certain assumptions, the Court of Chancery of Delaware arrived at its own value of $180.67/share.

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Chapter 30 Limited Liability Company and Limited Liability Partnership

How Can We Get The Best Of Both Worlds?

Learning Objectives: 1.

2.

3.

4.

5.

I.

Define limited liability company (LLC) and limited liability partnership (LLP).

Describe the process of organizing LLCs and LLPs. Describe the limited liability shield provided by LLCs and LLPs. Compare member-managed LLCs and manager-managed LLCs. Determine when members and managers owe fiduciary duties of loyalty and care to an LLC. Teacher-to-Teacher Dialogue

The advent of limited liability companies in our system of jurisprudence reflects a synthesis of both something new and something old. Various forms of limited liability companies have been used in other parts of the world for many years. For example, Germany is considered to be the latest country to add this form of doing business, and its enabling statute is “only” a century old.

What is it, then, that kept U.S. jurisprudence from adopting this form of business for so many years? In a word: taxes. More specifically, the specter of double taxation on corporations held back the implementation of limited liability companies. Traditional interpretations of state laws allowing for limited liability focused on corporate laws. As such, the possibility for legitimate tax structure avoidance was severely limited to the rules and regulations covering “Sub-S” corporations. Subchapter S was first added to the Internal Revenue Code in 1958 and has undergone numerous revisions and updates since. The essence of these provisions has been to allow a corporation to avoid double taxation only under very limited constraints outlined in Internal Revenue Code § 1361, et al.

With increasing pressures to attract more overseas capital and investment into the United States, a number of states decided to create new forms of business entities. They would not only be familiar to overseas investors who were already comfortable with the limited liability company, but also gain the Internal Revenue Service imprimatur for being taxed like a

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partnership and still provide limited liability to all participants in the entity. Wyoming was the first to venture forth in heralding the modern era of L.L.C. laws in the United States.

In 1977, Wyoming passed its L.L.C. law, and in 1978, the I.R.S. issued its Revenue Ruling (Rev.Rul.88-76, 1988-2 C.B.360), which accorded partnership tax treatment to the Wyoming L.L.C. This was the first of many rulings on similar statutes adopted by virtually all states. The I.R.S. subsequently adopted the “check-the-box” and the rest is history.

Because of all the possible permutations that have evolved since this opening foray into limited liability company laws, the demand for a uniform statute was not unexpected. This chapter focuses on the main element of the Uniform Limited Liability Company Act and revisions as promulgated by the National Conference of Commissioners on Uniform State Laws.

This act, in effect, seeks to “marry” the best elements of agency, partnership, and corporate law into a format that allows for uniformity and predictability on these issues throughout the United States. As with any major turn in the process of legal evolution, we are witnessing a work in progress. The final product is far from complete, but it surely has come a long way in a generation.

As we have seen in earlier chapters, business entity choices are strategic decisions based on a number of factors. These elements include choosing the best options for potential capital investment and financing growth, protection from personal liability, and tax planning. No one entity format is ideal for all objectives. However, recent trends have led to the use of the limited liability company format as the best vehicle for providing the “best of both worlds”—the single- layered conduit taxation of proprietorships and partnerships with the limited personal liability accorded to shareholders of a corporation.

II.

Text Materials

Limited Liability Company (LLC): • An incorporated business entity that combines the most favorable attributes of general • partnerships, limited partnerships, and corporations.

• An LLC may elect to be taxed as a partnership.

• The owners can manage the business.

• The owners have limited liability.

• Limited liability companies are creatures of state law, not federal law.

Limited liability companies can only be created pursuant to the laws of the state in which the LLC is being organized. o Limited liability company codes regulate the formation, operation, and dissolution of LLCs. • Legal Entity—An LLC is a separate legal entity (an artificial person) that can: o Own property o Sue and be sued o Enter into and enforce contracts o Be found civilly and criminally liable for violations of law The Uniform Limited Liability Company Act (ULLCA): • A model act that provides comprehensive and uniform laws for the formation, operation, • • and dissolution of LLCs. The ULLCA is not law unless a state adopts it as its LLC statue.

Many states have adopted all or part of the ULLCA as their limited liability company law.

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Limited Liability Company and Limited Liability Partnership 275

Member’s Limited Liability: • Member—an owner of an LLC. • Members have limited liability.

• Members are liable for the LLC’s debts, obligations, and liabilities only to the extent of • their capital contributions.

• The debts, obligations, and liabilities of an LLC are solely those of the LLC. A member is personally liable if he or she personally guarantees repayment of the debts of the LLC. Case 30.1. The Court Speaks: Siva v. 1138 LLC, 2007 Ohio 4667, Web 2007 Ohio App. Lexis 4202 (2007) Court of Appeal of Ohio Facts: Written agreement was signed by 1138 LLC allowing Siva to rent space in her building to operate a bar. Default and breach occurred after 6 months. Hess, a member was sued personally but argued he had limited liability as a member of the LLC. Issue: Is Richard Hess, a member of 1138 LLC, personally liable for the debt owed by the LLC to Siva?

Decision: No. Siva’s complaint against Hess was dismissed.

Reasons: There was no intended undercapitalization nor formation to avoid the situation. They became insolvent due to unprofitable operations. There was no intent to do fraud. Siva knew that he was dealing with an LLC.

Liability of Managers: • Mangers of LLCs are not personally liable for the debts, obligations, and liabilities of the LLC they manage. [ULLCA 303(a)] Liability of an LLC 1. Loss or injury from an act or omission of (within course of business or with authority of LLC) a. Member b. Agent c. Manager d. Employ 2. Managers not personally liable for debts of LLC 3. Tortfeasors (members and managers included) liable for injuries personally caused Taxation of LLC 1. Taxed as a partnership unless it elects to be taxed as a corporation 2. Avoids double taxation Powers of an LLC: • An LLC has the same powers as an individual to do all things necessary or convenient to carry on its business or affairs: o The power to own and transfer personal property o Sell, lease, and mortgage real property o Make contracts and guarantees .

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o Borrow and lend money o Issue notes and bonds o Sue and be sued Formation of an LLC: • Most LLCs are organized to operate businesses and real estate developments.

• An LLC can be organized in only one state even though it can conduct business in other • states.

The name selected must meet the requirements of the LLC codes of the states that are under consideration.

Articles of Organization: • An LLC is formed by delivering articles of organization to the office of the secretary of • • state of the state of organization for filing.

The existence of an LLC begins when the articles of organization are filed.

The filing of the articles of organization by the secretary of state is conclusive proof that an LLC has been created.

Duration: • At-Will LLC—an LLC that has no specified term of duration • Term LLC—an LLC that has a specified term of duration Capital Contribution: • Members Capital Contribution—may be money, tangible or intangible property, services performed or promised to be performed, promissory notes, or other agreements to provide cash or property.

• A member’s obligation to contribute capital is not excused by the member’s death, disability, or other inability to perform.

Certificate of Interest: • Document that evidences a member’s ownership interest in an LLC • Acts the same as a stock certificate issued by a corporation Operating Agreement: • An agreement entered into among members that governs the affairs and business of the • LLC and the relations among members, managers, and the LLC. The operating agreement may be amended by the approval of all the members unless otherwise provided in the agreement.

Conversion of an Existing Business to an LLC: • Some existing businesses (i.e., general partnerships, limited partnerships, and corporations) may want to convert to an LLC. o Want to obtain the tax benefits and limited liability shield of an LLC o The law permits such conversions • Agreement of Conversion—document that states the terms for converting an existing business to an LLC. • The conversion takes effect when the articles of organization are filed with the secretary • of state or at any later date specified in the articles of organization.

Terms of conversion must be approved. .

Limited Liability Company and Limited Liability Partnership 277

Dividing an LLC’s Profits and Losses: • Unless otherwise agreed, the ULLCA mandates that a member has the right to an equal • share in the LLC’s profits. [ULLCA 405(a)] This is a default rule that members can override by agreement and is usually a provision in their operating agreement.

Distributional Interest: • A member’s ownership interest in a LLC that entitles the member to receive distributions • of money and property from the LLC. A transferee of a distributional interest in an LLC receives the right to receive profit and other distributions of the LLC. Contemporary Environment: Dreamworks SKG, LLC This discusses a major LLC, Dreamworks SKG, formed by Steven Spielberg, Jeffrey Katzenberg, and David Geffen.

Member-Managed LLC: • In a member-managed LLC, all members can bind the LLC to authorized contracts.

• Each member has equal rights in the management of the business irrespective of the size • of his or her capital contribution.

Any matter relating to the business of the LLC is decided by a majority vote of the members.

Manager-Managed LLC: • In a manager-managed LLC, only the managers can bind the LLC to authorized • • contracts.

The members and nonmembers who are designated managers control the management of the LLC. The members who are not managers have no rights to manage the LLC unless otherwise provided for in the operating agreement.

Compensation and Reimbursement: • A nonmanager member is not entitled to remuneration for services performed for the • • LLC (except for winding-up LLC).

Managers of an LLC are paid compensation and benefits as specified in their employment agreements with the LLC. An LLC is obligated to reimburse members and managers for payments made on behalf of the LLC. Agency Authority to Bind an LLC to Contracts: • Member-Managed LLC o In a member-managed LLC, all members can bind the LLC to authorized contracts.

• Manager-Managed LLC o In a manager-managed LLC, only the managers can bind the LLC to authorized contracts.

Fiduciary Duties .

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Duty of Loyalty Owed to an LLC: • A duty owed by a member of member-managed LLC and manager-managed LLC to be honest in his or her dealings with the LLC and not to act adversely to the interests of the LLC. Breaches of the duty of loyalty by a covered member or manager include: 1. Usurping an LLC opportunity 2. Making secret profits 3. Secretly dealing with the LLC 4. Secretly competing with the LLC 5. Representing any interest adverse to the of the LLC Note: A nonmanager member of a manager-managed LLC owes no fiduciary duty to the LLC. Limited Duty of Care Owed to an LLC: • A duty owed by a member of a member of member-managed LLC and a manager of a manger-managed LLC to not engage in conduct that injures the LLC: o A known violation of law o Intentional conduct o Reckless conduct o Grossly negligent conduct • A member or manager of an LLC is not liable to the LLC for injuries caused to the LLC • by his or her ordinary negligence.

The ordinary negligent member or manager, and the LLC on whose behalf the member or manager was acting when the negligent act occurred, are liable to the injured third party.

No Fiduciary Duty Owed by a Nonmanager Member: • A nonmanager member of a manger-managed LLC owes no fiduciary duties of loyalty, • care, or good faith and fair dealing to the LLC or its members.

Basically, a nonmanager member of a manager-managed LLC is treated equally to a shareholder in a corporation.

Contemporary Environment: Advantages of Operating a Business as an LLC 1. Any number of members owners 2. Flow-through taxation (No IRS form) 3. Types of shareholders are greater than S-Corps 4. Can have nonresident alien member-owner 5. Can have more than one class of stock 6. Can be 100 percent of business 7. Members can manage and still have limited liability 8. Can be owned by one owner in most states 9. As hard to form as a corporation

Dissolution of LLC: • The ULLCA gives a member of an LLC the power todisassociatehim- or herself from the LLC. .

Limited Liability Company and Limited Liability Partnership 279

This could cause the dissolution of the LLC. A member who wrongfully disassociates from an LLC is liable to LLC and to the other members for any damages caused by his or her wrongful disassociation.

• Wrongful disassociation can give rise to damages. Otherwise distribution and interest paid.

• Statement of disassociation can give constructive notice if filed.

• LLC can be continued: o Unanimous vote prior to expiration o Majority vote at will LLC • •

Winding-Up an LLC’s Business: • The process of preserving and selling the assets of the LLC and distributing the money • • and property to creditors and members.

Creditors are paid first.

Thereafter, surplus amounts are distributed to members in equal amounts unless the operating agreement provides otherwise.

Articles of Termination: • Document that is filed with the secretary of state (of the state in which the LLC is organized) that terminates the LLC as of the date of filing or upon a later effective date specified in the document.

Limited Liability Partnership (LLP) 1. No general partner needed (all are limited partners)—limited liability 2. Often state-restricted 3. “Flow through” tax benefits 4. Need articles of partnership 5. Liability insurance often required Contemporary Environment: Accounting Firms Operate as LLPs The LLP was particularly created for accountants, lawyers, and other professionals to offer their services under an umbrella of limited liability.

III.

Answers to Critical Thinking Cases

In this section, Professor Cheeseman has developed 10 critical thinking case scenarios. Unlike the typical critical thinking cases in other chapters, these cases are all fictional. They cover various issues dealing with limited liability companies. All would make great teaching tools for this chapter. Also, it is important for you to check the Website for this text (http://www.prenhall.com/cheeseman) as some of these fictional issues become real and are decided by the courts.

IV.

Answers to Business Ethics Cases

In this section, Professor Cheeseman has developed two ethics case scenarios. Unlike the typical ethics cases in other chapters, these cases are all fictional. They cover various issues involving limited liability companies. They are great teaching tools for this chapter. Also, it is important for

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you to check the Website for this text (http://www.prenhall.com/cheeseman) as some of these fictional ethics issues become real and are decided by the courts.

V.

Answers to Policy Cases

30.9.

Bone, an LLC member, was not liable. Plaintiffs were held liable to sanctions imposed for improperly naming Bones as a defendant. Page v. Rosco, LLC., 128 N.C. Appl. 78, 497 S.E. 2d 422, Web F98 N.C. App Lexis 169 (Court of Appeals of North Carolina)

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Catalina Mortgage Co. Inc. v. Monier 166 Ariz. 71, 800 P.2d 574 (1990) Supreme Court of Arizona 2. Key Facts A. Defendant was a general partner in an organization called Coronado Industrial Investors Limited Partnership (Coronado).

B. Coronado had refinanced its property located in Tucson, AZ with plaintiff, Catalina Mortgage Co. Inc., in 1986.

C. In 1989, the plaintiff brought a collection action on the note against the defendant and claimed personal liability on the part of the defendant.

D. Defendant argued that, under the prevailing view of the Uniform Partnership Act, the plaintiff must first go against partnership property before it can go after personal assets.

E. Plaintiff claimed that Arizona law allows for an exception to that general common law rule.

3. Issue Does Arizona law create an exception to the general common law rule and allow the plaintiff to sue against the partner’s personal assets before the assets of the partnership are exhausted?

4. Holding Yes. 5. Court’s Reasoning A. Several liability rules the plaintiff go after the partner’s personal assets independently from any other joint and several partnership liability.

B. Because Arizona law created an exception to the general common law rule, this action was allowed to go forward against the partner’s personal assets without prior exhaustion of partnership assets.

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Chapter 31 Franchise and Special Forms of Business

Why Do You Want To Own A Franchise?

Learning Objectives: 1.

2.

3.

4.

5.

I.

Define franchise and describe the various forms of franchises.

Describe the rights and duties of the parties to a franchise agreement.

Identify the contract tort liability of franchisors and franchisees.

Define licensing and describe how trademarks and intellectual property are licensed.

Describe how international franchising, joint ventures, and strategic alliances are used in global commerce.

Teacher-to-Teacher Dialogue

Franchises are a way of doing business around the world. The objective of this chapter involves an introduction to the concept of franchising. The world of franchising combines concepts of marketing, management, finance, and many other diverse skills into a special kind of cooperative venture that is facilitated through the law. Like any “business marriage,” it can lead to the best of all worlds or the worst. Careful planning, skilled research, and, most of all, a good faith willingness to let each participant do what he or she does best appears to be the key to today’s most successful franchise operations. Under the franchise system, there is ample evidence of the positive effects of good franchise planning. The original basic technology, patent, process, or other trademarked service or product is allowed to reach many more users or consumers through a franchise system. With intelligent planning and quality control, the original franchisor of the product or service can see phenomenal growth through the use of equity-sharing participants in that growth.

Witness the fast-food industry, convenience stores, food product production, all sorts of consumer good retailing systems, or even professional sports teams. All of these industries rely on the franchise concept to further their businesses.

Another interesting aspect of franchising is its tie to basic capitalism for the little guy. With sufficient start-up capital and a willingness to provide a lot of personal effort, the franchising concept allows the small businessperson to ride the coattails of the goodwill, advertising, and technology developed by large multinational enterprises.

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There are some down sides to franchising as well. The “get rich quick” mentality of franchising has led to a number of abuses on the part of would-be franchisors. Many people have lost substantial sums of money trying to invest in pie-in-the-sky sales of bogus franchises. In addition, the franchise industry has seen more than its share of pyramid schemes, shallow capitalizations, adhesion contracts, and similar behavior in violation of the antitrust laws. It is interesting to note that many of the rules promulgated by the Federal Trade Commission are designed to protect persons about to enter into franchise agreements rather than the ultimate consumer of the franchise’s goods or services.

In addition, the franchise device has not always served the third party well. Because a franchisee is an independent contractor, the franchisor is not normally responsible to third parties for torts or contracts that the franchisee has been involved with. That may sound well and good in legal terms, but does it always make equitable sense? If the consumer of the goods or services thought he or she was dealing with a megacorporation, why not hold a megacorporation responsible rather than just its franchisee? Possibly have the students consider this as they proceed.

II.

Text Materials

Franchising: • An important method of distributing goods and services to the public.

• In the United States, franchising accounts for more than 25 percent of retail sales and 15 percent of gross domestic product (GDP) Joint Ventures allow two or more businesses to combine their resources to pursue a single project.

Licensing permits one business to use another business’s intellectual property in selling goods or services.

Franchise: • •

Established when one party licenses another party to use the franchisor’s trade name, trademarks, commercial symbols, patents, copyrights, and other property in the distribution and selling of goods and services.

Generally, the franchisor and the franchisee are established as separate corporations.

Advantages to Franchising: 1. The franchisor can reach lucrative new markets.

2. The franchisee has access to the franchisor’s knowledge and resources while running an independent business.

3. Consumers are assured of uniform product quality.

Types of Franchises: Distributorship Franchise • The franchisor manufactures a product and licenses a retail franchisee to distribute the • product to the public.

For example, the Ford Motor Company manufactures automobiles and franchises independently owned dealers to sell them to the public.

Processing Plant Franchise • The franchisor provides a secret formula or process to the franchisee. .

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• •

The franchisee manufactures the product and distributes it to retail dealers.

For example, the Coca-Cola Corporation licenses regional bottling companies to manufacture and distribute soft drinks under the “Coca-Cola” and other brand names.

Chain-Style Franchise • The franchisor licenses the franchisee to make and sell its products or distribute services • • to the public from a retail outlet serving an exclusive territory.

Most fast-food franchises use this form.

For example, the Pizza Hut Corporation franchises independently owned restaurant franchises to make and sell pizzas to public under the “Pizza Hut” name.

Area Franchise • The franchisor grants the franchisee a franchise for an agreed-upon geographical area.

• The franchise may determine where to locate the outlets in the designated area.

• An area franchisee may be granted the authority to negotiate and sell franchises in the designated area on behalf of the franchisor. o Franchisee is also called the subfranchisor.

State Disclosure Laws: • Many states have enacted statues that require franchisors to make specific presale • disclosures to prospective franchisee.

Some states use a uniform disclosure statement called the Uniform Franchise Offering Circular (UFOC).

Federal Trade Commission’s (FTC) Rule • The FTC requires franchisor’s to make presales disclosures to prospective franchisees.

• The franchisor must disclose assumptions underlying any estimates and hypothetical • data.

The franchisor must provide a mandated precautionary statement.

• Special disclosure required if: o Projections made based on actual figures of an existing franchise o Projections based on hypothetical FTC Franchise Notice FTC notice must appear in at least 12-point boldface type on the cover of a franchisor’s required disclosure statement to prospective franchisees.

Intellectual Property Issues 1. Registration of trademarks and service marks under Landham Trademark Act 2. Unauthorized use equals trademark infringement 3. Misappropriation of trade secret is unfair competition Franchise Agreement: • An agreement that the franchisor and the franchisee enter into that sets forth the terms and conditions of the franchise: o Quality control standards o Training requirements o Covenant not to compete .

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•

o Arbitration clause o Use of franchisor’s trade name, logo, and trademark o Conditions for the termination of the franchise o Territory o Licensing of IP o Required Payments Can be terminated for cause

Franchise Fees: • Franchise fees payable by the franchise are usually stipulated in the franchise agreement: o Initial license fee o Royalty fee o Assessment fee o Lease fee o Cost of supplies Breach of the Franchise Agreement: • A lawful franchise agreement is an enforceable contract.

• Each party owes a duty to adhere to and perform under the terms of the franchise • agreement.

If the agreement is breached, the aggrieved party can sue the breaching party to rescission of the agreement, restitution, and damages.

Trademarks: • A franchisor licenses the use of its trademarks and service marks to its franchisees in the • • franchise agreement.

Anyone who uses a mark without authorization from the franchisor may be sued for trademark infringement.

The franchisor can recover damages and obtain an injunction prohibiting further unauthorized use of the mark.

Misappropriation of Trade Secrets: • Anyone who steals and uses a franchisor’s trade secret is liable for misappropriation of a • trade secret.

The franchisor can recover damages and obtain an injunction prohibiting further unauthorized use of the trade secret.

Contract and Tort Liability: • Franchisors and franchisees are liable for their own contracts.

• Franchisors and franchisees are liable for their own tort liability.

• That is, if a person is injured by franchisee’s negligence, the franchisee is liable.

Independent Contractor Status: • If properly organized and operated, the franchisor and franchisee are separate legal • entities.

The franchisor deals with the franchisee as an independent contractor. o A franchisee is not the agent of the franchisor. o The franchisor is not liable for the franchisee’s contracts and torts. .

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Case 31.1.The Court Speaks: Martin v. McDonald’s Corp., 572 N.E. 2d,1073, Web 1991 Ill. App Lexis 715 (Court of Appeals of Illinois) Facts: This case arose from a murder and robbery that took place after closing hours at the McDonald’s restaurant in Oak Forest, Illinois, on November 29, 1979. On that evening, a sixwoman teenaged crew was working to clean up and close the restaurant. Laura Martin, Therese Dudek, and Maureen Kincaid were members of that crew. A person later identified as Peter Logan appeared in the back of the restaurant and ordered the crew into the refrigerator and the assistant manager, Therese Dudek, to open the safe and get him money. In the course of moving the crew into the refrigerator, Laura Martin was shot and killed, and Maureen Kincaid and Therese Dudek were assaulted by Logan. Laura Martin’s parents claimed damages from McDonald’s Corporation for the wrongful death of their daughter, and Therese Dudek and Maureen Kincaid claimed damages for the negligent infliction of emotional distress. The trial court awarded damages to all three victims, and McDonald’s Corporation appealed.

Issue: Is McDonalds liable for negligence?

Decision: McDonald’s was negligent for not making sure that security deficiencies it found at the Oak Forest franchise had been corrected.

Reason: McDonald’s had voluntarily assumed a duty to the crew at the Oak Forest franchise by establishing and requiring the franchisee to implement certain security measures, and by obligating itself to inspect the restaurant to see that the required security measures were implemented. The court held that McDonald’s was liable for its own negligence due to the failure of security measures and the failure of its employee, Carlson, to follow up to determine that the security deficiencies at the Oak Forest franchise had been corrected.

Ethics Spotlight: Franchiser Found Liable Under the Doctrine of Apparent Agency This discusses sales by a franchised licensee of non-franchise products.

Termination “For Cause”: • A franchisor can terminate a franchise agreement for “just cause”. o For example, nonpayment of franchise fees by the franchisee o For example, continued failure to meet quality control standards Termination at Will: • Prevents franchisor from taking advantages of the good will developed at the franchise • location by the franchisee.

Most state and federal laws regarding franchising prohibit franchisors from terminating the franchises at will.

Case 31.2.The Court Speaks:Dunkin’ Donuts of America, Inc. v. Middletown Donut Corporation, 495A 2d 61, Web 1985 NJ Lexis 2369 (Supreme Court of NJ) Facts: Smothergill entered into two franchise and lease agreements with Dunkin Donuts (DD).

DD notified Smothergill of termination due to intentional underreporting of gross sales (4.9 percent of which was the basic franchise fee and 2 percent of which was an advertising fee.

Smothergill made no attempt to cure as permitted in the agreement. DD sued. The trial court permitted DD to terminate the franchise agreements. Smothergill appealed.

Issue: Were the franchise agreements properly terminated “for cause” by DD? Decision: Yes. The decision to terminate was affirmed. .

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Reason: Smothergill was “guilty of unconscionable cheating”. The underreporting of gross sales involves cheating the franchisor and all other franchisees.

Wrongful Termination: • If a franchisor terminates a franchise agreement without just cause, the franchisee can sue • the franchisor for wrongful termination.

The franchisee can recover damages caused by the wrongful termination and recover the franchise.

Licensing Party that owns the intellectual property (Licensor) permits another to use (Licensee) in the distribution of goods, services, software, and digital information.

Joint Venture Two or more business entities combine to pursue single project or transaction. Joint venturers (fiduciary duty of loyalty) equal rights to manage unless otherwise agreed.

Strategic Alliance Two or more companies (potential competitors) in the same industry agree to ally themselves to accomplish a designated objective.

Note: In a joint venture partnership, each joint venturer is liable for the debts and obligations of the joint venture partnership. In a joint venture corporation, the joint venturers are shareholders of the joint venture corporation.

International Law: Franchising in Global Markets There is no question that international franchising has become the most visible form of economic cooperation around the world. Laws of other countries must, however, be considered.

III.

Answers to Critical Thinking Cases

Franchise Agreement 31.1.

H & R Block wins. The court held that June and Robert McCart had violated the covenant not to compete that was part of the franchise agreement with H & R Block.

First, the court held that the covenant not to compete was reasonable in scope (tax preparation), time (for two years after termination of the franchise), and place (250 miles from the location of the franchise). Second, the court determined that although Robert had not signed the franchise agreement, he was still bound by its terms. The court reasoned that Robert had acted together with June to breach her agreement with Block and that he had knowingly participated in and aided June’s violation of the agreement.

The court found that the opening of the new office under Robert’s name was a mere subterfuge designed to avoid June’s obligations under the franchise agreement.

The court held that the covenant not to compete was an enforceable provision of the franchise agreement that had been entered into between the parties. The court found that H & R Block had a valuable property right in its service mark, which was heavily advertised nationally, and that customers were attracted to the franchise office because of .

Franchise and Special Forms of Business 287

the company’s name recognition and goodwill. By including the covenant not to compete in its franchise agreements, Block preserved the value of this property right to itself alone after termination of the agreement. The court held that the McCarts had violated the covenant not to compete and issued an injunction enforcing provisions of the covenant. McCart v. H&R Block, Inc., 470 N.E.2d 756, 1984 Ind. App. Lexis 3039 (Ind.App. 1984).

Franchise Agreement 31.2.

No, McDonald’s is not liable for breaching the franchise agreement with LibbyBroadway Drive-In, Inc. (Libby). When McDonald’s granted a franchise to a third party to operate a franchise restaurant on the west side of Turney Road, the franchise agreement granted Libby an exclusive territory in which the westernmost boundary was simply described as “Turney Road.” The court held that even assuming by this description the parties intended that Libby’s exclusive territory should extend to the western edge of Turney Road, it is undisputed that the new franchise is located to the west of that boundary. Therefore, the granting of this franchise did not infringe upon the exclusive territory granted to Libby in the franchise agreement. The court held that McDonald’s had not breached the franchise agreement, and affirmed the trial court’s grant of summary judgment in favor of McDonald’s. Libby-Broadway Drive-In, Inc. v.

McDonald’s System, Inc., 391 N.E.2d 1, 1979 Ill. App. Lexis 2698 (Ill.App. 1979).

Franchisor Disclosure 31.3. Dowmont, the franchisee, wins on its counterclaim against My Pie International, Inc. (My Pie). The court held that My Pie had violated the Illinois Franchise Disclosure Act when it granted the franchise to Dowmont to operate the restaurant in Glen Ellyn, Illinois, because My Pie had failed to register with the state of Illinois or to qualify for an exemption from registration, and had failed to provide proper disclosures to Dowmont as required by the act.

The Illinois Franchise Disclosure Act provides for a private cause of action to persons who have been harmed by a franchisor’s noncompliance with the act. The court held that My Pie’s violations of the act permitted Dowmont to rescind the franchise agreement and recover the royalties it had paid to My Pie during the course of the franchise. The court of appeals remanded the case to the trial court for determination of the royalty damages to be awarded to Dowmont.

Note: If My Pie had violated the disclosure requirement of the Federal Trade Commission Disclosure Rules (FTC Rules), the government could have sued My Pie, alleging a violation of the federal law. The FTC rules do not, however, provide for a private cause of action. Therefore, Dowmont could not have sued My Pie to rescind the franchise agreement and recover damages under the FTC Rules. My Pie International, Inc. v. Dowmont, Inc., 687 F.2d 919, 1982 U.S. App. Lexis 16537 (7th Cir. 1982).

Tort Liability 31.4.

The trial court jury held the Seven-Up Company liable for the carton breaking and the Seven-Up bottle exploding, causing blindness in one of Sharon Koster’s eyes; the jury awarded her $150,000 in damages against Seven-Up. The law provides that a franchisor, like a manufacturer or supplier, may be liable to the consumer for its own negligence.

Seven-Up alleged, however, that it could not be held liable for Koster’s injuries because it did not manufacture, handle, or require its franchisee, Brooks, to use the cartons .

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manufactured by Olinkraft, Inc. The court rejected this argument, holding that a franchisor that retains the right to control the design of the product may be held liable for any injury that product may cause.

The court stated: In this case, the Seven-Up Company not only floated its franchisee and the bottles of its carbonated soft drink into the so-called “stream of commerce.” The Company also assumed and exercised a degree of control over the “type, style, size, and design” of the carton in which its product was to be marketed. The carton was submitted to Seven-Up for inspection. With knowledge of its design, Seven-Up consented to the entry in commerce of the carton from which the bottle fell, causing the injury. The franchisor’s sponsorship, management, and control of the system for distributing Seven-Up, plus its specific consent to the use of the carton, in our view, places the franchisor in the position of a supplier of the product for purposes of tort liability.

The court of appeals held that the case had been properly submitted to the jury based on the theory of breach of implied warranty. However, the court of appeals found that the trial court judge had given the jury an improper instruction regarding the doctrine of “inherently dangerous” products, and remanded the case for a new trial. Kosters v.

Seven-Up Company, 595 F.2d 347, 1979 U.S. App. Lexis 15945 (6th Cir. 1979).

Trademark 31.5.

Ramada Inns wins. The court held that Gadsden Motel Company (Gadsden) had infringed on Ramada Inns’ trademarks and service marks by its unauthorized use of such marks. The franchise agreement granted Gadsden, the franchisee, a license to use the “Ramada Inns” marks during the course of the franchise. However, when Ramada Inns properly terminated the franchise agreement with Gadsden on November 17, 1983, Gadsden lost the right to use the Ramada Inns trademarks and service marks. Evidence showed, however, that Gadsden continued to use the “Ramada Inns” marks for at least six months past that date. Therefore, the court found that Gadsden had engaged in trademark infringement in violation of the Lanham Act. The court of appeals affirmed the trial court’s judgment which awarded Ramada Inns $47,165 in trademark infringement damages, $29,610 in lost franchise fees for the six-month “hold over” period, $15,000 for advertising to restore Ramada Inns’ good reputation, and $20,000 in attorney fees. Ramada Inns, Inc. v. Gadsden Motel Company, 804 F.2d 1562, 1986 U.S. App Lexis 34279 (11th Cir. 1986).

Termination of a Franchise 31.6.

The dealership wins. The court found that Kawasaki USA had wrongfully terminated the franchise held by Kawasaki Shop of Aurora (Dealer). Illinois franchise law provides that a franchise agreement may not impose “unreasonable” restrictions on motor vehicle dealers. The court held that the site-control provision in the franchise agreement that required the franchisor’s written approval before the franchisee could relocate within its exclusive territory was an unreasonable restriction in violation of the law. The court cited evidence that Kawasaki USA had objected to the move because the dealer was creating a multiline franchise location from which it would sell Honda, Suzuki, and Yamaha motorcycles as well as Kawasaki motorcycles. The court held that a multiline franchise dealership was expressly permitted by the franchise agreement. Thus, Kawasaki was wrongfully using the site-control provision to violate the multiline dealership provision .

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in the franchise agreement. Based on the evidence, the court held that Kawasaki USA had wrongfully terminated the Dealer and awarded the Dealer $323,690 as compensatory damages and $79,422 in attorney fees. Kawasaki Shop of Aurora, Inc. v. Kawasaki Motors Corporation, U.S.A., 544 N.E.2d 457, 1989 Ill. App. Lexis 1442 (Ill.App. 1989).

IV.

Answers to Business Ethics Cases

31.7.

Campbell was not an agent of Southland. Only Campbell managed the day-to-day activities of the store: she hired and fired employees, and set their wages; and the contract provided that the relationship was one of independent contractor. The only evidence of agency is the fact that the liquor license was issued to “Campbell Valerie Southland #13974,” but this is simply an identification of the licensee as a franchisee of Southland. The license was not issued to Campbell and Southland. The issue of agency is a matter of fact. Here, the factfinder determined that there was no agency relationship and that finding is supported by substantial evidence. Wickham v. The Southland Corporation, 168 Cal. App. 3d 49, 213 Cal. Rptr. 825, 1985 Cal. App. Lexis 2070 (Cal. App. 1985).

Trademark 31.8.

KFC should win. Diversified infringed upon and tarnished KFC’s trademark Kentucky Fried Chicken Corporation v. Diversified Container Corporation, 549 F.2d 368, 1977 U.S. App. Lexis 14128 (5th Cir. 1977).

31.9.

Answers to Policy Cases The Cost Mesa franchise was not an agent of Southland and not liable. The franchises are independent contractors in fact and in law. They have complete control over all employee issues. Cislaw v. Southland Corp., 4 Cal. App. 4th 1284, 6 Cal. Rptr. 2d 386, Web 1992 Cal. App. Lexis 375 (Court of Appeal of California)

VI.

Answer to “Briefing the Case” Writing Assignment:

V.

1. Case Name, Citation, and Court Little v. Howard Johnson Co. 455 N.W. 2d 390 (1990) Court of Appeals of Michigan 2. Key Facts A. Plaintiff was injured in a fall on a sidewalk that she contends was not adequately cleared of ice and snow.

B. The sidewalk was located on the premises of a franchisee that operated a Howard Johnson restaurant.

C. The trial court found in favor of Howard Johnson, the franchisor, because it had no control over the property. The circuit court reversed.

3. Issue Is Howard Johnson liable for the harm to the plaintiff under either a theory of direct liability or agency law? .

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4. Holding No. 5. Court’s Reasoning The Court of Appeals of Michigan agreed with the original holding of the district court that the defendant was not liable because: A. Howard Johnson had no agency-based liability because it had no actual day-to-day control over the premises in question.

B. There was no genuine evidence of fact that an apparent agency existed.

C. The original ruling of the district court in favor of Howard Johnson was reinstated.

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Chapter 32 Investor Protection, E-Securities Transactions, and Wall Street Reform

Why Do We Have To Protect The Market?

Learning Objectives: 1. Describe the procedure for going public and how securities are registered with the Securities and Exchange Commission.

2. Describe the requirements for qualifying for private placement, intrastate, and small offering exemptions from registration.

3. Describe insider trading that violates Section 10(b) of the Securities Exchange Act of 1934.

4. Describe the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act that increases investor protection and extends regulation to previously unregulated institutions and investments.

Describe online securities transactions.

5.

I.

Teacher-to-Teacher Dialogue

One of the most unfortunate aspects of our overly litigious society is the notion that the government must somehow “cover” every loss. Witness the current costs of the so-called S & L bailout, which has already achieved the dubious distinction of being this country’s most costly financial debacle. I do not mean to say that we should allow every innocent depositor to suffer the losses incurred by the managers of these institutions. Nor can we afford to allow our financial institutions to lose their foundations of reliance and trust. The government does have a proper role and duty to support this financial infrastructure. But should the rules remain the same for stock investors as opposed to depositors? Many commentators argue that when investment choices are made, these choices should bring a higher degree of awareness and risk.

It is risk that must be fully emphasized at the outset of these materials. No government, no agency, no set of statutory protections can immunize a stock investor from the basic economic reality of stock investment—risk of loss. This risk was there before the Great Depression, and will be there no matter how many SECs we create. .

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Assume a sporting event were to be contested under the following conditions: a. All the players were well trained. b. The rules of the game were fully explained to the players. c. Those rules are fairly and evenhandedly applied to the players. d. An even playing field is used as a site for the contest.

With all these suppositions in place, can you rest assured your team will win? Or can you hope that, win or lose, your team was engaged in a fair contest?

In the broadest sense, the buying and selling of securities is similar to an athletic event. Each participant goes into the game with his or her own self-interest in mind. And all the fair rules in the world will not change one essential truth of these or any other contests—there will be winners and there will be losers. That reality must always be kept in mind from the outset by anyone seeking to make his or her fortune through the sale or purchase of securities. Risk is inherent in the nature of this activity, and anyone who fails to appreciate that simple fact should not be there in the first place.

It is most difficult for professionals to master the ins and outs of the financial markets, let alone the casual investor. Yet the lure of playing this game is so strong that every year millions of people invest hard-earned money with nothing more than high hopes and a prayer. Securities law was designed to at least give some substance to those hopes and prayers. That substance is public information upon which investment choices can be rationally made. These laws are not designed to assure a win in this high-risk game, but rather to provide a more even playing field.

The great financial stock market crash of 1929 and the ensuing Depression brought on by that calamity brought to the fore the need to create a greater governmental role in securities markets. Prior to that period, the sale of stocks in corporations remained essentially unregulated except for the common law doctrines of fraud and the like. Manipulative and unscrupulous trading practices coupled with a lot of hopes and prayers all pointed to a need for a better set of ground rules by which this game could be played.

The basic rules of the game go back to the Securities Act of 1933 and the Securities Exchange Act of 1934 that created the Securities and Exchange Commission. Over the years, the Commission’s role has greatly increased with the advent of new technologies like programmed trading and the need to expand its regulatory framework into the financial services arena. Because of recent scandals in this sector of the economy, a number of new white-collar crimes have been added to the government’s arsenal for dealing with abuses.

All in all, it has made the specialized practice of securities law or SEC accounting more difficult, yet more challenging, than ever.

II.

Text Materials

Purpose of Securities Laws 1. Information Disclosure 2. Prevention of Fraud SEC (Federal) Sarbanes Oxley Act of 2002: Bring more transparency to securities market and eliminate conflicts of interest.

Dodd-Frank Wall Street Reform and Consumer Protection Act: Regulate hedge funds, derivatives, and abusive practices.

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Landmark Law: Federal Securities Laws

Securities Act of 1933: primarily regulate issuance of securities; applies to original issue Securities Act of 1934: prevent fraud in subsequent trading of securities (includes insider trading and online trading) Definition of Security: • A security must exist before securities laws apply.

• Securities are defined as: o An interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant. o An interest or instrument that is expressly mentioned in securities act o An investment contract Securities and Exchange Commission:

• •

Administers federal securities law Includes investigating alleged violations, and regulation of activities of brokers and advisors

The Securities Act of 1933: • Issuer—seller • Investment Banker—employed to sell • Primarily regulates the issuance of securities by corporations, partnerships, associations, • and individuals Section 5 of the Act requires securities offered to the public through the use of the mails or any facility of interstate commerce to be registered with the SEC. Registration Statement: • A covered issuer of securities must file a written registration statement with the SEC. • It contains required information about the issuer and the securities to be issued.

• The SEC does not pass upon the merits of the registered securities.

• It decides only whether the issuer has met the disclosure requirements.

Prospectus: • Disclosure given to prospective purchasers Limitations on Activities During the Registration Process 1. Prefiling Period a. Issuer may not condition the market i. Selling campaing—No ii. Annual reports—Yes 2. Waiting Period (filing until effective statement) a. Issuer may condition the market b. Offers i. Preliminary Prospective ii. Summary Prospective .

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iii. Tombstone ads 3. Post Effective Period a. May close offers b. Final prospect Sale of Unregistered Securities: • Sale of securities that should have been registered with the SEC but are not violates the • • Securities Act of 1933.

Investors can rescind their purchases and recover damages.

Civil and criminal penalties can be imposed by the U.S. government.

Regulation A Offerings: • A regulation that permits the issuer to sell up to $5 million of securities pursuant to a • • simplified registration process.

Such offerings may have an unlimited number of process. o They do not have to be sophisticated investor.

There are no resale restrictions on the securities.

Contemporary Environment : Small Company Offering Registration Question-and-answer disclosure form for small businesses is discussed.

Civil Liability under Section 11 of the 1933 Act: Liability for injury from certain actions: • Intentionally defraud investors • Negligent in not discovering fraud • All but issuer can offer due diligence defense o Belief of no false statement or material omission of material affect (Scott v.

