b'This text was adapted by The Saylor Foundation under a Creative\nCommons Attribution-NonCommercial-ShareAlike 3.0 License without\nattribution as requested by the work\xe2\x80\x99s original creator or licensee.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n1\n\n\x0cPreface\nOur goal is to provide students with a textbook that is up to date and comprehensive in its\ncoverage of legal and regulatory issues\xe2\x80\x94and organized to permit instructors to tailor the\nmaterials to their particular approach. This book engages students by relating law to everyday\nevents with which they are already familiar (or with which they are familiarizing themselves in\nother business courses) and by its clear, concise, and readable style. (An earlier business law text\nby authors Lieberman and Siedel was hailed \xe2\x80\x9cthe best written text in a very crowded field.\xe2\x80\x9d)\nThis textbook provides context and essential concepts across the entire range of legal issues with\nwhich managers and business executives must grapple. The text provides the vocabulary and\nlegal acumen necessary for businesspeople to talk in an educated way to their customers,\nemployees, suppliers, government officials\xe2\x80\x94and to their own lawyers.\nTraditional publishers often create confusion among customers in the text selection process by\noffering a huge array of publications. Once a text is selected, customers might still have to\ncustomize the text to meet their needs. For example, publishers usually offer books that include\neither case summaries or excerpted cases, but some instructors prefer to combine case\nsummaries with a few excerpted cases so that students can experience reading original material.\nLikewise, the manner in which most conventional texts incorporate video is cumbersome\nbecause the videos are contained in a separate library, which makes access more complicating\nfor instructors and students.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n2\n\n\x0cChapter 1\nIntroduction to Law and Legal Systems\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should be able to do the following:\n1. Distinguish different philosophies of law\xe2\x80\x94schools of legal thought\xe2\x80\x94and explain their\nrelevance.\n2. Identify the various aims that a functioning legal system can serve.\n3. Explain how politics and law are related.\n4. Identify the sources of law and which laws have priority over other laws.\n5. Understand some basic differences between the US legal system and other legal systems.\nLaw has different meanings as well as different functions. Philosophers have considered issues\nof justice and law for centuries, and several different approaches, or schools of legal thought,\nhave emerged. In this chapter, we will look at those different meanings and approaches and will\nconsider how social and political dynamics interact with the ideas that animate the various\nschools of legal thought. We will also look at typical sources of \xe2\x80\x9cpositive law\xe2\x80\x9d in the United\nStates and how some of those sources have priority over others, and we will set out some basic\ndifferences between the US legal system and other legal systems.\n\n1.1 What Is Law?\n\nLaw is a word that means different things at different times. Black\xe2\x80\x99s Law Dictionarysays that\nlaw is \xe2\x80\x9ca body of rules of action or conduct prescribed by controlling authority, and having\nbinding legal force. That which must be obeyed and followed by citizens subject to sanctions or\nlegal consequence is a law.\xe2\x80\x9d [1]\n\nFunctions of the Law\nIn a nation, the law can serve to (1) keep the peace, (2) maintain the status quo, (3) preserve\nindividual rights, (4) protect minorities against majorities, (5) promote social justice, and (6)\nprovide for orderly social change. Some legal systems serve these purposes better than others.\nAlthough a nation ruled by an authoritarian government may keep the peace and maintain the\nstatus quo, it may also oppress minorities or political opponents (e.g., Burma, Zimbabwe, or\nIraq under Saddam Hussein). Under colonialism, European nations often imposed peace in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n3\n\n\x0ccountries whose borders were somewhat arbitrarily created by those same European nations.\nOver several centuries prior to the twentieth century, empires were built by Spain, Portugal,\nBritain, Holland, France, Germany, Belgium, and Italy. With regard to the functions of the law,\nthe empire may have kept the peace\xe2\x80\x94largely with force\xe2\x80\x94but it changed the status quo and\nseldom promoted the native peoples\xe2\x80\x99 rights or social justice within the colonized nation.