Buchins) Violations of the Securities Act of 1933: • SEC Actions o Consent order o Injunction o Request ancillary relief from the court o Criminal Liability—Section 24 imposes criminal liability on any person who willfully violates the act or the rules or regulations adopted thereunder.

• Private Actions—private parties who have been injured by violations of the act have the following recourse against the violator: o Section 12—civil liability o Section 11—civil liability o Due diligence defense Civil Liability under Section 12 of the 1934 Act: Civil Liability for: • Violation from selling pursuant to an unwarranted exemption • Making misrepresentations

.

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Violations of the Securities Act of 1934: • Criminal Liability—Section 32 imposes criminal liability on any person who willfully violates the act or regulations adopted thereunder.

• SEC Actions: o Consent order o Injunction o Seek court orders o Insider trading sanctions • Private Actions—the courts have implied private right or action under Section 10(b) and Rule 10b-5: o Generally, a plaintiff may seek rescission of the securities contract or recover damages from a defendant who has engaged in manipulation and deceptive practices that have caused the plaintiff injury.

Ethics: Sarbanes-Oxley Act Erects a Wall Between Investment Bankers and Securities Analysts Intended to avoid conflicts of interests Securities Exempt from Registration with the SEC: • Securities issued by a government in the United States.

• Short-term notes and drafts that have a maturity date that does not exceed nine months • Securities issued by nonprofit issuers • Securities of financial institutions that are regulated by the appropriate banking • authorities Securities issued by common carriers that are regulated by the Interstate Commerce • Commission • Insurance and annuity contracts issued by insurance companies • Stock dividends and stock splits Securities issued in a corporate reorganization where one security is exchanged for another security Small Offerings 1. Less than or equal to one million dollars 2. Use SCOR form Private and Other Transactions Exempt from Registration: • Certain transactions in securities are exempt from registration.

• Exempt transactions are subject to the antifraud provisions of the federal securities laws.

• The issuer must provide investors with adequate information.

1. Nonissuer Exemption 2. Intrastate Offering Exemption 3. Private Placement Exemption 4. Small Offering Exemption Resale Restrictions: .

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Certain resale restrictions are placed on securities issued pursuant to exemptions from registration.

• Restricted Securities—securities that were issued for investment purposes pursuant to the intrastate, private placement, or small offering exemptions o Rule 147 o Rule 144 •

Rule 144A (1990): • Rule adopted by the SEC to increase the liquidity of the registered securities.

• The rule permits “qualified institutional investors” to buy unregistered securities without being subject to the holding periods of Rule 144.

Private Placement Exemption versus Small Offering Exemption Private Placement 1. Unlimited accredited investors 2. Thirty-five nonaccredited investors 3. No registration Small Offering 1. Less than or equal to $1million 2. Twelve month 3. No registration Contemporary Environment: Hedge Funds and Derivatives Regulated by the Dodd-Frank Wall Street and Consumer Protection Act Hedge Funds usually use leverage to fund investments. They are speculative and risky. A derivate derives its value from other assets. They were unregulated until the passage of this statute.

Regulation and public disclosure is the statute’s objectives.

E-Securities Transactions: 1. Becoming more popular 2. NYSE is operated by NYSE Euronet—formed when NYSE merged with Euronet 3. NASDAQ is an electronic stock market 4. EDGAR—SEC’s electronic data and record system 5. E-Public Offerings Cyber Law: Google’s Internet IPO Google’s Internet IPO shares were offered over the Internet. Its prospectus was done electronically. Bidders could submit bids over the Internet.

The Securities Exchange Act of 1934: Trading in Securities • Federal statute that primarily regulates the trading in securities • It provides for the regulation of: o Securities exchanges o Brokers o Dealers .

Investor Protection, E-Securities Transactions, and Wall Street Reform 297

•

Contain provisions that assess civil and criminal liability on violators of the act

Section 10(b): • A provision of the Securities Exchange Act of 1934 • Prohibits the use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations prescribed by the SEC Rule 10b-5: • A rule adopted by the SEC to clarify the reach of Section 10(b) against deceptive and • fraudulent activities in the purchase and sale of securities All transfers of securities are subject to this rule o For example, stock exchange, over-the-counter, private sale, merger Note: Section 10(b) and Rule 10b5 require reliance by the injured party.

Insider Trading: • One of the most important purposes of Section 10(b) and Rule 10b-5 to prevent insider trading. o When an insider makes profit by personally purchasing shares of the corporation prior to public release of favorable information; or o By selling shares of the corporation prior to the disclosure of unfavorable information Insides Are Defined under Section 10(b) and Rule 10b-5 as: • Officers, directors, and employees at all levels of the company • Lawyers, accountants, consultants, and the other agents and representatives who are hired by the company on a temporary and nonemployee status to provide services or work to the company • Other who owe a fiduciary duty to the company Tipper-Tippee Liability: • Tipper o A person who discloses nonpublic information to another person o Liable for the profits made by the tippee • Tippee o The person who receives material nonpublic information from tipper o Liable for acting on material information that he or she knew (or should have known) was not public Case 32.1. The Court Speaks: United States v. Bhagat, 436 F. 3d 1140, Web 2006 U.S. App. Lexis 3008 (2006) U.S. Court of Appeals.

Facts: Nvidia entered into a contract with MICROSOFT for A 3-D graphics processor to be used

by Microsoft in the “X-Box.” The Nvidia president and CEO sent e-mails with an announcement of the deal to all employees. The next morning Nvidia’s VP sent an e-mail to keep the news quiet.

Trading blackouts by Nvidia employees were imposed in other e-mails. Bhagat, a Nvidia engineer, came in mid-morning of the second day (e-mails on his computer) and within 20 .

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minutes made his largest purchase of Nvidia stock in nearly 3 years. Gill, a friend did the same less than 30 minutes later and 10 minutes before Bhagat said he read the e-mails. There was evidence of an e-mail from Bhagat to Gill one day later with a link to an Internet article discussing Nvidia and the X-Box. Bhagat was charged with insider trading and tipping. The jury was asked to infer Bhagat’s actions (no direct evidence) from circumstantial evidence. Bhagat appealed from a guilty finding.

Issue: Is Bhagat guilty of insider trading and tipping?

Decision: Yes. Judgment was affirmed.

Reason: Evidence was sufficient to infer guilt from Bhagat’s actions on both counts as noted in the facts above.

Note: Misappropriation Theory usually involves an outsider misappropriating information in violation of a fiduciary duty.

Case 32.2. The Supreme Court Speaks: United States v. O’Hagan, 521 U.S. 642, 117 S. Ct. 2199, 138L. Ed. 724, Web 1997 U.S. Lexis 4033 (U.S. Supreme Court) Facts: James O’Hagan, a partner in the law firm of Dorsey & Whitney, began purchasing call options for Pillsbury stock. Each option gave O’Hagan the right to purchase 100 shares. In the meantime, Grand Metropolitan hired Dorsey and Whitney to represent it in a secret tender offer for stock of Pillsbury. When the tender offer was publicly announced, Hagan had purchased 5,000 shares at $39 per share; those shares went to $60. The SEC investigated, and the Justice Department charged O’Hagan with criminally violating Section 10(b) and Rule 10b-5. O’Hagan lost.

Issue: Can a defendant be criminally convicted of violating Section 10(b) and Rule 10b-5 based on misappropriation theory?

Decision: Yes. Reason: The misappropriation theory comports with Section 10(b)’s language, and it was property applied in this case.

Ethics: Aiders and Abettors Found Not Liable for Securities Fraud The Supreme Court has said that aiders and abettors are not liable based on an implied private civil cause of action because the investors did not rely upon their statements or misrepresentations.

Short-Swing Profits: Statutory Insiders • Section 16(a) of the 1934 act—defines any person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company as a statutory insider for Section 16 purposes Short-Swing Profits: Section 16(b) • Short-Swing Profits—profits made by statutory insiders on trades involving equity securities that occur within six months of each other • Section 16(b)—a provision of the 1934 act that requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation SEC Section 16 Rules: .

Investor Protection, E-Securities Transactions, and Wall Street Reform 299

1. “Officer” includes president, CEO, VP of business units or divisions, principal financial officer, principal accounting officer, and so on (not nonpolicy deciding officers) 2. No liability for transactions within 6 months before becoming an insider.

3. Six months rule for insider stays in effect State Securities Laws: • Most states have enacted securities laws that regulate the issuance and trading securities • These acts are often patterned after, and designed to coordinate with, federal securities • laws.

The Uniform Securities Act (a model state statue) has been adopted by many states.

International Law: Stock Markets in Developing Countries Many developing countries have stock markets.

III. Answers to Critical Thinking Cases Definition of a Security 32.1.

Yes, the Dare sales scheme is a security that should have been registered with the Securities and Exchange Commission (SEC). In SEC v. W.J. Howey Co., the U.S. Supreme Court defined an “investment contract” as a scheme that involves (1) an investment of money (2) in a common enterprise (3) with the profits to come solely from the efforts of others. The Supreme Court stated that this definition should be broadly and flexibility construed.

The court applied the Howey test in the instant case and held that the Dare multilevel sales scheme was an investment contract. There was obviously an investment of money in a common enterprise. The only difficult issue was whether the Dare plan derived profits for the investors from the efforts of others. The court held that the word “solely” should not be read literally. The court held although investors must exert some effort—mainly convincing friends, neighbors, and others to attend the Adventure Meetings—primarily their profits came from the efforts of others, that is, from the efforts of the Dare people at the meetings to convince the attendees to sign up and pay money for one of the Adventure levels.

The court held that the Dare multilevel sales scheme was an “investment contract” and therefore a security that had to be registered with the SEC before it was sold. The court held that Turner had sold unregistered securities in violation of securities laws and granted an injunction against Turner from selling any more Dare plans.

Note: previous purchasers could sue to rescind the purchase agreement and recover the money they paid. Securities and Exchange Commission v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 1973 U.S. Lexis 11903 (9th Cir. 1973).

Intrastate Offering Exemption 32.2.

No, the issue of securities by McDonald Investment Company (McDonald) does not qualify for the intrastate offering exemption from registration. The company met most of the requirements for an intrastate offering exemption, such as (1) the company was a resident of Minnesota, that is, it was incorporated in Minnesota; (2) its principal place of business was in Minnesota; (3) it was doing business in Minnesota with more than 80 percent of its assets located in the state and more than 80 percent of its revenues derived .

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from within the state; and (4) the purchasers of the securities were all residents of the state. However, to qualify for the exemption, at least 80 percent of the proceeds from the offering must be invested in the state. Here, the entire proceeds from the securities issue were invested in loans on real estate and other assets located outside the state of Minnesota. Because of this fact, the Court held that the transaction did not qualify for an intrastate offering exemption from registration and issued an injunction prohibiting the continued sale of the securities.

Note: Investors who purchased the securities could also rescind their purchase agreement. Securities and Exchange Commission v. McDonald Investment Company, 343 F.Supp. 343, 1972 U.S. Dist. Lexis 13547 (D.Minn. 1972).

Transaction Exemption 32.3.

No, the sale of the Continental securities by Wolfson and his family and associates does not qualify for an exemption from registration as a sale “not by an issuer, underwriter, or dealer.” The Court held that an issuer includes any person who directly or indirectly controls the issuer. In this case, Wolfson controlled Continental. He was its largest shareholder, made the policy decisions for the corporation, and controlled and directed the company’s officers.

The court found that the defendants had tried to conceal the sale of the securities by selling them over an 18-month period through many different brokers. The court held that these sales constituted a major “distribution” of Continental securities that should have been registered with the Securities Exchange Commission if the sales did not qualify for an exemption from registration. The court held that the securities sales did not qualify as a sale “not by an issuer” because Wolfson had been found to have been in control of the issuer of the securities—Continental. The court held that Wolfson and his family and associates should have registered the securities with the SEC, and that they had violated Section 5 of the Securities Act of 1933 because they had not registered the securities.

Note: On the witness stand, the defendants took the position that they operated at a level of corporate finance far above such “details” as securities laws and were too busy with “large affairs” as to bother themselves with such minor matters as securities laws.

The court, obviously, rejected this defense. United States v. Wolfson, 405 F.2d 779, 1968 U.S. App. Lexis 4342 (2nd Cir. 1968).

Insider Trading 32.4.

No, Chiarella is not criminally liable for violating Section 10(b) of the Securities Exchange Act of 1934. The U.S. Supreme Court reversed the trial court’s judgment that had convicted Chiarella on all counts. The Court of Appeals affirmed the conviction by holding that anyone—an insider or not—who receives material nonpublic information may not use that information to trade in securities until the information is made public.

The U.S. Supreme Court rejected this rule, holding that a person is not liable for insider trading under Section 10(b) unless he owes a duty to disclose the information. The Supreme Court held that this duty only arises if the person owes a fiduciary duty to the company in whose shares he has traded.

The Supreme Court held that Chiarella did not owe a fiduciary duty to the target companies of whose shares he purchased. The court stated: Not every instance of financial unfairness constitutes fraudulent activity under Section 10(b). The element required making silence fraudulent—a duty to disclose—is absent in this case. No duty could .

Investor Protection, E-Securities Transactions, and Wall Street Reform 301

arise from Chiarella’s relationship with the sellers of the target company’s securities for Chiarella had no prior dealings with them.

He was not their agent, he was not a fiduciary, and he was not a person in whom the sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions. We hold that a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.

The U.S. Supreme Court reversed Chiarella’s conviction. Chiarella v. United States, 445 U.S. 222, 100 S.Ct. 1108, 1980 U.S. Lexis 88 (1980).

Section 10(b) 32.5.

The plaintiff investors win and may sue the defendants for the alleged violations of Section 10(b) of the Securities Exchange Act of 1934. The defendants had asserted that the common-law defense of in pari delicto (“unclean hands”) prohibited the plaintiffs from suing because they had participated in the fraud with the defendants, that is, the plaintiffs thought they were trading on “inside information” when they purchased the TONM securities. Under the in pari delicto theory, if two parties to illegal conduct are mutually or equally at fault, they cannot use the court system to sue the other party to the illegal conduct. The issue in the instant case is whether the in pari delicto theory should be applied to securities laws.

The U.S. Supreme Court held that the in pari delicto theory does not apply to actions brought for alleged violations of securities laws. Thus, the plaintiffs in this case who had participated in the insider-trading scheme with the defendants could sue the defendants for disclosing false inside information to them. The Supreme Court stated: “We conclude that the public interest will most frequently be advanced if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders and broker dealers to full public view for appropriate sanctions.” The court held that the in pari delicto theory did not apply to suits alleging violations of Section 10(b) and that the plaintiffs could maintain their lawsuit against the defendants. Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct. 2622, 1985 U.S. Lexis 95 (1985).

Insider Trading 32.6.

The Sullair Corporation (Sullair) wins and, under Section 16(b) of the Securities Exchange Act of 1934, may recover the profits made by Hoodes on the sale and purchase of the securities of Sullair securities. The court held that Section 16(b) is a “flat rule” which imposes strict liability for profits earned by any officer or director or 10 percent shareholder who purchases and sells or sells and purchases equity securities of his corporation within a period of less than six months.

The court found that Hoodes, who was an officer of Sullair, was a statutory insider for purposes of Section 16(b). The court held that the Section 16(b) rule applied whenever the defendant held his position at the time of the initial transaction that gave rise to his liability. The court found that the two transactions—the sale of securities by Hoodes on July 20 and the purchase of securities on August 20—had occurred within six months of each other and were covered by Section 16(b). The court held that the corporation could recover $11,350 from Hoodes—the difference between the price he sold the original 6,000 shares for on July 20, 1982 ($38,350) and the fair market value of the 6,000 shares he purchased on August 20, 1982 ($27,000). Sullair Corporation v.

Hoodes, 672 F.Supp. 337, 1987 U.S. Dist. Lexis 10152 (N.D.Ill. 1987). .

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IV.

Answers to Ethics Questions

32.7.

No, each of the limited partnership offerings does not alone qualify for a private placement offering exemption from registration. To qualify for a private placement offering, the following requirements must be met: (1) there is no dollar limit on the amount of securities sold; (2) there is no limit on the number of accredited investors, but there is a limit of 35 unaccredited investors; and (3) disclosure of material financial and other information must be made to the investors.

In applying these requirements to the instant case, the court held that (1) Intertie had not kept track of the qualifications or the number of unaccredited investors; (2) the investors were not given material financial and other information about Intertie or its financial difficulties; (3) the investors were not informed that the limited partnerships could not support themselves or that partnership funds were being commingled; and (4) the investors were not informed that Intertie and the limited partnerships was a pyramid or “Ponzi” scheme whereby the funds raised in later partnership offerings were used to support earlier partnerships. The court held that each limited partnership did not on its own qualify for a private placement exemption because there were too many unaccredited investors and the investors were not provided with adequate disclosure of material information.

Integration: In addition, the court integrated all of the thirty limited partnership offerings into one offering. Separate securities offerings will be integrated if they are made about the same time, involve the same class of securities, are sold for the same consideration, and the proceeds are used for the same purpose. Here, the court found the existence of sufficient factors to integrate the offerings. The court held that this one integrated offering did not qualify for a private placement exemption from registration because there were too many unaccredited investors and material financial and other information was not disclosed to the investors. The court issued an injunction against Murphy. Securities and Exchange Commission v. Murphy, 626 F.2d 633, 1980 U.S. App. Lexis 15483 (9th Cir. 1980).

32.8.

They all conspire to violate the securities laws. Criminal liability should not be a question. Winans breached a fiduciary duty and acted unethically. Brant, however, although not acting in a manner popular to his co-conspirators did fulfill his ethical duty even though his motives may be questionable. [United States v. Carpenter, 484 U.S. 19, 108 S.Ct. 316, 1987 U.S. Lexis 4815 (1987)].

V.

Answers to Policy Cases

32.9.

They engaged in insider trading and are liable. They alone were in a position to evaluate the effects of one stock. Crawford phoned in order before the announcement. Centes placed orders only a few minutes after the announcement. He should have waited a reasonable time to put out the information. SEC v. Texas Gulf Sulphur Co, 401F. 2d 833, Web 1968 U.S. App. Lexis 5797 (U.S. Court of Appeals)

V.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court .

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Lampf, Pleva, Lipkind, Prupis, & Petigrow v. Gilbertson 111 S.Ct. 2773, 115 L.Ed.2d 321 (1991) United States Supreme Court 2. Key Facts A. Gilbertson, et al., had been advised by Lampf, et al., (a law firm) regarding the tax benefits of certain partnerships regarding computer hardware and software.

B. These partnerships filed and the IRS disallowed their claimed tax benefits.

C. Gilsbertson filed a complaint against Lampf alleging that Lampf’s actions violated Sec. 10(b) of the 1934 Securities Exchange Act and Rule 10b-5.

D. The lower court dismissed Gilbertson’s complaint on the grounds that it was not filed in a timely manner.

3. Issue Where there is a difference of opinion about the statute of limitations period for filing of a complaint under the Securities Act of 1934, can the Supreme Court impose a uniform interpretation?

4. Holding A uniform federal statute of limitations must be applied.

5. Court’s Reasoning A. The 1934 Act calls for a 1-year period after discovery combined with a 3-year period of repose.

B. Based on that interpretation, the action sought by Gilbertson was not filed in a timely manner and dismissal of the original complaint by the district court was correct.

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Chapter 33 Antitrust Law and Trade Practices

Why Should Competition Be Protected?

Learning Objectives: 1. Describe the enforcement of federal antitrust laws.

2. Describe the horizontal and vertical restraints of trade that violate Section 1 of the Sherman Act. 3. Identify acts of monopolization that violate Section 2 of the Sherman Act. 4. Explain how the lawfulness of mergers is examined under Section 7 of the Clayton Act. 5. Apply Section 5 of the Federal Trade Commission Act to antitrust cases.

I.

Teacher-to-Teacher Dialogue

Antitrust law lends itself to broad overviews of political and economic history. This entire body of law arose out of a need to stem and reverse some of the abuses of the “Robber Baron” era. For those of us who enjoy such exercises, and have the time, there is a wealth of political, sociological, and economic literature that can be plowed into this subject.

Most people do not think of the trust device as a business tool. As seen in other chapters, today’s use of trusts centers on the need to hold property for the benefit of others. In another era, however, the business trust was notoriously used as a device to eliminate competition and control markets. In the late 1800s, it was common to have key commodities and the industries related to those products controlled by large corporate enterprises. These entities would band together into a form of common trust ownership. The trustee, in turn, was able to control the prices and territories of distribution of the product. For example, prior to the enactment of antitrust laws, industries such as oil, cotton, sugar, and whiskey were all dominated by such trusts. Probably the best known of these trusts was Standard Oil. In 1890 the Standard Oil Trust controlled more than 90 percent of the market for oil products in the Unite3d States. By the time the trust was “busted” in 1911, more than thirty companies were ordered separated from the parent firm. This sort of monopolization of the marketplace led to the landmark antitrust legislation in 1890, the Sherman Antitrust Act. The act has two main objectives: 1.

2.

To prevent combinations in trust or otherwise, which act in restraint of trade, that is, illegal joining together to restrain trade.

To control markets thought to have a monopoly, that is, illegal domination so strong as to ipso facto restrain trade.

These objectives are set out in Sections 1 and 2 of the Act. What is interesting about this Act is that Congress used very broad language to give the Justice Department maximum latitude in .

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seeking enforcement of its provisions. This latitude has, in turn, not been consistently used. There appears to have been a constant shift in the enforcement strategies used by various administrations over the years.

The federal courts have taken a middle road. Under their rules of interpretation, two main classifications of offenses have evolved. The Per Se Rule is used to strike down restraints that courts deem to be so inherently anticompetitive that they cannot be allowed as a matter of law, regardless of any claimed justifications. On the other hand, the Rule of Reason has given courts latitude to accept restraints of trade on a case-by-case basis where legitimate concerns are overriding.

As strong and powerful a tool in the fight against monopolization and restraints of trade as the Sherman Act is, it has proven to be only a partial remedy. The Sherman Act sets the basic goals and objectives of keeping marketplaces open to competition. The Clayton Act and the Federal Trade Commission Act are designed to provide tools of implementation to those basic public policy objectives. As compared to the almost philosophical tenor of Sections 1 and 2 of the Sherman Act, the Clayton Act, and more particularly, the Robinson-Patman Amendment to it, speak to much more specific objectives. The objectives arose out of discriminatory practices aimed at getting the little guy.

The biggest problem with the Clayton Act, and to a lesser extent with the FTC, is the government’s commitment to enforcement combined with some very problematic aspects of the statutes themselves. On the issue of governmental level of commitment to enforcement, there is no question that things have changed in the global scheme of economic competition. In many ways the market factors that were sought to be protected in the early part of the twentieth century are different as we enter the twenty-first century. A free and open market is not measured now on regional or even national scales, but rather on worldwide competitive position. These changes have provided the philosophical underpinnings for the much more tolerant view taken by the government toward mergers, acquisitions, combinations, and the like. Yet the basic economic principles of monopolization, restraint of trade, and unfair trade practices have not changed. So government finds itself in a dilemma. It is trying to recognize the need to allow our economy to stay competitive in the worldwide playing field; yet it must continue to keep the game rules fair.

The second factor involves questions that have been raised about the economic sense of the Clayton Act itself. Many critics of the Act have argued that although provisions like price discrimination look good in theory, they are difficulty to enforce. The reason these particular measures have failed to live up to their billing is that some price volume cuts, incentives, and the like are all part of the competitive edge that all players are constantly looking for. To deny the reality of those competitive needs not only frustrates real competition, it may give noncompetitive parties an unwarranted wedge against more efficient competitors by way of officious intermeddling on the part of government.

II.

Text Materials

Antitrust Laws: A series of laws enacted to limit anticompetitive behavior in almost all industries, businesses, and professions operating in the United States.

Landmark Law: Federal Antitrust Statutes • Sherman Act of 1890 • Clayton Act of 1914 • Federal Trade Commission (FTC) Act of 1914 .

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Robinson-Patman Act of 1930

Antitrust Enforcement: • The federal antitrust statues are broadly drafted to: o Reflect the government enforcement policy o Allow the government to respond to economic, business, and technological changes • Each administration adopts an enforcement policy for antitrust laws.

• Antitrust laws are enforced more stringently at some times than at other times.

Antitrust Penalties: • Federal antitrust laws provide the following penalties: o Criminal sanctions o Civil penalties—including damages o Private civil actions o Effect of a government judgment—may be used as prima facie evidence in private case o Injunctions under Sec. 16 of Clayton Act Section 1 of the Sherman Act: Restraints of Trade • Prohibits contracts, combinations, and conspiracies in restraint of trade • To violate Section1, the restraint must be found to be unreasonable under either two tests: o Rule of reason o Per se rule • Requires the concerted action of two or more parties Rules to Determine Lawfulness of a Restraint: • Rule of Reason o A rule that holds that only unreasonable restraints of trade violate Section of the Sherman Act • Per Se Rule o A rule that is applicable to those restraints of trade considered inherently anticompetitive Horizontal Restraint of Trade: A restraint of trade that occurs when two or more competitors at the same level of distribution enter into a contract, combination, or conspiracy to restrain trade.

Examples: • Price-Fixing—occurs where competitors in the same line of business agree to set the price of the goods they sell. A per se violation.

• Division of Markets—occurs when competitors agree that each will serve only a designated portion of the market. A per se violation.

• Group Boycott—occurs when two or more competitors at one level of distribution agree not to deal with others at another level of distribution.

Ethics: U.S. Department of Justice Flunks the Ivy League Schools

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For years, the administrators of eight Ivy League schools traded information about applicants seeking scholarships. The Justice Department alleged that these schools had conspired and engaged in a horizontal restraint of trade in violation of Section 1 of the Sherman Act. Vertical Restraint of Trade: • Two or more parties on different levels of distribution enter into a contract, combination, or conspiracy to restrain trade Examples: • Resale Price Maintenance (vertical price-fixing)—occurs when a party at one level of distribution enters into an agreement with a party at another level to adhere to a price schedule that either sets or stabilizes prices o A per se violation of Section 1 of the Sherman Act • Nonprice Vertical Restraints—are unlawful under Section1 of the Sherman Act if their anticompetitive effects outweigh their pro-competitive effects. o include situations where a manufacturer assigns exclusive territory to retail dealers, or o Limits the number of dealers that may be located in a certain territory Case 33.1. The Supreme Court Speaks: American Needle, Inc. v. NFL, 130 S.Ct. 2201, Web 2010 US Lexis 4166 (2010) U.S. Supreme Court Facts: The NFLP markets NFL sports memorabilia for all of the teams. They granted exclusive license. One was given to Reebok. American Needle claiming a violation of the Sherman Act. Issue: Were the NFL, the NFL teams, and the NFLP separate legal entities capable of engaging in a contract, combination, or conspiracy as defined by Section 10 of the Sherman Act? Decision: Yes. The case was removed to determine if there was an unreasonable restraint of trade.

Reasoning: Here the teams compete not only on the field but also off to get together to grant exclusive license is a violation of the antitrust laws.

Contemporary Environment: Conscious Parallelism Does Not Violate Antitrust Law This suggests activities to avoid if you want to avoid antitrust liability.

Defense to Section 1 of the Sherman Act: • Unilateral Refusal to Deal o A unilateral choice by one party not to deal with another party o This does not violate Section 1 of the Sherman Act because there is no concerted action with others o This rule was announced United States v. Colgate & Co. o Often referred to as the Colgate doctrine • Conscious Parallelism o Occurs when two or more firms act the same but without concerted action o This doesn’t violate Section 1 because there has been no concerted action • Noerr Doctinre o Two or more parties may petition the government to enact laws or to take other action

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Section 2 of the Sherman Act: Monopolization • Prohibits the act of monopolization as well as attempts and conspiracies to monopolize • o Can be violated by the conduct of one firm The following elements are necessary to prove a defendant in violation of Section 2: o Relevant market o Monopoly power o Act of monopolizing Defining the Relevant Market: • Relevant product or service market—includes substitute products or services that are reasonably interchangeable with the defendant’s products or services • Relevant geographical market—the area in which the defendant and its competitors sell the product or service.

Monopoly Power: • The power to control prices or exclude competition • Measured by the market share the defendant possesses in the relevant market Willful Act of Monopolizing: • A required act for there to be a violation of Section 2 of the Sherman Act o For example, predatory pricing o Possession of monopoly power without such an act does violate Section 2 of the Sherman Act Defenses to Monopolization: • Innocent Acquisition o Superior business acumen o Monopoly that is acquired by superior skill, foresight, or industry • Natural Monopoly o Monopoly that is thrust upon the defendant o Small market that can support only one competitor Section 7 of the Clayton Act: Mergers • Section 7 of the Clayton Act provides that it is unlawful for a person or business to acquire the stock or assets of another “where in any line of commerce or in any activity affecting commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or tend to create a monopoly.”

• The following elements are necessary to prove a violation Section 7 of the Clayton Act: o Line of commerce—the market that will be affected by the merger. o Section of the country—geographical market that will be affected by the merger. o Probability of a substantial lessening of competition Types of Mergers: Horizontal Mergers • A merger between two or more companies that compete in the same business and • geographic market United States v. Philadelphia National Bank established the presumptive illegality test Vertical Mergers • A merger that integrates the operations of a supplier and a customer • Backward vertical merger .

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o The customer acquires the supplier Forward vertical merger o The supplier acquires the customer Market Extension Mergers • A merger between two or more companies in similar fields whose sales do not overlap • Geographical market extension merger • Product market extension merger Conglomerate Mergers • A merger that does not fit into any other category • A merger between firms in totally unrelated businesses • Unfair advantage theory •

Defenses to Section 7 Actions: 1. The Failing Company Doctrine 2. The Small Company Doctrine Premerger Notification: • Hart-Scott-Rodino Antitrust Improvement Act of 1976 o An act that requires certain firms to notify the FTC and the Department of Justice in advance of a proposed merger o Unless the government challenges the proposed merger within 30 days, the merger may proceed Section 3 of the Clayton Act: Tying Arrangements • A tying arrangement is a restraint of trade where a seller refuses to sell one product to a • customer unless the customer agrees to purchase a second product from the seller Section 3 of the Clayton Act prohibits tying arrangements involving sales and leases of goods. o That is, tangible personal property • Section 1 of the Sherman Act prohibits tying arrangements involving goods, services, • intangible property, and real property.

A tying arrangement is lawful if there is some justifiable reason for it.

Section 2 of the Clayton Act: Price Discrimination • Commonly referred to as the Robinson-Patman Act. • Sellers often offer favorable terms to their preferred customers.

• Price discrimination occurs if the seller does this without just cause.

• Illegal if it results in substantially lessening competition or creating a monopoly in any line of commerce.

Direct Price Discrimination • To provide a violation of Section 2(a), the following elements must be shown: o The defendant sold commodities of like grade and quality; o To two or more purchasers at different prices at approximately the same time; and o The plaintiff suffered injury because of the price discrimination Indirect Price Discrimination • A form of price discrimination that is less readily apparent than direct forms of price discrimination .

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That is, favorable credit terms, freight charges, and such to favored customers These are violations of the Robinson-Patman Act

Defenses to Section 2(a) Actions: • The Robinson-Patman Act establishes three statutory defenses to Section 2(a) liability: o Cost justification defense o Changing conditions defense o Meeting the competition defense Section 5 of the Federal Trade Commission Act: Unfair Methods of Competition • Section 5 of the FTC Act—prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce.

• Section 5 is broader than the other antitrust laws.

• The FTC is exclusively empowered to enforce the FTC Act. Exemptions from Antitrust Laws: • Statutory Exemptions—exemptions from antitrust laws that are expressly provided in statutes enacted by Congress • Implied Exemptions—exemptions from antitrust laws that are implied by the federal courts • State Action Exemptions—business activities that are mandated by state law are exempt from federal antitrust laws Examples 1. Statutory—unions, utilites 2. Implied—baseball 3. Others—nonstatutory labor State Antitrust Laws: • Most states have enacted antitrust statutes.

• State statutes are usually patterned after the federal antitrust statutes.

• State antitrust laws are used to attack anticompetitive activity that occurs in intrastate commerce.

International Law: European Union Strictly Enforces Antitrust Law The EU’s commission on competition enforces EU antitrust Law. III.

Answers to Critical Thinking Cases

Price Fixing 33.1.

The State of Arizona wins. The U.S. Supreme Court held that the defendants, the Medical Society Foundation, and its members, engaged in price fixing in violation of Section 1 of the Sherman Act. The Supreme Court held that price fixing is a per se violation of Section 1 of the Sherman Act, that is, once price fixing is found, no defenses may be raised to try to justify the price fixing. The defendants argued that Section 1 only prohibited the fixing of minimum prices and did not prohibit the fixing of maximum prices, as set by the doctors in this case. The Supreme Court rejected this argument, holding that the setting of a maximum price is really the setting of a minimum price if all .

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doctors agreed to charge the maximum price. The court reaffirmed that all price fixing, whether the setting of minimum or maximum prices, is judged by the per se rule and not the rule of reason. Therefore, the Supreme Court refused to consider evidence of the procompetitive effects alleged by the doctors to justify their price fixing. The Supreme Court held that the doctors’ price fixing was a per se unreasonable restraint of trade that violated Section 1 of the Sherman Act. Arizona v. Maricopa County Medical Society, 457 U.S. 332, 102 S.Ct. 2466, 1982 U.S. Lexis 5 (1982).

Division of Markets 33.2.

The United States wins. The U.S. Supreme Court held that Topco and its members engaged in illegal geographical division of markets which constituted a per se violation of Section 1 of the Sherman Act. The Supreme Court held that the per se rule, and not the rule of reason, applies to horizontal division of markets. The court stated that after considerable experience in examining these types of relationships, it found that division of markets stifled competition. The court held that when the Topco members agreed to divide the country into exclusive geographical markets and not sell Topco products in other members’ territories, they engaged in a geographical division of markets. The Supreme Court held that the Topco members’ geographical division of markets was an unreasonable restraint of trade and a per se violation of Section 1 of the Sherman Act. United States v. Topco Association, Inc., 405 U.S. 596, 92 S.Ct. 1126, 1972 U.S. Lexis 67 (1972).

Tying Arrangement 33.3.

Metrix Warehouse, Inc. (Metrix) wins. The court held that Mercedes-Benz of North America (MBNA) engaged in an illegal tying arrangement when it required its franchised dealers to purchase their replacement parts for Mercedes-Benz automobiles from MBNA. A tying arrangement occurs when a seller refuses to sell one product or service (the tying item) unless the customer purchases another product or service (the tied item). In this case, the court held that the Mercedes-Benz franchise granted by MBNA to dealers was the tying product and the replacement parts it required the dealers to purchase were the tied products.

Although some tying arrangements are considered so anticompetitive as to be per se illegal, in this case the court did not find the tie to rise to this level of unlawfulness.

Instead, the court applied the rule of reason and examined the procompetitive and anticompetitive nature of the tying arrangement. The court concluded that the anticompetitive aspects outweighed the procompetitive aspects. The court rejected MBNA’s claims that the tie was necessary as a device to regulate quality control. The court found that there were less anticompetitive methods for assuring quality control, such as setting published quality control standards that must be met by all manufacturers of Mercedes-Benz replacement parts. Applying the rule of reason, the court held that the tying arrangement in this case was an unreasonable restraint of trade that violated Section 1 of the Sherman Act. Metrix Warehouse v. Mercedes-Benz of North America, Inc., 828 F.2d 1033, 1987 U.S. App. Lexis 12341 (4th Cir. 1987).

Resale Price Maintenance 33.4.

Simpson, the franchised dealer, wins. The U.S. Supreme Court held that Union Oil Company (Union Oil) had engaged in resale price maintenance, which in this case constituted unreasonable restraint of trade in violation of Section 1 of the Sherman Act. .

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Resale price maintenance occurs when a manufacturer or distributor sets the price at which retailers may sell products to consumers. In this case, Union Oil had set the price at which Simpson and other franchised service station dealers could sell Union Oil gasoline and other products. Union Oil terminated Simpson when he sold gasoline to the public at less than the retail price set by Union Oil. The U.S. Supreme Court held that the resale price maintenance, or vertical price fixing, in this case was coercively applied by Union Oil and constituted a per se violation of Section 1 of the Sherman Act. Simpson v. Union Oil Company, 377 U.S. 13, 84 S.Ct. 1051, 1964 U.S. Lexis 2378 (1964).

Note: Not all vertical price fixing constitutes a per se violation of Section 1 of the Sherman Act. In Monsanto Company v. Spray-Rite Service Corporation, 465 U.S. 752, 104 S.Ct. 1464 79 L.Ed.2d 775 (1984), the U.S. Supreme Court held that in less egregious and coercive situations, resale price maintenance is to be examined using the rule of reason.

Monopolization 33.5.

Greyhound Computer Corporation, Inc. (Greyhound) wins. First, the court defined the relevant section of the country to be the nation and the relevant product market to be the leasing of computers. The court rejected IBM’s assertion that the relevant market was the sale and leasing of computers. Second, the court found that IBM, which controlled approximately 80 percent of the leasing market for computers, possessed the requisite monopoly power in the relevant market. Third, the court held that IBM had engaged in the willful organization and maintenance of monopoly power in violation of Section 2 of Sherman Act. The court found that IBM, by reducing the discounts at which it sold computers to leasing companies with the stated reason of increasing its market share of the leasing market engaged in an act of monopolization. The court reasoned that although IBM was under no duty to originally offer substantial discounts on its computers, once it did, it could not abruptly reduce the discounts without causing anticompetitive effects.

Fourth, the court held that Greyhound had suffered antitrust injury because of IBM’s actions. The court held that IBM had engaged in the act of monopolization that violated Section 2 of the Sherman Act. Greyhound v. International Business Machines Corporation, 559 F.2d 488, 1977 U.S. App. Lexis 11957 (9th Cir. 1977).

Merger 33.6.

The proposed merger between Lipton Tea Co. (Lipton) and Celestial Seasonings would be a horizontal merger. A horizontal merger occurs when two or more firms in the same line of commerce (product market) serving the same section of the country (geographical market) merge. The relevant “line of commerce” in this case was the production and distribution of herbal teas nationally, the relevant “section of the country” was the nation.

Because both firms were in the same line of commerce and served the same section of the country, their proposed merger would be a horizontal merger.

If Lipton and Celestial Seasonings were to merge, the resulting firm would control 84 percent of the national market for herbal teas. The next largest competitor, plaintiff Bigelow, would only have a 13 percent market share. The remaining 3 percent of the market was comprised of “trace” competitors. The merger of Lipton--the second largest competitor with 32 percent market, and Celestial Seasonings, the largest competitor with 52 percent market share, would create a merged firm that would have “monopoly power” over the marketplace. The size of the resulting firm and increase in concentration that it would cause would violate the “presumptive illegality” test announced by the U.S. .

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Supreme Court in Philadelphia National Bank, as well as the Justice Department Merger Guidelines computed by using the Herfindhal index.

Although the presumption of illegality is rebuttable, the court held that it is unlikely to be rebutted in this case because of the market shares controlled by Lipton and Celestial Seasonings and the monopoly power that would result from their proposed merger. Based upon the alleged deliberate acquisition of monopoly power in the herbal tea market, the court found that there may be a substantial lessening of competition in that market if the merger were consummated. The court ordered that the proposed horizontal merger between Lipton and Celestial Seasonings be enjoined. R.C. Bigelow, Inc. v. Unilever, N.V., 867 F.2d 102, 1989 U.S. App. Lexis 574 (2nd Cir. 1989).

IV.

Answers to Ethics Exercises:

33.7.

Yes, Corn Products engaged in price discrimination in violation of Section 2(a) of the Robinson-Patman Act. The U.S. Supreme Court held that the “base-point pricing” system, whereby every purchaser paid the freight charges from Chicago even if the glucose was shipped from Kansas City, constituted indirect price discrimination.

This pricing scheme created a favorable zone around Chicago and vicinity. The “phantom freight” paid by nonfavored buyers not located in the favored zone caused them to pay a higher price for glucose than did the favored buyers located in the favored price zone. Evidence showed that this difference in price was important enough to cause several manufacturers of low-priced candy to move their plants to the Chicago area to avoid having to pay the phantom freight charge. The Supreme Court held that Corn Products had engaged in “indirect” price discrimination in violation of Section 2(a) of the Robinson-Patman Act, and upheld the trial court’s judgment against Corn Products. Corn Products Refining Company v. Federal Trade Commission, 324 U.S. 726, 65 S.Ct. 961, 1945 U.S. Lexis 2749 (1945).

33.8.

The meeting the competition defense probably protects Falls City from liability for price discrimination.

The court generally reviews the meeting the competition defense.

The defendant must only show that its lower price was made in good faith to meet a competitor’s price. The lower price may come about not only from a reduction of price, but also from an increase lesser than that to other customers. The price reduction

V. 33.9.

may be made on a territorial basis, rather than on a customer-by-customer basis, but the defendant must prove that this was a reasonable way to do it. Case was remanded for proceedings consistent with this opinion. Falls City Industries, Inc. v. Vanco Beverage,

Inc. 460 U.S. 428, 103 S.Ct. 1282, 1983 U.S. Lexis 148 (1983).

Answers to Policy Cases: Yes. It was “formed for the purpose and with the effect of raising” the bar review course’s price. Agreements such as this are illegal, regardless of whether the parties split a market or merely reserve market for each other. Palmer v. BRG of Georgia, Inc., 498 U.S. 46, 111 S. Ct. 401, 112 L. Ed. 2d 349, Web 1990 U.S. Lexis 5901 (U.S. VI. Answer to “Briefing the Case” Writing Assignment: Supreme Court) 1. Case Name, Citation, and Court .

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Texaco v. Hasbrouck dba Rick’s Texaco 496 U.S. 543 (1990) United States Supreme Court 2. Key Facts A. Hasbrouck was engaged in the retail sale of Texaco gasoline products in the Spokane, WA area between 1972 and 1981.

B. It purchased its gasoline directly from Texaco, Inc. at what is known in the industry as retail tank prices.

C. At the same time, Texaco, Inc. granted substantial discounts from retail tank prices.

D. Hasbrouck claimed these discounts were given in violation of the Robinson-Patman Amendment to the Clayton Act. E. The district court and court of appeals ruled in favor of Hasbrouck.

3.

Issue Did the discounts granted to the two distributors between 1972 and 1981 constitute a violation of the Act?

4. Holding Yes. 5. Court’s Reasoning A. In order to find a violation of the Act, four elements must be shown: 1. The sales were made in interstate commerce.

2. The same goods and quality were sold to Hasbrouck as to the distributors.

3. There was discrimination in pricing.

4. This discrimination had a prohibited effect on competition.

B. The four elements were found within the overall record of the findings by the lower courts; therefore, those findings were affirmed.

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Consumer Safety, Consumer Financial Protection, and Environmental Protection 315

Chapter 34 Consumer Safety, Consumer Financial Protection, and Environment Protection

Should The Buyer Beware?

Learning Objectives: 1. Describe government regulation of food, drugs, and cosmetics and consumer product safety laws.

2. List and describe federal consumer-debtor protection laws.

3. Describe the consumer finance reform protections added by the Dodd-Frank Wall Street Reform and Consumer Protection Act. 4. Describe the protections afforded by the Clean Air Act, the Clean Water Act, and other environmental protection laws.

5. Explain how environmental laws regulate the use of toxic substances and the disposal of hazardous wastes.

I.

Teacher to Teacher Dialogue

Anyone who has dealt with a large governmental bureaucracy can readily appreciate the frustrations of trying to get through a maze with sanity intact. Government’s burgeoning growth of administrative agencies at every level is indeed cause for concern for its constituents. In spite of constant calls to reduce the size of government’s role in the average person’s affairs, that role has grown tremendously as reflected in these statistics. The real functions of government are carried out “in the trenches” by this “fourth branch of government” every day.

The basic function undertaken by administrative agencies is to carry out the ministerial functions necessary to the operation of the government. These functions are first authorized by what are called organic statutes, which create the agency, and enabling statutes, which delegate certain powers to the agency to act for the executive, legislative, or judicial branches of government. It is interesting to note at the outset that the “clean functional lines” of executive, legislative, and judicial can and do often become quickly blurred when examining the breadth and scope of administrative agency activities.

Once the existence of the agency is settled upon and its scope of authority is established, you must then look to see if it is acting within that scope vis-à-vis the particular issue at hand.

Remember the basic assumption here is that the executive branch, legislative branch, or judicial branch has chosen to designate and delegate a certain portion of its authority to act. This delegation is based on the presumption that the agency can be expected to have certain levels of .

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expertise, scales of economy, and attention to detail that could not be readily expected of the policy makers. The next step is to see if the power in question was in fact truly delegated, and if so, is it being properly exercised by the agency?

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

This chapter covers the fourth major set of venues within a list of remedies available to a wronged or injured consumer. First, there is criminal law. Victims of consumer fraud and similar offenses have always been able to seek state-supported sanctions against wrongdoers. This venue may provide some satisfaction for the victim and may even, at least temporarily, protect society from further harm. But criminal law does not truly make the victim whole. As a matter of fact, most of the individuals convicted of consumer fraud are also judgment proof, that is, they have no assets from which civil judgments can be satisfied.

The second area of consumer protection is found in tort law and the permutations of intentional tort, negligence tort, and strict liability. These remedies can and do provide meaningful substance to civil correction of wrongdoing where the defendant is found to have some financial means. As seen in the prior discussions of these areas, tort law generally and products liability specifically are ripe with controversy and a great deal of uncertainty in today’s legal environment. The major drawback to both the criminal law and tort law methods of consumer protection is that they represent after-the-fact remedies for harm already done. They are reactive remedies as opposed to proactive forms of prevention of harm. It has been argued that large civil judgments act as societal signals that are designed to discourage repetition of undesirable behavior.

The third side to our picture is found in contract. Contract law has the advantage of providing the consumer with the opportunity to anticipate any problems before they befall him or her. This notion is traditionally found in the doctrine of caveat emptor which courts of another age used with cavalier abandon. Both the common law of contracts and the Uniform Commercial Code have come a long way from the bad old days of: “Let the buyer beware.”

In spite of all this progress in the areas of crime, torts, and contract, the gap between consumer harm and consumer protection continues to remain unfilled. Legislators at all levels of government have sought to help fill this void with a number of consumer protections measures.

These measures can and often do have a chilling effect on many potential harms to the consumer.

Unfortunately, another hallmark of many of these measures is that they are the end product of a trail of harm that has reached a crisis or disastrous level. Consider how long it took to take certain dangerous prescription drugs or unsafe toys off the market. Where these laws do provide a measure of safety, some consumer comfort may be found in “at least better late than never.” On some public safety issues, however, the damage remains at serious levels year in and year out.

Some topics are easier to teach than others. When dealing with subjects such as negotiable instruments, students appreciate the necessity of learning the ins and outs of the system, but they often do not like it. The same goes for topics involving taxation. In both scenarios, the subject matter is seen as a necessary evil or a cost of getting by in society. Environmental law is different.

Most students are keenly aware of the environmental issues found in the news every day. They want to know more about what our government is doing to protect its citizens from harm. From the teaching point of view, it is nice for a change to have such a jump start on a teaching assignment.

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The materials in this chapter dealing with environmental law can be quite extensive in that they literally cover the earth! Try to focus on one illustrative issue from each area of air, land, and water. Possibly explain to the student how pollution is inevitable and clarify the options. Move from tort to statute to unsolved problems keeping in mind the purpose.

II.

Text Materials

Introduction: • Federal and state governments enact laws that regulate business.

• The legislative and executive branches of government have created numerous • administrative agencies to assist in implementing and enforcing these laws.

The operation of these administrative agencies is governed by a body of administrative law.

Note: Administrateive law deals with the rules and regulations enforced by administrative agencies.

Examples of Agencies: 1. FDA—enforces Federal Food, Drug, and Cosmetics Act 2. EPA—enforces Federal Environmental Protection laws Administrative Agencies 1. Delegation Doctrine—powers 2. Administrative Procedure Act—ALJ’s and orders Administrative Law: • Administrative Law—a body of law that governs the operation of administrative agencies.

• Administrative Law is a combination of substantive and procedural law.

• Each federal administrative agency is empowered to administer a particular statute or statutes. o These statutes are the substantive law that is enforced by the agency.

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

Administrative Procedure Act of 1946: • Establishes certain administrative procedures that federal administrative agencies must follow in conducting their affairs: o Notice and hearing requirements o Rules for conducting agency adjudicative actions o Procedures for rules making • Most states have enacted administrative procedural acts that govern state administrative agencies. .

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Administrative Law Judges (ALJs)—preside over administrative proceedings. o Decide questions of law and fact concerning the case o No jury o The ALJ is an employee of the administrative agency

Food Safety Case 34.1. The Court Speaks: United States of America v. La Grou Distribution Systems, Inc, 466 F. 3d 585, Web 2006 US. App. Lexis 25986 (2006) U.S. Court of Appeals.

Facts: La Grou operated a cold storage warehouse and distribution center where it stored food for customers. The warehouse had a serious rat problem that the manager, president, and employees were aware of. After a USDA inspection discovered the problem to be extensive and potentially causing serious illness, the USDA shut the warehouse down. 8 million of the 22 million pounds of food was found to be adulterated and was destroyed. The rest were decontaminated. LaGrou was charged with violating federal food safety laws and ordered to pay restitution of $8.2 million, pay a fine of $2 million and sentenced to a 5-year probation. LaGrou appealed.

Issue: Did LaGrou violate federal food safety laws?

Decision: Yes. The judgment was affirmed except the $2 million fine was reduced to $1.5 million.

Reason: Authorized agents or employees knowingly stored products under unsanitary conditions.

Landmark Law: Federal Food, Drug, and Cosmetic Act (FDCA) of 1938 • Provides the basis for the regulation of much of the testing, manufacture, distribution, and sale of foods, drugs, cosmetics, and medicinal products and devices in the United States.

• Administered by the Food and Drug Administration (FDA).

• The FDA is empowered to regulate food, food additives, drugs, cosmetics, and medicinal devices.

Regulation of Food: • The FDCA prohibits the shipment, distribution, or sale of adulterated food.

• The FDCA prohibits false and misleading labeling of food products.

• It mandates affirmative disclosure of information on food labels.

• A manufacturer may be held liable for deceptive labeling or packaging.

Nutrition Labeling and Education Act: • A federal statute that requires food manufacturers and processors to provide nutritional • • information on most foods.

It prohibits them from making unscientifically unsubstantiated health claims.

FDA regulations require food processors to provide uniform information about serving sizes and nutrients on labels.

International Law: United Nations Biosafety Protocol for Genetically Altered Foods All genetically engineered food are to be clearly labeled with the phrase “may contain living modified organisms.” .

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Regulation of Drugs: • The FDCA gives the FDA the authority to regulate the testing, manufacture, distribution, • and sale of drugs.

• The Drug Amendment to the FDCA gives the FDA broad powers to license new drugs in • the United States.

The manufacture, distribution, or sale of adulterated or misbranded drugs is prohibited.

The law requires all users of prescription and nonprescription drugs to receive: o Proper directions for use ▪ Including method and duration of use o Adequate warnings about any related side effects Regulation of Cosmetics: • The FDA has issued regulations that require cosmetics: o To be labeled o To disclose ingredients o To contain warnings if they are carcinogenic or otherwise dangerous to a person’s health • The manufacture, distribution, or sale of adulterated or misbranded cosmetics is • prohibited.

The FDA may remove from commerce cosmetics that contain unsubstantiated claims. o For example, preserving youth o For example, growing hair Ethics: Ethics of Using Animal Testing in Development of Cosmetics The FDA requires testing of cosmetics in any way for safety even to the including of animals.

This is a contested issue.

Regulation of Medical Devices: • The Medicinal Device Amendment to the FDCA gives the FDA authority to regulate • • medicinal devices and equipment.

The mislabeling of medicinal devices is prohibited.

The FDA is empowered to remove “quack” devices from the market.

Product Safety: Consumer Product Safety Act (CPSA) of 1972 • Federal statute that regulates potentially dangerous consumer products • Created the Consumer Product Safety Commission (CPSC) o Independent federal regulatory agency empowered to: 1. Adopt rules and regulations to interpret and enforce the CPSA 2. Conduct research on safety 3. Collect data regarding injuries Unfair and Deceptive Practices: Section 5 of the Federal Trade Commission Act • Prohibits unfair and deceptive practices including: o False and deceptive advertising o Bait and switch o Abusive sales tactics o Consumer fraud .

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Deceptive: o Misinformation or omission likely to mislead reasonable customer or; o Unsubstantiated claim

Contemporary Environment: Do-Not-Call Registry Protects Against Unwanted Telemarketing Phone Calls Telemarketers have 3 months to remove the name from their sales call list and it stays on for 5 years and can be renewed. The Supreme Court said this was a valid restriction on commercial speech.

Landmark Law: Federal Consumer-Debtor Protection Laws • Truth-In-Lending Act: disclosures • Regulation Z: disclosure of price, APR, total financing, prepayment penalties, and so on • Consumer Lending Act • Fair Credit Billing Act: acknowledgment of billing complaints and laws • Fair Credit Reporting Act: guidelines for credit reports and handling of issues • Fair Debt Collection Practices Act: no breach of peace or unreasonable methods like • inconvenient times and places, harassment, threats, lies, and so on • Equal Credit Opportunity Act: no discrimination in extension of credit • Fair Credit and Charge Card Disclosure Act: disclosure in tabular form of relevant information Credit Card Act of 2009 o Not to younger than 21 o No promotional items from banks o Stable first year interest o Payments above minimum applied to higher interest balance o No retroactive increase of interest rates o No prepayment fees o Notice on statement on time needed to pay-off with minimum payments • Dodd-Frank Wall Street Reform and Consumer Protection Act o Regulates consumer credit and mortgage lending • Landmark Law: Bureau of Consumer Protection o Enforces Consumer Financial Protection Act o Dodd-Frank was to eliminate abusive loan practices ▪ Disclosure ▪ Uniform forms ▪ Watchdog over credit cards Contemporary Environment: Credit CARD Act of 2009 Landmark Law: Bureau of Consumer Financial Protection Environmental Protection Environmental Protection Agency: .

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• • • •

An administrative agency created by Congress in 1970 to coordinate the implementation and enforcement of the federal environmental protection laws.

The EPA has broad rule-making powers.

The EPA has adjudicative powers.

The EPA can initiate judicial proceedings in court against suspected violators of federal environmental laws.

National Environmental Policy Act (NEPA): • A federal statue enacted in 1969 that mandates that the federal government consider the adverse impact a federal government action would have on the environment before the action is implemented.

• Created the Council on Environmental Quality.

• Does not apply to action by state or local governments or private parties.

Environmental Impact Statement (EIS): • The NEPA and rules adopted there under require that an environmental impact statement (EIS) must be prepared for all proposed legislation or major federal action that significantly affects the quality of the human environment.

• The purpose of the EIS is to provide enough information about the environment to enable • the federal government to determine the feasibility of the project.

• The EIS is also used as evidence in court whenever a federal action is challenged as • violating the NEPA or other federal protection laws.

Once an EIS is prepared, it is subject to public review.

Most states and many local governments have enacted laws that require an EIS to be prepared regarding proposed state and local government action as well as private development.

Air Pollution: Clean Air Act: • A federal statute enacted in 1963 to assist states in dealing with air pollution.

• o Pollution caused by factories, homes, vehicles, and the like that affects the air The Clean Air Act, as amended (1970, 1977, 1990), provides comprehensive regulation of air quality in the United States.

National Ambient Air Quality Standards: • The Clean Air Act directs the EPA to establish national ambient air quality standards • (NAAQS) for certain pollutants.

Standards are set at two levels: o Primary—to protect human beings o Secondary—to protect vegetation, matter, climate, visibility, and economic values • Regions that do not meet air quality standards are designated nonattainment areas.

Contemporary Environment: Indoor Air Pollution Causes Health Risks This discusses “sick building syndrome.” The two chief causes are overinsulation with sealed windows and hazardous chemicals and construction materials.

Water Pollution: • River and Harbor Act of 1886 • National Discharge Pollutant Discharge Elimination System (NPDES) of 1972 .

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• Federal Water Pollution Control Act (FWPCA) of 1948 (as amended) o Clean Water Act of 1972 o Clean Water Act of 1977 o Clean Water Quality Act of 1987 • Water pollution o Pollution of lakes, rivers, oceans, and other bodies of water o Point sources of water pollution o Sources of water pollution such as paper mills, manufacturing plants, electric utility plants, and sewage plants.

Case 34.2. The Supreme Court Speaks: Entergy Corp. v. Riverkeeper, Inc., 129 S.Ct. 1498, 173 L. 159. 2d 369, Web 2009 U.S. Lexis (2009) U.S. Supreme Court.

Facts: Entergy operates power plants and uses water intake structure to cool the facilities. They are environmentally risky. The Clean Water Act requires the best available technology to deal with these risks but the EPA adopted a most effective technology rule. But here expensive effective methods are not required due to the high cost.

Issue: Is the EPA permitted to use cost-benefit analysis in promulgating rules for technology to be deployed by existing point sources of water pollution under the Clean Water Act? Decision: Yes. Cost-benefit analysis is permitted in setting performance standards for point sources of water pollution.

Reason: The EPA tried to avoid extreme differences between cost and benefit. They feel this is reasonable. The statute does not require a strict application of most effective technology.

Water Pollution Cont.: • Thermal pollution o Heated water or material discharged into waterways that upsets the ecological balance and decreases the oxygen content • Wetlands o Areas that are inundated or saturated by surface water or ground water that support vegetation typically adapted for life in such conditions • Safe Drinking Water Act of 1972, 1986 o Authorizes the EPA to establish national primary drinking water standards o Prohibits the dumping of wastes into wells used for drinking water o That states are primarily responsible for enforcing the act • Marine Protection, Research, and Sanctuaries Act of 1972 o Extended environmental protection to the oceans o Requires a permit for dumping wastes and other foreign materials into ocean waters o Establishes marine sanctuaries in ocean waters and in the great Lakes and their connecting waters.

• Ocean Dumping o Marine Protection, Research, and Sanctuaries Act of 1972—extends environmental protection to the oceans o The Clean Water Act authorizes the U.S. government to clean up oil spills and spills of other hazardous substances in ocean water within 12 miles of the shore and on the continental shelf and to recover the cleanup costs from responsible parties .

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•

The Federal Oil Pollution Act of 1990 required procedures and plans to readily respond to and clean up oil spills.

Toxic Substances: • Chemicals used for agricultural, industrial, and mining uses that cause injury to humans, • birds, animals, fish and vegetation Key federal laws: o Toxic Substances Control Act of 1976 o Insecticide, Fungicide, and Rodenticide Act of 1947 (as amended in 1972) Toxic Substances Control Act of 1976: • Requires manufactures and processors to test new chemicals to determine their effect on • human health and the environment before the EPA will allow them to be marketed.

The EPA may limit or prohibit the manufacture and sale of toxic substances, or remove them from commerce, if it finds they pose an imminent hazard or an unreasonable risk of injury to human health or the environment.

Insecticide, Fungicide, and Rodenticide Act of 1947: • Requires pesticides, herbicides, fungicides, and rodenticide to be registered with the • EPA. The EPA may deny, suspend, or cancel registration.

Hazardous Waste: • Hazardous Waste o Solid waste that may cause or significantly contribute to an increase in mortality or serious illness or pose a hazard to human health or the environment if improperly managed • Land Pollution o Pollution of the land that is generally caused by hazardous waster being disposed of in an improper manner • Resource Conservation and Recovery Act (RCRA) of 1976 o Federal statute that authorizes the EPA to regulate facilities that generate, treat, store, transport, and dispose of hazardous wastes o States have primary responsibility for implementing the standards established by the act and EPA regulations Landmark Law: Superfund This statute gave the federal government a mandate to deal with hazardous wastes that have been spilled, stored, or abandoned. Recovery can be from generator, transporter, prior, and current site owners.

Nuclear Waste: • Radiation Pollution o Emissions from radioactive wastes that can cause injury and death to humans and other life and can cause severe damage to the environment • Nuclear Waster Policy Act of 1982 o A federal statue that says the federal government must select and develop a permanent site for the disposal of nuclear waste .

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Nuclear Regulatory Commission o Licenses the construction and opening of commercial nuclear power plants o Continually monitors the operation of nuclear power plants and may close a plant if safety violations are found • Environmental Protection Agency (EPA) o Empowered to set standards for radioactivity in the environment and to regulate the disposal of radioactive waste o Regulates thermal pollution from nuclear power plants o Regulates emissions from uranium mines and mills Endangered Species Act of 1973: • Protects endangered and threatened species of animals.

• The Secretary of the Interior is empower to declare a form of wildlife as endangered or • threatened.

• The Act requires the EPA and the Department of Commerce to designate critical habitats for each endangered and threatened species.

The Act prohibits the taking of any endangered species.

•

Landmark Law: Endangered Species: Snail Darter Saved from Extinction This statute was enacted to protect endangered and threatened species of animals.

Other Federal Laws That Protect Wildlife: • Migratory Bird Treaty Act • Bald Eagle Protection Act • Wild Free-Roaming Horses and Burros Act • Marine Mammal Protection Act • Migratory Bird Conservation Act • Fishery Conversation and Management Act • Fish and Wildlife Coordination Act • National Wildlife Refuge System State Environmental Protection Laws: • Many state and local governments have enacted statues and ordinances to protect the • environment States are entitles to set pollution standards that are stricter than federal requirements International Law: Global Warming Increase atmospheric pressure from release of greenhouse gases is referred to as global warming.

III.

Answers to Critical Thinking Cases

Food Regulation 34.1.

Yes, Engel and Gel Spice violated the section of the Federal Food Drug and Cosmetic Act that concerns adulterated foods. The FDA prohibits the shipment, distribution, or sale of adulterated food. Under the Act, a food is deemed adulterated if it consists in whole or in part of any “filthy, putrid, or decomposed substance,” or if it is otherwise .

Consumer Safety, Consumer Financial Protection, and Environmental Protection 325

“unfit for food.” The court found that Gel Spice was in the business of shipping, distributing, and selling spices that were used as food. Gel Spice had allowed rodents to infest their McDonald Avenue warehouse, and these rodents had caused the spice to become adulterated. The presence of rat droppings, rodent urine, and insects in the spice meant that the spice consisted in part of “filthy and putrid substances” and was, therefore, “unfit for food.” Because Engel and Gel Spice had allowed food to become adulterated, the court found that Engel and his company had violated the FDA. United States v. Gel Spice Co., Inc., 601 F.Supp. 1205, 1984 U.S. Dist. Lexis 21041 (E.D.N.Y 1984).

Cosmetics Regulation 34.2.

The government wins the case and has the right to seize the French Bronze Tablets.

Under the Food, Drug, and Cosmetic Act of 1938, the Federal Drug Administration is empowered to regulate the composition of Cosmetics. Cosmetics include substances and preparations for cleaning, altering the appearance of, and promoting the attractiveness of a person. The Color Additives Amendment to the FDA requires the approval of the FDA before color additives can be used in cosmetics. The court held that French Bronze Tablets were cosmetics within the definition of the FDA. The French Bronze Tablets were a substance used both to alter the appearance of and to promote the attractiveness of the consumer. Because the tablets were a cosmetic, the FDA had to approve the use of any color additive in them. Because canthaxanthin had never been approved for use as a color additive in cosmetics, the French Bronze Tablets violated the FDA and could be seized and condemned. U.S. v. Eight Unlabeled Cases of an Article of Cosmetic, 888 F.20 945, 1989 U.S. App. Lexis 15589 (2nd Cir. 1989).

Clean Air Act 34.3.

The United States prevails. In this case, pursuant to the Clean Air Act (CAA), it is illegal to sell unleaded gasoline that contains a lead concentration in excess of that proscribed by law. Because Pilot was engaged in the business of reselling and distributing gasoline to the individual retailers where samples were taken that revealed a violation of the CAA, the court found Pilor liable. United States v. Pilot Petroleum Associates, Inc., 712F.Supp.

1077,1989 U.S. Dist Lexis 6119 (E.D.N.Y.).

Wetlands 34.4.

The Army Corps of Engineers (Army Corps) prevails pursuant to the Clean Water Act (CWA). The CWA provides that the Secretary of the army may issue permits for the discharge of dredged or fill material into the navigable waters at specified disposal sites.

Furthermore, before any discharge or rill is carried out, a permit must be granted or such discharging or filling is unlawful. In this case, the court held hat the Army Corps could require Leslie Salt to obtain a permit before draining and filling the land since the property had also acquired some natural “ aquatic characteristics,” such as fish, wildlife, and migratory birds. Leslie salt Co. v. United states, 896 F. 2d 354, 1990 U.S. App. Lexis 1524 (9th Cir. )

Clean Water Act 34.5.

The United States prevails. The court held that the dumping of approximately 67,000 tons of carcinogenic waste into Lake Superior polluted the public water supplies in .

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violation of its state discharge permit. In reaching this outcome, the court relied on the evidence that the discharges were causing discoloration of the surface waters outside of the zone of discharge. Because Reserve Mining was in violation of their permit, Reserve was fined for each day that the violation occurred. [United States v. Reserve Mining Co., 543 F.2d 1210, 1976 U.S. App. Lexis 6503 (8th 1976)] Hazardous Waste 34.6.

The United States prevails. In this case, the Environmental Protection Agency (EPA) determined that the paint drums that were buried were hazardous materials and can only be disposed of at facilities with EPA permits. No such permit had been obtained by Hoflin. The court stated that those individuals who handle hazardous waste are required to provide information to the EPA in order to secure permits. Placing this burden on those handling hazardous waste materials makes it possible for the EPA to know who is handling hazardous waste, monitor their activities, and enforce compliance with the statute. Thus, because Hoflin failed to inform the EPA of its disposal of the paint, he was liable for the dumping of hazardous waste. United States v. Hoflin, 880 F.2d 1033, 1989 U.S. App. Lexis 10169 (9th Cir. 1989).

IV.

Answers to Ethics Cases

34.7.

FTC v. Colgate-Palmolive Company, 380 U.S. 374, 85 S.Ct. 1035, 13 L. 501 2d 904, Web 1965 U.S. Lexis 2300 (U.S. Supreme Court) Facts: Colgate manufactures and sells a shaving cream called “Rapid Shave.” In a television commercial promoting Rapid Shave, a person is shown shaving what was called sandpaper. This sandpaper was in fact a simulated prop of plexiglass with sand glued on. The FTC issued a complaint against Colgate for false and deceptive advertising.

Issue: Was this commercial false and deceptive advertising in violation of the Federal Trade Commission Act? Decision: Yes. Reason: The court found this to be a material deceptive practice. Colgate could have labeled this as a demonstration, or, they could have found another advertisement. The fact that some products do not lend themselves to television commercials does not allow the manufacturer to be deceptive. This case is distinguishable from the case where ice cream companies use mashed potatoes instead of ice cream in their commercials, because the potatoes are not used as additional proof of the claims being made. Here, the sandpaper is being used to give the viewer objective proof of the claims being made.

Finally, the FTC order to Colgate not to use such methods in advertising any other products in the future is permissible.

34.8.

The West Michigan Environmental Action Council (WMEAC) prevails. The court held that the WMEAC demonstrated the likelihood of the impairment or destruction of the natural resources in the areas, specifically of the elk, as a result of the proposed drilling of the ten exploratory wells. Based upon an Environment Impact Statement that indicated that elk would (1) avoid roads even when there is no traffic, (2) avoid the impact areas for at least 40 to 50 years, and (3) result in further shrinkage of the already diminishing elk population, the court determined that this constitutes an impairment or destruction of a natural resource. Although virtually all human activities can be found to adversely .

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impact natural resources in some way or another, the present case does not justify the destruction of the elk population for the exploration of oil and gas deposits. West Michigan Environmental Action Council, Inc. v. Natural Resource Commission, 275 N.W.2d 538, 1979 Mich. Lexis 347 (Mich. 1979).

V.

Answer to Policy Cases:

Endangered Species 34.9.

The Sierra Club is granted the injunction to prevent the Forest Service from leasing these national forests for lumbering. In the present case, the court held that the conduct of the Forest Service had a detrimental impact upon the red-cockaded woodpecker in violation of the Endangered Species Act. By allowing the Forest Service to lease several national forests for lumbering in Texas, this action would have jeopardized the survival of the woodpecker. Thus, because the Forest Service’s management practices are similar to the monitoring of an endangered species, the court properly issued an injunction to protect the red-cockaded woodpecker from extinction in Texas. Sierra Club v. Lyng, Secretary of Agriculture, 694 F.Supp. 1260, 1988 U.S. Dist. Lexis 9203 (E.D. Tex. 1990).

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court FMC Corp. v. U.S. Dept. of Commerce 786 F. Supp.471 (E.D.Pa 1992) U.S. District Court 2. Key Facts A. FMC owned and operated the Facility which was taken over during World War II to produce rayon for war purposed while “hazardous substances” were “disposed of” at the Facility.

B. FMC is being ordered to pay for clean-up under CFRCLA. C. FMC seeks indemnification from the Government for some portion of related costs.

Issue 3.

Is the Government responsible for costs resulting from release of the hazardous substance?

4. Holding Yes. 5. Court’s Reasoning A. Liability of an owner or operator for removal costs “is strict and joint and several”.

B. The United States was an owner and is liable.

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Chapter 35 Labor, Worker Protection, Employment, and Immigration Law

Why Did Labor Need To Be Organized?

Learning Objectives: 1. Explain how state workers’ compensation programs work and describe the benefits available.

2. Describe employers’ duty to provide safe working conditions under the Occupational Safety and Health Act. 3. Describe the pay rules of the Fair Labor Standards Act. 4. Describe how a labor union is organized and describe employees’ rights to strike and picket.

5. Describe immigration laws and how they apply to the employment relationship.

I.

Teacher-to-Teacher Dialogue

This chapter is designed to introduce the student to our nation’s sometimes-controversial history with regard to the development of public policies toward organized labor. Organized labor has suffered from a long and steady decline in membership, power, and influence over the past forty years. In spite of this consider the working conditions that existed before unions. It is a hallmark of advanced industrialized economies that the work force is highly organized and has a strong bargaining power over its affairs. The immediate post–Civil War era of industrialization saw the possibilities for abuse of the work force not only become reality, but also a tragedy, when it came to workers’ safety. Most modern social legislation, however, ranging from the minimum wage, to child labor laws, to workplace and antidiscrimination statutes are traceable to hard fought collective bargaining agreements aimed at solving the problems.

The basic employer–employee relationship is a contractual one. As with any contract, both parties are expected to enter into the relationship with their own best interests at heart. Each side of the labor–management relationship still looks out for itself. But in looking out for number one, both must appreciate their mutual interdependence on each other. Labor must realize that it cannot sustain its own survival on the backs of failed companies brought down by union imposed inefficiencies. Labor must adjust to the situation and make concessions to both the technological and economic realities of trying to compete in a global economy. Management, in turn, must do the same. This chapter describes how the law can help in this process.

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This chapter also discusses the various legal efforts to protect the employment environment.

The FLSA, Workers’ Compensation, OSHA, and Immigration Law are among the topics discussed.

II.

Text Materials

Workers’ Compensation Acts: • Acts that compensate workers and their families if workers are injured in connection with their jobs Employment-Related Injuries 1. Out of and in the course of employment 2. Cafeteria or business lunch included 3. Personal lunch or off-premises not included Case 35.1. The Court Speaks: Medrano v. Marshall Electrical Contracting, Inc, 1735. W. 3d 333, Web 2005 Mo. App. Lexis 1088 (2005) Court of Appeals of Mississippi.

Facts: Medrano was a journeyman electrician for Marshall who paid tuition and book fees for him to attend an electrician apprenticeship night class. Round-trip was a 75 mile drive. On the way home one night he was killed by a drunk driver. His family filed for workers’ compensation death benefits. An ALJ denied claim as not occurring within the course and scope of employment. The LIRC reversed. Marshall appealed.

Issue: Was Medrano acting within the scope of employment when the accident occurred?

Decision: Yes. LIRC’s finding was affirmed.

Reason: The injury suffered occurred while he was acting for the mutual benefit of the employer and employee. This was compensable. After the training he would have been more valuable by improving the quality of customer services. Driving to and from the class helped foster this mutual benefit.

Occupational Safety and Health Act: • Enacted in 1970 to promote safety in the workplace.

• Established the Occupational Safety and Health Administration (OSHA).

• Generally, all private employers are within the scope of the act.

• Federal, state, and local governments are exempt.

• The act imposes record keeping and reporting requirements on employers.

• Employers are required to post notices in the workplace informing employees of their • rights under this act.

OSHA is empowered to administer the act and adopt rules and regulations to interpret • and enforce it.

OSHA is empowered to inspect places of employment for health hazards and safety • violations.

If a violation is found, OSHA can issue a written citation. o Requires the employer to abate or correct the situation OSHA Duty Standards: .

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1. Specific duty 2. General duty Fair Labor Standards Act (FLSA) of 1938: • Federal act enacted to protect workers o Prohibits child labor ▪ Younger than 14—only newspaper delivery ▪ 14 and 15—nonhazardous jobs (limited hours) ▪ 16 and 17—nonhazardous jobs (unlimited hours) ▪ 18 and older—no restrictions o Establishes minimum wage requirements o Establishes overtime pay requirements • Exemptions: o Executive o Administrative Employee o Learned Positions o Highly Compensated o Computer Employee o Outside Sales Case 35.2. The Supreme Court Speaks: IBP,Inc. v. Alvarez, 546 U.S. 21, 126 S. Ct. 514, 163 L. Ed. 2d 288, Web 2005 U.S. Lexis 8373 (2005) U.S. Supreme Court Facts: IBP produces beef, pork, and related products. All workers must wear specific clothing and those using knives must wear additional protective equipment. They are required to store the equipment and tools in locker rooms where they change before and after work. They are paid while cutting and bagging and are paid for 4 minutes to change. A class action suit was filed for compensation for time spent changing and walking between the lockers and the production floors.

The suit was based on the FLSA. The district court agreed and awarded damages. This affirmed by the court of appeals. IBP appealed with respect to the walking time.

Issue: Is the time spent by employees walking between lockers and production areas compensable under the FLSA? Decision: Yes. The Supreme Court agreed.

Reason: The Department of Labor work day is from “whistle to whistle”. Walking before and after a shift between lockers and production is integral and indispensable to a principal activity and is thus a principal activity itself.

Other Worker Protection Laws: 1. Employee Retirement Income Security Act (ERISA)—Prevents fraud and other abuses associated with private pension plans.

2. Consolidated Omnibus Budget Reconciliation Act (COBRA)—Permits employees and their beneficiaries to continue their group health insurance after an employee’s employment has ended.

3. Family and Medical Leave Act (FMLA)—Guarantees workers unpaid time off from work for medical emergencies, birth, or adoption of a child. No loss in pay, benefits, and status upon returning to work.

4. Immigration Reform and Control Act—Makes it unlawful for employers to hire illegal immigrants. Employers are required to complete INS Form I-9 attesting legal U.S. citizenship or legal alien status of each employee. .

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Landmark Law: Federal Labor Law Statutes This discusses the Norris-LaGuardia Act, the National Labor Relations Act, the LaborManagement Relations Act, the Labor-Management Reporting and Disclosure Act, and the Railway Labor Act. Federal Labor Union Statutes (A description) 1. Norris-LaGuardia Act (1932)—Employees can organize 2. NLRA (1935)—Employees can join union; collective bargaining and rights.

3. Taft-Hartley Act (1947)—Employees can oppose union formation; 80 day cooling off 4. Landrum-Griffin Act (1959)—Internal union after regulation 5. Railway Labor Act (1934)—Railroad and airlines carrier employees Note: NLRB is a federal agency that oversees union elections, prevents unfair labor practices, and enforces and interprets certain federal labor laws.

Organizing a Union: • Section 7 of the NLRA—gives employees the right to join together to form a union. o Unfair labor practice to influence joining or not joining a union or to interfere with election • Appropriate Bargaining Unit—the group that the union is seeking to represent: o Must be defined before the union can petition for an election o Managers and professional employees may not belong to unions formed by employees whom they manage Types of Union Elections: 1. Contested—needs a simple majority 2. Consent—NLRB not always needed 3. Decertification—NLRB is needed Case 35.3. The Supreme Court Speaks: National Labor Relations Board v. Exchange Parts Co., 375 U.S. 405, 84 S. Ct. 457, 11 L. Ed. 2d 435, Web, 1964 U.S. Lexis 2263 (U.S. Supreme Court) Facts: Exchange Parts Co. is engaged in the business of rebuilding automobile parts in Fort Worth, TX. Prior to November 1959, a union did not represent its employees. In November 1959, the International Brotherhood of Boilermakers, Iron Shipbuilders, Blacksmiths, Forgers, and Helpers advised Exchange Parts that it was going to conduct a campaign to organize workers at the plant. The NLRB ordered an election date. In February 1960, Exchange Parts held a dinner for its employees and announced new company benefits including an extra holiday, increased wages, and an extended vacation plan. The Union lost the election. The NLRB ordered a new election, which was reversed by the court of appeals.

Issue: Is it an unfair practice for an employer to confer new economic benefits on its employees on the eve of an election?

Decision: Yes.

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Reason: An employer’s conferral of benefits on employees on the eve of a union election, which are designed to affect the outcome of that election, is an unfair labor practice.

Collective Bargaining: • The act of negotiating contract terms between an employer and the members of a union.

• Collective Bargaining Agreement—the resulting contract from a collective bargaining • procedure.

The employer and the union must bargain with each other in good faith.

• Compulsory subjects—wages, and so on • Permissive subjects—not compulsory or illegal • Illegal subjects—closed shops, and so on Union Security Agreements: • Union Shop o Employee must join the union within a certain number of days after being hired. o Employees who do not join must be discharged by the employer upon notice from the union. o Union members pay union dues to the union. o Union shops are lawful.

• Agency Shop o Employees do not have to become union members. o They do not have to pay an agency fee (an amount equal to union dues) to the union. o Agency shops are lawful.

• Closed Shop o Hire only union members—illegal.

Contemporary Environment: State Right-to-Work Laws This statute represents a test of a state’s loyalty to or opposition to unionization within its borders.

There is a perception that the less a state does to control the activities of business entities within its borders, the more likely will business choose to move there. These laws often outlaw union and agency shops.

State Right-to-Work Laws: • Section 14(b) of the Taft Hartley Act—allows states to enact right-to-work laws that outlaw union or agency shops. o Individual employees cannot be forced to join a union or pay union dues and fees even though a union has been elected by other employees. o Twenty-one states have enacted right-to-work laws.

Illegal Strikes are: • Violent Strikes • Sit-Down Strikes • Partial or Intermittent Strikes • Wildcat Strikes—no proper union authorization • Strikes during the 60-day Cooling-Off Period • Strikes in Violation of a No-Strike Clause .

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Note: An employer may prevent potential strikers from entering. This is called a lockout.

Crossover Worker: • Individual members of a union do not have to honor the strike • They may: 1. Choose not to strike, or 2. Return to work after joining the strikers for a time Replacement Workers: • Workers who are hired to take the place of striking workers.

• They can be hired on either a temporary or permanent basis.

• If replacement workers are given permanent status, they do not have to be dismissed when the strike is over.

Ethics: Labor Union Conducts Mock Funeral While Picketing a Hospital Not coerced, threatening, restraining, or intimidating and was not illegal Ethics: WARN Act Requires Employers to Notify Employees of Impending Plant Closures and Layoffs Warn Act 1. More than 100 employess—60 day notice for certain closings or layoffs 2. Plant closings, temporary or permanent, with 50 or more employees—30 day notice 3. Mass layoffs, either a 33 percent reduction or 50 or more employees—30 day notice Exemptions 1. Not reasonably foreseeable business circumstances 2. Good faith effort to stay opened (possibly hampered by notice requirements) Unemployment Compensation Federal act requiring employees to pay unemployment taxes. Benefits for temporary unemployment: 1. Usually must be able and available for work and seeking employment 2. No benefits if bad conduct 3. No benefits if quit without just cause Government Programs: Unemployment Compensation • Federal Unemployment Tax Act (FUTA)—a federal act that requires employers to pay unemployment taxes: o Unemployment compensation is paid to workers who are temporarily unemployed.

• State governments administer unemployment compensation programs under general guidelines set by the federal government.

Government Programs: Social Security .

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• • •

A Federal system that provides limited retirement and death benefits to covered employees and their dependents.

Federal Insurance Contributions Act (FICA)—a federal act that say employees and employers must make contributions into social security.

Self-Employment Contributions Act—a federal act that says self-employed persons must pay Social Security taxes equal to combined employer–employee amount

International Law: H-1B Foreign Guest Worker Visa III.

Answers to Critical Thinking Cases

Workers’ Compensation 35.1.

Yes. The accident was causally connected to his employment. As a teacher there was some expectation of participation in extracurricular activities. Participation was considered part of his duties. His accident resulted from attendance at a required event and was part of entertainment which is causally connected to his employment. Smith v.

Workers’ Compensation Appeals Board, 191 C. App. 3d 127, 236 Cal. Rptr. 248, Web 1987 Cal. App. Lexis 1587 (Court of Appeal of California)

Occupational Safety 35.2.

The Occupational Safety and Health Review Commission prevails because an employer is required to furnish a safe place of employment for its employees. The court stated that to violate the Occupational Safety and Health Act, the Secretary must prove that (1) the employer failed to render its workplace “free” of a hazard that was (2) recognized, and (3) causing or likely to cause death or serious physical harm. In this case, the failure to pressure test a pressure vessel before activation was an apparent and obvious hazard that was likely to cause serious injury. Furthermore, it created an extremely high probability of rupture and ensuing harm. Thus, the court stated that it is clear the hazard at issue here was both “recognized” and likely to cause serious harm, as well as preventable by the simple expedient of pressure testing. Getty Oil Company v. Occupational Safety and Health Review Commission, 530 F.2d 1143 (5th Cir. 1976).