\nIn nations that were former colonies of European nations, various ethnic and tribal factions\nhave frequently made it difficult for a single, united government to rule effectively. In Rwanda,\nfor example, power struggles between Hutus and Tutsis resulted in genocide of the Tutsi\nminority. (Genocide is the deliberate and systematic killing or displacement of one group of\npeople by another group. In 1948, the international community formally condemned the crime\nof genocide.) In nations of the former Soviet Union, the withdrawal of a central power created\npower vacuums that were exploited by ethnic leaders. When Yugoslavia broke up, the different\nethnic groups\xe2\x80\x94Croats, Bosnians, and Serbians\xe2\x80\x94fought bitterly for home turf rather than share\npower. In Iraq and Afghanistan, the effective blending of different groups of families, tribes,\nsects, and ethnic groups into a national governing body that shares power remains to be seen.\n\nLaw and Politics\nIn the United States, legislators, judges, administrative agencies, governors, and presidents\nmake law, with substantial input from corporations, lobbyists, and a diverse group of\nnongovernment organizations (NGOs) such as the American Petroleum Institute, the Sierra\nClub, and the National Rifle Association. In the fifty states, judges are often appointed by\ngovernors or elected by the people. The process of electing state judges has become more and\nmore politicized in the past fifteen years, with growing campaign contributions from those who\nwould seek to seat judges with similar political leanings.\nIn the federal system, judges are appointed by an elected official (the president) and confirmed\nby other elected officials (the Senate). If the president is from one party and the other party\nholds a majority of Senate seats, political conflicts may come up during the judges\xe2\x80\x99 confirmation\nprocesses. Such a division has been fairly frequent over the past fifty years.\nIn most nation-states (as countries are called in international law), knowing who has power to\nmake and enforce the laws is a matter of knowing who has political power; in many places, the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n4\n\n\x0cpeople or groups that have military power can also command political power to make and\nenforce the laws. Revolutions are difficult and contentious, but each year there are revolts\nagainst existing political-legal authority; an aspiration for democratic rule, or greater \xe2\x80\x9crights\xe2\x80\x9d for\ncitizens, is a recurring theme in politics and law.\n\nKEY TAKEAWAY\n\nLaw is the result of political action, and the political landscape is vastly different from nation\nto nation. Unstable or authoritarian governments often fail to serve the principal functions of\nlaw.\n\nEXERCISES\n\n1. Consider Burma (named Myanmar by its military rulers). What political rights do you have\nthat the average Burmese citizen does not?\n2. What is a nongovernment organization, and what does it have to do with government? Do\nyou contribute to (or are you active in) a nongovernment organization? What kind of rights\ndo they espouse, what kind of laws do they support, and what kind of laws do they oppose?\n\nAnnotate\n[1]\n\nBlack\xe2\x80\x99s Law Dictionary, 6th ed., s.v. \xe2\x80\x9claw.\xe2\x80\x9d\n\n1.2 Schools of Legal Thought\n\nLEARNING OBJECTIVES\n\n1. Distinguish different philosophies of law\xe2\x80\x94schools of legal thought\xe2\x80\x94and explain their\nrelevance.\n2. Explain why natural law relates to the rights that the founders of the US political-legal system\nfound important.\n3. Describe legal positivism and explain how it differs from natural law.\n4. Differentiate critical legal studies and ecofeminist legal perspectives from both natural law\nand legal positivist perspectives.\nThere are different schools (or philosophies) concerning what law is all about. Philosophy of law\nis also called jurisprudence, and the two main schools arelegal positivism and natural law.\nAlthough there are others (see Section 1.2.3 "Other Schools of Legal Thought"), these two are the\nmost influential in how people think about the law.\n\nLegal Positivism: Law as Sovereign Command\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n5\n\n\x0cAs legal philosopher John Austin concisely put it, \xe2\x80\x9cLaw is the command of a sovereign.