Unemployment Benefits 35.3.

The CTA wins. The court following Sec. 602(A) of the Unemployment Insurance Act stated “an individual shall be ineligible for benefits for the week (or time period) in which he has been discharged for misconduct connected with his work.” The court defined misconduct as behavior that is willful or a wanton disregard of an employer’s interests. Such interests include the intentional and substantial disregard of the employee’s duties and obligations to his employer. In this case, Devon Overstreet’s use of cocaine prior to reporting for work constituted a deliberate violation of her employer’s policy and indicated a disregard of the standards of behavior that the employer had the right to inspect. Overstreet v. Illinois Department of Employment Security, 522 N.E.2d 185 (Ill.App. 1988).

Unfair Labor Practice .

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35.4.

Yes, the president of the Sinclair Company violated federal labor law by unlawfully interfering with the union election. The Supreme Court held that although an employer is free to communicate to his employees his general views about unionism or his specific views about a particular union, his statements may not contain a threat of reprisal, force, or coercion. He may make predictions of the effects he believes unionization will have on his company. The court held that the president’s statements were not cast as predictions but rather as threats of retaliatory action if the employees elected a union.

The court concluded that the intended and understood import of the president’s messages was to threaten to throw the employees out of work if the union won the election. The Supreme Court held that the president of the Sinclair Company interfered with the election and ordered that the election be set aside. NLRB v. Gissel Packing Co., 395 U.S. 575, 89 S.Ct. 1918, 23 L.Ed.2d 547 (1969).

Illegal Strike 35.5.

No, Bownds and the employees who engaged in the walkout cannot get their jobs back.

Bownds, who was discharged for his actions in cutting the bags of flour, was properly discharged for his conduct. The court found that the other employees had engaged in an illegal “wildcat strike” that was not sanctioned by their union. The National Labor Relations Act indicates a preference for collective bargaining. Because the employer is required to bargain with the representative of the workers, it must have some assurance as to the identity of that agent and that it can deal with that agent as a responsible spokesperson for the employees of the unit. There cannot be bargaining in any splinter groups. The court held that because this was an illegal wildcat strike, then the workers were illegal strikers who could be discharged without the right to reinstatement. NLRB v.

Shop Rite Foods, Inc., 430 F.2d 786 (5th Cir. 1970).

Employer Lockout 35.6.

Yes, American Ship Building can lawfully lay off the employees in what is called an employer lockout. Federal labor law permits an employer to lockout employees if it reasonably anticipates a strike or has reached an impasse in collective bargaining negotiations and there is a threat of damage to the employer’s property. In this case, evidence showed an impasse had been reached in collective bargaining; there was a threat of an impending strike by the unions that would shut the shipyard down for the winter months.

The Supreme Court held that the use of a temporary layoff of employees by the employer in this case solely as a means to bring economic pressure to bear in support of its bargaining position was lawful under the National Labor Relations Act. The court held that an employer can engage in a lockout and preempt the threatened strike by the unions, and that in this case the lockout was a reasonable response to the threatened strike. American Ship Building Company v. NLRB, 380 U.S. 300, 85 S.Ct. 955, 13 L.Ed.2d 855 (1965).

IV.

Answers to Ethics Cases

35.7.

Employees can engage in self-help under certain circumstances under OSHA regulations.

The Secretary of Labor has promulgated a regulation providing that an employee may choose not to perform his assigned tasks if he has a reasonable apprehension of death or .

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35.8.

serious injury coupled with a reasonable belief that no less drastic alternative is available, without being subject to subsequent discrimination. The issue here is whether that regulation is valid. The fundamental purpose of OSHA is to prevent occupational deaths and serious injuries. This legislation is broad in nature. It would be anomalous to construe this act as to not allowing the employee to withdraw from a dangerous workplace. Further, there is an affirmative duty on all employers to provide a safe workplace. Because an OSHA inspector cannot be present all the time, this regulation allows the employee to get the benefit of a safe workplace in all circumstances. The regulation is valid. Whirlpool Corp. v. Marshall, Secretary of Labor, 445 U.S. 1, 100 S.Ct. 883, 63 L.Ed.2d 154 (1980).

No, the picketing of the five neutral title insurance companies is not lawful. The Supreme Court held that the picketing of the neutral employers constituted an illegal secondary boycott in violation of the National Labor Relations Act. Although in Tree Fruits, 377 U.S. 58, 84 S.Ct. 1063 (1964), the court held that secondary picketing against a struck product is lawful, the picketing becomes an illegal secondary boycott if the picketing threatens, coerces, or restrains a person from buying or using the services of the neutral employer.

The product picketed in Tree Fruits (apples) was but one item among the many that made up the grocery store’s trade. If the appeal against the product succeeds, it simply induces the neutral retailer to reduce its orders for the product or to drop the item as a poor seller. Under this circumstance, the incidental injury to the neutral employer will be tolerated. However, in this case the five local title insurance companies sell only the primary employer’s product. Secondary picketing against consumption of the primary employer’s product leaves responsive consumers no realistic option other than to boycott the five local title companies altogether. The court held that the union did more than merely follow the struck product; it created a separate dispute with the secondary employers. The Supreme Court upheld the NLRB’s decision that ordered the union to cease picketing the five local title insurance companies. NLRB v. Retail Store Employees Union, Local 1001, Retail Clerks International Association, AFL-CIO, 447 U.S. 607, 100 S.Ct. 2372, 65 L.Ed.2d 377 (1980).

V.

Answers to Policy Cases:

35.9.

Lechmere could prohibit nonemployee union organizers from distributing letters to employees in the store’s parking lots. The inaccessibility exception is a narrow one. It does not apply where non-trespassing access to employees may be cumbersome, but where the location of the plant and living quarters places the employees beyond the reach of reasonable communication. Here other means of communication were readily available. Signs would have worked here. Lechmere, Inc. v. NLRB, 502 U.S. 527, 112 S.Ct. 841, 117 L. E9. 2d 79, Web 1992 U.S. Lexis 555 (U.S. Supreme Court)

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Wiljef Transportation v. NLRB 946 F.2d 1308 (1991) United States Court of Appeals for the 7th Circuit

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2. Key Facts A. The employer, Wiljef, was involved in a dispute with its employees who were seeking to unionize.

B. In response to the unionization efforts, Wiljef amended its bylaws to call for the company’s dissolution if unionization were to take place.

C. The employer contended that this by-law was an expression of free speech as protected by the First Amendment.

D. The NLRB claimed that the by-law violated the National Labor Relations Act. E. The lower court held in favor of the NLRB, and Wiljef appealed.

3.

Issue Did the by-law violate the National Labor Relations Act?

4. Holding Yes. 5. Court’s Reasoning The U.S. Court of Appeals for the 7th Circuit held that: A. The general freedom of expression is recognized in Section 8© of the NLRA. B. However, Section 8© states that if the expression is used as a threat against the employee’s right to associate, it can be interpreted as an unfair labor practice.

C. In this case, the lower court found that the by-law was designed to coerce employees to reject the attempted unionization of their ranks.

D. The lower court’s ruling in favor of the NLRB was upheld.

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Chapter 36 Equal Opportunity in Employment

Why Is Discrimination In Employment Wrong?

Learning Objectives 1. Describe the scope of coverage of Title VII of the Civil Rights Act of 1964.

2. Identify race, color, and national origin discrimination that violate Title VII. 3. Identify sex discrimination—including sexual harassment—that violates Title VII. 4. Describe the scope of coverage of the Age Discrimination Employment Act. 5. Describe the protections afforded by the Americans with Disabilities Act. I. Teacher-to-Teacher Dialogue Today’s students appear far more divided on employment issues than in the past. Perhaps it is the tight job market or the polarization, which comes from crime, economic disparities, and the like.

As a possible way to break the barriers, try to initially clearly define the terms. Second, try to present both sides of every argument. This is especially important in the most controversial areas such as affirmative action. After all arguments have been listed, attempt to have students engage in open debate. Allowing all sides an opportunity to be heard is a fair approach. If the class as a whole wants to take only one side, we owe it to fair inquiry and academic freedom to put forward opposite views, even if we personally do not support those views. Teaching these materials is never easy, but remains always exciting.

No single American legal issue is inflamed with more controversy than discrimination in the workplace. The genesis of our nation’s heritage is rooted in a diversity of peoples who immigrated to the New World in order to flee the royalist, class, or caste systems that so often predestined their opportunities for social and economic advancement. The U.S. Declaration of Independence, and the government founded on it, was the first major system of self-governance premised on the assumption that all persons are born equal and should be treated equally in the eyes of the law. As we all know, that equality has often been a hope rather than a reality for many.

The same diversity that has been a source of national pride has also been the basis of disparate treatment of persons in the workplace for many years. The term “discriminate” has within it two distinct and opposite meanings. On the positive side, discrimination is simply a fact .

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of life. We are not all equal in all ways. We have different talents, strengths, levels of training, and abilities. Employers, in turn, should be allowed and expected to seek utilization of these divergent talents and strengths in their own best interests. To discriminate in the positive sense is to reward ability and merit on its face. The positive aspect of discrimination really says that uniqueness should be discerned, differentiated, distinguished, and rewarded in the workplace. In the end, economic marketplace factors are blind to any other factors but job performance. For example, you cannot expect the average man on the street to play golf as well as Tiger Woods.

He, in turn, is duly rewarded for these talents.

The negative side of discrimination is found in wrongful selection processes. For a society founded on a premise of equality, we have certainly had more than our share of unequal treatment in the workplace. The negative side of discrimination is inequality of treatment based on wrongful motive, justifications, or rationalizations. Each choice not based on talent, ability, and merit is a step away from the inherent basis of equality before the law. None of us can afford to look the other way and say: “It’s not my problem.” Wrongful discrimination against any group is a wrong upon the society at large. Almost everyone appreciates that fact intuitively, if not intellectually.

One element that provides hope for positive change is goodwill. Where people of goodwill cling to the basic rightness of equity before the law, that equity will eventually result in a changed culture. Until then, law and our courts will continue to be the testing grounds for this necessary change in the social order.

II.

Text Materials

EEOC: • Federal agency responsible for enforcing most federal antidiscrimination laws • Complainant must go here before going to court Lilly Ledbetter Fair Pay Act of 2009 • Each discriminatory pay decision restarts the statutory 180 day clock • Back pay can be awarded for up to 2 years preceding filing of a claim if similar violations occur during the prior 2-year period.

Title VII of the Civil Rights Act of 1964 • Intended to eliminate job discrimination based on five protected classes: o Race o Color o Religion o Sex o National Origin There can be no discrimination in employment based on race, color, religion, sex, or national origin without a good job-related reason. There is basically no good job-related reason for race and color.

Landmark Law: Title VII of the Civilenacted Rights Act 1964 After substantial debate, Congress the of Civil Rights Act of 1964. Title VII focuses on eliminating job discrimination based on race, color, religion, sex, or national origin.

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Scope of Coverage of Title VII • Title VII applies to: o Employers with 15 or more employees o All employment agencies o Labor unions with 15 or more members o State and local governments and their agencies o Most federal government employment • Indian tribes and tax-exempt private clubs are expressly excluded from coverage • Title VII applies to any term, condition, or privilege of employment including, but not limited to: o Hiring and firing o Work rules o Promotion and demotion o Payment of compensation and benefits o Availability of job training opportunities Forms of Title VII Actions • Disparate Treatment Discrimination

o Occurs when an employer discriminates against a specific individual because of

•

his or her race, color, national origin, sex, or religion.

Disparate Impact Discrimination

o Occurs when an employer discriminates against an entire protected class o Often, this is proven through statistical data about the employer’s employment

practices Remedies: • Back pay • Reasonable attorneys fees • Reinstatement • Fictional seniority • Injunctions • Sometimes punitive damages—malice or reckless indifference

Case 36.1. The Court Speaks: NAACP v. Town of Harrison, New Jersey, 907 F.2d 1408, Web 1990 U.S. App. Lexis 11793 (U.S. Court of Appeals).

Facts: The town of Harrison had followed a policy, and later adopted an ordinance, requiring that all officers and employees of the town be residents of the town. The town had virtually no black residents and none of its employees were black. Harrison is a small, industrial community in Hudson County, but is closely aligned with the contiguous Essex County and the City of Newark.

In fact, 22.1 percent of the private employees in Hudson County were black, virtually all of whom came from outside Hudson County. Further, there was evidence that approximately 22.2 percent of the black population proximate to Harrison was qualified for jobs as firefighters or police officers.

Issue: Does the residency requirement violate Title VII of the Civil Rights Act of 1964?

Decision: Yes. Reason: The court found that: (1) the proportion of blacks hired by Harrison did not fit the racial makeup of the pool of qualified applicants from the four county labor market; (2) the residency requirement was the cause of at least a substantial part of this disparity; and (3) the business

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reasons for this employment practice could be met in other, nondiscriminatory ways, such as requiring all police and firemen to live within a reasonable response time of Harrison. This is an example of a racially neutral policy that has a disparate impact on a protected group.

Case 36.2. The Court Speaks: Rivera v Baccarat, Inc, 10 F. Supp. 2d318, Web 1998 U.S. Dist.

Lexis 9099 (U.S. District Court) Facts: Rivera, a Hispanic woman, worked for Baccarat, Inc. in Manhattan. After 8 years she was the top sales representative and was praised as one of the best by Watts, the store manager. Negre became the new president and was in charge of personnel. Negre told her that her attitude was bad and she should not speak Spanish on the job. Russell, the CFO, told Rivera 6 months later Negre was terminating her, along with another Hispanic sales rep, Brigganty, allegedly for being Hispanic. A non-Hispanic salesperson was retained by the store. Rivera sued for violation of Title VII of the Civil Rights Act. Issue: Did Baccarat engage in unlawful national origin discrimination?

Decision: Yes. River awarded $206,810.

Reason: National origin discrimination can be based on linguistic characteristics. If an accent does not interfere with job performance, it cannot legally be the basis for an adverse employment action. Here, Negre did not like Rivera’s accent, did not want Hispanic employees, and two Hispanics were fired while a non-Hispanic was not.

Landmark Law: Civil Rights Act of 1866 This deals with the rights to make contracts. Employment issues are covered. This statute allows for less procedural issues and lack of cap on recovery.

Gender Discrimination: • Also known as sex discrimination Pregnancy Discrimination: • Discrimination because of pregnancy is prohibited Case 36.3. The Court Speaks: Barbano v. Madison County, NY, 922 F.2d 139, Web 1990 U.S. App. Lexis 22494 (U.S. Court of Appeals) Facts: The Madison County Veterans Service Agency offers counseling, information, and other services to veterans and their dependents. In February 1980, the position of Director of the Agency became vacant. The board decided to hold interviews before appointing a new Director.

The interviews were to be conducted by the Committee, which would then submit its recommendation to the board. Barbano applied for the position and was interviewed in February 1980.

Before entering the interview, Barbano heard someone say, “Here are copies of the next resume,” followed by the comment, “Oh, another woman.” The interview began, and after Barbano stated why she thought she was qualified for the job, committee member Greene said that he would not consider “some woman” for the position. Greene then asked Barbano her plans on having a family and whether her husband would object to her transporting male veterans.

Barbano said that the questions were irrelevant and discriminatory.

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The Committee interviewed several other candidates, and found all of them (including Barbano) to be qualified for the position. Following the interview process, the interviewers ranked the applicants and unanimously agreed to recommend Allan Wagner to the Board.

Barbano commenced this action in 1982. The court found that Barbano has established a prima facie case of discrimination under Title VII, thus bringing into issue appellant’s purported reasons for not hiring her. Appellants provided four reasons why they chose Wagner over Barbano, which the district court rejected as either unsupported by the record or a pretext for discrimination in light of Barbano’s interview. The district court then found that due to Barbano’s education and experience in social services, appellants had failed to prove that, absent the discrimination, they still would not have hired Barbano. Accordingly, the court awarded Barbano back pay, prejudgment interest, and attorney’s fees.

Issue: Did Madison County engage in sex discrimination in violation of Title VII? Decision: Defendant was liable for violating Title VII. Reason: The court held that the record supported a finding that the committee and Board engaged in sex discrimination against Barbano in making the hiring decision. The court held that the questions asked of Barbano were unrelated to a bona fide occupational qualification and that Green’s questions were discriminatory and tainted the decision process.

Contemporary Environment: Sex-Plus Discrimination: This involves treating a subset of a class differently. For example, women with children. Some court says this violates Title VII. Sexual Harassment 1. Lewd remarks, touching, and so on 2. Sexual favors often for job advancement Types 1. Quid pro quo 2. Hostile—look to frequency and severity Case 36.4. The Court Speaks: PA State Police v. Suders, 542 U.S. 129, 124 S.Ct. 2342, 159 L. Ed 2d 204, Web 2004 U.S. Lexis 4176 (2004) U.S. Supreme Court Facts: Suders was hired by PSP as a police communications operator. She subjected to continuous sexual harassment that only ceased when she resigned. She contacted PSP’s equal opportunity officer who she found to be insensitive and unhelpful. She resigned and sued PSP alleging that she was constructively discharged and forced to resign. The court said yes to the sexual harassment but no to PSP’s vicarious liability and granted PSP’s motion for summary judgment. The court of appeals reversed and the case was remanded. PSP appealed.

Issue: Can an employer be held vicariously liable when the sexual harassment conduct of its employees is so severe that the victim of the harassment resigns?

Decision: Yes. The case was remanded.

Reason: The behavior was so severe or pervasive that it created a work environment abusive to employees because of their gender against Title VII’s broad rule of workplace equality. If, as in this case, the abusive conduct was so intolerable that resignation was a fitting response, there is “constructive discharge”. Because the employer does not seem to have a readily accessible and effective policy for reporting and resolving sexual harassment complaints, an otherwise affirmative defense is not available. The case presents a “Worst Case” harassment scenario.

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Employer’s Defense to a Charge of Sexual Harassment Recent cases give rise to certain affirmative defenses: 1. Reasonable care to prevent and commit 2. Plaintiff did not use number 1 above 3. Importance of policy is stressed.

Cyber Law: Offensive E-Mails Can Cause Sexual Harassment This discusses how e-mail has increased the exposure of businesses to sexual and racial discrimination lawsuits.

Same-Sex Discrimination: • The U.S. Supreme Court has held that same-sex sexual harassment and discrimination • violates Title VII. Many state and local laws also prohibit this form of discrimination and harassment in the workplace.

Religious Discrimination 1. Reasonable accommodation 2. Sometimes permitted in religious groups Defenses to a Title VII Action: Merit • Employers can select or promote employees based on merit.

• Merit decisions are often based on work, educational experience, and professionally • developed ability tests.

To be lawful under Title VII, the requirement must be job related.

Defenses to a Title VII Action: Seniority • An employer may maintain a seniority system that rewards long-term employees. o For example, higher wages, fringe benefits, and other preferential treatment o Such systems are lawful if they are not the result of intentional discrimination Defenses to a Title VII Action: Bona Fide Occupational Qualification (BFOQ) • Employment discrimination based on a protected (other than race or color) is lawful if it is: o Job related; and a o Business necessity o This exception is narrowly interpreted by the courts.

Case 36.5. The Court Speaks: International Union Etc. v. Johnson Controls, Inc, 499 U.S. 187, 111 S. Ct. 1196, 113 L. Ed. 2d 158, Web 1991 U.S. Lexis 1715 (U.S. Supreme Court) Facts: A primary ingredient in Johnson Control’s battery manufacturing process is lead, occupational exposure to which entails health risks, including the risk of harm to any fetus carried Copyright © 2012 Pearson Education, Inc, publishing as Prentice Hall

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by a female employee. After eight of its employees became pregnant while maintaining blood lead levels exceeding that were noted by the Occupational Safety and Health Administration (OSHA) as critical for a worker planning to have a family, respondent announced a policy barring all women, except those whose infertility was medically documented, from jobs involving actual or potential lead exposure exceeding the OSHA standard. Petitioners, a group including employees affected by respondent’s fetal-protection policy, filed a class action in the District Court, claiming that the policy constituted sex discrimination violating Title VII of the Civil Rights Act of 1964, as amended. The court granted summary judgment for respondent, and the Court of Appeals affirmed. The latter court held that the proper standard for evaluating the policy was the business necessity inquiry applied by other Circuits and that respondent was entitled to summary judgment because petitioners had failed to satisfy their burden of persuasion as to each of the elements of the business necessity defense. Respondent was entitled to summary judgment because its fetal-protection policy is reasonably necessary to further the industrial safety concern that is part of the essence of respondent’s business.

Issues: Is Johnson Control’s fetal-protection policy a BFOQ? Decision: Title VII, as amended by the Pregnancy Discrimination Act (PDA), forbids sexspecific fetal-protection policies.

Reason: Blackmun, J. By excluding women with childbearing capacity from lead-exposed jobs, respondent’s policy creates a facial classification based on gender and explicitly discriminates against women on the basis of their sex under Sec. 703(a) of Title VII. Moreover, in using the words “capable of bearing children” as the criterion of exclusion, the policy explicitly classifies on the basis of potential for pregnancy, which classification must be regarded, under the PDA, in the same light as explicit sex discrimination. The Court of Appeals erred in assuming that the policy was facially neutral because it had only a discriminatory effect on women’s employment opportunities, and because it asserted purpose, protecting women’s unconceived offspring, was ostensibly benign. The policy is not neutral because it does not apply to male employees in the same way as it applies to females, despite evidence about the debilitating effect of lead exposure on the male reproductive system. Also, the absence of a malevolent motive does not convert a facially discriminatory policy into a neutral policy with a discriminatory effect.

Respondent cannot establish a BFOQ. Fertile women, as far as appears in the record, participate in the manufacture of batteries as efficiently as anyone else. Moreover, respondent’s professed concerns about the welfare of the next generation do not suffice to establish a BFOQ of female sterility.

Title VII, as amended by the PDA, mandates that decisions about the welfare of future children be left to the parents who conceive, bear, support, and raise them rather than to the employers who hire those parents or the courts. An employer’s tort liability for potential fetal injuries and its increased costs due to fertile women in the workplace do not require a different result. The incremental cost of employing members of one sex cannot justify a discriminatory refusal to hire members of that gender.

Equal Pay Act of 1963: • Protects both sexes from pay discrimination based on sex.

• The act prohibits disparity in pay for jobs that require: o Equal skill o Equal effort o Equal responsibility o Similar working conditions Criteria That Justify a Differential in Wages: • The Equal Pay Act expressly provides four criteria that justify a differential in wages: .

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o Seniority o Merit o Quantity or quality of product o Any factor other than sex Age Discrimination in Employment Act (ADEA) of 1967 • Prohibits age discrimination of all employment decisions, including: o Hiring o Promotions o Payment of compensation o Other terms and conditions of employment o The Older Workers Benefit Protection Act (OWBPA) amended ADEA to prohibit age discrimination with regard to employee benefits.

• ADEA applies to employees who are 40 years of age and older.

• Covered employers cannot establish mandatory retirement ages for their employees.

• ADEA is administered by the EEOC. Americans with Disabilities Act (ADA) of 1990: • The ADA imposes on employers and providers of public transportation, telecommunications, and the public accommodations to accommodate individuals with disabilities.

• Title I of the ADA prohibits employment discrimination against qualified individuals with disabilities.

• Approach: • Is it a disability? (substantially limits one or more major life functions) • Is there a reasonable accommodation?

1. Physical or mental impairment 2. Record of number 1 3. Regarded as having number 1 4. Not covering current illegal drug use or alcoholism Note: A qualified individual can perform the essential functions of the job that they desire or hold. An employer cannot ask an applicant about a disability but can ask about the ability to perform a job. A pre-employment medical exam is forbidden before an offer.

Landmark Law: Americans with Disabilities Act This statute prohibits discrimination in regard to a job against qualified individual with disabilities. Reasonable Accommodations are required. 2008 amendments require a broad construing of the definition of disability.

Title I of the ADA: • Requires an employer to make reasonable accommodations to individuals with disabilities that do not cause undue hardship to the employer.

Job Testing: • ADA forbids asking about a disability.

• Medical exam is appropriate after an offer, if for all.

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Case 36.6. The Court Speaks: PGA Tour, Inc. v. Martin, 532 U.S. 661, 121 S.Ct. 1879, 149 L. Ed 2d 904, Web 2001 U.S. Lexis 4115 (U.S. Supreme Court) Facts: Casey Martin is a talented amateur golfer who has Klippel-Trenaunay-Weber Syndrome, a degenerative circulatory disorder that obstructs the flow of blood from his right leg to his heart.

When he turned professional, he qualified for the PGA Tour. He requested to use a golf cart while playing in PGA tournaments, but the PGA Tour denied his request. Martin sued the PGA in violation of the ADA for not making reasonable accommodations for his disability. Martin won at the district court and court of appeals levels.

Issue: Does the Americans with Disabilities Act of 1990 require the PGA Tour to accommodate Casey Martin, a disabled professional golfer, by permitting him to use a golf cart while playing in PGA sponsored golf tournaments?

Decision: Yes. Reason: Golf is a game where it is impossible to guarantee that all competitors will play under exactly the same conditions or that an individual’s ability will be the sole determinant of the outcome. The ADA requires that the PGA Tour accommodate Casey Martin by allowing him to use a golf cart.

Affirmative Action: • Policy that provides that certain job preferences will be given to minority or other • protected class applicants when an employer makes an employment decision Key issues: o Affirmative action plans o Reverse discrimination o Race norming • Explanation: o Narrowly tailored for compelling interest o No quotas o Reversed discrimination not actionable Protection from Retaliation: None allowed for filing a charge of discrimination.

International Law: Companies from South Korea, Japan, and Israel Operating in the United States Are Not Subject to Antidiscrimination Laws They are not subject to antidiscrimination laws. These agreements are by treaty and have been criticized.

III.

Answers to Critical Thinking Cases

Equal Pay Act 36.1.

Yes, the wage practices by Corning violated the Equal Pay Act. In order to establish a violation of the Act, it must be shown that an employer pays different wages to employees of opposite sexes “for equal work on jobs the performance of which requires

.

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equal skill, effort, and responsibility, and which are performed under similar working conditions.” Here, the Supreme Court held: 1. The term “working condition” encompasses only physical surroundings and hazards and not the time of the day worked. Thus, the original pay differential between the day (female) shift and the night (male) shift violated the Act. 2. The violation was not cured when Corning began hiring women to work the night shift because the higher “red circle” rate paid to previously hired male night shift workers perpetuated the discrimination.

Corning Glass Works v. Brennan, Secretary of Labor, 417 U.S. 188, 94 S.Ct. 2223, 41 L.Ed.2d 1 (1974).

Sex Discrimination 36.2.

Yes, the practice of requiring female employees to make larger contributions to the pension fund than male employees constitutes sex discrimination in violation of Title VII. Although the Supreme Court acknowledged that as a class, women do live longer than men, it is not true that all individuals of the respective classes will do so. In fact, many women do not live as long as the average man and many men outlive the average woman. It is clear that any individual’s life expectancy is based on a number of factors, of which sex is only one.

Note: Although the Supreme Court found a violation of Title VII, it reversed the District Court’s award of retroactive relief to the entire class of female employees and retirees. In doing so, the court cited the potential economic impact that such an award would cause to insurance companies and pension plans. Thus, the challenged practice was only outlawed in the future. City of Los Angeles Department of Water and Power v.

Manhart, 435 U.S. 702, 98 S.Ct. 1370, 55 L.Ed.2d 657 (1978).

Hostile Work Environment 36.3.

Yes, the conduct of the male employees and manager of RDC in this case constitutes sexual harassment in violation of Title VII by creating a hostile work environment. The court held that an employer can be held liable for sexual harassment of its employees under the doctrine of respondeat superior (let the master answer) if the employer either (1) had actual knowledge of the harassment or (2) the harassment was so pervasive that an inference of constructive knowledge arises. In this case, Huddleston made out a prima facie case against RDC for the sexual harassment attributable to the sales manager of RDC. Huddleston v. Roger Dean Chevrolet, Inc., 845 F.2d 900 (11th Cir. 1988).

National Origin Discrimination 36.4.

Yes, the FBI is liable for a pattern or practice of discrimination in violation of Title VII. The court held that the FBI’s actions constituted unlawful national origin discrimination against Hispanic agents. As a remedy, the court ordered that those Hispanic agents who had been discriminated against would be awarded additional seniority to make them whole had such discrimination not occurred. The court ordered that an independent panel be created to decide these claims. In addition, the court ordered the FBI to overhaul its system of promoting Hispanic agents and those from other minority groups to eliminate any discriminatory practice. The court did not grant an award of back pay. Perez v.

Federal Bureau of Investigation, 714 F.Supp. 1414 (W.D. Texas 1989).

Religious Discrimination Copyright © 2012 Pearson Education, Inc, publishing as Prentice Hall

348 Chapter 36

36.5.

No, TWA is not liable for religious discrimination in violation of Title VII. The Supreme Court held that TWA had taken all actions necessary to reasonably accommodate Hardison’s religious preference. The court held that TWA could not force other employees to work in place of Hardison without violating the collective bargaining agreement with the union that would be a violation of federal labor law.

The Supreme Court also held that TWA did not have to meet Hardison’s request to work only a four-day workweek. The court reasoned that this would give Hardison an employment benefit that would be based on religion, which would itself be religious discrimination against the other employees of TWA. Further, the court held that this would cause an undue hardship on TWA by requiring it to hire and train a part-time employee to work Saturdays only or to incur the additional cost of paying overtime wages to a current employee to work overtime on Saturdays. Thus, TWA did not violate Title VII. Trans World Airlines v. Hardison, 432 U.S. 63, 97 S.Ct. 2264, 53 L.Ed.2d 113 (1977).

Bona Fide Occupational Qualification 36.6.

The city and county of Honolulu are not liable for violating Title VII. The court held that the ability to communicate clearly in English was a bona fide occupational qualification (BFOQ) for the position. Because of the required contact with a sometimes-contentious public, the ability to speak clear English was one of the most important skills required for the position. Because Fragante’s English oral skills were hampered by his accent and manner of speaking, he did not meet the bona fide occupational qualification for the job, and was therefore properly denied the position. The court found that the inability to communicate well in English was not a cover for unlawful discrimination. Fragante v.

City and County of Honolulu, 888 F.2d 591 (9th Cir. 1989).

IV.

Answers to Ethics Cases

36.7.

Rawlinson proved a prima facie case of sex discrimination by showing that the racially neutral height and weight restrictions disparately impacted upon women. The trial court found that the height rule excluded more than 32 percent of women but less than 2 percent of men. The weight requirement excluded more than 22 percent of women but less than 2.5 percent of men. Together, these restrictions would exclude more than 41 percent of women but less than 1 percent of men. Dothard argues that height and weight are job related, because they have a relationship to strength that is required. The court held that a strength test should be given to establish strength, rather than using height and weight, for which there was no correlation proven.

The essence of a prison guard’s job is to maintain order. A woman’s relative ability to maintain order in a male, maximum security, unclassified prison could be directly reduced by her womanhood. There is a basis for expecting that sex offenders who have attacked women before would do so again in prison. Also, there is a real risk from other prisoners who are deprived of a normal, heterosexual environment. This is a threat not only to the victim, but also to the safety of the other inmates. Thus, in this case, the applicant’s womanhood directly undermines her ability to do the job. (NOTE: Generally, the woman should be able to decide what employment risks she wants to take.

Here, it is not her safety that the court is protecting; it is the safety of the other inmates.

ALSO NOTE: There is no evidence that women guards are more subject to attacks than men guards; this was an assumption made by the state.) Dothard, Director, Department .

Equal Opportunity in Employment 349

of Public Safety of Alabama v. Rawlinson, 433 U.S. 321, 97 S.Ct. 2720, 53 L.Ed.2d 786 (1977).

36.8.

Machakos wins. The court held that Title VII of the Civil Rights Act of 1964 prohibits racial that discrimination against all races, including whites. In this case, the court found the CRD had engaged in reverse discrimination against Machakos in violation of Title VII. The court found that the CRD’s systematic policy of unlawful minority preference

in hiring had adversely impacted the plaintiff, ordered that Machakos be promoted, and awarded had the Machakos back pay retroactive to when she should have been promoted

V.

CRD not to discriminated Answers Policy Casesagainst her. Machakos v. Attorney General of the United

36.9.

States, The Supreme Court Speaks:Harris v. Forklift Systems, Inc. 510 U.S. 17, 114 S. Ct. 859 F.2d 1487 (D.C. Cir. 1988).

367, 126 L. Ed. 2d 295, Web 1993 U.s. Lexis 7155 (U.S. Supreme Court) Facts: Petitioner Harris sued her former employer, respondent Forklift System, Inc., claiming that the conduct of Forklift’s president toward her constituted “abusive work environment” harassment because of her gender in violation of Title VII of the Civil Rights Act. Forklift’s president often insulted Harris because of her gender and often made her the target of unwanted sexual innuendos.

Issue: To be abusive work environment harassment, must the conduct seriously affect the victim’s psychological well-being?

Decision: No. Reason: To be actionable as “abusive work environment” harassment, conduct need not “seriously affect an employee’s psychological well-being” or lead the plaintiff to suffer injury. Title VII does not require a victim to prove that the challenged conduct seriously affected her psychological well-being.

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Robinson v. Jacksonville Shipyards Inc. 760 F. Supp. 1486 (1991) United States District Court 2. Key Facts A. Jacksonville Shipyards is engaged in a number of contracts with the federal government, and as such, is bound by federal work rules relating to affirmative action and nondiscrimination.

B. Plaintiff is an employee of defendant and works as one of the few woman welders in the defendant’s ship repair facilities.

C. Plaintiff brought this complaint against her employer for failure to comply with federal nondiscrimination rules regarding sexual harassment and its alleged failure to prevent a hostile work environment.

D. Plaintiff complained of a number of incidents of unwelcome sexually harassing behavior by co-employees and of a work environment where nude and suggestive photos of women were allowed by management to be displayed in public.

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350 Chapter 36

E. Defendant claims that it is now in compliance with federal antidiscrimination rules after it adopted a new sexual harassment policy in April 1987.

3. Issue Did the new sexual harassment policy comply with federal anti discrimination rules?

4. Holding No. 5. Court’s Reasoning The United States District Court ruled that: A. The current sexual harassment policy failed to comply with federal regulations on sexual harassment.

B. The defendant was ordered to cease and desist from the continued maintenance of a work environment that was hostile to women because of their sex.

C. Defendant was ordered to implement a new policy, which would be in compliance with federal workplace rules regarding sexual harassment prevention.

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Personal Property, Bailment, and Insurance 351

Chapter 37 Personal Property, Bailment, and Insurance

Who Owns The Property?

Learning Objectives: 1. Define personal property and the methods of acquiring and transferring ownership in personal property.

2. Describe and apply rules regarding ownership rights in mislaid, lost, and abandoned property.

3. List and describe the elements for creating a bailment and explain the liability of bailees for lost, damages, or destroyed goods.

4. Describe an insurance contract and define an insurable interest.

5. List and describe the various types of life, health, disability, and business insurance.

I.

Teacher-to-Teacher Dialogue

The laws of contracts, property, and torts all have not only significant roles in business, but also play vital roles in how one arranges his or her personal affairs. Personal property is one such key area.

In addition to the substantive areas of the law of personal property, you might want to introduce these materials as part of a body of law (the others being real property, insurance, wills, and trusts) that is very much interconnected with their personal planning strategies.

Insurance is defined as a contractual arrangement whereby one undertakes to indemnify another against loss, damage, or liability. Even though the law of insurance is derived from contract, the need for insurance is rooted in reality. Few activities in today’s overly litigious world are not in one way or another involved with insurance. Insurance is more important than ever because it appears that new risks never even fathomed by our forefathers emerge every day.

One very real and unfortunate truth of conducting one’s personal and business affairs is that financial safety nets are more necessary than ever. In spite of many problems, the role of insurance is more vital than ever.

The study of personal property revolves around being able to answer three key questions: 1. How it this property classified?

2. How is this property acquired or transferred?

3. What are the legal consequences of the answers to questions 1 and 2? .

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All personal property falls into one classification or another. The type of classification used will have important consequences on how property will be treated in the eyes of the law.

For example, consider the basic distinction between real and personal property. Sales of real property transactions come generally under the purview of the common law of contracts. Sales of goods, however, are generally covered by the UCC. If you are selling trees on the land, that property is classified as real, and the common law of contracts controls. If the trees have been cut and are being sold to a mill, the UCC will now call the shots. If that lumber becomes part of a house, the common law of contracts again controls because the house is treated as the realacquisition property. and transfer of rights and duties to property are of In addition to classification, key personal and business importance. Most property is transferred by way of contract with some sort of reciprocal exchange of consideration. You work, get paid, and that money is exchanged for property. You may be lucky, however, and find it, or inherit, or just have it given to you. In all these events, the acquisition or transfer must be made in compliance with the elements required by law. Once you have acquired the property, what are the rights and duties that arise out of that ownership? What if you found it? What if others have claims against it? These issues are of key importance in both business and private lives.

II.

Text Materials

There are two kinds of property: 1. Real Property—includes land and property that is permanently attached to it a. For example, buildings, trees, soil, minerals, timber, and plants 2. Personal Property—consists of everything that is not real property.

3. May be owned by more than one person—Concurrent Ownership Personal Property: • Tangible Property—all real property and physically defined personal property. o For example, buildings, goods, animals and minerals • Intangible Property—rights that cannot be reduced to physical form. o That is, stock certificates, certificates of deposit, bonds, and copyrights Acquiring Ownership of Personal Property: • By Possession or Capture o A person can acquire ownership in unowned personal property by taking possession of it or capturing it.

• By Purchase of Production o Purchase—purchasing the property from its rightful owner. o Production—producing a finished product from raw materials and supplies.

• By Gift o A voluntary transfer of title to property without payment of consideration by the donee o Three elements necessary to be a valid gift: 1. Donative intent 2. Delivery 3. Acceptance o Types of gifts: 1. Gifts inter vios—gifts made during a donor’s lifetime that are irrevocable present transfers of ownership.

2. Gifts causa mortis—gifts that are made in anticipation of death. .

Personal Property, Bailment, and Insurance 353

•

o Uniform Gifts to Minors Act o Revised Uniform Gifts to Minors Act Established procedures for adults to make gifts of money and securities to minors

Contemporary Environment: Gift Inter Vivos and Gift Causa Mortis If made during a lifetime, it is interv ivos. If done in contemplation of death, it is causa mortis. By Will or Inheritance o Will—gift to beneficiaries named in a will. o Inheritance—heirs stipulated in an inheritance statute.

• By Accession o Occurs when the value of personal property increases because it is added to or improved by natural or manufactured means • By Confusion o Occurs when fungible goods are commingled o The owners share title to the commingled goods in proportion to the amount of goods contributed.

• By Divorce o When a marriage is dissolved by a divorce, the parties obtain certain rights in the property of the marital estate.

Mislaid Property: • Property is mislaid when its owner voluntarily places the property somewhere and then • inadvertently forgets it.

The owner of the premises where the personal property is mislaid is entitled to take possession of the property against all except the rightful owner.

Lost Property: • Personal property that an owner leaves somewhere because of negligence, carelessness, • • or inadvertence The finder of lost property obtains title to the found property against everyone except the true owner.

The lost property must be returned to its rightful owner whether he or she discovers the loser’s identity or the loser finds him or her.

Ethics: Estray Statues Promote Honesty in Finders • Most states have enacted estray statutes that give a finder of mislaid or lost property clear title to the property if certain requirements are met: o Reporting the find to an appropriate government agency o Advertising the lost property o The owner not claiming the property within a stated time period (i.e., one year) Case 37.1.The Court Speaks: Willsmore v. Township of Oceola, Michigan, 106 Mich. App. 671, 308 N.W. 2d 796, Web 1981 Mich. App. Lexis 2993 (Court of Appeals of Michigan)

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The Facts: Willsmore found a suitcase while hunting. After reporting this to the police, the two of them opened it and found $383,840. The police took custody and, by statute, deposited it into an interest bearing account. The statute provides that the finder and the township must share the value if finder published notice and no true claim made within one year. Willsmore published the notice and sought a judgment determining ownership of the money in his favor. Thereafter, Powell, the landowner where the suitcase was found claimed ownership but incorrectly stated the amount of money. The trial court awarded the money to Willsmore and the Township. Issue: Who is the owner of the lost suitcase and its contents? Decision/Remedy: Willsmore and the Township and trial court’s judgment was affirmed. Reason: Powell did not prove ownership and Michigan’s Estray law had been met

by Willsmore. Certainty of title and honesty are considered by the courts as well as the fact that notice was given.

Abandoned Property: • Property is classified as abandoned if: o An owner discards the property with the intent to relinquish his or her rights in it; or o An owner of mislaid property gives up any further attempts to locate it o Anyone who finds abandoned property acquires title to it.

Bailment: • Occurs when the owner of personal property transfers the property to another to be held, • stored, delivered, or for some other purpose Title to the property does not transfer.

• Bailor—the owner of the property in bailment.

• Bailee—a holder of goods who is not a seller or a buyer.

• o For example, a warehouse of common carrier Examples:  Check your bags with an airline o Drop clothes at dry cleaner Elements Necessary to Create a Bailment: • Personal Property o Only personal property can be bailed. o Delivery of possession. o The bailee has exclusive control over the personal property. o The bailee must knowingly accept the personal property.

• Bailment Agreement o A bailment may be either express or implied. o Express bailments can be either written or oral. o Under the Statute of Frauds, a bailment must be in writing if it is for more than one year. o A bailment may be implied from the circumstances.

Bailments are essentially a special kind of contract. Normal contract rules apply except that a number of special situations have arisen often enough to warrant legislative responses to the problems raised by those situations. Consider the example of common carriers. Here the public wants and expects a high level of reliance in being assured that goods entrusted to a common

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Personal Property, Bailment, and Insurance 355

carrier, for a fee, will be protected. The public’s expectation has been reflected in the insurancestyled strict liability of carriers for goods in their possession.

Case 37.2.The Court Speaks: Ziva Jewelry, Inc. v. Car Was Headquarters, Inc., 897 So. 2d 1011, Web 2004 Ala. Lexis 238 (2004) Supreme Court of Alabama.

Facts: Smith was a traveling salesman for Ziva Jewelry and knew that when he attended trade shows he should be alert for thieves. As such, Smith padlocked the trunk where he kept the jewelry while traveling for business. He had the only padlock key. On a business trip he went to CWH to have the car washed. He watched the car carefully, but at the last minute someone jumped into the car, drove off, and the jewelry was gone. Ziva sued CWH alleging a bailment and negligence. The trial court held no bailment and summary judgment was entered or CWH. Ziva appealed.

Issue: Was a bailment created between Ziva and CWH? Decision: No. Judgment was affirmed.

Reason: A bailment involves delivery of personal property for a specific purpose with a contract with expectation of a return or accounting for accomplishment of purpose. Custody and possession must be voluntarily assumed by the bailee. There was no express or implied agreement in this case since the jewelry was hidden in the trunk and there was no reasonable expectation of its existence on Ziva,s part.

Types of Ordinary Bailment: 1. Bailments for the sole benefit of the bailor 2. Bailments for the sole benefit of the bailee 3. Bailments for the mutual benefit of the bailor and bailee Duration and Termination of Bailments: Bailment for a Fixed Term • A bailment that terminates at the end of the term or, • Sooner by mutual consent of the parties Bailment at Will • A bailment without a fixed term • Can be terminated at any time by either party Bailee’s Rights: • Depending on the type of bailment, bailees may have the right to: o Exclusive possession of the bailed property o Use of the bailed property o Compensation for work done or services provided Bailor’s Duties: • The bailor owes the duty to: o Pay the agreed-upon compensation to the bailee o Not interfere with the bailee’s possessory interest during the term of the bailment o Notify the bailee of any defects in the bailed property that could cause injury to the bailee or others Special Bailments: • Special (or extraordinary) bailees include: .

356 Chapter 37  Common carriers—consignor (bailor) to carrier (bailee) to consignee/ bill of

•

lading. Strictly liable for 1. Act of god 2. Act of a public enemy 3. Order of the government 4. Act of the shipper 5. Inherent nature of the goods.

May limit the dollar amount of liability by offering the bailor the right to declare a higher value for the bailed goods for an additional charge.  Inn keepers—special rules with sales. Strictly liable. State statutes may limit the liability of an innkeeper for others’ rights.  Warehouse companies—warehouse receipts. Ordinary negligence. May limit the dollar amount of liability by offering the bailor the right to declare a higher value for the bailed goods for an additional charge.

Special bailees must follow the rules applicable to ordinary bailees.

Documents of Title: • Negotiable instruments developed to represent the interests of the different parties in a transaction that uses storage or transportation between the parties o Warehouse Receipts o Bills of Lading Warehouse Receipts: • A written document issued by a person who is engaged in the business of storing goods for hire o Warehouse company or storage company • Often a preprinted form drafted by the warehouseman Bill of Lading: • Document of title that is issued by a carrier when goods are received for transportation • Issued by: o Common carriers o Contract carriers o Freight forwarders o Other persons engaged in the business of transporting goods for hire Insurance: • Insurance is defined as a contract whereby one undertakes to indemnify another against • • loss, damage, or liability arising from a contingent or unknown event.

It is a means of transferring and distributing risk of loss.

The risk of loss is pooled • Insured—the party who pays a premium to a particular insurance company for insurance coverage.

• Insurer—the insurance company that underwrites the insurance coverage.

• Policy—the insurance contract.

• Premium—the money paid to the insurance company.

• An insurable interest is necessary to have an enforceable insurance contract.  Property Insurance: or monetary lossbenefit at timefrom of loss Life Insurance: familyownership relationship or economic continued life of 

insured .

Personal Property, Bailment, and Insurance 357

Types of Insurance 1. Life—Whole term, universal, double indemnity, annuity 2. Health and Disability—Health, disability, dental 3. Fire and Homeowners—Standard fire, homeowners, personal articles, renters 4. Automobile—Collision, comprehensive, liability, medical payment, uninsured motorist 5. Other—Credit, title, marine, umbrella

Terms of Importance 1. Insurable interest—personal interest in insured item or person 2. Beneficiary—person or organization who receives benefits at time of death 3. No-Fault—auto insurance where driver’s company pays no matter who caused the accident 4. Business Insurance—business interruption, workmen’s compensation, fidelity, keyperson life 5. Suicide Clause—no payment if suicide within a certain time period 6. Subrogation—insurers get rights of insured after payment 7. Warranty—insured’s representation 8. Incontestability—no contesting claim after a certain time 9. Deductible—proceeds payable after this is paid 10. Exclusions from Coverage—risks that are not covered 11. Co-Insurance—requirement that insured pay a percentage of the cost o funinsured loss

Case 37.3. The Court Speaks: Amex Life Assurance Company v. Slome Capital Corp., 14 Cal. 4th 1231, 60 Cal. Rptu. 2d. 898, 930 P.2d 1264, Web 1997 Cal. Lexis 404 (Supreme Court of California) Facts: In January 1991, Jose Morales applied for a life insurance policy from Amex Life Assurance Company (Amex). Although he knew he was HIV (human immunodeficiency virus) positive, Morales lied on the application form and denied having the AIDS (acquired immune deficiency syndrome) virus. As part of the application process, Amex required Morales to have a medical examination. In March 1991, a paramedic working for Amex met a man claiming to be Morales and took blood and urine samples. On his application, Morales listed his height as 5’6” and his weight as 147 pounds. The examiner registered the man taking the examination as 5’10” and weighing 172 pounds, and appearing to be “older than the stated age.” The blood samples tested HIV negative. Amex issued Morales a life insurance policy on May 1, 1991; the policy included a two-year incontestability clause as required by state law. All premiums were paid.

Morales sold the policy to Slome Capital Corp. (Slome), a vertical company that purchased life insurance policies at a discount from AIDS carriers before their death.

On June 11, 1993, Morales died of AIDS-related causes. When Slome presented Morales’s policy to Amex for payment, Amex refused to pay, alleging that Morales had engaged in fraud and had an imposter take his physical examination for him. The trial court denied Amex’s summary judgment motion. The court of appeals held that the incontestability clause prevented Amex from denying coverage. Amex appealed.

Issue: Does the two-year incontestability clause prevent Amex from raising the insured’s fraud as a reason not to pay the life insurance proceeds?

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358 Chapter 37

Decision: Yes. The California Supreme Court held that the incontestability clause prevented Amex from denying coverage. The court ordered Amex to pay the proceeds of Morales’s life insurance policy to Slome.

Reason: Most states, including California, have enacted statutes that require that an incontestability clause be part of a life insurance contract. In California, the statute requires a two-year incontestability clause, which was part of the life insurance contract between Morales and Amex. The court noted that incontestability clauses are designed to require the insurer to investigate and act with reasonable promptness if it wishes to deny liability on the grounds of false representation or warranty by the insured. The facts can best be ascertained and proved early, rather than waiting until the death of the insured, who can no longer give testimony or defend himself or herself. The court stated that incontestability clauses apply to fraud claims as well as nonfraud claims. Therefore, Morales’s fraudulent statements on the life insurance application form and his having an imposter take the physical exam for him does not prohibit payment of life insurance benefits because the two-year incontestability clause had run on May 1, 1993, and Morales did not die until six weeks later.

III.

Answers to Critical Thinking Cases

Gift 37.1.

Yes. The painting was awarded to Michael. The interest required by the donor to make an irrevocable present transfer of ownership, but to retain a life estate was all but conclusive in this case via the letters. There must be either physical or symbolic or constructive delivery. This was done by title without possession. Greu v. Greu., 68 N.Y. 2d 48, 496 N.E. 2d 869, 505 NYS 2d 849, Web 1986 N.Y. Lexis 19366 (Court of Appeals)

Mislaid Property 37.2.

The money was awarded to Kazi, the hotel owner. Mislaid property was intentionally put in a certain place and forgotten. It is presumed to be left with the property owner. The finder has no ownership rights and must turn it over to the owner of the premises where it is found. The owner becomes a gratuitous bailee. The court looked to where it was found in reasoning this decision. Franks v. Kazi, 88 Ark. App 243, 197 S.W. 3d5, Web 2004, Ark. App. Lexis 771 (Court of Appeals of Arkansas)

Bailment 37.3.

Sisters of Charity. A landlord-tenant agreement and not a bailment had been created. In a lease only ordinary care in maintaining the premises is required. This does not go to the lessor’s property stored there. Where exclusive possession has not been delivered and control and domain of the property is dependent in no way upon the owner’s cooperation, we have a landlord–tenant relationship. This occurred here. Sister’s of Charity of the Incarnate World v. Meanux, 122 S.W. 3d 428, Web 2003 Tex. App. Lexis 10189 (Court of Appeals of Texas)

Bailment 37.4.

No, a bailment was not created between Merritt and Nationwide Warehouse Co., Ltd. (Nationwide). A bailment is a delivery of personal property by a bailor to a bailee for a .

Personal Property, Bailment, and Insurance 359

particular purpose. The creation of a bailment requires actual or constructive delivery of personal property to the bailee. Such full delivery must be made as to entitle the bailee to exclude the possession of all other persons and put him in sole custody and control of the bailed property. The court in this case held that no bailment was created when Merritt stored his personal possessions in a locker leased from Nationwide. This was because there was no delivery of the goods to Nationwide as a bailor, and Nationwide was not given exclusive possession and control over the goods. Merritt merely leased a locker, locked the premises with his own lock and key, and did not furnish a key to Nationwide.

The court held that because there was no delivery of the goods by Merritt to Nationwide, no bailment was created. Merritt v. Nationwide Warehouse Co., Ltd., 605 S.W.2d 250, 1980 Tenn. App. Lexis 338 (Tenn.App. 1980).

Exclusion from Insurance Policy 37.5.

No, this accident is not covered by the homeowner’s policy issued by National America.

Although most homeowner’s policies include personal liability insurance, which provides coverage for accidents occurring on the insured’s property, accidents of the type involved in this suit had been specifically excluded from coverage by Usher’s policy.

Most insurance policies contain such exclusions, limiting the liability of the insurer in certain instances. In this case, Usher’s policy excluded from coverage personal injuries occurring during the loading or unloading of motor vehicles. Graham Coburn was killed when a Chevrolet van that Usher had been loading was accidentally set in motion. The Court held that the exclusionary clause of the policy was clear and unambiguous and, therefore, there was no coverage for this accident under the policy. Because his homeowner’s policy did not cover this accident, Richard Usher was forced to pay any judgment against him out of his own pocket. National American Insurance Co. of California v. Coburn, 257 Cal.Rptr. 591, 209 Cal. App. 3d 914, 1989 Cal. App. Lexis 356 (Cal.App. 1989).

Malpractice Insurance 37.6.

Yes. The policy was in effect when the advice was given and thus Travelers is liable.

Travelers Insurance Company v. National Union Fire Insurance Company of Pittsburgh , 207 Cal. App. 3d 1390, 255 Cal. Rptr. 727, Web 1989 Cal App. Lexis 130 (Court of Appeal of California)

IV.

Answers to Business Ethics Cases

37.7.

No, Red Roof Inns, Inc. is not liable for the alleged value of the jewelry contained in Nova Stylings sample jewelry case, which was stolen from the Inn. In common law, an innkeeper was strictly liable for guests’ property that was lost or stolen from the possession of the innkeeper. Most states, including Kansas, have adopted statutes that abrogate this common law rule and limit an innkeeper’s liability if certain statutory requirements are met. Kansas Statute Section 36-402(b) limits an innkeeper’s liability to$250 if the guest notifies the innkeeper of the nature of the merchandise and gives the innkeeper an itemized list of the property. The innkeeper has no dollar liability if the guest does not meet these requirements. For the act to apply, the innkeeper is required to post a notice containing the requirements of Section 36-402(b) in the guest’s room. The evidence showed that Red Roof Inn properly posted the required notice in Ms. Ruston’s room. The evidence further showed that Ruston did not notify the hotel clerk that .

360 Chapter 37

37.8.

Kulwin’s bag contained sample jewelry or give the clerk an itemized list of the property in the bag. The court held that Red Roof Inns had complied with the requirements of the statute. Therefore, the court held that the Red Roof Inns was not liable to Nova Stylings for the loss of the sample jewelry bag. Nova Stylings, Inc. v. Red Roof Inns, Inc., 747 P.2d 107, 1987 Kan. Lexis 469 (Kan. 1987).

Great American wins. AMD had fraudulently and unethically represented the condition of the property prior to purchasing the insurance and cannot, therefore, claim the policy proceeds. This was an obvious lie and fraud. Advanced Mich. Devices Inc. v. Great American Surplus Lines Insurance Company, 199 Cal. App. 3d 791, 245 Cal. Rptr 44, Web 1988 Cal. App. Lexis 226 (Court of Appeals of California)

V.

Answer to Policy Cases

37.9.

The two year suicide clause justified the nonpayment of the insurance proceeds.

Needleman intended the actions that took his life even if he was not aware of the consequences of his actions. Needleman v. John Hancock Life Insurance Co., Web 2006 U.S. Dist. Lexis 14850 (U.S. Dist. Court)

VI.

Answer to “Briefing the Case” Writing Assignment:

1. Case Name, Citation, and Court Michigan Mutual Insurance Co. v. Marriott Corporation 1992 WL 82498 N.D. ILL. (1992) United States District Court, N.D. Illinois 2. Key Facts A. Jack Sonneveldt is president of Sonneveldt Inc. and is insured for losses by Michigan Mutual Insurance Co. B. In October 1988, Mr. Sonneveldt was a paying guest at the O’Hare Hotel in Chicago. The hotel is operated by the Marriott Corporation.

C. At the direction of Marriott employees, Mr. Sonneveldt parked his motor coach at the hotel’s general parking lot because it would not fit into the hotel’s valet parking area.

D. The motor coach was stolen, and Michigan Mutual paid Sonneveldt, Inc. $265,000.00 for its loss.

E. As subrogee for Sonneveldt, Michigan Mutual now seeks reimbursement for the loss from Marriott, Incorporated by claiming that a bailment was created when the coach was parked on its property.

3. Issue Was a bailment created?

4. Holding No. The United States District Court for the Northern District of Illinois held that no bailment had been created, and Marriott Incorporated was not responsible for the loss of the coach.

5. Court’s Reasoning A. A prima facie claim for a bailment must show the following elements: 1. An agreement to take possession of the plaintiff’s property. .

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2. Delivery of the property to the defendant’s exclusive possession and control.

3. A failure to return the property by the defendant.

B. Here, because the keys to the coach were at no time controlled by Marriott Incorporated, a bailment did not take place.

C. Therefore, no prima facie case is made against Marriott Incorporated, and the complaint

by Michigan Mutual failed as a matter of law.

D. The defendant motion for a judgment on the pleadings was granted.

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Chapter 38 Real Property, Landlord-Tenant Law, and Land Use Regulation

What Do You Really Own? Learning Objectives: 1. List and describe the different interests in real property.

2. Explain how ownership interests in real property can be transferred.

3. Explain how a landlord-tenant relationship is created and describe the various types of tenancy.

4. Describe the landlord’s and tenant’s duties and the tort liability of landlords and tenants.

5. Describe the various forms of land use regulation.

Teacher-to-Teacher Dialogue I. Real Property This chapter tends to be an eye opener for the students in that, although they already have a basic grasp of real property as tenants, they generally do not have much contact with the law of real estate as it relates to issues of minerals, air rights, coownership, and the like. As such, this chapter allows you to broaden their horizons beyond the metes and bounds of what they can immediately see before them.

To introduce students to the law of air rights, it might be useful to describe some of the changes going on in major metropolitan areas. For many years, much valuable land has been used for railroads because of the early development of our nation’s transportation infrastructure.

Chicago had long been considered the original hub of the railway universe. Yet much of that land can and does have additional or alternative uses by way of development of the air rights over the land.

In the mid-1800s, the state of Illinois had granted to the Illinois Central Railroad a grant “in fee simple” of land along the lakefront of Chicago to be used for railroad development. In the late 1960s, the railroad wanted to build a billion dollar development of hotels, office buildings, and shopping malls by selling the air over its railroad tracks. The state of Illinois objected, and Chicago Title had guaranteed the railroad’s title. The Illinois Supreme Court eventually reaffirmed the basic definition of “fee simple absolute” to include air rights (subject to zoning restrictions).

By using such examples, students quickly come to appreciate the importance of real property law in both their business and personal lives.

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This chapter is designed to introduce students to the law of real property from two key perspectives: first, ownership and the rights and duties that arise out of the ownership of real property, and second, use of real property and the respective rights and duties that can arise out of that use vis-à-vis others.

Real property represents the largest single outlay most people make in the course of their earning years. Even if they choose to rent, the price of keeping a roof over one’s head will still probably be their biggest expense. Real estate is not only necessary as a matter of physical survival, it is critically important to our economic system because of this large dollar outlay. One of the most basic terms used in the law of real estate is “fee simple absolute.” It connotes the highest form of recognized ownership in real property. It is infinite, with no limitation on inheritability, and does not end upon the happening of any event. Think of fee simple absolute as the whole pie. That pie, in turn, may be sliced and diced into all sorts of smaller morsels.

Another way to look at real estate as a circular object is in the physical shape of the earth. It is round, and each ownership of land is a unique wedge-shaped slice of that round body. The basic parameters of that ownership start with the surface rights as defined by the surveyed metes and bounds in the legal description. In addition to those rights, real estate extends theoretically to the center of the earth in minerals below the surface and in development of air rights. Both these rights are subject to use limitations and the rights of other owners of adjoining properties.

The other interesting aspect of this chapter goes into more detail on forms of co-ownership of property. Most of us, sooner or later, will get involved with co-ownership of property.

Anyone who is married is a likely co-owner. Anyone who shares property interests by gift, inheritance, or earnings is likely to be a co-owner. Even if one’s property is entirely his own, he or she will need to know the rules of the co-ownership game for purposes of credit, finance, business planning, and the like. How, when, and where co-ownership rights and duties are created is as important as the basic terms of real property law itself.

Landlord–Tenant Relationship One sure way to engage student interest in a topic is to build on their personal experiences outside the classroom. The most difficult topic of negotiable instruments is made much easier by illustrating the rules of the UCC as they relate to the student’s own checking account relationship with his or her bank. So too can you generate interest and discussion regarding landlord–tenant law by asking students to tell their own war stories of finding housing at college.

An interesting comparative measure of the U.S. way of life is the percentage of home ownership versus rental. Our economy has traditionally boasted a high percentage of home ownership relative to most any other part of the world. In many countries, the percentage of home ownership is very low. Even in more highly developed parts of the world such as Western Europe, the percentage has been much lower than in the United States. This achievement has been one of the foundations of the great middle class dream of Americans and certainly a stabilizing influence in our society.

The disturbing aspect of this particular economic and sociological measure is that recent history has witnessed a decline in the number of Americans who can realistically aspire to own their own homes. As the percentage goes down, the laws involving the rights, duties, and obligations of persons involved in nonfreehold estates of all sorts become increasingly important.

With more than half of our population now living under someone else’s roof, the law of leasing needs constant and fair reexamination and updating. As in any such process, the legitimate claims of both sides must be listened to.

The landlord is entitled to a fair return on his or her investment. This includes not only a financial return but also a return on the investment. Income property should be protected from waste and harm just like any other property.

Conversely, the bargaining power between landlord and tenant has never been entirely equal.

Between market limitations of supply and the tenant’s lesser economic bargaining position, the .

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common law can hardly have been accused of being the tenant’s friend in the past. More modern attitudes and statutory enactments have given the tenant a more even playing field, but not real parity.

This chapter also examines some of the main land use statutes used in this country. Here, the law moves away from its first and second tier treatment based on ownership and looks instead more to the common good. The days of wide-open spaces are long gone, and along with them is the notion that an owner can do whatever he or she wants with his property. Land use is simply too important and too interwoven with the rights of others to adapt a laissez-faire attitude.

Various branches of government must perform the constant balancing act. On the owner’s and user’s side of the equation, public policy wants free, quiet, environmentally sensitive uses of land.

Good zoning, controlled growth, and other governmental regulations can and do provide enlightened measures toward those goals.

But where government sets up measures that are unreasonable and even confiscatory, a problem is created. The results are not only higher costs of doing business, but also depreciation of the American Dream. Zoning laws have been criticized as an insidious subterfuge to extend governmental control too far into our personal lives. We must, however, keep in mind that the government does have the duty to assure the health, safety, and welfare of its citizenry through the use of its police power on land use.

II. Text Materials Real Property: • The land itself as well as buildings, trees, soil, minerals, timber, plants, and other things permanently affixed to the land: o Land o Buildings o Subsurface rights o Plant life and vegetation o Fixtures o Air rights Contemporary Environment: Air Rights This discusses the value of air rights.

Estates in Land: • Ownership rights in real property • The bundle of legal rights that the owner has to possess, use, and enjoy the property • The type of estate that an owner possesses is determined form the deed, will, lease, or other document that transferred the ownership rights to him or her Freehold Estate: • An estate where the owner has a present possessory interest in the real property • Estates in Fee o Fee simple absolute o Fee simple defeasible o Life Estates o Estate pour autre vie .

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Estates in Fee: • Fee Simple Absolute • Highest form of ownership of real property • Ownership: o Is infinite in duration o Has no limitation on inheritability o Does not end upon the occurrence or nonoccurrence of an event • Fee Simple Defeasible • Grants owner all of the incidents of a fee simple absolute except that it may be taken away if a specified condition occurs or does not occur Life Estate: • Interest in property that lasts for the life of a specified person • A life estate terminates upon the death of a named person and reverts back to the grantor or his or her estate or other designated person.

Concurrent or Co-Ownership: • When two or more persons own a piece of real property • Forms of concurrent ownership o Joint tenancy o Tenancy in common o Tenancy by the entirety o Community property Summary: Concurrent Ownership: 1. Joint Tenancy—Deceased tenant’s interest automatically passes to co-tenants. Tenant may transfer his or her interest without the consent of co-tenants. Transfer severs joint tenancy.

2. Tenancy in Common—Deceased tenant’s interest passes to his or her estate. Tenant my transfer his or her interest without the consent of co-tenants. Transfer does not sever tenancy in common.

3. Tenancy by the Entirety—Deceased tenant’s interest automatically passes to his or her spouse. Neither spouse may transfer his or her interest without the other spouse’s consent.

4. Community Property—When a spouse dies, the surviving spouse automatically receives one-half of the community property. The other half passes to the heirs of the deceased spouse as directed by a valid will. Neither spouse may transfer his or her interest without the other spouse’s consent.

Case 38.1.The Court Speaks: Cunningham v. Hastings, 556 N.E. 2d 12, Web 1990 Ind. App. Lexis 764 (Court of Appeals of Indiana) Facts: Cunningham and Hastings, who were unmarried, purchased a house together. Hastings made the down payment and the property was deeded to them as “joint tenants with the right of survivorship, and not as tenants in common.” They occupied the premises until they ended their .

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relationship when Hastings took sole possession. Cunningham sought to have the property partitioned. The court ordered the sale of the property because it could not be partitioned.

Furthermore, the court ordered the proceeds be divided between the partners equally after Hastings was paid the amount of his down payment. Cunningham appealed.

Issue: What interest did Cunningham have in the property?

Decision: The court reversed ordering equal division of the proceeds without allowance for the down payment.

Reason: The deed created a joint tenancy in the property. Tenants have an equal right to share in the enjoyment of the land during their lives. Because there are two tenants, each owns a one-half interest regardless of whose funds were used to acquire the land. Therefore, upon partition and sale, each has a right to one-half of the proceeds.

Condominium: • Common form of ownership in a multiple-dwelling building • Purchasers of a condominium: o Have title to their individual units o Own the common areas as a tenant in common with the other condominium owners • Owners may sell or mortgage their units without the permission of the other owners.

Cooperative: • Form of a co-ownership of a multiple-dwelling building o A corporation owns the building. o The residents own shares in the corporation. o Each cooperative owner then leases a unit in the building from the corporation under a renewable, long-term, proprietary lease.

Future Interest: • The right to possess property in the future • The interest that the grantor retains for him- or herself or a third party • Reversion—a right of possession that returns to the grantor after the expiration of a limited or contingent estate.

• Remainder—a right of possession that goes to a third party upon the expiration of a limited or contingent estate.

Transfer of Ownership of Real Property: Sale of Real Property • The passing of title from a seller to a buyer for a price—done by deed • Also called a conveyance • Closing—the finalization of a real estate sales transaction that passes title to the property from the seller to the buyer Transfer of Ownership of Real Property: Deed • A writing that describes a person’s ownership interest in a piece of real property o Warranty Deed o Quitclaim Deed • Grantor—the party who transfers an ownership interest in real property • Grantee—the party to whom an interest in real property is transferred .

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Note: Grantor must transfer marketable title or good title.

Transfer Ownership of Real Property: Recording Statute • Aof state statute that requires the mortgage or deed of trust to be recorded in the county recorder’s office of the county in which the real property is located.

• Quiet title action—a party concerned about ownership rights in a parcel of real property can have a court determine the extent of those rights.

Transfer of Ownership of Real Property: Marketable Title (Good Title) • Title that is free from any encumbrances or other defects that are not disclosed but would • affect the value of the property The three most common ways of assuring marketable title: o Attorney’s opinion o Torrens system o Title insurance Transfer of Ownership of Real Property: Tax Sale • A method of transferring property ownership that involves a lien on property for unpaid • • property taxes.

• If the lien remains unpaid after a certain amount of time, a tax sale is held to satisfy the lien.

Any excess proceeds are paid to the taxpayer.

The buyer receives title to the property.

Transfer of Ownership of Real Property: Gift, Will, or Inheritance • Gift o A transfer of property from one person to another without exchange of money • Will or Inheritance o If a person dies with a will, his or her property is distributed to the beneficiaries o as designated in the will.

If a person dies without a will, his or her property is distributed to the heirs as stipulated in the state’s intestate statute.

Transfer of Ownership of Real Property: Adverse Possession • Occurs when a person who wrongfully possesses someone else’s real property obtains • • title to that property if certain statutory requirements are met.

Property owned by federal and state governments is not subject to adverse possession.

To obtain title under adverse possession, the wrongful possession must be: 1. For a statutorily prescribed period of time 2. Open, visible, notorious 3. Actual and exclusive 4. Continuous and peaceful 5. Hostile and adverse Case 38.2.The Court Speaks:Witt v. Miller, 845 S.W. 2d 665, Web 1993 Mo. App. Lexis 20 (Court of Appeals of Missouri)

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The Facts: Witt purchased land in 1967 adjacent to a four-acre tract kept by the Shaughnessey’s after they had purchased and divided adjacent property. Witts built a house and moved in. In 1968 they cleared land extending 40 feet onto the 4-acre tract on which they had made many outward improvements. Neither party realized that there was an encroachment. In 1988, the Shaughnessey’s sold the four-acre tract to Miller whose survey showed the Witts’ encroachment.

Miller sued to quiet title. The court held no adverse possession.

Issue: Had the elements for adverse possession been met?

Decision/Remedy: Yes. The decision was reversed and an order issuing quiet title in favor of the Witts was entered.

Reason: The following elements of adverse possession had been met: • Notorious and open occupation • Actual and exclusive • Hostile and adverse • Continuous and peaceful • Far over the statutory period of 10 years Nonpossessory Interests: Easements • A given or required right to make limited use of someone else’s land without owning or leasing it o Easement Appurtenant—created when the owner of one piece of land is given and easement over an adjacent piece of land o Easement in Gross—authorizes a person who does not own adjacent land the right to use another’s land Case 38.3.The Court Speaks: Walker v. Ayres, Web 1993 Del. Lexis 105 (Supreme Court of Delaware) Facts: Elizabeth Ayres and Clara Quillen own, in fee simple absolute, a tract of land in Sussex County known as “Bluff Point.” The tract is surrounded on three sides by Rehoboth Bay and is landlocked on the fourth side by land owned by Irvin C. Walker. At one time, the tracts were held in common. In 1878, Bluff Point was sold in fee simple absolute apart from the other holdings, thereby land locking the parcel. Ayres and Quillen sought an easement to use a narrow public road, the only means of access, and Walker objected. The trial court granted the easement.

Issue: Should Ayres’ and Quillen’s estate be granted an easement against Walker’s estate?

Decision: Yes. Reason: An easement appurtenant had been created between two adjacent parcels of property when Bluff Point was separated from the rest of the holdings in 1878. The easement was created by necessity because Bluff Point was landlocked and its only access was over Walker’s property.

Nonpossessory Interests: License • Grants a person the right to enter upon another’s property for a specified and usually • • short period of time A license does not transfer any interest in the property.

A license is a personal privilege that may be revoked by the licensor at any time.

Nonpossessory Interests: Profit • Grants a person the right to remove something from another’s real property .

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o Gravel, minerals, grain, or timber o Profit Appurtenant—grants the owner of one piece of land the right to go onto another’s adjacent land and remove things from it o Profit in Gross—authorizes someone who does not own adjacent land the right to go onto another’s property and remove things from it.

Landlord–Tenant Relationship: • A relationship created when the owner of a freehold estate (landlord) transfers a right to exclusively and temporarily posses the owner’s property to another (tenant) • Nonfreehold Estate—an estate in which the tenant has a right of possession of the property but not title to the property • Leasehold—a tenant’s interest in the property • Landlord—he owner who transfers the leasehold • Tenant—the party to who the leasehold is transferred Note: The rental agreement is called the lease.

Types of Tenancy: 1. Tenancy for Years—Continues for the duration of the lease and then terminates automatically without notice. It does not terminate by the death of either party.

2. Periodic Tenancy—Continues from payment interval to payment interval. It may be terminated by either party with adequate notice. It does not terminate upon the death of either party.

3. Tenancy at Will—Continues at the will of the parties. It may be terminated by either party at any time with adequate notice. It terminates upon the death of either party.

4. Tenancy at Sufferance—Arises when a tenant wrongfully occupies real property after the expiration of another tenancy or life estate. It continues until the owner either evicts the tenant or holds the tenant over for another term. It terminates upon the death of the tenant.

Landlord’s Duties: Possession • A lease grants the tenant exclusive possession of the leased premises: (1) for the term of • the lease or (2) until the tenant defaults on the obligations under the lease.

A landlord may not enter leased premises unless the right is specifically reserved in the lease.

Landlord’s Duties: Covenant of Quiet Enjoyment • The law implies a covenant of quiet enjoyment in all leases.

• The landlord may not interfere with the tenant’s quiet and peaceful possession, use, and enjoyment of the leased premises.

• Wrongful eviction—a violation of the covenant of quiet enjoyment.

• If the landlord causes the leased premises to become unfit for intended use, this is called construction eviction.

Landlord’s Duties: Duty to Maintain Leased Premises Building Codes

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State and local statues that impose specific standards on property owners to maintain and repair leased premises Implied Warranty of Habitability • A warranty that provides that the leased premises must be fit, safe, and suitable for • ordinary residential use.

Can o Withhold rent o Repair and deduct o Cancel lease o Sue •

Case 38.4. The Court Speaks: New Haverford Partnership (NHP) v. Stroot, 772 A. 2d 792, Web 2001 Del. Lexis 2278 (2001) Supreme Court of Delaware Facts: Stroot rented from NHP where she found mold and leaks. She tried to remove but to no avail. She moved to another apartment where the ceiling leaked and other damages occurred.

Management did nothing after she complained. After a ceiling collapsed a lot of mold was exposed. She was sick and was taken to the hospital a number of times. She sued.

Issue: Was NHP liable, and if so, was the amount of the damages to Stroot appropriate?

Decision: Yes, NHP was liable and damages were awarded to Stroot.

Reason: Stroot showed a reasonable degree of medical probability that her symptoms were reduced when she moved out. Testimony was given and probably believed that cognitive deficits (attention, concentration and other functions) were caused by her exposure in the apartment complex.

Tenant’s Duties: 1. Duty to pay rent 2. Duty not to use leased premises for illegal or nonstipulated purposes 3. Duty not to commit waste 4. Duty not to disturb other tenants

Note: Many jurisdictions apply the implied warranty of habitability stating that the premises must be fit, safe, and suitable for ordinary residential use. Remedies include withholding rent, repair and deduct, cancel, or sue.

Transferring Rights to Leased Property • Landlords may sell, gift, devise, or otherwise transfer their interests in the leased property. o If complete title is transferred, the property is subject to the existing lease.

• The tenant’s right to transfer possession of the leased premises to another depends on the terms of the lease. o Assignment of the lease o Sublease Land Use Regulation:

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Generally, the ownership of property entitles the owner to use that property as the owner wishes.

Such use is subject to limitations imposed by government regulation.

• Land Use Regulation—the collective term for the laws that regulate the possession, ownership, and use of real property.

• •

Zoning Ordinances: • Local laws that are adopted by municipalities and local governments to regulate land use • • within their boundaries.

• Adopted and enforced to protect the health, safety, morals, and general welfare of the community.

Zoning is the primary form of land use regulation in the United States.

Zoning ordinances generally:  Establish use districts within in the municipality (i.e., residential, commercial, or industrial)  Restrict the height, size, and location of buildings on a building site Establish aesthetic requirements or limitations for the exterior or buildings 

Variance • An exception that permits a type of building or use in an area that would not otherwise be allowed by a zoning ordinance.

Nonconforming Uses • Uses and buildings that already exist in the zoned area that are permitted to continue even though they do not fit within new zoning ordinances.

Compensable Taking of Real Property: Contemporary Environment: The Kelo “Takings” Case: Kelo v. City of New London, Connecticut Facts: To try and combat the ongoing economic decline of the city of New London, state and local officials created the NLDC to assist in planning the city’s economic development. The projects were to be constructed and owned by private developers and parties selected by the city in order to make the city more attractive, create jobs, and increase tax revenue. Most of the land was purchased from private owners except Kelo and others refused to sell. The NLAC initiated eminent domain actions. Kelo argued that the taking violated the “public use” requirement of the Fifth Amendment. The state trial court held for Kelo. The state Supreme Court held for the NLDC. Kelo appealed to the Supreme Court.

Issue: Does the city’s taking of the property for economic development satisfy the “public use” requirement of the Fifth Amendment under eminent domain?

Decision: Yes, The decision was affirmed.

Reason: The development plan must serve a “public purpose” which has been defined broadly.

This plan was formulated to provide appreciable benefits to the community. Because of the overall planning process, and the character of the plan, the Court looked at the entire plan and did not take a piecemeal approach. The Court chose not to second-guess the city’s determinations. It was sufficient to accept that the entire plan served the “public purpose”.

Civil Rights Act: • A federal statute that prohibits racial discrimination in the transfer of real property.

• The Act prohibits private and public discrimination. .

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•

It permits lawsuits to recover damages and obtain injunctions against offending conduct.

Fair Housing Act: • Federal statute that makes it unlawful for a party to refuse to rent or sell a dwelling to any • person on the basis of race, color, national origin, sex, or religion.

Prohibits discrimination by real estate brokers, mortgage lenders, and advertisers concerning the sale or rental of real property.

Title III of the Americans with Disabilities Act (ADA) ADA A federal statute that prohibits discrimination against disables individuals in employment, • public services, public accommodations and services, and telecommunications.

Title III of the ADA • A title of the ADA that prohibits discrimination on the basis of disability in places of public accommodation operated by private entities.

III.

Answers to Critical Thinking Cases

Recording Statute 38.1. The Court Speaks: The Howard Savings Bank v. Brunson, 244 N.J. Super. 571, 582 A. 2d, 1305, Web 1990 N.J. Super. Lexis 436 (Superior Court of NJ) Facts: Brunson bought land and had a deed property recorded. He borrowed $50,000 from Howard with a mortgage that was properly recorded, but the records did not list it in its index for recorded documents. Brunson sold the property to the Ijalba’s and delivered a deed that was property recorded. The Ijalba’s borrowed money from Chrysler secured by a property recorded and indexed mortgage. Howard’s mortgage from 2 years earlier was then indexed. Howard brings foreclosure against the property due to Brunson’s default and claimed the property over Ijalba’s deed and Chrysler’s mortgage.

The Ijalba’s and Chrysler filed motions for summary judgment.

Issue: Was Howard’s mortgage property recorded and indexed so as to give notice of its existence to subsequent parties?

Decision: No. Summary judgment was granted.

Reason: Using the index in a title search is reasonable. The mortgagee has a duty to make sure the mortgage is properly indexed.

Reversion 38.2.

The school board wins. A reversion is a right of possession that returns to the grantor after the expiration of a limited or contingent event. In this case, the court held that the site was still being used for “school purposes” where the property was being used as a warehouse for storage of school supplies and materials. The court found that in order to accommodate changing school populations, storage facilities are necessary to house surplus equipment and supplies and to replace worn out and damaged items over time.

Accordingly, the court held that having such equipment and supplies on hand clearly furthers the ultimate goal of educating students and that the property does not revert back to the Mahrenholzes. Mahrenholz v. County Board of School Trustees of Lawrence County, 544 N.E.2d 128, 1989 Ill. App. Lexis 1445 (Ill.App. 1989). .

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Adverse Possession 38.3.

The Naabs win. In West Virginia the doctrine of adverse possession enables one who has been in possession of a piece of real property for more than ten years to bring an action asserting that he is now the owner of that piece of property even when title rests in another. One who asserts title under the doctrine of adverse possession must prove that (1) he has held the tract adversely; (2) the possession has been actual; (3) it has been open and notorious; (4) possession has been exclusive; (5) possession has been continuous; and (6) possession has been under color of title. In this case, the record revealed that the predecessors in title of both the Naabs and the Nolans accepted the erection of the concrete garage sometime before 1952. The record also indicated that when the Naabs’ predecessors built the garage no complaint was registered by the Nolans’ predecessors. Accordingly, because the owner of burdened premises is bound by the actions or inactions of his predecessors in title, the court held that the evidence was sufficient to establish title by adverse possession in that portion of the Nolan’s lot occupied by the Naabs’ garage. Naab v. Nolan, 327 S.E.2d 151, 1985 W.Va. Lexis 476 (W.Va. 1985).

Implied Warranty of Habitability 38.4.

The Court Speaks: Solew v. Wellner, 150 Misc. 2d 642 ,569 N.Y.S. 2d 882, Web 1991 N.Y. Misc. 169 (Civil Court of the City of NY) Facts: 80 tenants of a luxury apartment building in Manhattan where the rents were very high engaged in a rent strike putting a long list of deteriorating conditions (poor running of water, stench and mice near the garbage, missing public fixtures, wet mailboxes, and broken air conditioners). The landlord sued to recover rent. The tenants wanted rent abatement for breech of the implied warranty of habitability.

Issue: Did the landlord breech the implied warranty of habitability?

Decision: Yes. The rent was abated by about 70 percent in total. The landlord was also required to pay the tenants’ attorneys’ fees.

Reason: The premises are to be maintained in accordance with the “reasonable expectations” of the tenant. Certain amenities fall under this protection. Predictability and reliability of services is another factor. In this case the higher rents, the building itself, and the brochure produce certain obvious expectations which include many of the items in question.

Zoning 38.5.

Berkley, the building commissioner, prevails. The court upheld the commissioner’s denial of the petitioner’s permit to construct the modern home. In reaching this determination, the commission considered three factors: (1) whether the proposed house meets the customary architectural requirements in appearance and design for a house of the particular type that is proposed (Colonial, English Tudor, French Provincial, or Modern), (2) whether the proposed house is in general conformity with the style and design of surrounding structures, and (3) whether the proposed house lends itself to the proper architectural development of the city. In applying this standard, the commission determined that the petitioner’s plans did not fall within the general conformity of the style and structure of the surrounding homes in the neighborhood, and would not add to the architectural development of the city. Since the plans failed to meet those .