\xe2\x80\x9d Law is\nonly law, in other words, if it comes from a recognized authority and can be enforced by that\nauthority, or sovereign\xe2\x80\x94such as a king, a president, or a dictator\xe2\x80\x94who has power within a\ndefined area or territory. Positivism is a philosophical movement that claims that science\nprovides the only knowledge precise enough to be worthwhile. But what are we to make of the\nsocial phenomena of laws?\nWe could examine existing statutes\xe2\x80\x94executive orders, regulations, or judicial decisions\xe2\x80\x94in a\nfairly precise way to find out what the law says. For example, we could look at the posted speed\nlimits on most US highways and conclude that the \xe2\x80\x9ccorrect\xe2\x80\x9d or \xe2\x80\x9cright\xe2\x80\x9d speed is no more than\nfifty-five miles per hour. Or we could look a little deeper and find out how the written law is\nusually applied. Doing so, we might conclude that sixty-one miles per hour is generally allowed\nby most state troopers, but that occasionally someone gets ticketed for doing fifty-seven miles\nper hour in a fifty-five miles per hour zone. Either approach is empirical, even if not rigorously\nscientific. The first approach, examining in a precise way what the rule itself says, is sometimes\nknown as the \xe2\x80\x9cpositivist\xe2\x80\x9d school of legal thought. The second approach\xe2\x80\x94which relies on social\ncontext and the actual behavior of the principal actors who enforce the law\xe2\x80\x94is akin to the \xe2\x80\x9clegal\nrealist\xe2\x80\x9d school of thought (see Section 1.2.3 "Other Schools of Legal Thought").\nPositivism has its limits and its critics. New Testament readers may recall that King Herod,\nfearing the birth of a Messiah, issued a decree that all male children below a certain age be\nkilled. Because it was the command of a sovereign, the decree was carried out (or, in legal\njargon, the decree was \xe2\x80\x9cexecuted\xe2\x80\x9d). Suppose a group seizes power in a particular place and\ncommands that women cannot attend school and can only be treated medically by women, even\nif their condition is life-threatening and women doctors are few and far between. Suppose also\nthat this command is carried out, just because it is the law and is enforced with a vengeance.\nPeople who live there will undoubtedly question the wisdom, justice, or goodness of such a law,\nbut it is law nonetheless and is generally carried out. To avoid the law\xe2\x80\x99s impact, a citizen would\nhave to flee the country entirely. During the Taliban rule in Afghanistan, from which this\nexample is drawn, many did flee.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n6\n\n\x0cThe positive-law school of legal thought would recognize the lawmaker\xe2\x80\x99s command as\nlegitimate; questions about the law\xe2\x80\x99s morality or immorality would not be important. In\ncontrast, the natural-law school of legal thought would refuse to recognize the legitimacy of laws\nthat did not conform to natural, universal, or divine law. If a lawmaker issued a command that\nwas in violation of natural law, a citizen would be morally justified in demonstrating civil\ndisobedience. For example, in refusing to give up her seat to a white person, Rosa Parks believed\nthat she was refusing to obey an unjust law.\n\nNatural Law\nThe natural-law school of thought emphasizes that law should be based on a universal moral\norder. Natural law was \xe2\x80\x9cdiscovered\xe2\x80\x9d by humans through the use of reason and by choosing\nbetween that which is good and that which is evil. Here is the definition of natural law according\nto the Cambridge Dictionary of Philosophy: \xe2\x80\x9cNatural law, also called the law of nature in moral\nand political philosophy, is an objective norm or set of objective norms governing human\nbehavior, similar to the positive laws of a human ruler, but binding on all people alike and\nusually understood as involving a superhuman legislator.\xe2\x80\x9d [1]\nBoth the US Constitution and the United Nations (UN) Charter have an affinity for the naturallaw outlook, as it emphasizes certain objective norms and rights of individuals and nations. The\nUS Declaration of Independence embodies a natural-law philosophy. The following short extract\nshould provide some sense of the deep beliefs in natural law held by those who signed the\ndocument.