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requirements, the court agreed with the commissioner’s findings.

State of Missouri v.

Berkley, 458 S.W.2d 305, 1970 Mo. Lexis 902 (Mo.1970).

ADA 38.6.

The Court Speaks: USA v. Cinemark USA, Inc., 348 F. 2d 569, Web 2003 U.S. App Lexis 22757 (U.S. Court of Appeals) Facts: Cinemark constructed “stadium-style” movie theaters which have a relatively steep incline. This is inaccessible for wheelchairs. Wheelchair patrons are put on a flat area down in front of the screen. The sight-line is not the same as the line for the others.

Title II of the ADA requires that public accommodations must be “readily accessible to and usable by individuals with disabilities”. Prices and sight lines for wheelchair patrons must be comparable to those for the general public. A companion seat is needed and more than one area is needed if capacity exceeds 300. USA sued and the district court granted summary judgment to Cinemark. USA appealed.

Issue: Does Cinemark’s wheelchair seating arrangement in its stadium-style theaters violate Title II of the ADA? Decision: Yes. Judgment was reversed and the case was remanded.

Reason: Wheelchair patrons need more than just an unobstructed view. They should be given the choice of sight lines similar to those non-wheelchaired patrons. Without these choices, wheelchaired patrons will not be afforded the “full and equal” treatment as noted in the language of Title II.

IV.

Answers to Ethics Cases

38.7.

Garber acquired title to the land up to the old fence line by adverse possession. Adverse possession occurs when there is actual open, notorious, exclusive, and continuous possession of another’s property for the statutory period of ten years. There is no question that the Garbers met this criterion of possession. Doenz had moved the fence more than ten years after the Garbers acquired the land but less than ten years from when the Garbers filed their deed. The time period began running when the Garbers moved onto the property and began using it. Thus, the ten-year period had run before Doenz had moved the fence. Therefore, the Garbers have acquired the land by adverse possession.

Doentz v. Garber, 665 P.2d 932, 1983 Wyo. Lexis 339 (Wy. 1983).

38.8.

The variance is denied. The town’s ordinance was created to preserve the views of the abutting water, to maintain and enhance property values due to those views, to preserve the recreational zone’s atmosphere, and to preserve an abutter’s right to air and light. In this case, Alexander, in violation of the valid ordinance, began construction without either a building permit or a zoning variance. In order to obtain a variance, five conditions must be met: (1) no diminution in value of surrounding properties would be suffered, (2) granting the permit would be of the benefit to the public interest, (3) denial of the permit would result in unnecessary hardship to the owner seeking it, (4) granting the permit would do substantial justice, and (5) the use must not be contrary to the spirit of the ordinance. In the present case, Alexander failed to meet the requirements for a variance. The court held that Alexander could not benefit from his knowing violation or disregard of the variance by making illegal alterations to his property, and attempt to claim that it would be an unfair hardship to deprive him of his improvement. Because Alexander knowingly violated the ordinance and did not satisfy the five requirements for

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a variance, he was not entitled to a variance.

Alexander v. Town of Hampstead, 525,A.2d 276,1987 N.H. Lexis 171(N.H.).

V.

Answers to Policy Cases

38.9.

Secondhand smoke can cause breach of implied warranty of habitability and a constructive eviction. It is just as insidious and invasive as some of the more common conditions. Even the U.S. Surgeon General and others talked of the danger of secondhand smoke. Poyck v. Bryant, 13 Mis. 3d 699, 1820 N.Y.S. 2d 774, Web 2006 N.Y.Misc. 2278(Civil Court of the City of NY).

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court Walker v. Quillen 622 A. 2d 1097 (1993) Supreme Court of Delaware 2. Key Facts A. Walker owns land, which adjoins land owned by Quillen. Quillen’s land is generally known as “Bluff Point.”

B. Bluff Point is surrounded on three sides by Rehobath Bay and is landlocked on the fourth side by Walker’s land.

C. At one time the two tracts were owned by a common owner but Bluff Point was sold off as a separate parcel in 1878.

D. The only access to Bluff Point is a narrow dirt road which traverses Walker’s property.

E. Quillen asked the lower court to declare that an implied easement be upheld in favor of the servient estate (the landlocked land owned by Quillen) over the dominant estate (the land owned by Walker) in order to provide access to “Bluff Point.”

F. The lower court held in favor of Quillen. Walker appeals.

3. Issue Would it be an abuse of judicial discretion to grant an implied easement in this case?

4. Holding The Supreme Court of Delaware held that an implied easement was appropriately granted by the lower court.

5. Court’s Reasoning A. This land was at one time owned by a common owner who subsequently subdivided the land into several parcels.

B. Because of this subdivision, no practical access was available to “Bluff Point” but for a narrow path which traverses the Walker property.

C. Therefore the granting of an implied easement was necessary and not an abuse of judicial discretion.

D. The holding of the lower court was affirmed.

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Chapter 39 Family Law, Wills, and Trusts

Who Gets It? Learning Objectives: 1. Define marriage and enumerate the legal requirements of marriage.

2. Define divorce, describe how assets are distributed upon the termination of marriage, and describe alimony and child support.

3. List and describe the requirements for making a valid will and identify how property is distributed under intestacy statutes if a person dies without a will.

4. Define trusts and living trusts and describe the purposes of these trusts.

5. Describe a living will and a health care directive.

I.

Teacher-to-Teacher Dialogue

This chapter covers the law of wills and trusts. You can’t take it with you, but you have some control over where it goes. The laws of wills and trusts are about control. This control is not absolute now and never has been. Yet with intelligent foresight and timely estate planning, the extent and breath of possible control would surprise most people. It is no coincidence that the money of large family fortunes, first accumulated in the early industrial age, remains essentially intact today with the help of wills, trusts, and proper estate planning.

Transfers of property can be generally categorized into two main classifications: lifetime or inter vivos and death or testamentary transfers. With lifetime transfers, the main motivation elements are taxes, control, and present needs. The federal wealth transfer tax structure is extensive and very complicated.

The three main components of that tax structure are the gift, estate, and generation skipping taxes. In addition, states have also developed their own property transfer tax structures based on inheritance taxes, estate pickup taxes, or some combination thereof. All these taxes are premised on the notion that wealth accumulation was done with the blessings of the law structure, and transfers of that wealth afford an opportunity for the government to share in those riches.

The control element also goes to the issue of how much the owner is actually willing to give up before he or she departs this life. Tax laws are specifically designed to tax the substance of control rather than just the appearance of having given up control. Various code provisions with regard to life estates, incomplete transfers, retained powers over trusts, and possibilities of reverter are all patterned on that premise. In addition, simple human nature is such that it can be most difficult to give up control over assets that took the better part of a lifetime to accumulate. This problem is further exacerbated if the intended donee is too young, too immature, or an out and out spendthrift.

Lifetime needs make inter vivos transfers ever more difficult. In an age of being exposed to possible catastrophic health care costs late in life, many people simply cannot afford to make lifetime transfers that .

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would otherwise make for good estate planning. The burgeoning growth of living trusts and similar financial planning devices are testaments to efforts to try to resolve this dilemma.

Once the end has come, the next classification of transfers can be subcategorized into testate and intestate death transfers. Testate means that the person has spoken by way of a legally recognized will or will substitute. The law of wills is much like the law of death taxes—very complicated and formalized.

The general public often looks at the cases on admission of wills to the probate process and sees them as being overly harsh or doctrinaire. The basic point that must be remembered is that the decedent is not there to challenge any arguments against his or her purported intent.

If a person has not written a will, or the will is not admitted to probate, he or she is deemed to have died intestate. Every state has stepped into this void and written a will by way of an intestate statute.

The problem is that in an age of a high national divorce rate, the possibility of multiple families’ claims makes having a will more necessary than ever. In all events, if you want to control the disposition of your property at your death, have an up-to-date will at the ready.

Once a probate proceeding has begun, the person appointed by the court to administer the estate will be charged with three major duties: 1. To garner the assets of the estate.

2. To net out those assets by paying all proper claims, taxes, and costs of administration.

3. To distribute the net proceeds of the estate per the will or the intestate statute.

II.

Text Materials

Marriage Issues and Terms of Importance 1. Promise to marry—usually breach of promise-to-marry lawsuits are not recognized by most courts 2. Engagement—who gets the ring? a. Fault rule: depends on who breaks the engagement b. Objective rule: groom 3. Marriage—state requirements: most say man and woman, not closely related, not currently married to someone else 4. License—recorded 5. Common law—no license or ceremony: okay if eligible to marry, voluntary intent, live together, hold out as husband and wife Contemporary Environment: Same-Sex Marriage Massachusetts and other states allow, DOMA says no federal benefits 6. Parents’ rights and duties—until 18 7. Paternity actions 8. Parents’ liability for a child’s wrongful act—generally no 9. Adoption—regulated by state law a. Agency b. Independent c. Court approval d. Foster care 10. Termination a. Annulments—never existed b. Divorce (No Fault) (1) Petition .

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(2) Settlement agreement (a) Division of assets [1] Separate property [2] Marital property: equitable distribution of community property acquired during marriage Contemporary Environment: Prenuptial Agreement Voluntary, full disclosure, attorney, fair distribution 11. Spousal support (alimony) 12. Child support 13. Family Support Act—allows for automatic wage withholding from a noncustodial parent’s income 14. Child custody—best interests of the child—not automatically with the mother in all cases a. Joint custody b. Visitation rights Case 39.1. The Court Speaks: In the Matter of the Marriage of Joyner 196 S.W. 3d883, Wels 2006 Tex. App. Lexis 5691 (2006) Court of Appeals of Texas Facts: Belinda and Thomas Joyner entered into a settlement agreement subsequent to filing for divorce.

After the judge finished the settlement and stated that the divorce was granted but before he signed the final divorce decree, Thomas won a $2,080,000 lottery. The trial court awarded the money to Thomas as separate property. Belinda appealed.

Issue: Was the $2,080,000 separate property or community property?

Decision: Separate property. The judgment was affirmed.

Reason: A judgment of divorce was rendered when the court announced it either orally or in writing.

Once the divorce was final they could no longer accumulate community property.

Will—a declaration of how a person wants his or her property distributed after death. A codicil is a separate document amending a will Special Issues Relating To Wills 1. Parties a. Testator/Testatrix: makes the will b. Beneficiary: receives the property 2. Requirements for making a will a. Testamentary Capacity b. Writing c. Testator’s signature 3. Attestation—witnesses (states are different) 4. Revoking a. By subsequent will b. By law (e.g. divorce revoked—is position to former sponge under a will) 5. Ethics: Videotaped Wills—procedures must be followed .

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6. Simultaneous Deaths: Uniform Simultaneous Death Act: each deceased person’s property is distributed as though he or she survived 7. Probate—process of settling the estate: personal representative—executer named in will; administrator named by the court.

8. Special Types of Wills a. Holographic—handwritten and signed b. Nun capative—oral done during last illness 9. Intestate Succession: no will—follow rules of state—usually to heirs (relatives) or finally escheats to the state.

Undue Influence • Occurs where one person takes advantage of another person’s mental, emotional, or physical • weakness and unduly persuades that person to make a will.

The persuasion by the wrongdoer must overcome the free will of the testator.

Case 39.2. The Court Speaks: Medlock v. Mitchell, Wels 2006 Ark. App. Lexis 320 (2006) Court of Appeals of Arkansas Facts: Richard’s will leave his estate to Mark and Michelle. He married Glenda 4 months later and simultaneously termination of created a revocable living trust to terminate 10 years after his death. At the

the trust it was to be distributed to Mark and Michelle. Three months after he was diagnosed with terminal months lung cancer (5 years later) he executed another will leave his estate to Glenda. He died 2 later. Both wills were probated. Glenda died with a trial pending and her son Jerald pursued the suit.

Burden was on Jerald to prove no undue influence. The court said he did not rebut the presumption.

He

appealed.

Issue: Did Jerald rebut the presumption of undue influence?

Decision: No. Judgment was affirmed. Mark and Michelle received the estate.

Reason: Because of the confidential relationship between Glenda and Richard (marriage, illness, and durable power of attorney) there is a presumption of undue influence. But there must be more.

There must be a malign influence based on fear, coercion, and so on. This could be inferred here: Richard’s weakened Types of Testamentary Gifts state and the pressure by Glenda (ire and presence at will signing). Glenda also made some false • Devise—a gift ofMark real estate will statements about which by precipitated the will changes.

• Bequest—a gift of personal property by will • Specific gift—a gift of a specifically named piece of property • General gift—a gift that does not identify the specific property from which the gift is to be made • Residuary gift—a gift of the estate left after the debts, taxes, and specific and general gifts have been paid Ademption and Abatement Ademption: • If a testator leaves a specific devise of property to a beneficiary, but the property is no longer in the estate when the testator dies, the beneficiary receives nothing.

Abatement: • If the property the testator leaves is not sufficient to satisfy all the beneficiaries named in a will and there are both general and residuary bequests, the residuary bequest is abated first. .

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Per Stirpes Distribution • A distribution of the estate that makes grandchildren and great-grandchildren of the deceased inherit by representation of their parent. o That is, they split what their deceased parent would have received.

• If their parent is not deceased, they receive nothing.

Per Capita Distribution • A distribution of the estate that makes each grandchild and great-grandchild of the deceased inherit equally with the children of the deceased.

Ethics: Videotaping the Signing of a Will to Prevent Fraud The use of videotape in law trials certainly has been in the news over the past few years. If anything at all has been learned from those painful experiences, having the tape alone does not assure the proverbial “slam dunk!” The laws of wills and trusts have long revolved around the use of the best evidence possible based on a simple reality: the key witness is not there to testify personally. We can use more and more technology, such as videotapes, to bring that testimony in. But if there is any area of the law where you have to dot every “i” and cross every “t” with total accuracy, this is it.

Joint and Mutual Wills • Joint Will: o A will that is executed by two or more testators o A joint will may be held invalid as to one testator but not the others • Mutual Will: o Occur where two or more testators execute separate wills that leave their property to each other on the condition that the survivor leave the remaining property at the time of death as agreed by the testators

Parties Who Receive Deceased’s Property Beneficiaries name in the will.

Heirs set forth in the applicable intestacy statute.

If there are no heirs, the deceased’s property escheats (goes) to the state.

Intestate Succession Situation Deceased dies with a valid will.

Deceased dies without a valid will.

Trust • A legal arrangement established when one person transfers title to property to another person to be held and used for the benefit of a third person.

• Trust Corpus—the property held in trust. o The trust has legal title to the trust corpus. o The beneficiary has equitable title. o Revocable unless settler reserves the right to revoke.

Trusts could be: 1. Express—created by settler .

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2. Inter Vivos—created while alive 3. Testamentary—created by will 4. Resulting—implied from conduct 5. Constructive—implied to avoid fraud, and so on 6. Charitable 7. Spendthrift—protect beneficiaries from creditors 8. Totten—in settlor’s own name held as trustee for another Parties to a Trust • Settlor or Trustor—person who creates a trust.

• Trustee—person who holds legal title to the trust corpus and manages the trust for the benefit of the beneficiary or beneficiaries.

• Beneficiary—person for whose benefit a trust is created.

Living Trust • A legal entity used for estate planning o Also called a grantor’s trust, revocable trust, or inter vivos trust • Trust Corpus—the property that is placed in the trust to fund the trust.

• The primary purpose of using a living trust is to avoid probate.

• Special Facts: o No reduction in estate taxes any more than a will o No reduction in grantor’s income taxes o Does not avoid creditors o Subject to divorce property division Parties to a Living Trust • Grantor—person who establishes a living trust.

• Trustee—person who is responsible for maintaining, investing, buying, and selling trust assets.

• Income beneficiary—person who is entitled to receive income from a living trust.

• Remainder beneficiary—person who is entitled to receive the assets upon the death of the grantor • Pour-over will—necessary to distribute any of the grantor’s property not in the living trust at the time of the grantor’s death to the trust upon the grantor’s death.

Living Trust—Primarily to Avoid Probate (Grantor’s revocable or inter vivos) 1. Corpus a. Funds the Trust 2. Parties a. Grantor i. Establishes b. Trustee i. Maintains c. Income Beneficiary d. Remainder 3. Pour-Over Will a. Distributes Property Not in Living Trust

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Case 39.3. The Court Speaks: Right to Die: A Controversial Issue: Gonzales, Attorney General v.

Oregon, 546 U.S. 243, 126 S.Ct. 904, 163L.Ed. 201 748, Web 2006 U.S. Lexis 767 (2006) U.S. Supreme Court.

Facts: Oregon, subsequent to ODWDA, allowed doctors to give lethal doses of drugs at the request of a terminally ill patient if diagnosis is death within 6 months. It must be voluntary, informed, and often subsequent to counseling. There must be second doctor. Only certain doctors can administer but not Oregon doctors (may write prescription). The drugs are regulated by the CSA and the physician must be registered with the U.S. Attorney General who can rule based on “the public interest.” The U.S. Attorney General decided that this type of action is not in the public interest. Oregon, et al., challenged the interpretation, and a permanent injunction against the ruling was issued. He appealed.

Issue: Does the U.S. Attorney General have the statutory power, pursuant to the federal controlled substances act, to issue the interpretive rule criminalizing medical practices authorized by the state of Oregon law?

Decision: The rule was invalid. The ODWDA can be administered.

Reason: The Congress can regulate illicit drugs. That is not the case here. The statute has excellent limitations.

Living Will—Signed stating not to prolong life indefinitely through artificial means (healthcare agent) III.

Answers to Critical Thinking cases

Marital Assets 39.1.

Because the medical degree was attained during the marriage it might be argued that this was marital property (obtained using spousal income). But she was already in medical school so it could be argued that this was here or set up prior to marriage. Neville v. Neville, 734 So2d 352, Web 1999 Miss. App. Lexis 68(Court of Appeals of Mississippi)

Child Custody 39.2.

Because the “best interests test” could involve providing for a stable environment and for the emotional needs of the child, and since the new husband had a history of problems, Randolph should be awarded custody. Schweinberg v. Click, 627 So. 2d 548, Web 1993 Fla. App. Lexis 11660(Court of Appeals of Florida)

Will 39.3.

The first will, executed on or about June 10, 1959, should be admitted into probate. In Texas, every will must be in writing, signed by the testator, and if not wholly in the handwriting of the testator, attested by two or more witnesses. In this case, it is uncontroverted that the handwritten document is not signed by the deceased and that the typewritten document, although signed, was not executed before at least two witnesses. Appellant contends, however, that although neither instrument by itself is sufficient, both instruments taken together constitute a valid will. The court held that none of the authorities cited support such a proposition and that the clear statutory requirements are satisfied only with respect to the first document. In re Estate of Jansa, 670 S.W.2d 767, 1984 Tex. App. Lexis 5503 (Tex.App. 1984).

Ademption .

Family Law, Wills, and Trusts

39.4.

383

The Court speaks: Opperman v. Anderson, 782 S.W. 298, Wels 1989 Tex. App. Lexis 3175 (Court of Appeals of Texas).

Facts: Ethel made a will bequesting one-half of her Pabst stock to Mary Lee, all of Houston Gas to Baker, and remainder to Boysville. Later the Pabst and Houston stock were sold and the cash proceeds were put into two separate accounts. At probate Anderson and Baker received the money. There was an appeal.

Issue: Were the bequests specific bequests that were adeemed with the sale of the stock?

Decision: Yes. The proceeds went to Boysville.

Reason: The bequests were comprised of specific items to which ademption apply.

Will 39.5.

Because the one original had been torn in the presence of the attorney, the intent to revoke was present and Lois should win. Succession of Talbot, 530 So. 2d1132, Web 1988 La. Lexis 1597 (Supreme Court of Louisiana).

Intestacy 39.6.

Because both parties were dead and the time of death could not be determined, they are treated as having died simultaneously. In that case the estate is split and each inherits each other’ share which is then split according to the laws of intestate succession. In re Estate of Campbell, 56 Ore. App. 222, 641 P.2d 610, Web 1982 Ore. App. Lexis 2448 (Ct. of Appeals of Oregon).

IV.

Answers to Ethics Cases

39.7.

The Court Speaks: Giha v. Giha, 609 A.2d945, Wels 1992 R.I. Lexus 133 (Supreme Court of Rhode Island) Facts: On October 7, 1987, the husband, Nagib Giha, filed a complaint for divorce on the grounds of irreconcilable differences. The trial began on May 20, 1988. During a recess on the first day of trial the parties reached an agreement for the disposition of their property. Both parties testified that the husband would retain the future income from his medical practice from May 20, 1988, the date of the trial. The parties also agreed to divide equally the net proceeds from the sale of their marital assets. On May 31, 1988, the Family Court entered a decision pending entry of final judgment confirming the parties’ agreement reached at trial.

On December 25, 1988, the husband learned that he had won the MEGABUCKS game.

His winning lottery ticket was worth approximately $2.4 million, payable over twenty years at $120,000 per year. The husband waited until October 6, 1989, to claim his prize from the Massachusetts State Lottery Commission. He testified that he delayed claiming his prize for health reasons and because he was trying to liquidate his medical practice.

On April 27, 1989, six months prior to the husband’s claiming his prize, the Family Court entered its final judgment severing the parties’ marriage. The wording of the final judgment was slightly different from the interlocutory order. The final judgment stated, “Commencing as of May 20, 1988, all income of Plaintiff shall be the sole property of Plaintiff.”

In December 1990 the wife filed a complaint for post final judgment relief pursuant to Rule 64A of the Rules of Procedure for Domestic Relations. She argued that the husband committed fraud by failing to disclose his lottery prize to her and to the Family Court. The wife

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asserted that the $2.4 million lottery prize was a marital asset because the husband won the prize during their marriage and that the prize should be divided equally between the parties.

After a hearing the trial justice dismissed the wife’s complaint. He concluded that an individual need not update information on a change in his or her financial circumstances after the trial concludes. Therefore, the trial justice determined that the husband had not committed fraud by failing to disclose his lottery prize.

Issue: Was the lottery prize personal property of the marital estate?

Decision: The lottery prize was a marital asset.

Reason: The marital agreement did not sever either the matrimonial or economic ties between the husband and the wife. Because the parties’ marriage remained in effect during the statutory waiting period, so did the property rights each spouse had in the property acquired by the other spouse during that period. The court concluded that the lottery prize was a marital asset.

39.8.

Mr. Chadwick did not act ethically in that he intentionally hid the money and refused to give it back. This circumvents the law and ignores any semblance of fair play. Chadwick v. Janecka Warden, 312 F.3d 597, Web 2002 U.S. App. Lexis 25 ch. 393 (U.S. Court of Appeals)

V.

Answers to Policy Cases

39.9.

The wife did not receive too much according to the court. “It is not unfair that she be able, like him, to enjoy a more opulent lifestyle made possible by the frugality of their building years.”

Johnston v. Johnston, 38 Mass. App. Ct. 531, 649 N.E. 2d799, Web 1995 Mass. App. Lexis 429 (Appeals Court of Massachusetts)

V.

Answer to Writing Assignment:

1. Case Name, Citation, and Court In reN.E. Estate Vallerius 629 2d of 1185 (1994) Appellate Court of Illinois 2. Key Facts A. D.W. murdered grandmother A.V. and C.W. murdered C.P. (A.V.’s friend) who was in the house with A.V. B. A.V. died with a will naming D.W. and C.V. as sole beneficiaries. A.V.’s only heir was R.W. (D.W. and C.W.’s mother).

C. D.W. and D. J. were appointed legal representatives of A.V.’s estate.

D. Two-and-a-half months later R.W. died leaving D.W. and C.W. as her only heirs.

E. Appellees filed a petition to intervene and consolidate the estates of A.V. and R.W. and an “Objection of Distribution” alleging the murderers could not receive A.V.’s or R.W.’s property.

This was granted.

3. Issue Can D.W. and C.W. receive property of A.V. from her estate or through the estate of R.W.?

4. Holding No. 5. Court’s reasoning

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Family Law, Wills, and Trusts

A. Public policy prevents wrongdoers from profiting directly or indirectly from intentionally committed wrongful acts.

B. D.W. murdered grandmother and C.W. murdered her friend.

C. The Court found that D. W. and C.W. intentionally caused the death of A.V. D. Neither can benefit from the death of A.V. whether directly or indirectly.

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386 Chapter 40

Chapter 40 Accountants’ Liability

What Does An Accountant Do? Learning Objectives: 1 .

2 .

3 .

Describe an accountant’s liability to his or her client for breach of contract and fraud.

Describe an accountant’s liability to third parties Ultramares under thedoctrine.

Describe an accountant’s liability to third parties under the and theRestatement foreseeability standard.

(Second) of Torts Describe the accountant’s civil liability and criminal liability under federal securities laws. Describe the duties of accountants under the Sarbanes-Oxley Act.

4 I.

.

Teacher-to-Teacher Dialogue

5 Much has been written about the dramatic changes in the legal environment in which accountants and professionals find themselves working today. The proverbial pot of gold known . as partnership has become an anxiety-ridden fear of personal liability for many a CPA and other professionals. There is no single root cause for this, although statutes such as RICO, the IRC, and securities laws have all done their share to contribute to today’s situation.

Try to put all this in perspective for your students. The fear of personal liability is real, but I try to encourage students to think of it as a challenge rather than a liability. If the net result of malpractice suits is to raise the overall level of skill and competence in the profession, can the bottom line be all that bad? CPAs, like every other professional, need to work harder and be more disciplined than ever before. The special status accorded in the past through cases like Ultramares simply can no longer provide safe harbors from liability. It is a tough lesson to learn, but a very necessary one indeed The origins of the accounting profession go all the way back to a Franciscan Monk, Fra Luca Pacioli (1445–1509), who is credited with first having devised the double entry method-of-record keeping of financial information in his work entitled “Summa de Arithmetica, Geometria Proportion et Propotionality.” Since that time, it has evolved into a critical and highly respected profession. One of the old clichés still often heard in the halls of business schools is that accounting is the language of business. There is no question that in today’s legal environment of business, the accounting profession has also become one of the prime targets of change. Albeit still a very highly respected profession, it has not been “business as usual” for accountants in recent history. The profession’s future has become more uncertain than ever because of the increased scope of an accountant’s legal liabilities.

What have been some of the factors that have led to these convulsive contretemps within this profession? First and foremost must be the shift of scope of reliance from a two-party scenario (accountant–client) to a three-party situation. The new order involves not only the two original .

Accountant’s Liability387

parties but also third parties who for whatever reason have found standing in the courts to sue based on their reliance on the accountant’s work product. The traditional privity and privity-like protections accorded to the profession by cases such as Ultramares are falling more and more to the wayside. The work product of accountants is simply too important to be expected to be kept in the four walls of the client’s office. Today’s “glass jar” world of information technology transfer makes it not only foreseeable but probable that information used to establish financial credibility will in fact be used by many third parties, ranging from governmental entities to investors and financial institutions all over the world. It is interesting to note that the word “public” has always been associated with the accounting profession. In today’s scheme of things, the public is more involved than ever with the workings of the accounting profession and is holding accountants more accountable than ever.

Another factor that has led to so many suits being filed against accountants today is that the profession has not really decided how it will ultimately react to these drastic changes. It continues to seek the public’s confidence in its work and reliance on its work products. In many ways certain elements of its work are not even optional but rather held to a captive audience. Can you imagine the IRS or the SEC waiving its record-keeping and financial reporting requirements? Yet when things have gone awry for the accounting profession, it has constantly sought to limit its intended scope of service or reliance on that service. This has led to a sort of schizophrenia within the profession in not knowing what is really expected and losing contact with the changing legal environment. A number of commentators have said that real equilibrium will return to the profession when it decides that its role has evolved into a real-world insurance function. Under this thinking, ultimate reliance on the work product of the accounting profession will be restored on the basis that what users really wanted all along is comfort in knowing that they can “bank” on what the financial statements are really saying. This sort of change will probably happen only when the government is willing to step in to provide financial assurances to the accounting profession the way it has in the financial institution arena. Until that does happen, the private sector-funded accounting profession will remain under siege for all sorts of faults that were not of its own making. All too often, today’s changing legal environment has allowed the accountants to become the last deep pocket in a chain of sequential liability traced back to them through a series of bankrupt stock issuers, tax dodgers, and other miscreants. In a very real sense the accounting profession is a profession in crisis today, and time only will tell if future generations of the profession will be transmogrified from the practice of this profession asaccountants we know it today.

The primary functions of are to audit financial statements and render opinions about those audits. They also provide unaudited financial statements, render tax advice, prepare tax forms, and provide consulting services.

II.

Text Materials

Public Accounting A Certified Public Accountant (CPA) meets certain educational standards and passes the CPA exam. A public accountant is not certified.

Accounting Standards—Generally accepted accounting principles (GAAPs) are the standards for the preparation and presentation of financial statements, and generally accepted accounting standards (GAASs) specify the methods and procedures that must be used to conduct audits.

Audits—Audits are a verification of a company’s books and records that must be performed by an independent CPA. The auditor conducts a sampling of the inventory and verifies third-party information.

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Contemporary Environment: Auditor’s Opinions After completing the audit, auditors render an opinion about how fairly the company’s financial position is represented by its financial statement. They also issue an opinion on the result of operations and any change in the financial position.  Unqualified opinions are the most favorable opinion, and represent that the auditor’s finding is a fair representation.  Qualified opinions state that the financial statements are fairly represented except for an exception or departure from to a generally accepted accounting principal, or a material uncertainty.  An adverse opinion is one that says the statements do not represent the company’s financial position.  Disclaimer of opinions express that the auditor cannot draw a conclusion as to the accuracy.

Limited Liability Partnership (LLP)—Most accounting firms are organized as this form of partnership, offering limited liability to the partners. Liability is limited to the amount of their capital contribution, with the exception of intentional misconduct.

Liability of Accountants to Their Clients Breach of Contract—Terms of engagement are specified when an accountant and client enter into a contract. Accountants who fail to perform as expected are considered to be in breach. Fraud—The client is allowed recovery if the accountant is liable for either actual or constructive fraud. Negligence—Accountants owe a duty to use the reasonable care, knowledge, skill, and judgment expected from the profession. Failure to perform to this standard is negligence.

Violations of GAAPs or GAASs are considered prima facie evidence of negligence.

Case 40.1. The Court Speaks: Greenstein, Logan& Company (GLC) v. Burgess Marketing, Inc. (BMI), 744 S.W. 201 170, Wels 1987 Tex. App. Lexis (Court of Appeals of Texas) Facts: BMI (JB owner) had GLC as CPAs for 15 years. The controller underaccrued and underpaid the federal excise tax for the last 3 years. GLC did not discover the error during its audits but also did not follow GAAS. The new auditor [Patillo, Brown(PB)] discovered the delinquency which would have created a net loss instead of a net profit. The IRS levied a tax lien for the deficiency against BMI and JB. JB and BMI sued GLC and six of its partners for malpractice. The jury found malpractice and awarded damages to plaintiffs. Defendants appealed.

Issue: Is GLC liable to BMI for accounting malpractice?

Decision: Yes. Jury’s finding was affirmed.

Reason: Expert described GLC’s work as such a “flagrant, violent violation of GAAS.” Following GAAS would have found the delinquency. There was negligence here.

Liability of Accountants to Third Parties The Ultramares Doctrine—In Ultramares Corp v. Touche, et. al., based on an unqualified opinion given by Touche and distributed by the borrower, Ultramares made a loan which was later defaulted upon. Judge Cardozo held that Touche could not be held liable for negligence unless the plaintiff Ultramares was in either privity of contract or a privity-

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like relationship with the accountant. Because the financial statements were not prepared specifically for use in obtaining a loan, the accountant was not liable.

Case 40.2. The Court Speaks:Credit Alliance Corporation v. Arthur Andersen & Co. 65 N.Y.2d 535, Web 1985 N.Y. Lexis 15157(Court of Appeals of NY) Facts: Arthur Andersen & Co., CPAs, prepared audited financial statements of L.B. Smith, Inc., for the years 1977 to 1979. An unqualified opinion was given for all years. These financial statements were prepared negligently, and failed to discover the precarious financial position of Smith. Without Andersen’s knowledge, Smith gave these financial statements to Credit Alliance Corporation, which loaned Smith more than $15 million, relying on these financial statements. In 1980, Smith went into bankruptcy. Credit Alliance sued Andersen for negligence. The trial court denied Andersen’s motion to dismiss and the Appellate Division affirmed. Andersen appeals.

Issue: Is Andersen liable under the Ultramares doctrine?

Decision: No. Reason: The court reaffirms Ultramares. For an accountant to be liable in negligence to noncontracting parties, the following must occur: 1) the accountant must have been aware that the financial statements were to be used for a particular purpose; 2) in furtherance of that purpose a known party was intended to rely on those statements; and 3) there must have been some conduct on the part of the accountant linking them to that party which evidences that the accountant understood that party’s reliance. Here there is no link between Andersen and Credit Alliance, so Andersen is not liable to them.

• The Forseeability Standard—Some states have broadened the Ultramares Rule to apply to any foreseeable third parties that may see the statements.

• Fraud—A third party that relies on an accountant’s actual or constructive fraudulent activities and is injured, may bring an action in torts.

• Breach of Contract—Third parties are usually excluded from bringing a suit for breach of contract because there is no privity of contract.

Case 40.3. The Court Speaks: Johnson Bank v. George Kovbakes & Co., LLP, 472 F.3d 439, Wels 2006 U.S. App. Lexis 31058 (2006) U.S. Court of Appeals Facts: Johnson made a loan to Bravelon after reviewing GKCO’s audit report of Bravelon (showing problems but with several errors on the report).

Issue: Is GKCO the auditor of Bravelon, liable to Johnson Bank for negligent misinterpretation?

Decision: No. Reason: Liability to third party only goes if the auditor knew the client wanted to use the audit report to influence the third party. Information in this audit report was okay if the numbers were read with the footnotes. Damages would also be very speculative.

Liability of Accountants Under Security Laws

• Section 11—Civil liability is imposed upon accountants who fraudulently or negligently issue financial statements that are included with registration statements in SEC filings.

They can raise the due diligence defense if they can prove that, after reasonable

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investigation, grounds to believe that the statements made were true at the time of preparation and certification.

• Section 10(b) and Rule 10b-5—These two antifraud provisions of the Securities

Exchange Act of 1934 often are used to bring actions against accountants. The Supreme Court has ruled that only intentional and reckless behavior can be considered under these sections.

• Section 18(a)—The Securities Exchange Act of 1934 imposes civil liability for anyone •

making false or misleading statements in any application, report, or document filed with the SEC. This section requires a showing of fraud or reckless conduct.

Defenses that can be raised include a showing that the accountant acted in good faith or that the plaintiff had knowledge of the false or misleading statement when the securities were purchased or sold.

Ethics: Accountant’s Duty to Report Client’s Illegal Activity Section 10a of the Securities Exchange Act of 1934 requires that auditors must detect and report all but “clearly inconsequential” illegal acts to the client’s management and audit committee. If they fail to act, the auditor must report the acts to the client’s full board and either issue a nonstandard report or resign from the audit engagement. If the board fails to take action, the auditor must notify the SEC. Ethics: Aiders and Abettors Not Liable Under Section 10(b) Criminal Liability of Accountants

• Section 24—It is a criminal offense for any person to make untrue statements or omit any material fact in SEC filings or to willfully violate and provisions of the Securities Act of 1933. Penalties include a fine of up to $10,000 and five years imprisonment.

• Section 32(a)—This makes it a criminal offense to willfully and knowingly make or

cause to be made false or misleading statements in any SEC filings. Fines may reach up to $1 million for an individual, with imprisonment of up to 10 years. Corporations may be fined up to $2.5 million. Additional charges may be brought by the Justice Department if mail or wire fraud statutes were violated.

• Criminal Liability Regarding Tax Preparation—The 1976 Tax Reform Act imposes a fine of up to $100,000 and imprisonment of up to 5 years for an individual and fines of up to $500,000 for a corporation for aiding and assisting in the preparation of a false return.

• Racketeer Influenced and Corrupt Organizations Act—Accountants may be charges under RICO for securities fraud. Not only is there criminal liability, but this act allows for civil liability and treble damages in a civil action.

• State Securities Law—Most states have enacted the Uniform Securities Act, patterned after federal laws and establishing criminal liabilities.

Sarbanes-Oxley Act

• Sarbanes-Oxley Act Regulates Accounting Practices—SOX establishes a Public

Company Accounting Oversight board and requires that public accounting firms register with the board in order to audit a public company. It furthers require that there be a separation of audit and nonaudit services and requires that all audits be signed by the audit partner of the firm that supervised and approved the audit report. All audit papers must be retained for at least 7 years. Rotating of the lead audit partner and the reviewing .

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partner must rotate off and on every 5 years. Public corporations must have an audit committed with independent directors (at least one financial expert). Finally, any person employed by a public accounting firm that audits a client cannot accept a position with that client as a CEO, CFO, controller, chief accounting officer, or its equivalent for a period of one year.

Accountant’s Privilege and Work Papers In some states the accountant’s work papers cannot be discovered because of work product immunity. Some discovery is allowed in federal cases.

III. Answers to Critical Thinking Cases Audit Opinion 40.1. Yes, the qualified opinion protects Haskins and Sells from liability. The court held that the qualified opinion clearly indicated that the accounts receivable of Colorado Rent-ACar, Inc., was an exception to the audit and that Stephens Industries was bound by this qualification. Absent fraud, accountants are not liable for items excepted from the audit by a qualified opinion. Therefore, Haskins and Sells cannot be held liable for the alleged negligence asserted by Stephens Industries. Stephens Industries, Inc. v. Haskins and Sells, 438 F.2d 357 (10th Cir. 1971).

Auditor’s Liability to Third Party 40.2. No, Ernst & Whinney is not liable for either fraud or negligence in this case. To be held for fraud, a party must have participated in the fraudulent activity or acted with recklessness or gross negligence. The court found that Ernst & Whinney had no knowledge of the fraudulent activity, and did not act recklessly or with gross negligence.

There was no evidence that the work done by Ernst & Whinney was done to defraud or deceive Hutton, or with reckless disregard of Hutton’s interest. Therefore, the court held that Ernst & Whinney was not liable to Hutton for fraud.

With regards to the negligence claim, the court held that Ernst & Whinney was not liable for negligence to Hutton either. This was because the court found that any negligence by Ernst & Whinney was not the proximate cause of Hutton’s losses. The court found that Hutton’s losses were caused solely by the massive fraud of Mr. Cotts and

by Hutton’s own negligence in not discovering the fraud by not investigating the loans more cautiously before purchasing them from FAMCO. Therefore, the court dismissed Hutton’s petition against Ernst & Whinney for fraud and negligence. E.F. Hutton Mortgage Corporation v. Pappas, 690 F.Supp. 1465 (D.Md. 1988).

Auditor’s Liability 40.3. Yes, under the Ultramares doctrine, Arthur Andersen is liable to the limited partners. The Ultramares doctrine provides that an accounting firm is not liable to third parties for its negligence in conducting audits unless the third party is in privity of contract or privitylike relationship with the accountant. The court held that in this case the limited partners had this kind of privity-like relationship with Arthur Andersen. The court found that Arthur Andersen knew that the audit was being conducted for the partners’ benefit. The court stated: Here, the services of the accountant were not extended to a faceless or unresolved class of persons, but rather to a known group possessed of .

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vested rights, marked by a definable limit and made up of certain components. The instant situation did not involve prospective limited partners, unknown at the time and who might be induced to join, but rather actual limited partners, fixed and determined. Here, accountant Arthur Andersen was retained to perform an audit and prepare the tax returns of Associates, known to be a limited partnership, and the accountant must have been aware that a limited partner would necessarily rely on or make use of the audit and tax returns of the partnership, or at least constituents of them, in order to properly prepare his or her own tax returns. The court found particularly relevant the fact that Arthur Andersen’s negligence was with respect to an item of substantial significance to the limited partners—the amount of capital that the general partners had in the partnership. The court reversed the trial court’s dismissal of the action. White v. Guarente, 372 N.E.2d 315 (N.Y.Ct.App. 1977).

Accountant’s Liability to Third Party 40.4. Following is a discussion of Touche’s liability under the three theories: 1. The Ultramares Doctrine. Under the Ultramares doctrine, an accountant is only liable for his negligence to third parties who are in privity of contract or a privity-like relationship with the accountant. Here, the Rosenblums are not in privity of contract or a privity-like relationship with Touche. Touche is only in privity of contract with Giant, who employed it to conduct the audit. The Rosenblums had no involvement with Giant when Touche conducted the audit. Therefore, under the Ultramares doctrine, Touche owes no duty to the Rosenblums and is not liable to them for its negligence.

2. Section 552 of the Restatement (Second) of Torts. Under Section 552, an accountant may be held liable for his negligence to any member of a limited class of intended users for whose benefit the accountant has been employed to audit the company and prepare its financial statements. Here, Touche was not employed to conduct the audit of Giant for the Rosenblums’ benefit. In fact, Touche had no knowledge of the Rosenblums when it conducted the audit, and had no knowledge that Giant’s audited financial statements would be used by the Rosenblums to assist them in their sale of their business to Giant. The Rosenblums did not qualify as “intended users” of the financial statements. Therefore, Touche did not owe a duty to the Rosenblums and is not liable to them for accounting malpractice under Section 552 of the Restatement (Second) of Torts.

3. The Foreseeability Standard. The foreseeability standard stipulates that accountants are liable for their negligence to any foreseeable user of the client’s financial statements. This is the broadest standard of liability for accounting malpractice.

Under this standard, Touche would be liable to the Rosenblums. This is because it is foreseeable that the client would provide its audited financial statements to third parties, including parties like the Rosenblums who are contemplating selling a business to the client in exchange for stock of the client.

The Supreme Court of New Jersey adopted the foreseeability standard for judging an accountant’s negligence liability to third parties. The court stated: When the independent auditor furnishes an opinion with no limitation in the certificate as to whom the company may disseminate the financial statements, he has a duty to all those whom that auditor should reasonably foresee as recipients from the company of the statements for its proper .

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business purposes, provided that the recipients rely on the statements pursuant to those business purposes.

The court found that the Rosenblums were foreseeable recipients of the financial statements and that they relied on the statements when they made their decision to sell their business to Giant. The court held Touche liable to the Rosenblums for accounting malpractice. Rosenblum v. Adler, 461 A.2d 138 (N.J. 1983).

Section 10(b) 40.5. Yes, Laventhol is liable for violating Section 10(b) of the Securities Exchange Act of 1934. Section 10(b) and Rule 10b-5 prohibit deceptive and manipulative practices in connection with the sale of securities. However, to be held liable under Section 10(b) and Rule 10b-5, a person must have acted with scienter; negligent conduct is not sufficient to find a violation. After reviewing the evidence in this case, the court held that Laventhol had acted with scienter, and not just negligently.

The court held that the recordation of the profit from the sales transaction of the nursing homes was a materially misleading statement that distorted the financial figures of Firestone. The court further found that Hersfeld and the other investors relied on the audited financial statements and might not have purchased Firestone’s securities if they had known the truth about that sale. The court found that Laventhol’s labeling of the $1,750,000 as “deferred gross profit”—as opposed to “unrealized gross profit”—gave the erroneous impression that the profit was cash in hand that only had to be recorded in the future. Here, the court held that Laventhol acted with scienter and had violated Section 10(B) and Rule 10b-5. The court affirmed the trial court’s judgment against Laventhol.

Herzfeld v. Laventhol, Krestein, Horwath & Horwath, 540 F.2d 27 (2nd Cir. 1976).

Accountant-Client Privilege 40.6. Roberts, the client, wins. Chaple, the accountant, was bound by Georgia’s accountant– client privilege. A state’s accountant–client privilege prevents an accountant from disclosing information about a client or becoming a witness against the client in state court proceedings. The court held that the purpose of the state’s accountant–client privilege is to insure an atmosphere wherein the client will transmit all relevant information to his accountant without fear of any future disclosure in subsequent litigation. The court held that Chaple’s voluntary disclosure of the confidential information about Roberts to the Internal Revenue Service (IRS), without waiting for a subpoena, violated Georgia’s accountant–client privilege.

However, no accountant–client privilege exists under federal law. Thus, Georgia’s accountant–client privilege is inapplicable to federal proceedings not involving state law claims. In this case, the IRS, an agency of the federal government, is investigating Roberts for violation of the Internal Revenue Code, a federal law.

Therefore, if the IRS issued an administrative summons or subpoena to Chaple requesting the confidential information about Roberts, the Georgia accountant–client privilege could not be asserted to prevent disclosure of this information to the IRS. Because the IRS could eventually issue such a summons or subpoena in this case, the court held that Roberts suffered minimal, if any, damages. The court reversed the trial court’s grant of summary judgment in favor of Chaple. Roberts v. Chaple, 369 S.E.2d 482 (Ga.App. 1988).

IV.

Answers to Ethics Cases .

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40.7. Yes, Coopers & Lybrand (Coopers) is liable to the Archdiocese of Miami for the amount of the defalcations of the insurance premiums by McGee. Accountants are liable for their negligence in performing audit services for the client. The court held that Coopers was negligent in failing to adhere to the audit program by not obtaining a copy of the stop-loss policy from Lloyd’s and not verifying the existence of the insurance. If Coopers had done so, the court found, McGee’s defalcations would have been discovered and reported to the Archdiocese. An accounting expert testified that Coopers’ conduct violated General Accepted Auditing Standards (GAASs). The court held that Coopers was negligent and therefore liable to its client. The court remanded the case for a determination of the losses suffered by the Archdiocese. Coopers & Lybrand v. Trustees of the Archdiocese of Miami, 536 So.2d 278 (Fla.App. 1989).

Yes, Howard is criminally liable for violating Section 24 of the Securities Act of 1933.

40.8. Section 24 makes it a crime for any person to “willfully” violate any provision of the 1933 Act. The court found that Howard, as the accountant for American Equities, made false and misleading statements in the pro forma accounting reports he prepared for the company. The evidence was sufficient to find that (1) Howard knew that his reports were going to be used by brokers to sell American Equities’ securities to investors, (2) the accounting reports were little more than a regurgitation of materially misleading statements requested by Mende to be included in the accounting reports, and (3) Howard acted willfully and had the state of mind required for criminal conviction. The Court of Appeals affirmed Howard’s conviction. United States v. Howard, 328 F.2d 854 (2nd Cir. 1964).

V.

Answers to Policy Cases

40.9. Following is a discussion of Cooper’s liability under the three theories: 1. The Ultramares Doctrine. Under the Ultramares doctrine, an accountant is only liable for his negligence to third parties who are in privity of contract or a privity-like relationship with the accountant. Here, the Lindner Funds were not in privity of contract or a privity-like relationship with Coopers. Coopers was only in privity of contract with Texscan, its client who employed it to conduct the audit. The Lindner Funds had no involvement with Texscan when Coopers conducted the audit. Under the Ultramares doctrine, Coopers owes no duty to the Lindner Funds and cannot be held liable to them for its alleged negligence.

2. Section 552 of the Restatement (Second) of Torts. Under Section 552, an accountant may be held liable for his negligence to any member of a limited class of intended users for whose benefit the accountant has been employed. Here, Coopers was not employed to conduct the audit of Texscan for the benefit of the Lindner Funds.

Coopers did not have knowledge that Texscan’s audited financial statements would be used by the Lindner Funds in making their decision to invest in the company. The Lindner Funds do not belong to a very small group of persons for whose guidance Coopers prepared the financial statements. Therefore, under Section 552 of the Restatement (Second) of Torts, Coopers did not owe a duty to the Lindner Funds and is not liable to them for their alleged negligence. The Missouri Court of Appeals took this middle ground and chose to apply a balancing test to determine whether Coopers could be held liable to the Lindner Funds. The court held that the Lindner Funds did not state a cause of action against Coopers and dismissed the complaint.

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3. The Foreseeability Standard. The foreseeability standard stipulates that accountants are liable for their negligence to any foreseeable user of the client’s financial statements. This is the broadest standard of liability for accounting malpractice.

Under this standard, Coopers could be held liable to the Lindner Funds for its alleged negligence in preparing the audited financial statements of Texscan. This is because it is foreseeable that potential investors—such as the Lindner Funds—would obtain, review, and rely on the audited financial statements of a company before investing in that company. Thus, under the foreseeability standard, Coopers could be held liable to the Lindner Funds for its alleged negligence in conducting the audit of the Texscan Corporation. Lindner Fund v. Abney, 770 S.W.2d 437 (Mo.App. 1989).

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court United States v. Natelli 527 F.2d 311 (1975) United States Court of Appeals, Second Circuit, Summary of the Key Facts 2. A. Anthony M. Natelli and Joseph Scansaroli are both CPAs who are employed by the Washington D.C. office of Peat, Marwick, Mitchell and Co. (Peat). Peat is a large national independent audit firm.

B. Both were engaged in the preparation of proxy statements for National Student Marketing Corporation (Marketing) in 1968.

C. These statements were issued with regard to a special meeting of the Marketing stockholders to consider increasing its authorized capital stock and the merger of six companies including Interstate National Corporation (Interstate) into Marketing.

D. Subsequent to that meeting it was found that certain facts alleged in the proxy statements were untrue and based on actions not in compliance with GAAP. E. Natelli and Scansaroli were found guilty of having violated Section 32 of the Securities Exchange Act of 1934 and now appeal from that decision.

3. Issue Was there sufficient evidence upon which these convictions should stand?

4. Holding Yes. The United States Court of Appeals for the Second Circuit affirmed the decision of the lower court.

5. Summary of the Court’s Reasoning The United States Court of Appeals for the Second Circuit held that: A. Section 32(a) of the Securities Act of 1934 hold persons liable for willingly and knowingly making false and misleading statements with respect to material facts in a proxy statement.

B. In the proxy statement issued by Marketing in 1968, the defendant accountants and four of marketing officers acted in violation of Section 32(a) by not following GAAP resulting in false and misleading statements in the proxy.

C. Even though Scansaroli was subject to the supervision and orders of Natelli, he was still responsible for his participation in the presentation of wrongful information on a footnote in the proxy. .

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D. Based on the expectations of professional independence of auditors which were not met, coupled with the active preparation of false and misleading material misstatements, there was sufficient grounds to uphold the convictions rendered by the lower court.

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International and World Trade Law 397

Chapter 41 International and World Trade Law

Where Do You Find International Law? Learning Objectives: 1. Describe the U.S. government’s power under the Foreign Commerce Clause and Treaty Clause of the U.S. Constitution.

2. Describe the nations’ court’s jurisdiction over international disputes.

3. Describe the functions and governance of the United Nations.

4. Describe the North American Free Trade Agreement (NAFTA) and other regional economic organizations.

5. Describe the World Trade Organization (WTO) and explain how its dispute resolution procedure works.

I.

Teacher-to-Teacher Dialogue:

A good way to start off this chapter is possibly with an opening discussion on the practical difficulties involved in the enforcement of international law. This material always stirs a good opening debate among students as to just what the practical limitations in this area are. At best, defining international law along the traditional domestic lines of a body of rules of behavior and mechanisms designed to enforce those rules cannot work as well when the protagonists are sovereign nations. By definition, sovereignty incorporates the notion of freedom from external controls and supreme power over one’s own affairs. A nation does need to have ultimate control over its internal affairs, but its national interests and the welfare of its citizens do not end at its borders. Nations, just like individuals, can only find protection for their own rights when they are willing to honor the rights of others. Law eventually works its way through to a system of cooperative behavior for the larger mutual good. Law, domestic or international, calls for some sacrifice of individual freedoms for the betterment of the corporate body. This is the fundamental reality upon which all law is ultimately based. Consequences of the failure to honor that reality at the global level are readily apparent to all of us. If the role of law is to act as a mechanism for civilization and to make violence the last resort, then international law is a goal worth striving for by all nations, even at the cost of some of their respective autonomies.

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II.

Text Materials

International Law • Law that governs affairs between nations.

• Law that regulates transactions between individuals and businesses of different countries • No single legislative source of international law. o All countries of the world (and numerous international organizations) are responsible for enacting international laws.

• No single world court is responsible for interpreting international law.

• Several courts or tribunals hear and decide international legal disputes of parties that • agree to appear before them.

• There is no world executive branch that can enforce international laws.

Nations do not have to obey international law enacted by other countries or international organizations.

The United States and Foreign Affairs • The Constitutions gives the federal government most of the power to deal with foreign affairs of this country o Foreign Commerce Clause—Article I, Section 8, Clause 3 vests Congress with the power “to regulate commerce with foreign nations.” o Treaty Clause—Article II, Section 2, clause 2 states that the president “shall have power, by and with advice and consent of the Senate, to make treaties, provided two-thirds of the senators present concur.”

• Any state or local law that unduly burdens foreign commerce is unconstitutional under • the Foreign Commerce Clause.

The president is the agent of the United States in dealing with foreign countries.

• • Under the Treaty Clause, only the federal government may enter into treaties with foreign nations.

Under the Supremacy Clause of the Constitution: o Treaties become part of the “law of the land” o Conflicting state or local law is void Sources of International Law • Sources of international law—those things that international tribunals rely on in deciding international disputes.

• Article 38(1) of the Statute of the International Court of Justice lists four sources of international law: o Treaties and conventions o Custom o General principles of law o Judicial decisions and teachings The United Nations (UN) • International organization created by multinational treaty in 1945 • Goals of the United Nations (U.N.): o Maintain peace and security in the world o Promote economic and social cooperation .

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•

o Protect human rights Many Agencies: o UNESCO o UNICEF o IMF o IFAD o World Bank

• General Assembly—all member nations (legislative body) • Security Council—maintains peace (China, France, Russia, UK, and 10 others) • Secretariat—administers day-to-day operations (secretary-general) • International Court of Justice—World Court: judicial branch of UN International Law: The International Monetary Fund (IMF) IMF was established to promote the world economy (sound monetary, fiscal, and macroeconomic policies).

International Law: The World Bank The World Bank provides funds to developing countries for humanitarian and poverty relief purposes.

Regional International Organizations The European Union (EU) • Comprises many countries of Western and Eastern Europe • Created to promote o Peace and security o Economic, social, and cultural development • The EU treaty creates open borders for trade between members • The EURO is the single monetary unit • European Court of Justice—the judicial branch of the EU. o European Court of First Instance (CFI) The North American Free Trade Agreement (NAFTA) • An international treaty that creates a regional free-trade zone consisting of the United • States, Canada, and Mexico Eliminates or reduces most of the duties, tariffs, quotas, and other trade barriers between the members Asian Economic Communities • Association of South East Asian Nations (ASEAN)—does not include China and Japan • ASEAN plus three (China, Japan, South Korea) Middle Eastern Economic Communities • Organization of Petroleum Exporting Countries (OPEC) Dominican Republic—DR-CAFTA .

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• CAFTA: United States and several Central American countries • DR-CAFTA: includes Dominican Republic Others Latin, Central and South America • Africa • World Trade Organization (WTO) • International organization of more than 150 member nations • Created to promote and enforce trade agreements among member nations • WTO members have entered into many trade agreements among themselves • By enforcing trade agreements among its members the WTO has become the world’s most important trade organization In 2002 China became a member of the WTO. Vietnam was admitted in 2007.

Hear and decide trade disputes between member nations: • 1st: WTO panel • 2nd: WTO settlement body • 3rd: WTO appellate body The International Criminal Court (ICC) • Created by the Rome Treaty of 1998 • The ICC has the authority to prosecute individuals accused of genocide, war crimes, and • crimes against humanity The ICC may prosecute nationals located in the more than 100 countries that have ratified • the treaty The ICC has complementary jurisdiction with the national courts of a country Note: ICJ is the judicial branch of the UN (World Court) National Courts Decide International Disputes • The majority of commercial litigation involving international business transactions are • heard by national courts of individual nations.

Judicial Procedure o Choice of forum clause—designates the judicial or arbitral forum that hear and decide the case. o Choice of law clause—designates the law to be applied by the court or arbitrator in deciding the case • Act of State Doctrine o Judges of one country cannot question the validity of an act committed by another country within that other country’s borders o Based on the principle that a country has absolute authority over what transpires within its own territory • The Doctrine of Sovereign Immunity o A doctrine that states that countries are granted immunity from suits in courts of other countries o Foreign Sovereign Immunities Act—exclusively governs suits against foreign nations that are brought in federal or state courts in the United States. .

International and World Trade Law 401

Exceptions: 1. Waiver of immunity 2. Based on commercial activity in the United States by a foreign country or having a direct effect on the United States Case 41.1. The Court Speaks: Glen v. Club Mediteranee, S.A., 450 F.3d 1251, Web 2006 U.S. App. Lexis 13400 (2006) U.S. Court of Appeals Facts: The Glen sisters owned beachfront property in Cuba that was expropriated in 1959. The sisters also fled Cuba in 1959. One sister died but passed her interest to her nephew. Club Med developed the property in a joint venture with Cuba. The Glens sued Club Med in a U.S. District Court in Florida. They claimed the expropriation was illegal and Club Med was unjustly enriched.

The court held the act of state doctrine barred the Glen’s recovery and the Glens appealed.

Issue: Does the act of state doctrine bar recovery by the Glens?

Decision: Yes. Judgment was affirmed and the claim was dismissed.

Reason: Official acts, if they are valid in their countries, of a foreign sovereign within its own territory are valid under the act of state doctrine. The Cubans’ act was valid.

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

International Law: Islamic Law and the Qur’an Today, Islamic law is primarily used in the areas of marriage, divorce, and inheritance and used to a limited degree in criminal law. The Islamic law system is derived from the Koran, the Sunnah, and reasoning by Islamic scholars.

International Law: Hindu Law—Dharmasastra More than 20 percent of the world’s population is Hindu. Most live in India, where they make up 80 percent of the population. Hindu law is linked to the divine revelation of Veda.

III.

Answers to Critical Thinking Cases

Act of State Doctrine 41.1.

The United States government owns the depository account. The U.S. Supreme Court held that the United States government, which has the power to deal in foreign affairs, properly recognized the government of the Soviet Union. Thus, the government entered into a valid international compact with the Soviet Union that covered the Petrograd Metal Work’s (Petrograd) deposit with August Belmont & Co. (Belmont) in the United States. The Soviet Union had confiscated Petrograd’s deposit with Belmont and then assigned this deposit to the United States in settlement of claims between the two countries. Under the Act of State Doctrine, which is recognized by the United States, an act of government .

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in its own country is not subject to suit in another country’s court. Therefore, the act of the Soviet Union, in confiscating the property of Petrograd is not subject to suit in the courts of the United States. The Supreme Court reasoned that although the U.S. Constitution provides that private property shall not be taken without payment of just compensation, under the Act of State Doctrine, the United States must recognize the Soviet Union’s right to confiscate property in its own country without payment of compensation. Therefore, Petrograd’s original deposit account with Belmont now belongs to the United States government pursuant to the international compact entered into with the Soviet Union. United States v.

Belmont, 301 U.S. 324, 54 S.Ct. 758, 1937 U.S. Lexis 293 (1937).

Act of State Doctrine 41.2.

The private United States lending bank wins. The borrowing bank, Banco National de Costa Rica that was wholly owned by the government of Costa Rica, is not protected by the Act of State Doctrine, even though the government of Costa Rica has enacted a law prohibiting the repayment of foreign debt. The U.S. District Court held that the Act of State Doctrine did not preclude the court from hearing and deciding the case. The Act of State Doctrine provides that judges of one country cannot question the validity of an act committed by another country within that country’s own borders. This restraint is based upon the doctrine of separation of powers, that only the executive branch of government and not the judicial branch, may arrange affairs with foreign governments. However, in the instant case, the court held that the source of the debt was in New York, not Costa Rica, because the court considered where the loan and promissory notes were signed and where the money was to be repaid. Thus, the U.S. District court can hear and decided the case. Libra Bank Limited v. Banco Nacional de Costa Rica, 570 F. Supp. 870, 1983 U.S. Dist. Lexis 14677 (S.D.N.Y. 1983).

Forum-Selection Clause 41.3.

Unterweser Reederei GMBH (Unterweser) is correct that the forum selection clause in its contract with Zapata Off-Shore Company (Zapata) is enforceable. A forum selection clause (or choice of forum selection) is a clause in a contract that designates that nation’s courts have jurisdiction to hear cases or disputes that arise concerning the performance of the contract. In the instant case, the contract between Unterweser, a German corporation, and Zapata, a United States corporation, contained a clause that provided that “Any dispute arising must be treated before the London Court of Justice.” The U.S. Supreme Court stated that a forum selection clause should be specifically enforced unless it is clearly shown that such enforcement would be unreasonable or unjust or that the clause was obtained by fraud or overreaching. In the instant case, the Supreme Court found that the forum selection clause had been agreed to by sophisticated companies who conducted international business. The court found no unfairness in the clause, fraud, or overreach in its inclusion in the Unterweser–Zapata contract. Therefore, the Supreme Court held that the forum selection clause designating the London Court of Justice as the tribunal to hear the dispute between Unterweser and Zapata was valid and enforceable. M/S Bremen and Unterweser Reederei, GMBH v. Zapata Off-Shore Company, 407 U.S. 1, 92 S.Ct. 1907, 1972 U.S. Lexis 114 (1972).

IV.

Answers to Ethics Cases .

International and World Trade Law 403

41.4.

41.5.

V. 41.6.

Actions of the Bank of Jamaica were “commercial activities,” excluded from the doctrine of sovereign immunity. Although “commercial activity” is not defined in the FSIA, legislative history indicates that lines of credit were intended to be covered. Contracts for the purchase of goods were clearly considered commercial activity. Here the contract is for the purchase of a service. Once a government enters into a contract, it must play by the contract rules. Further, the test is not whether the government enters into commercial activity frequently, but whether this particular activity was commercial. Chisholm & Co. v. Bank of Jamaica, 643 F.Supp 1393, 1986 U. S. Dist. Lexis 20789 (S.D. Fla. 1986).

Texas Trading and Milling Corporation (Texas Trading) wins. The U.S. District Court held that the Federal Republic of Nigeria (Nigeria) could not raise the doctrine of sovereign immunity to avoid paying for the cement it had ordered from Texas Trading.

The doctrine of sovereign immunity provides that countries are immune from lawsuits in the courts of another country. The United States has enacted the Foreign Sovereign Immunities Act of 1976 (FSIA), which provides an exception to this general rule where a foreign nation is involved in a “commercial activity” that is carried on in the United States, but causes a “direct effect” in the United States. The district court found that Nigeria was carrying on a “commercial activity” when it signed the contract to purchase cement from Texas Trading to be used in building roads, dams, and other infrastructure in the country. The court also held that this commercial activity had a “direct effect” in the United States because many U.S. companies contracted to sell Nigerian cement. The district court held that the contract in the instant case fell within the “commercial activity” exception of the FSIA, and therefore that the doctrine of sovereign immunity did not protect the country of Nigeria from lawsuit in the court of the United States.

Texas Trading & Milling Corp. v. Federal Republic of Nigeria, 647 F.2d 300, 1981 U.S. App. Lexis 14231 (2nd Cir. 1981).

Answer to Policy Cases The Supreme Court Speaks:Republic of Argentina v. Weltover, Inc., 504 U.S. 607, 112 S.Ct. 2160, 119 L.Ed. 2d394, Web 1992 U.S. Lexis 3542 (U.S. Supreme Court) Facts: As part of a plan to stabilize petitioner Argentina’s currency, that country and petitioner bank (collectively Argentina) issued bonds, called “Bonods,” which provided for repayment in U.S. dollars through transfer on the market in one of several locations, including New York City. Concluding that it lacked sufficient foreign exchange to retire the Bonods when they began to mature, Argentina unilaterally extended the time for payment, and offered bondholders substitute instruments as a means of rescheduling the debts. Respondent bondholders, two Panamanian corporations and a Swiss bank, declined to accept the rescheduling and insisted on repayment in New York. When Argentina refused, respondents brought this breach-of-contract action in the District Court, which denied Argentina’s motion to dismiss. The Court of Appeals affirmed, ruling that the District Court had jurisdiction under the Foreign Sovereign Immunities Act of 1976 (FSIA), which subjects foreign states to suit in American courts for acts taken “in connection with a commercial activity” that have “a direct effect in the United States.” Issue: Does the doctrine of sovereign immunity prevent the plaintiff from suing Argentina in a U.S. Court? Decision: No. The District Court properly asserted jurisdiction under the FSIA.

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404 Chapter 41

Reason: Scalia, J. The issuance of the Bonods was a “commercial activity” under the FSIA, and the rescheduling of the maturity dates on those instruments was taken “in connection with” that activity within the meaning of Sec.1605(a)(2). When a foreign government acts, not as a regulator of a market, but in the manner of a private player within that market, its actions are “commercial” within the meaning of the FSIA. Moreover, because Sec.1603(d) provides that the “commercial character of an act is to be determined by reference to its nature rather than its purpose,” the question is not whether the foreign government is acting with a profit motive or instead with the aim of fulfilling uniquely sovereign objectives. Rather, the issue is whether the government’s particular actions (whatever the motive behind them) are the type of actions by which a private party engages in commerce. The Bonods are in almost all respects garden-variety debt instruments, and, even when they are considered in full context, there is nothing about their issuance that is not analogous to a private commercial transaction. The fact that they were created to help stabilize Argentina’s currency is not a valid basis for distinguishing them from ordinary debt instruments, since, under Sec.1603(d), it is irrelevant why Argentina participated in the bond market in the manner of a private actor. It matters only that it did so.

The unilateral rescheduling of the Bonods had a direct effect on the United States with the meaning of Sec.1605(a)(2). Respondents had designated their accounts in New York as the place of payment, and Argentina made some interest payments into those accounts before announcing that it was rescheduling the payments. Because New York was thus the place of performance for Argentina’s ultimate contractual obligations, the rescheduling of those obligations necessarily had a direct effect in this country; money that was supposed to have been delivered to a New York bank was not forthcoming.

Argentina’s suggestion that the direct effect requirement cannot be satisfied where the plaintiffs are all foreign corporations with no other connections to this country is untenable under Verlinden B.V. v. Central Bank of Nigeria, 461 U.S. 480, 489.

Moreover, assuming that a foreign state may be a person for purposes of the Due Process Clause of the Fifth Amendment, Argentina satisfied the minimum contacts test of International Shoe Co. v. Washington, 326 U.S. 310, 316, by issuing negotiable debt instruments demonstrated in U.S. dollars and payable in New York and by appointing a financial agent in that city.

VI.

Answer to “Briefing the Case” Writing Assignment

1. Case Name, Citation, and Court OHG v. Kolodny 1st Jud. Dept. IA Part II (1992) 2. Key Facts A. Plaintiff is a German-based auction house dealing in works of art. It sent a catalogue to the defendant in New York that described works of art that would be put up for auction.

B. One such work of art was described as “a bronze sculpture produced by Hiliare Germain Edgar Degas before 1900 (Dancer Gazing).”

C. Defendant’s bid of DM 220,000 won the auction, and the money was wired to the plaintiff.

D. Upon trying to resell the sculpture, defendant was informed by an art expert that the sculpture was not an authentic Degas.

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International and World Trade Law 405

E. The defendant sued for a refund in the German courts, but lost on the basis that no warranty of authenticity was given by the plaintiff.

F. Plaintiff seeks collection enforcement of the German Court’s judgment, contending that its enforcement would violate New York’s public policy under CPLR Sec. 5304(b)(4).

3. Issue Would enforcement of the German Court’s decision violate New York public policy as described in CPLR Sec. 5304 (b) (4)?

4. Holding No. Court’s Reasoning 5. A. The normal rule is to enforce the judgment of a foreign state unless to do so would be repugnant to the public policy of this state.

B. Differences between the laws of the two jurisdictions do not constitute a violation of public policy.

C. The German court properly applied German law.

D. There was no claim by the defendant that the German law was unfairly applied regarding the issue of warranty exclusion.

E. No public policy of New York would be undermined by enforcement of the German decree.

F. The German judgment is enforceable.

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INTRODUCTION TO THE TEACHING MANUAL

The questions with each video are meant to be discussion questions and so there often is no “correct” answer. This document contains references and some prompts or talking points for faculty to use with the questions posed in the videos.

Legal Heritage and the Digital Age - Brown v. Board of Education One: Because we want stability and predictability in the law, discuss what criteria the Supreme Court should look to when evaluating whether to overturn or reinterpret a prior decision.

The Supreme Court should consider the following: •

The functions of law. The purposes of law include keeping the peace, shaping moral standards, promoting social justice, facilitating orderly change, maximizing individual freedom.

Two: Review the different theories of jurisprudence discussed in the text and discuss what theories would support changes in interpretations, and which theories would argue against changing opinions.

• Theories of jurisprudence that might support changes in interpretation. Justices who subscribe to the historical theory are more likely to uphold precedent without compelling reasons to overturn it.

• Justices who subscribe to a sociological theory are more likely to look to current •

data, studies and reports to determine if the precedent is outdated.

Other theories are less tied to precedent as a concept but instead look to changing circumstances and ideas of logic. The Law and Economics theory would support a change in a precedent if the economic impact of the original decision is minimal and there are good economic reasons to change the rule. The analytical theory looks at the logic of the decision and so is more likely to support change if it “makes sense.”

Three: Review the United States Constitution. What provisions of the Constitution are involved in this case? Discuss whether this should be a federal or a state issue and why.

The primary provision of the United States Constitution involved in this case is the Equal Protection Clause of the 14th Amendment. That clause states that “no state shall . . . deny to any person within its jurisdiction the equal protection of the laws.” U.S. Constitution. Amendment 14, Section 1.

Because this is such an important issue, it should be a federal case. The case involves a federal question – a question related to the Constitution and so federal courts are the appropriate venue for the questions to be resolved.

Court Systems and Jurisdiction - Supreme Court Sides With Walmart One: This story is about the Supreme Court’s decision. What process did this case have to go through to get to the Supreme Court?

• This case started in U.S. District Court with several women suing Wal-Mart for discrimination under title VII of the Civil Rights Act of 1964. The women wanted the case to be heard as a class action (meaning a large class of people is impacted). The District Court granted the motion for the case to move forward as a class action.

• The United States Court of Appeals for the Ninth Circuit affirmed that decision.

• Wal-Mart petitioned certiorari to the Supreme Court. They granted certiorari to determine if this case is appropriate for a class action.

Two: In the story, two justices wrote differing opinions about the issue. Discuss the differences between a majority opinion, a concurring opinion and a dissenting opinion. What effect does each type of opinion have on the state of the law in America?

• A majority opinion is the opinion of at least 5 justices. The effect of the majority opinion is that it serves as the official interpretation or statement of law and lower courts must follow it.

• A concurring opinion agrees with the result of the majority but has additional or

•

different reasons. These opinions do not have any effect on the law, but many concurring opinions are cited in later cases as the Court modifies the law.

A dissenting opinion is written by a justice who disagrees with the overall result of the case. The dissenting opinion does not have any immediate impact on the law but may have a significant impact in the future if the precedent is overturned.

Three: What type of jurisdiction did the federal courts have in this case? Was it a federal question case or a diversity of citizenship case? Why? • This case was a federal question case because The Civil Rights Act of 1964 is a major federal statute. Because the case was brought as a class action, some of the plaintiffs could be from the same state as Wal-Mart and so diversity of citizenship would not be possible.

Judicial, Alternative, and E-Dispute Resolution - Arbitrators Favoring Creditors One: What is the difference between arbitration and litigation? What steps in the litigation process are missing in arbitration?

• Litigation is the formal dispute resolution system in our judicial system. It contains many steps – pleadings, discovery, pretrial motions, settlement conferences, the trial (jury selection, cases of both parties, closing arguments), and a formal appeal process.

Arbitration is less formal, though can be as legally binding. The process is less formal and is based on agreement of the parties.

Two: If the parties to arbitration instead went to court, discuss the steps that the parties would have to take in order to go to trial.

• Pleadings – one party would have to file a complaint asserting a legal harm, the other party then responds to the complaint.

• Discovery – depositions (sworn testimony); interrogatories (sworn written responses to questions); document production; potential physical or mental examinations • Pretrial motions - judgment on the pleadings or summary judgment • Trial – o Jury selection o Opening statements o Plaintiff’s case o Defendant’s case o Rebuttals o Closing Arguments o Jury instructions and deliberations o Verdict and judgment o Appeal Three: The story talked about “repeat players”- companies that end up in arbitration repeatedly over time. Because arbitrators are selected by a negotiation between the two parties in the arbitration, this story indicates they are more likely to find for these repeat players. Discuss the ethics of this conflict of interest and what might be done to overcome the problem.

Students should be asked to review this using various ethical theories. This text has an ethics chapter which describes a number of those theories. Theories for overcoming this problem would be to allow the non-repeat player to select the arbitrator pool first and then have the repeat player select from that pool or limit the number of times an

arbitrator could come before the same client. This question is meant to involve creative and critical thinking by the students.

Constitutional Law for Business and E-Commerce - Violent Video Games Allowed for Children One: The state of California attempted to ban the sale of violent video games to young people.

If the federal government attempted to do the same thing, what provisions of the Constitution might allow that regulation?

• The United States Supreme Court has ruled that the Congress has significant power under the Commerce Clause (Article I, Section 8). This clause allows Congress to regulate commerce among the states. In addition, the Congress could look to the First Amendment and the exemptions for dangerous speech, though it is not clear that this would be effective.

Two: In this case, The Supreme Court ruled the California statute was unconstitutional. Discuss the three branches of government and the role each has to play in our system, including the checks and balances that each has on the others.

• The three branches of government are the Legislative branch, the Executive branch and the Judicial branch. o The Legislative branch consists of Congress (the House of Representatives and the Senate). This branch “makes law” by passing statutes in line with their constitutional authority. The Legislature can overrule a President’s veto if there is enough support in the two houses. It also can rewrite legislation or propose amendments to the constitution if it disagrees with court rulings. o The Executive branch consists of the President and the Executive agencies. This branch “enforces” law. The President can veto the acts of the legislative branch so that they cannot take effect. o The Judicial Branch is made up of the Supreme Court and lower federal courts.

This branch interprets the law to ensure that it is constitutional. The courts can declare acts of the other two branches unconstitutional and therefore invalid.

Three: If the state of California had passed this law, and the federal government passed a law or regulation related to the sale of video games, which would prevail and why? Discuss the relationship between the states and the federal government, and which has priority.

• The federal law would prevail, or preempt, the state statute. If the two are identical, the federal law would completely preempt the state law. The Supremacy clause of the constitution declares the constitution to be the supreme law of the land. Congress can allow states to be more protective (i.e. minimum wage) than the federal government, but the states cannot pass laws directly in opposition to federal statutes.

Intentional Torts and Negligence - Deadly Swimming Pools One: If a hotel hosts a pool with a dangerous drain cover, and someone dies due to the drain cover, what sort of liability might that hotel have? Ignore criminal issues related to the new law passed, and focus on civil liability under torts and negligence.

•

The hotel could have liability for the following: o Negligence (A duty to the guest to provide a safe environment, a breach of that duty which causes harm) o Intentional Infliction of Emotional Distress – for outrageous conduct. This would be a potential liability if the plaintiffs can show that the defendants should have known of the harm.

Two: Again, ignore the new Virginia Graham Baker Pool and Spa Safety Act. Would a plaintiff meet the requirements of negligence if they sued a pool manufacturer for the danger? What defenses might that manufacturer have?

• The plaintiff should be able to show the elements of negligence: o Duty – the manufacturers do have a duty to provide a safe product o Breach of that duty o Injury – assuming an injury occurred o Causation – the injury would not have occurred but for the breach of duty • The defendant may be able to argue assumption of risk, arguing that it is obvious that a pool filter would be a powerful and dangerous item.

Three: Discuss the difference between negligence and an intentional tort. Is it possible for an action to move from a negligent action to an intentional tort?

•

Negligence is based on a failure to act to an expected standard. In negligence, an actor

fails to act reasonably and someone is harmed by that act or failure to act.

• Intentional torts are defined as harm caused by affirmative action by an actor against the harmed person.

• Strict Liability and Product Liability – New Car Tires: How “New” Are They?

One: In thinking about the different types of product defects discussed in your text, which types of defects might be involved in a lawsuit about separating tires?

• Plaintiffs may be able to sue for o Defect in Design – that the tires were not designed properly and so the tread separates o Defect in Manufacturing – that the tires were properly designed but were not properly put together or tested. o Failure to Warn – that the tires were designed properly and were manufactured properly but that there was an inherent danger in how they age and that danger is hidden from the average consumer.

Two: Because tires are a part of an inherently dangerous activity – driving – should manufacturers and retailers be subject to strict liability for defective tires? Why or why not?

•

Student can argue either side of the case. o If arguing for strict liability to manufacturers, students could argue that the manufacturer of any part of an automobile is engaging in the creation of an inherently dangerous product and should be liable without fault. o If arguing against strict liability, students can argue that it is too tenuous to hold the manufacturer of any part of an automobile responsible when there are so many components that could cause an accident. In addition, with an automobile, the danger often is not in owning an automobile or in using it as instructed and in accord with the law, but the danger often is related to someone using the automobile recklessly or outside the scope of the law.

Three: If tire manufacturers or retailers were sued for defective tires, would they have any defenses? Why or why not?

• Manufacturers could argue “Generally Known Danger,” “Assumption of Risk,” “Misuse of Product,” and “Supervening Event” depending on the circumstances of the harm. In all likelihood, any claim based on a manufacturing or design defect would be successful for the injured party and these defenses would not eliminate liability.

Intellectual Property and Cyber Piracy - Virtual Wallets Poised to Take Over One: The technology involved in this type of pay system may cross over many types of intellectual property or “IP.” Discuss the different IPs that may be involved and how protection of those differs.

• Trade Secrets – there may be some trade secrets involved. These are protected by maintaining the secret. This is often difficult.

• Patent – there is protection for patented goods – goods that are novel, useful and nonobvious. Patent protection for inventions is good for 20 years and then the patent is available for anyone to use.

• Copyright – there may be copyright protection for any manuals or written instructions.

Others cannot copy those instructions or written manuals for either 95 years from the publication or 120 years from creation if the creator is a business. There also is copyright protection for any software or computer coding in the devices.

• Trademark – there may be trademark protection for design, shape, logos, etc.

Two: PayPal sued Google for misappropriation of trade secrets. Discuss trade secrets – what makes something a trade secret? What steps should a company take to ensure that a trade secret remains a trade secret?

• Trade secrets are composed of information that a company has that may or may not be eligible for other intellectual property protection. It is protected by the company by maintaining a reasonable protection of the secret.

• Companies should protect trade secrets using reasonable means. This can include nondisclosure agreements by any employee who may have access to the trade secret, locking up, and limiting access to, written documentation, dividing tasks and limiting those who have knowledge of the different components that are a part of the creation of the good, and other similar ideas.

Three: If the technology really does make life easier for consumers and for businesses, discuss the ethics of allowing a company to have a monopoly on the technology through our IP laws.

• Students should review or refer to the Ethics chapter in the text. This question is meant to engender discussion and not have any particular answer. Arguments for allowing a monopoly could include: public policy to encourage invention, or to reward inventors for their work. Arguments against could include: increased price when there is a monopoly, and difficulty or impossibility in improving upon an invention without violating the IP protection.

Criminal Law and Cyber Crimes - California PTA Moms Accused of Ponzi Scheme One: The book describes intent crimes as crimes that require a guilty act and a criminal intent.

Using the example of the PTA Ponzi scheme, discuss how the evidence shows both the criminal intent and guilty act.

• Guilty Act – fraud. They convinced people that investing with them would result in large returns to the investors. Over $2.5 million was still missing at the time of the arrests.

• Intent – The women developed a scheme where they told investors that they had some exclusive rights in a dairy. They did not have those rights.

Two: If a crime is essentially a wrong against society, why is the Ponzi scheme a crime? If the three women conned other individuals, why isn’t it a lawsuit between the different individuals?

What criteria should be used to designate something a crime, as opposed to a civil wrong?

• Students should brainstorm and debate this issue.

• It is important to note that there may be a civil wrong in this situation as well as a criminal wrong.

• The crime has been determined by the legislative body of the state or federal government.

• This type of scheme may be a crime because of several reasons, including: 1) the actions potentially affect a large number of people (the scheme only works so long as new investors continue to invest and so the incentive is to continue to expand the pool of victims); 2) they may be hard to detect; and 3) victims may not be able to recover from the perpetrator as the money more often than not is gone. Because the perpetrator may be “judgment proof” in a civil case, criminal penalties Three: Using the categories of crimes in your text, discuss what type of crime this is (common crime or white-collar crime).

• The crime is a white-collar crime. These crimes are more typically related to fraud and cheating instead of physical force.

Nature of Traditional and E-Contracts - 50 Cent Files Suit Against Taco Bell One: In the clip shown, 50 cent was suing Taco Bell for allegedly using his likeness without permission. Discuss whether 50 cent’s failure to do this could have resulted in an implied-infact contract.

• An implied-in-fact contract exists when the plaintiff: o Provides property or services to the defendant; o Expects to be paid for the property or services; and o The defendant had an opportunity to reject the property or services.

• In the situation if 50 Cent did not sue Taco Bell, it could be argued that 50 Cent allowed Taco Bell to use his music or likeness. It is less clear if a court would find that he expected to be paid for it without some discussion between the parties.

• In this situation, the two parties settled out of court for an undisclosed amount. The original lawsuit was based in tort theories of misappropriation as well as violation of intellectual property rights.

Two: Taco Bell was ordered to pay over $42 million to the company that created the Psycho Chihuahua cartoon character that was the model for the Taco Bell commercials. Discuss whether the contract should be classified as an implied-in-fact or an implied-in-law contract.