\n\nThe Unanimous Declaration of the Thirteen United States of America\nJuly 4, 1776\nWhen in the Course of human events, it becomes necessary for one people to dissolve the\npolitical bands which have connected them with another, and to assume among the powers of\nthe earth, the separate and equal station to which the Laws of Nature and of Nature\xe2\x80\x99s God entitle\nthem, a decent respect to the opinions of mankind requires that they should declare the causes\nwhich impel them to the separation.\nWe hold these truths to be self-evident, that all men are created equal, that they are endowed by\ntheir Creator with certain unalienable Rights, that among these are Life, Liberty and the Pursuit\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n7\n\n\x0cof Happiness. That to secure these rights, Governments are instituted among Men, deriving\ntheir just powers from the consent of the governed.\xe2\x80\xa6\nThe natural-law school has been very influential in American legal thinking. The idea that\ncertain rights, for example, are \xe2\x80\x9cunalienable\xe2\x80\x9d (as expressed in the Declaration of Independence\nand in the writings of John Locke) is consistent with this view of the law. Individuals may have\n\xe2\x80\x9cGod-given\xe2\x80\x9d or \xe2\x80\x9cnatural\xe2\x80\x9d rights that government cannot legitimately take away. Government\nonly by consent of the governed is a natural outgrowth of this view.\nCivil disobedience\xe2\x80\x94in the tradition of Henry Thoreau, Mahatma Gandhi, or Martin Luther King\nJr.\xe2\x80\x94becomes a matter of morality over \xe2\x80\x9cunnatural\xe2\x80\x9d law. For example, in his \xe2\x80\x9cLetter from\nBirmingham Jail,\xe2\x80\x9d Martin Luther King Jr. claims that obeying an unjust law is not moral and\nthat deliberately disobeying an unjust law is in fact a moral act that expresses \xe2\x80\x9cthe highest\nrespect for law\xe2\x80\x9d: \xe2\x80\x9cAn individual who breaks a law that conscience tells him is unjust, and who\nwillingly accepts the penalty of imprisonment in order to arouse the conscience of the\ncommunity over its injustice, is in reality expressing the highest respect for law.\xe2\x80\xa6One who\nbreaks an unjust law must do so openly, lovingly, and with a willingness to accept the\npenalty.\xe2\x80\x9d [2]\nLegal positivists, on the other hand, would say that we cannot know with real confidence what\n\xe2\x80\x9cnatural\xe2\x80\x9d law or \xe2\x80\x9cuniversal\xe2\x80\x9d law is. In studying law, we can most effectively learn by just looking\nat what the written law says, or by examining how it has been applied. In response, natural-law\nthinkers would argue that if we care about justice, every law and every legal system must be held\naccountable to some higher standard, however hard that may be to define.\nIt is easier to know what the law \xe2\x80\x9cis\xe2\x80\x9d than what the law \xe2\x80\x9cshould be.\xe2\x80\x9d Equal employment laws, for\nexample, have specific statutes, rules, and decisions about racial discrimination. There are\nalways difficult issues of interpretation and decision, which is why courts will resolve differing\nviews. But how can we know the more fundamental \xe2\x80\x9cought\xe2\x80\x9d or \xe2\x80\x9cshould\xe2\x80\x9d of human equality? For\nexample, how do we know that \xe2\x80\x9call men are created equal\xe2\x80\x9d (from the Declaration of\nIndependence)? Setting aside for the moment questions about the equality of women, or that of\nslaves, who were not counted as men with equal rights at the time of the declaration\xe2\x80\x94can the\nstatement be empirically proven, or is it simply a matter of a priori knowledge? (A priori means\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n8\n\n\x0c\xe2\x80\x9cexisting in the mind prior to and independent of experience.\xe2\x80\x9d) Or is the statement about\nequality a matter of faith or belief, not really provable either scientifically or rationally? The\ndialogue between natural-law theorists and more empirically oriented theories of \xe2\x80\x9cwhat law is\xe2\x80\x9d\nwill raise similar questions. In this book, we will focus mostly on the law as it is, but not without\nalso raising questions about what it could or should be.\n\nOther Schools of Legal Thought\nThe historical school of law believes that societies should base their legal decisions today on the\nexamples of the past. Precedent would be more important than moral arguments.\nThe legal realist school flourished in the 1920s and 1930s as a reaction to the historical school.