• The court in the case, Wrench, LLC v. Taco Bell Corp., 256 F. 3d 446 (6th Cir. 2001), found that an implied-in-fact contract existed in this case. Taco Bell used a character similar to the Psycho Chihuahua in its advertisements. It did so knowing that the other party created the character for profit and had been in negotiation with Taco Bell for use of the character at one point.

Three: Contracts can be classified in many ways. Using the classifications from the text, what type of contract would the Taco Bell/50 Cent contract be?

• Assuming Taco Bell and 50 Cent worked out an agreement for the use of 50 Cent’s likeness in exchange for some compensation, it would be a bilateral contract – both parties would have made promises – 50 Cent’s promise to let Taco Bell use his likeness and trademark and Taco Bell’s promise to compensate him for it.

• The contract also would be an informal contract because it is not one of the special types of contracts considered formal contracts.

• It would be a valid contract because it would have the conditions of agreement, consideration, capacity and legality all met.

• The contract would be executory until both parties had fulfilled their promises.

Agreement – Credit Card Victims Fight Back One: In the video, the representative of the credit card companies stated that the law does not need to get involved because competition will resolve any problems. Discuss the potential power differential between the credit card company and the consumer in this contract.

• Many issues may come up with students. Some potential topics include: o The credit card companies state that the interest rates would be resolved by competition but they do not address the impact on consumer credit ratings if consumers open and close credit cards often. o In today’s economy, it is nearly impossible to complete purchases without some sort of credit card. Given that, credit card companies wield an extreme amount of power. o Credit card contracts are lengthy and contain lots of fine print – much of it required under consumer protection laws. Consumers are not likely to read all of the fine print. While that is not an excuse for not knowing what is in the contract, it is a fairly universally recognized phenomenon which gives credit card companies even more power.

Two: In theory, the agreement process includes some negotiation of terms. Do you believe that most contracts today have some room for negotiation? Is the negotiation of terms a part of the American culture? How does this compare to other cultures?

• Again, this is an opportunity for students to brainstorm and discuss their opinions and thoughts outside of the text. Students with experiences with other cultures should be encouraged to share those experiences.

• In general, there is very little room for negotiation in most consumer purchases in America. Form contracts are quite prevalent. More room exists for contracts for large ticket items and in business contracts.

• Negotiation is a part of the business culture in America, but not the consumer culture.

Other countries have much higher rates of negotiation on individual purchases.

Three: With the credit card contracts, the video states that the credit card companies can unilaterally change the interest rate. Discuss whether there should be any requirements of reasonableness or fair dealing implied in the agreement.

• Students should be free to argue either side of this question. For information: • The Uniform Commercial Code – which governs contracts for the sales of goods, includes a non-waiveable good faith provision (Section 1-304). This provision does not necessarily apply to credit card contracts but is an indicator of the importance of good faith.

• Students may balance the rights of the consumer to have a predictable and stable contract with the right of the credit card company to adjust rates based on economic conditions or individual consumer behaviors.

Four: The credit card company representative stated that interest rates are related to risk. The woman in the video was told that her rate went up because she approached her credit limit which made her a higher risk. Should the contract specifically link the rate to some objective measure of risk? If so, would the company then have an obligation to lower the rate if the risk level goes down? Do you believe that credit card companies would ever agree to this type of provision?

•

Students can argue either side on this question.

• For stability and predictability, rates should be linked to some identifiable measures of risk. The rate should fluctuate with the risk – both up and down.

Consideration and Promissory Estoppel - Gold Prices Up

One: If two parties are signing a contract using gold as the source of payment, what risks do the parties have if the trend in the video continues? How can they reduce or eliminate those risks?

• Should the prices of gold change dramatically in either direction, the parties are taking a risk that the consideration on either side would become unbalanced.

Courts do not get in to valuation of consideration unless it is unconscionable.

• Risk can be reduced or eliminated by putting upper and lower limits on the tolerance for •

change in the price of the gold. They also could select payment in gold as it was valued on a particular date.

Two: If a man promises to give his neighbor two gold bars in exchange for the neighbor painting his house, discuss how each factor of consideration is met.

• The painter is promising to perform the service of painting. This is an action that he had no prior legal obligation to perform.

• The homeowner is promising to pay two bars of gold.

Three: The video discussed the value of gold. Internationally, currency fluctuates in value against other currency on a regular basis. Discuss the risks and solutions for basing a contract on any one particular currency.

• The fluctuation in currency is similar to the fluctuation in gold prices discussed in

•

question 1. Internationally, companies should select a currency and reference particular exchange rates or dates of exchange rates to value the goods.

This is a good opportunity to tie the law of contracts in with principles students will learn about in other classes – hedging, forecasting and risk allocation in Finance, accounting principles for recording losses or gains due to exchange rate changes, etc.

Capacity and Legality - Man Sues Casino for Gambling Debt One: Consider the level of intoxication required to allow Mr. Watanabe to be relieved of his contractual obligation to pay. What evidence would Mr. Watanabe have to provide to show that level of intoxication?

• The majority rules states that Mr. Watanabe would have to be so intoxicated that he was incapable of understanding the nature of the transaction.

• Mr. Watanabe would have to have not ratified the contract in any way after becoming sober. If there was evidence that he paid off part of his debt or that he acknowledged the debt while sober, he could not claim intoxication.

• Mr. Watanabe would have to rely on witnesses to testify that he was incapable of determining the consequences of his actions. This is not an easy issue to prove.

Two: If Mr. Watanabe was gambling in a state where gambling was not legal, discuss how the courts would treat the case. Who would win the case and why?

• If Mr. Watanabe was gambling in a state where it is illegal, the contract would be void.

•

The gambling establishment could not sue Mr. Watanabe to recover the money and Mr. Watanabe could not sue recover any money he had paid or lost.

Neither party would “win” the case.

Three: Discuss whether the law should allow someone to voluntarily become intoxicated and then sign contracts only to claim intoxication as a defense in being held to the contract.

•

Students can debate either side of this issue.

• The correct answer depends on the state of the case. In most states, intoxication is a valid defense no matter how the party became intoxicated. In some states, however, the party cannot assert intoxication as a defense unless he or she was forced to become intoxicated or did so unknowingly.

Digital Law and E-Commerce - Rise of Mobile Banking One: Discuss the special or unique aspects of doing business via phone as discussed in the video. What risks may exist in these transactions that may not exist in traditional contract situations?

•

Contract law has traditionally been seen as secure because of original signatures as evidence of intent to contract. Mobile business has given rise to the electronic signature (the E-SIGN Act). These signatures can be biometric (fingerprints or retinal scans), through use of a secret password or questions or through a smart card. With the last two, there are higher risks of theft. In theory it is easier to steal a smart card or phone than to forge a signature.

• Other risks that may exist include tracking of consumers. It may be possible for companies accepting payment or contracting by phone to track where consumers are using their phone which could lead to more targeted advertising and a sense that “big brother is watching.”

This could lead to privacy concerns and tort claims against companies.

Two: As cell phone banking and payment becomes more prevalent, discuss whether new laws and regulations are needed to address the cyber aspects of commerce or whether traditional contract/tort and criminal laws adequately protect participants in these cyber arrangements.

• Several new laws have been passed related to electronic commerce (see the Counterfeit Access Device and Computer Fraud and Abuse Act, the Electronic Funds Transfer Act, the Information Infrastructure Protection Act, and the Identity Theft and Assumption Deterrence Act. • There has not been a popular move to change the basic contract principles simply because of technology.

Three: The Statute of Frauds requires that contracts for the sale of goods over 500 dollars must be in writing. As we begin to accept and even rely on cell phone technology for banking and purchasing items, discuss whether the Statute of Frauds should be amended or eliminated.

• The E-SIGN Act has essentially eliminated the need for a physical writing of a contract. That law recognizes electronic signatures and electronic formatting for contracts.

Title to Goods and Risk of Loss - Package Pile Up

One: In sorting out the mess of the Fed Ex accident, someone will have to determine who had the risk of loss of these goods. Discuss the default risk of loss in this situation. If no one had a contract stating otherwise, which party lost the value of the goods?

• Under common law, the party with title held the risk of loss.

• Under the UCC, parties can agree when the risk of loss passes from the seller to the buyer.

• If there is no agreement, the goods are put on a third party carrier (such as Fed Ex) then the contract is considered a shipment contract and the risk of loss passes to the buyer when the goods are placed on the carrier.

• The rules change if there is a breach of contract by the seller. If nonconforming goods are put on the carrier, then the seller has the risk of loss until the buyer either accepts the nonconforming goods or the defect is cured.

• In this situation, if the goods were conforming goods and the contract is silent as to the risk of loss, the buyers have the risk of loss.

Two: In drafting agreements, the risk of loss is one of the many items that should be discussed.

What are some factors that need to be considered by parties when discussing who will have the risk of loss?

• In discussing the risk of loss, the parties should consider items such as: o Location of the goods o Which party is better able to bear the loss if it occurs o Conditions of delivery (i.e. the buyer may need the goods with a particularly fast turnaround time or to a very specific location).

Three: Under the Uniform Commercial Code’s default rules, who has title to the goods on the truck? What information do you need to know in order to determine who has title?

•

Under the UCC, if the parties do not agree otherwise, the title passes when the obligation of the seller related to physical delivery is complete. This relates to the type of contract (shipment or destination contract). In a shipment contract, title will pass when the goods are shipped (FAS, FOB (shipping point), CIF). In a destination contract, title does not pass until deliver (FOB (delivery point, Ex-ship). If there is no evidence to show if the contract is a shipment contract or a destination contract, then the assumption is that it is a shipment contract.

Warranties - The True Meaning of 'Lifetime' Warranty One: The reporter spent about 25 seconds discussing the Implied Warranty of Merchantability, Warranty of Fitness for a Particular Purpose, and the “as is” disclaimer. Discuss other ways to disclaim the warranties presented.

• The “as is” disclaimer is very common for used goods and is a valid disclaimer of any implied warranty so long as it is clearly worded and a reasonable consumer would believe that there are no warranties based on that language.

• To disclaim the implied warranty of merchantability, the disclaimer must specifically use the term merchantability. This can be an oral or written disclaimer though there are evidentiary issues related to an oral disclaimer.

• The warranty of fitness for a particular purpose can also be disclaimed in general language without any specific requirements. This must be in writing.

Two: Discuss the ethics of the situation where a “lifetime” warranty is defined as based on the “life of the product” as discussed in the early seconds of the clip.

• As an opinion question, the students should be encouraged to be creative. Items to discuss could include: o Misleading statements or fraud if it is not clear how the “lifetime” is defined. o Issues of good faith on the part of the manufacturer and seller of the goods.

Three: Based on what you heard in the video, discuss “extended warranties.” Brainstorm situations in which you might recommend one.

• Based in the video clip, the extended warranties may begin when the regular warranty ends or they could begin at the date of purchase and run concurrently with the regular warranty.

• A consumer may be interested in purchasing an extended warranty once the consumer has clarified that it would begin at the end of the regular warranty for items that are very expensive or for items that may appreciate in value.

Creation of Negotiable Instruments - California May Say IOU to Taxpayers One: Discuss how these IOUs meet the requirements of a negotiable instrument.

• Negotiable instruments must: o Be in writing o Be signed o Be an unconditional promise or order o Be payable on demand or at a specific time o Be payable to order or to bearer o State a fixed amount of money o Not require any additional actions • The IOU’s may meet each of these requirements so long as they are specific enough. The California IOU’s (or registered warrants) had a specific dollar amount, with a date after which they could be redeemed, and signed by the State Controller. They appear to be legitimate negotiable instruments. http://www.mymoneyblog.com/picture-of-californiatax-refund-iou-registered-warrant.html Two: Discuss how the IOU differs from a check even though both are negotiable instruments.

Discuss the practical problems with the IOU. •

The IOU does not include a third party bank which a check does. The banks generally are viewed as stable and insured by the government so there is a guarantee of payment.

• Checks typically can be deposited in any bank and through the banking processes, money moves from the bank of the maker to the bank of the holder.

• The IOU requires the holder to present the IOU to the maker. In California, the holders had to go in person to Sacramento or mail it to the State Treasurer’s office.

• In July 2009, several major banks stated that they would stop accepting the California IOU’s. http://online.wsj.com/article/SB124692354575702881.html • For the California IOU’s, the Securities and Exchange Commission labeled them securities which creates increased protection for purchasers and increased responsibilities for those who are trading or selling them. http://www.sec.gov/news/press/2009/2009-154.htm Three: The video stated that the IOU would earn interest. Discuss the issues surrounding a “black market” for state-issued IOUs. • It is not clear that a black market for the IOU’s ever appeared.

•

The interest rate on the IOU’s was 3.75%.

• The risk of a black market could go either way – for consumers who receive an IOU but need cash, they could turn in their IOU’s for face value and the receiver could hold them to collect the interest. On the flip side, if interest rates dip below 3.75% for other types of

instruments, demand for the California IOU’s could rise and consumers could trade them for higher than face value.

Banks, E-Money, and Financial Reform - Will Current Spending Methods Soon Be Outdated?

One: Historically there has been a relationship between the consumer and the bank when using a check or a credit card. The law has clearly settled who is responsible if there are fraud or security problems. Discuss how cell-phone payments may be different and whether the law should treat new technologies with the same rules as older technologies.

• The law probably should address new technologies • The Electronic Funds Transfer Act and Regulation E (promulgated by the Federal Reserve) are examples – These rules regulate items such as unsolicited cards, lost cards, receipts for transactions, and requirements for bank statements.

• Even so, these may not address all of the needs of an electronic wallet where one walks past or waives a cell phone and the account is charged.

Two: Discuss the type of evidentiary problems that one might have in a lawsuit involving fraud or misuse of a cell-phone-based money transfer, and brainstorm whether there are ways to create evidence.

• Because of the nature of the computerized world, fraud and misuse are major concerns.

And people may believe that any security measures will simply slow things down and reduce the convenience.

• The law already has created evidentiary rules related to receipts but will need to go further to authenticate e-receipts.

Three: The text discusses the duty of the consumer to review bank statements in a timely manner to identify any forged payments. With more and more payments being made online, what should the law require of bank customers? Does review of a monthly statement suffice or should there be other duties?

• This is a brainstorming question for students.

• If review of statements is required, perhaps consumers who engage in electronic business

•

should be required to do a weekly review of their online bank account in order to more quickly detect fraud.

Perhaps there should be a hold on using the electronic wallet if an account hits a certain minimum dollar amount or if a certain dollar amount of purchases are made in one day without prior notice to the bank of a shopping trip.

Credit, Mortgages, and Debtor’s Rights - Fed Approves Mortgage Crackdown One: What rights should a debtor have if a creditor is going to transfer the debt to someone else?

• Regulation Z has clarified what information a consumer should receive before entering in to a credit agreement. It is less clear what needs to be communicated when a debt is transferred.

• There may be some common sense in that someone who receives a debt will communicate any new payment terms. In theory, a debt may not be modified in the transfer.

• Students should brainstorm what information they would like to receive if they have debt transferred.

Two: If the homeowner in the video had not attempted to contact the mortgage owner and had failed to make her payments, what remedies would the mortgage owner have had? Discuss the process. • The mortgage owner could have foreclosed on the property. That process is governed by state statute. Typically the mortgage owner files a Notice of Default with a government office. If the mortgage is not brought current within approximately 3 months, then the homeowner receives a Notice of Sale, which is posted with the government office and is placed in the newspapers. The government office holds a trustee’s sale and the property is auctioned to the highest bidder. If the bid is for less than the mortgage, the mortgage owner can obtain a deficiency judgment against the former property owner for the difference. If the bid is more than the mortgage, then fees and costs for the foreclosure are taken out of the excess and anything left goes to the former property owner.

Three: When the homeowner was in the process of purchasing the home, Regulation Z covered the disclosures of the lender. Discuss what Regulation Z requires and whether it is comprehensive enough.

•

Regulation Z requires the following: o Cash price of the good or service o Down payments required and any trade-in allowance o Unpaid cash price o Finance charges (interest, points, other fees) o Annual Percentage Rate (APR) o Total amount financed o Key dates for fees and charges

o Number of payments with due dates and amounts o Security interest held

Employment, Worker Protection, and Immigration Law - Family Medical Leave One: Under what authority in the constitution could Congress mandate that employers give paid leave for maternity or other family medical leave?

• The most likely places in the constitution to justify this leave would be: o The Equal Protection clause of the Fourteenth Amendment ▪ This one is fairly tenuous because if Congress grants leave to women only, men would be able to claim it is unconstitutional gender discrimination. If everyone receives the benefits, then there are no equal protection concerns. o The Commerce Clause – because of the breadth of Congress’ power under the Commerce Clause, it is likely that they could pass leave laws.

Two: Review the laws discussed in the chapter and whether the Family Medical Leave Act, or FMLA, is comparable in coverage.

• OSHA – almost all private employers are under OSHA. The primary purpose of the act is to protect workers from unsafe conditions. There are strict standards of safety with harsh penalties for violations.

• The FLSA applies to nearly all employers as well. It has very clear guidelines that are primarily to protect workers.

• The FMLA applies only to companies with 50 or more employees but also applies to the government where the others do not. There are fairly high barriers for employees to meet (at least one year of work for the company and at least 1250 hours of service). There are well-designated reasons for the leave.

Three: Discuss the policies behind giving the medical leave – what is the nation trying to accomplish, and is the FMLA written appropriately to meet those goals?

• This is another brainstorming or critical thinking question for the students.

• The policy behind the leave is to allow those who have some family emergency or health needs to attend to those needs without negative consequences at work.

As the video discusses, we have a policy which is better than not, but the policy is not as progressive as other industrialized nations.

• Students should address issues such as the ability (or inability) of classes of employees to take FMLA leave (while the job is essentially guaranteed, there is no pay or accrual of seniority during the leave making it difficult for lower paid employees to take the leave).

•

Labor Law and Collective Bargaining - 45,000 Verizon Workers Strike One: Discuss the purposes of unions and whether they are effective tools to serve their purposes.

• Labor unions originated to combat significant abuses by the powerful owners of manufacturing facilities in the late 1800s.

• The underlying purpose of unions is to give individual employees who would not be in a position to negotiate with management a stronger voice. If many employees band together and can impact the work of the company, the management is more likely to listen and negotiate.

• Whether they are effective is a matter of opinion for the students.

• Unions can be very effective but also can be detractions from work. The courts and legislative bodies in the U.S. have attempted over time to balance the power of the unions with the power of the management to maximize negotiations and to ensure that neither has too much power.

Two: The Verizon strike affected only certain segments of the company. As stated in the clip, “Verizon Wireless customers are not affected.” This is because the strikers are part of a bargaining unit that does not include wireless employees. Discuss what the legal parameters for determining a bargaining unit should be.

• The basic principle of determining a bargaining unit is that the employees should have common bargaining interests. The unit could be geographic or could be based on job description/duties.

• The unit is generally determined by a federal agency, the Federal Labor Relations Authority and then voted upon by the employees.

Three: In the video, we see that the strikers are picketing and protesting. There is no discussion of any other activities. Discuss what striking union members are and are not allowed to do in order to strengthen their bargaining position.

• Union members are allowed to strike peacefully. Picketing also is allowed so long as it is •

peaceful.

Unions are not allowed to have violent strikes, strikes where they occupy the place of work and eliminate the ability of the company to continue to function, or strike part-time. They also may not hold secondary pickets against the employer’s suppliers or customers.

Equal Opportunity in Employment - Isiah Thomas One: Discuss whether there should be a different standard of behavior in the workplace compared to personal relationships.

• This is a brainstorming question for students. Because of the difference in power in the workplace, it is necessary to establish different standards of behavior. What may be considered flirtatious between two individuals in a social setting might be considered threatening in a work situation.

Two: According to the video, Isiah Thomas put his arm around the victim, tried to kiss her on the cheek, called her sexually charged names and made her feel uncomfortable on the job.

Discuss how a court should determine what constitutes sexual harassment and what does not.

Should culture play any part in that determination?

• The U.S. Supreme Court has stated, “We can say that whether an environment is ‘hostile’ or ‘abusive’ can be determined only by looking at all the circumstances. These may include the frequency of the discriminatory conduct; its severity; whether it is physically threatening or humiliating, or a mere offensive utterance; and whether it unreasonably interferes with an employee’s work performance.” Harris v. Forklift Systems, Inc., 510 U.S. 17 (1993).

Three: As part of this case, Madison Square Garden had to pay the victim because of retaliation – she was fired for reporting the sexual harassment. In this case, the jury determined sexual harassment occurred, that she complained to the appropriate parties, and was fired for that.

Given the dollar amounts discussed in the video, discuss the risk that false sexual harassment claims might be filed and what might be done to prevent that.

• The dollar amount in this case was significant: $11.6 million.

• The best way to prevent damages like these against an employee is to have good policies and internal procedures in place and for employers to follow those procedures exactly. These could include policies and procedures for handling false claims.

Corporate Acquisitions and Multinational Corporations - SCOTUS Puts the Brakes on Chrysler Sale One: In the video, the representative for the retirees stated that he believed the retirees would receive more money if Chrysler dissolved and distributed assets. Discuss which groups may benefit from this approach and which groups would benefit from the completion of the merger and the survival - in some form - of Chrysler.

• From the video, it appears that the retirees would be better off with the dissolution of the company.

• Current employees likely would be better off if the merger is completed if they are allowed to keep their jobs. Shareholders also would likely be better off with a completed merger.

• In addition, consumers may be harmed by the removal of the Chrysler products from the market.

Two: Mergers can take a lot of time to complete. Discuss, from a strategy standpoint, all of the different components of a merger, including merging product lines, marketing issues and customer relations issues.

• The goal of this question is to get students to think from a strategic standpoint. Some topics: • One of the issues include the merger of product lines – if the two companies have different quality control standards, will they merge those standards or will the new company continue to manufacture products with different qualities? If the new company raises the standards to the higher of the standards, they may be giving up a segment of market that would be loyal.

• The merger of product lines is related to the merger of internal services and processes. Will the new company consolidate those processes (payroll, supply chains, distribution mechanisms, etc.). There are potential efficiencies to combining those processes but contracts would have to be evaluated closely.

• The new company will have to work to merge the two cultures of the companies, especially if they are from different nations.

Three: Discuss the process that Chrysler and Fiat will have to complete in order to be legally merged. What votes are required? What approvals must be obtained?

• The Board of Directors of each company would have to approve the merger • A majority of voting shares of each company also would have to approve the merger

•

The merger may have to get the approvals of the Federal Trade Commission and the Department of Justice under the Hart-Scott-Rodino Act. This act requires information disclosure to those government agencies for evaluation of market power.

Ethics and Social Responsibility of Business - Whistleblower on the NSA One: Under what circumstances might it be ethical for the federal government to record or track calls or Internet searches without any sort of warrant?

• Students may have a variety of opinions about this question • This is a good opportunity to tie the criminal law chapter in with ethics and the whistleblower information from the text.

• Some talking points: o Do national security concerns justify this sort of warrantless activity?

▪ The USA Patriot Act was signed by President Bush in 2001. It was extended in part for 4 years by President Obama in 2011 and so is current law.

▪ The act allows the FBI to search telephone, e-mail and financial records without a warrant or court order by using National Security Letters – demand letters for records. The NSLs do not allow for content searches, but do allow the government to track phone numbers called, web sites visited, e-mail addresses sent to and received from and similar transactional information. o The Fourth Amendment protects against “unreasonable searches.” According to the criminal law chapter, warrants are required in most cases, but warrantless searches are allowed if 1) evidence is in plain view; 2) evidence is likely to be destroyed; 3) the search is incident to arrest; or 4) highly regulated industries.

▪ Would the activity by the government in recording telephone conversations fall under the exception for destructible evidence?

Without the recording, there would be no evidence for the illegal activity.

Two: If the government states they are doing the surveillance to protect all Americans, even at the risk of invading the privacy of a few Americans, what ethical theory is it using? Would the answer be different if the government employed a different ethical theory?

• This argument is based in utilitarianism- the greatest good for the greatest number. Though some may be harmed, the majority will benefit.

• Students should evaluate this situation in light of Kantian ethics, Social Justice Theory and any other ethical theory or decision-making model used in the class.

Three: If Congress passed a law making this activity specifically legal, would that automatically make it ethical? Why or why not?

• •

This is a philosophical question exploring the differences between ethics and the law.

Talking points: o At times ethics and the law result in the same answer to a question (i.e. is it OK to take the life of another person without provocation?) o At times, they may not result in the same answer (Is it OK to put pollutants in to the

air?)

• Students and faculty should discuss the differences in making legal decisions and making ethical decisions, where those processes intersect and why some things may be legal but not ethical or ethical but not legal.

Administrative Law and Regulatory Agencies - Internal Problems at the FDA

One: Discuss the process that was employed to create the Food and Drug Administration.

• Administrative agencies are created by Congress and given powers through an enabling statute and the delegation doctrine. With regard to the FDA, Congress passed a law to regulate food and drug safety and created and authorized the FDA to administer the law.

The enabling legislation for the FDA was the Food and Drugs Act (or Wiley Act) of 1906 which created the Bureau of Chemistry. (See http://www.fda.gov/AboutFDA/WhatWeDo/History/Origin/ucm054819.htm) • Over time, the name of the agency was changed and the responsibilities of the agency were broadened and modified – all through Legislation.

Two: The Congresswoman in the video stated that she would not vote to give funds to an agency that does not know how to use them and that is structured so poorly. As Congress creates administrative agencies and delegates authority, what obligations do they have to oversee and fund those agencies?

• This is a good political debate question. Some talking points: o Government often attempts to lower taxes (or the burden of government on the individual) at the same time it attempts to increase services to the voters. This is not always possible.

▪ Should the government be required to anticipate and provide funding for all of its activities?

▪ In the larger scheme, should there be some limit to the spending of the government so that any new program or agency could only be created if the government reduces or eliminates other programs?

Three: Discuss the powers that the Food and Drug Administration and other agencies have. Are the agencies too powerful, or is this an appropriate delegation of authority by the Congress?

• Agencies are often called the fourth branch of government and have the powers of the other three: o Legislative powers - Agencies can create rules through the Administrative Procedures Act to carry out their charge from Congress. o Executive powers – Agencies can investigate and prosecute violations of agency rules.

o Judicial powers - Agencies can hold hearings related to violations of agency rules.

Administrative law judges (ALJs) preside over these hearings which require due process (notice and a chance to be heard) for the “accused.”

Consumer Protection and Product Safety - Vitamin Water Advertising Claims One: According to the video, Coca Cola advertises that Vitamin Water will give people protection similar to exercise or flu shots. Discuss whether this is deceptive advertising or mere promotion.

• False advertising is defined in the Federal Trade Commission Act (FTC Act) in Section 5. It states that advertising is false if it would mislead a “reasonable consumer” or makes unsubstantiated claims.

• Students could argue either way: o Vitamin Water does not state directly that it has the same benefits as a flu shot and students may argue that no reasonable consumer would believe that an over-the-counter drink could replace a medical procedure. In addition, students may argue that the reasonable consumer in today’s society understands that no advertising is completely accurate and all consumers have a duty to investigate products, read labels and be informed. o On the other hand, the posters imply that Vitamin Water is a replacement for a flu shot without any evidence that it would reduce the incidence of flu.

Two: Vitamin Water responds to the claim by stating that the ingredients are clearly on the label. Discuss whether manufacturers have any duty to warn the public about their products or whether the law should adopt the idea of “buyer beware” so that consumers read the labels.

• Manufacturers have an obligation to put complete information about ingredients on their products. The Food, Drug and Cosmetic Act requires common information and formatting of labels for nutritional content, serving size and ingredients.

• Manufacturers have a duty to warn consumers about hidden dangers (with more requirements for drugs than for foods). At this point, there is no legal requirement for a company like Vitamin Water to warn that the amount of sugar exceeds that of a candy bar, that excessive consumption could lead to health problems, or similar warnings.

• Students should debate the role of the government – should the government be more like “big brother” and watch out for its citizens or should the government be more “laissezfaire” and allow citizens to make their own decisions?

Three: Near the end of the video clip, the health and medical editor states that washing hands and drinking water will keep one healthier than most of the “health products” on the market.

Should Congress or the states be more assertive about regulating products based on health issues or is that too much like “big brother” watching?

•

This question ties in to the previous question as far as the political debate. Students should discuss the role of government in regulating industries.

Environmental Protection - Environmental Victory One: The idea of global warming has not been universally accepted. Discuss how the law must balance competing scientific opinions and make decisions in light of uncertainty. How should this be done?

• •

This question can tie back to theories of jurisprudence in earlier chapters of the text.

Issues to consider o Theories and knowledge change rapidly in the environmental field due to improvements in technology. Should we have a “reasonable” standard for use of information and regulation of industries? o As technology improves and companies are able to pollute less, should we have

aggressive regulation to force upgrades of plants and facilities to reduce emissions?

• This question also can lead in to a discussion about the global aspects of environmental law, the Kyoto Protocol and why the United States did not sign on to that document. Reference http://www.pbs.org/newshour/bb/environment/jan-june05/kyoto_2-16.html Two: Discuss the different stakeholders who have concern in this situation. What are their interests, and which stakeholder should have the priority position?

•

The stakeholders in the situation include: o The Environmental Protection Agency o Environmental Activists and the global citizenry who may be impacted by pollution o Automobile manufacturers and other greenhouse gas emitters o Employees of those companies who may be impacted through downsizing or who may benefit by cleaner work environments o Consumers of those products who may end up paying increased costs

•

The priority stakeholder should be debated by the students.

Three: Environmental law is both federal and state-controlled. Discuss the effect on state regulations if the federal government, through the Environmental Protection Agency, changes the standards for air pollution and carbon dioxide emissions.

• Many state statutes parallel the federal statutes.

• States may be more protective of the environment than the federal government (stricter emissions standards, broader definitions of protected lands, etc.).

• This question presents an opportunity to revisit the concepts of federalism.

Personal Property and Bailment - $500K Ring Found on Sunken Ship

One: What sort of property is that ring? Lost, abandoned, mislaid? Why? • •

The ring is personal property This ring could be classified as lost or abandoned. o Mislaid property is intentionally placed somewhere and then left o Lost property is negligently, carelessly , or inadvertently left somewhere o Abandoned property is intentionally discarded or if it was originally lost or mislaid and the owner has given up attempts to find it. o Because the ring was “lost” in the sea, it could be argued that the owner’s descendants have given up any attempt to find it and so it is abandoned. Alternatively, it could be argued that the owner’s descendants have done everything reasonable to recover it, are aware that it is still under the sea and have not given up hope of future recovery but merely cannot afford continual efforts to recover it. Before any decision can be made, the family of the original owner would have to be interviewed and evidence of attempts to recover would be reviewed.

Two: Who owns the ring at this point? What if the descendants of the true owners come forward?

•

•

If the property is considered lost, then the finder has title of the property against everyone except the true owner. If the true owner (or in this case the heir of the true owner) comes forward, then the original owner’s family may reclaim the property.

If the property is considered abandoned, then the finder has sole title to it and the true owner may not reclaim it.

Three: If the law is meant to be fair and stable, yet flexible, who should own the ring at this point?

• This is a good debate question for the students. Some issues to address: o Should the public policy to be to encourage “treasure hunters” to find these types of lost treasures? If so, perhaps policy would dictate that the finder is the owner. o Should the policy be to recognize established ownership of property without clear evidence of abandonment? If so, perhaps the true owner’s family should own the ring.

Real Property - Texas Man Gets McMansion for $16 One: Discuss adverse possession – what policy reasons exist for it to be a valid way to get title to property? Are there policy reasons not to allow this?

• Adverse possession is a legal way to obtain title to real property. To obtain title, one must possess the property: o for a statutory period of time (generally 5-20 years) o openly and visibly so that the true owner is on notice for the possession o actually and exclusively – the possessor must actually be in possession of the property o continuously and peacefully – if the true owner requests the possessor to move, then the adverse possession process ends o hostile and adverse- the possessor cannot be there with the permission of the true owner • Adverse possession exists under the basic premise that property is better for society if it is productive and in use as opposed to vacant or abandoned.

• One of the original intents of adverse possession was to resolve border disputes between neighboring farmers or ranchers. Public policy in today’s society would discourage people from moving in to homes where they have no responsibility as owners to maintain the property.

Two: If Mr. Robinson stays in the house for three years and obtains title to the house, discuss the type of estate he would have in that property. If you could write the law in this area, what sort of estate would be fair for him to have?

• Mr. Robinson would obtain clear title, or total title, to the property. He would have a fee simple absolute.

Three: In this case, the bank has a significant interest in this property if the original owner stops paying the mortgage. Discuss whether the bank has, or should have, any right to go in and evict Mr. Robinson. If Mr. Robinson obtains the property, does the bank have any rights in it?

• In this case, the mortgage company went out of business and it is not clear what company owns the mortgage on the property (presumably the mortgage was acquired by another company when the original mortgage lender went bankrupt). This is a good chance to tie the bankruptcy chapter to the real property chapter.

• Assuming that the bank which owns the mortgage can be found, that bank would have a right to foreclose on the property and evict Mr. Robinson.

• If Mr. Robinson obtains clear title to the property, the bank would have no claims against him but would have the right to sue the original owner for the amount owed.

Insurance - Disaster Insurance Premiums Going Up One: The video discusses the possibility that homeowners sometimes can’t get insurance to cover certain disasters, such as flood insurance, if their home is in a flood plain. Discuss the ethics of companies denying insurance for those potential disasters.

• Students could debate either side of this issue. Some talking points: o Insurance is a business and so should not be forced to make decisions that are riskier than they are willing to take. To mandate that the insurance industry provide coverage in areas of extreme risk would be unfair.

▪ Insurance companies may be willing to cover those great risks but at high costs which may make the coverage impossible to afford. o Lack of insurance coverage for the greatest risks in an area may impact the ability of buyers to get mortgages and buy homes in those areas. This could lead to run-down neighborhoods or uninhabited areas.

▪ If areas previously were uninhabited, this could have positive environmental ▪ impacts.

If the areas have been inhabited, it could have negative consequences for property values in nearby areas, for crime rates and for property abandonments.

Two: The deductible often has a relationship with the premium – as the deductible goes up, the premium goes down. Why might this be the case?

• Insurance is a business of risk management. The deductible is the amount the insured pays before any money is paid by the insurance company. As the deductible goes up, the insured is taking more risk if there is a disaster. Because the risk is shifting, the insurance company can lower the premium as it is less likely to have to pay out on the policy, or would pay out less if there was a disaster.

Three: In addition to the disaster insurance discussed in the video, your textbook discusses different types of business insurance. With business insurance, the risk of loss is generally purely financial (not personal or real property). Should business insurance exist or should the risk of financial loss just be a part of the risk of doing business?

• This is a subjective debate. Some talking points: o Note that Worker’s compensation insurance is required in many states and so there are no options for this type of business insurance. o If a business can identify risks, the options would be 1) to create a “savings account” to save for the potential disaster; 2) to obtain insurance where the risk of the loss is shifted to the insurance company. If the loss never occurs, this costs the company more; if the loss does occur, the company may pay less than under option 1; or 3) do nothing and “take a chance.”

o If a company decides to do nothing and the law considers risk of financial loss to be a part of doing business, then a loss could result in layoffs of employees or bankruptcy of the entire business.

Wills, Trusts, and Estates - An Early Inheritance/Giving While Living One: The inheritance from the Rockefeller’s to the family in the video was not a living gift.

Discuss the different ways that someone can inherit property from a deceased relative.

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By will – one can inherit property under a valid will o A devise is a gift of real property o A bequest or legacy is a gift of personal property o Gifts can be given as specific gifts (identified property) or as a general gift (money or value but not specifically identified) o Gifts can be given per stirpes (by representation of the first descendant line with at least

one living relative) or per capita (equally distributed among all living descendants).

• By intestacy – if no will exists, the laws of each state have created a scheme for property distribution. Typically the property is distributed to lineal descendants. If no lineal descendants can be found, then the property is given to the deceased’s parents and their descendants. If none of those relatives can be found, the law may go to the grandparents of the deceased and then their lineal descendants. Typically, if no relatives can be found through those processes, the property escheats (becomes the property of the state).

Two: The video addresses gifts to living relatives. By definition, a gift changes the control and ownership of the property. Discuss the other alternative to gifting – the trust and its different types.

• In a trust, legal title is transferred from the owner to the trustee to be held for the benefit of the beneficiary.

• Inter vivos trusts are created while the owner is still alive. The trust can last until the death of the original owner or for a specific time. o Charitable trusts give the income or benefit to a charity o Spendthrift trusts have restrictions on who can access the trust and typically do not allow the beneficiary’s creditors from reaching the trust interest. o Totten trusts is a bank account trust where the owner puts money in an account

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with the owner’s name on it and manages the account for the benefit of another. The owner maintains control over the assets and can add to, or subtract from, those assets at any time.

Trusts can be revocable or irrevocable.

Three: As was mentioned in the introduction to this news story, tax law allows people to gift a certain amount of money tax-free. Can you think of any situations where taxes should be levied on a gift between family members? Should an estate tax even exist?

• This is a political discussion to have with the students. Some talking points: o The concept of an estate tax may be valid because the money in question was inherited without any work on the part of the person who inherited it. The concentration of income or wealth merely by luck of birth can be counterbalanced if the government taxes the inheritance and uses that money for social programs – a redistribution of wealth argument. o Those who oppose the estate tax may argue that the wealth was generated by a family – not an individual – and so the wealth should be freely moveable between family members.

Family Law - Larry King Divorce Fight Ahead One: As reported, the couple did not have a prenuptial agreement. What is the purpose of a prenuptial agreement, and why might it be a good idea to have one?

• A prenuptial agreement is a contract that allows the couple to determine the distribution of assets should the marriage dissolve. They must be in writing.

• Prenuptial agreements allow the parties to control where assets go when a marriage terminates as opposed to looking to state laws which vary greatly.

• Prenuptial agreements are often subject to debate as some people believe that the prenuptial agreement is an indication that the marriage is not to be taken seriously and that termination is preplanned.

Two: If Larry King and his wife, Shawn Southwick King, were married and lived in California, which is a community property state, how would their assets be evaluated by the court, and how should the assets be divided?

• California is a community property state. As such, assets acquired during marriage are presumed to be community property and will be divided equally. Assets acquired prior to marriage are presumed to be separate property and will not be divided. Inheritances are also not community property and would not be divided.

• Under California law, Shawn Southwick King is entitled to the value of 50% of the assets acquired during the marriage, including money placed in Larry King’s retirement accounts.

Three: Assume Larry and Shawn lived in a state that is not a community property state. What should the court consider when assigning property rights and dividing the estate?

• Larry and Shawn King did not get divorced. http://www.cbsnews.com/8301-31749_16220010002-10391698.html • If the couple were to divorce in a non-community property state, the courts in that state would look to an “equitable distribution” of assets. Factors would include: o The length of the marriage o The occupations of the spouses and the employability of the spouses o The standard of living during the marriage and how to maintain that for the spouses o Child custody issues o Health issues

International and World Trade Law - Counterfeiting in China One: There has been a movement in the last decade encouraging people to “buy American.”

Discuss the legal and ethical issues related to boycotting goods from other countries. What are the practical business implications of such a move?

• Depending on the other countries involved, there may be treaty issues. For example, NAFTA essentially eliminated tariffs and trade barriers between the US, Mexico and Canada.

Any official boycott by the government of the United States would violate the NAFTA. • There is nothing illegal about consumers boycotting products from other nations.

• Students should evaluate the ethics of such a boycott.

• From a practical standpoint, it may be impossible to completely boycott another country – with the global economy in which we live, components of products manufactured in the US may come from other nations and products manufactured in other nations may primarily be made from US parts.

Two: The World Trade Organization, or WTO, is the largest and most influential of the trade organizations. China and other heavy counterfeiting nations are part of this group. What could WTO-participating nations do to address the problems of counterfeiting? What should they do?

• The WTO has a judicial branch which hears disputes between members. A three-member panel would hear the dispute and render an opinion. The panel consists of judges from member nations.

• The report is given to the WTO dispute-settlement body which adopts the report and makes it an official position of the WTO. • There is an appellate body made up of 7 judges from member nations.

• If the losing nation refuses to comply with the report, the WTO can order sanctions such as tariffs against the offending nation.

Three: The United Nations Security Council, the main decision-making body at the UN, is comprised of five regular members: China, France, the Russian Federation, the United Kingdom and the United States. Ten more members are elected from the General Assembly. Given the make-up of the committee, what type of action might the UN take with regard to the counterfeiting issue?

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The United Nations could take significant actions against counterfeiting. The UN has an Office on Drugs and Crime (http://www.unodc.org/unodc/index.html) which has created a Container Control Programme to seize drugs and counterfeit goods.

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The UN issued a report on counterfeit products through the UNODC: http://www.unodc.org/documents/data-and-analysis/tocta/8.Counterfeit_products.pdf.

While the report is not dated, it includes data from financial year 2009, so it is relatively recent.

This is a good question to get students thinking about international diplomacy. How does the United States bring up this type of concern in a Security Council meeting with China at the table? What sort of diplomacy may be needed?