\nLegal realists pointed out that because life and society are constantly changing, certain laws and\ndoctrines have to be altered or modernized in order to remain current. The social context of law\nwas more important to legal realists than the formal application of precedent to current or\nfuture legal disputes. Rather than suppose that judges inevitably acted objectively in applying an\nexisting rule to a set of facts, legal realists observed that judges had their own beliefs, operated\nin a social context, and would give legal decisions based on their beliefs and their own social\ncontext.\nThe legal realist view influenced the emergence of the critical legal studies (CLS) school of\nthought. The \xe2\x80\x9cCrits\xe2\x80\x9d believe that the social order (and the law) is dominated by those with\npower, wealth, and influence. Some Crits are clearly influenced by the economist Karl Marx and\nalso by distributive justice theory (see Chapter 2 "Corporate Social Responsibility and Business\nEthics"). The CLS school believes the wealthy have historically oppressed or exploited those with\nless wealth and have maintained social control through law. In so doing, the wealthy have\nperpetuated an unjust distribution of both rights and goods in society. Law is politics and is thus\nnot neutral or value-free. The CLS movement would use the law to overturn the hierarchical\nstructures of domination in the modern society.\nRelated to the CLS school, yet different, is the ecofeminist school of legal thought. This school\nemphasizes\xe2\x80\x94and would modify\xe2\x80\x94the long-standing domination of men over both women and\nthe rest of the natural world. Ecofeminists would say that the same social mentality that leads to\nexploitation of women is at the root of man\xe2\x80\x99s exploitation and degradation of the natural\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n9\n\n\x0cenvironment. They would say that male ownership of land has led to a \xe2\x80\x9cdominator culture,\xe2\x80\x9d in\nwhich man is not so much a steward of the existing environment or those \xe2\x80\x9csubordinate\xe2\x80\x9d to him\nbut is charged with making all that he controls economically \xe2\x80\x9cproductive.\xe2\x80\x9d Wives, children, land,\nand animals are valued as economic resources, and legal systems (until the nineteenth century)\nlargely conferred rights only to men with land. Ecofeminists would say that even with increasing\ncivil and political rights for women (such as the right to vote) and with some nations\xe2\x80\x99\nrecognizing the rights of children and animals and caring for the environment, the legacy of the\npast for most nations still confirms the preeminence of \xe2\x80\x9cman\xe2\x80\x9d and his dominance of both nature\nand women.\n\nKEY TAKEAWAY\n\nEach of the various schools of legal thought has a particular view of what a legal system is or\nwhat it should be. The natural-law theorists emphasize the rights and duties of both\ngovernment and the governed. Positive law takes as a given that law is simply the command\nof a sovereign, the political power that those governed will obey. Recent writings in the\nvarious legal schools of thought emphasize long-standing patterns of domination of the\nwealthy over others (the CLS school) and of men over women (ecofeminist legal theory).\n\nEXERCISES\n\n1. Vandana Shiva draws a picture of a stream in a forest. She says that in our society the stream\nis seen as unproductive if it is simply there, fulfilling the need for water of women\xe2\x80\x99s families\nand communities, until engineers come along and tinker with it, perhaps damming it and\nusing it for generating hydropower. The same is true of a forest, unless it is replaced with a\nmonoculture plantation of a commercial species. A forest may very well be productive\xe2\x80\x94\nprotecting groundwater; creating oxygen; providing fruit, fuel, and craft materials for nearby\ninhabitants; and creating a habitat for animals that are also a valuable resource. She criticizes\nthe view that if there is no monetary amount that can contribute to gross domestic product,\nneither the forest nor the river can be seen as a productive resource. Which school of legal\nthought does her criticism reflect?\n2. Anatole France said, \xe2\x80\x9cThe law, in its majesty, forbids rich and poor alike from sleeping under\nbridges.\xe2\x80\x9d Which school of legal thought is represented by this quote?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n10\n\n\x0c3. Adolf Eichmann was a loyal member of the National Socialist Party in the Third Reich and\nworked hard under Hitler\xe2\x80\x99s government during World War II to round up Jewish people for\nincarceration\xe2\x80\x94and eventual extermination\xe2\x80\x94at labor camps like Auschwitz and Buchenwald.\nAfter an Israeli \xe2\x80\x9cextraction team\xe2\x80\x9d took him from Argentina to Israel, he was put on trial for\n\xe2\x80\x9ccrimes against humanity.\xe2\x80\x9d His defense was that he was \xe2\x80\x9cjust following orders.\xe2\x80\x9d Explain why\nEichmann was not an adherent of the natural-law school of legal thought.\n\nAnnotate\n\n[1] Cambridge Dictionary of Philosophy, s.v. \xe2\x80\x9cnatural law.\xe2\x80\x9d\n[2] Martin Luther King Jr., \xe2\x80\x9cLetter from Birmingham Jail.\xe2\x80\x9d\n\n1.3 Basic Concepts and Categories of US Positive Law\nLEARNING OBJECTIVES\n\n1. In a general way, differentiate contract law from tort law.\n2. Consider the role of law in supporting ethical norms in our society.\n3. Understand the differing roles of state law and federal law in the US legal system.\n4. Know the difference between criminal cases and civil cases.\nMost of what we discuss in this book is positive law\xe2\x80\x94US positive law in particular. We will also\nconsider the laws and legal systems of other nations. But first, it will be useful to cover some\nbasic concepts and distinctions.\n\nLaw: The Moral Minimums in a Democratic Society\nThe law does not correct (or claim to correct) every wrong that occurs in society. At a minimum,\nit aims to curb the worst kind of wrongs, the kinds of wrongs that violate what might be called\nthe \xe2\x80\x9cmoral minimums\xe2\x80\x9d that a community demands of its members. These include not only\nviolations of criminal law (see Chapter 6 "Criminal Law") but also torts (see Chapter 7\n"Introduction to Tort Law") and broken promises (see Chapter 8 "Contracts"). Thus it may be\nwrong to refuse to return a phone call from a friend, but that wrong will not result in a viable\nlawsuit against you. But if a phone (or the Internet) is used to libel or slander someone, a tort\nhas been committed, and the law may allow the defamed person to be compensated.\nThere is a strong association between what we generally think of as ethical behavior and what\nthe laws require and provide. For example, contract law upholds society\xe2\x80\x99s sense that promises\xe2\x80\x94\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n11\n\n\x0cin general\xe2\x80\x94should be kept. Promise-breaking is seen as unethical. The law provides remedies\nfor broken promises (in breach of contract cases) but not for all broken promises; some excuses\nare accepted when it would be reasonable to do so. For tort law, harming others is considered\nunethical. If people are not restrained by law from harming one another, orderly society would\nbe undone, leading to anarchy. Tort law provides for compensation when serious injuries or\nharms occur. As for property law issues, we generally believe that private ownership of property\nis socially useful and generally desirable, and it is generally protected (with some exceptions) by\nlaws. You can\xe2\x80\x99t throw a party at my house without my permission, but my right to do whatever I\nwant on my own property may be limited by law; I can\xe2\x80\x99t, without the public\xe2\x80\x99s permission,\noperate an incinerator on my property and burn heavy metals, as toxic ash may be deposited\nthroughout the neighborhood.\n\nThe Common Law: Property, Torts, and Contracts\nEven before legislatures met to make rules for society, disputes happened and judges decided\nthem. In England, judges began writing down the facts of a case and the reasons for their\ndecision. They often resorted to deciding cases on the basis of prior written decisions. In relying\non those prior decisions, the judge would reason that since a current case was pretty much like a\nprior case, it ought to be decided the same way. This is essentially reasoning by analogy. Thus\nthe use of precedent in common-law cases came into being, and a doctrine\nof stare decisis (pronounced STAR-ay-de-SIGH-sus) became accepted in English courts. Stare\ndecisis means, in Latin, \xe2\x80\x9clet the decision stand.\xe2\x80\x9d\nMost judicial decisions that don\xe2\x80\x99t apply legislative acts (known as statutes) will involve one of\nthree areas of law\xe2\x80\x94property, contract, or tort. Property law deals with the rights and duties of\nthose who can legally own land (real property), how that ownership can be legally confirmed and\nprotected, how property can be bought and sold, what the rights of tenants (renters) are, and\nwhat the various kinds of \xe2\x80\x9cestates\xe2\x80\x9d in land are (e.g., fee simple, life estate, future interest,\neasements, or rights of way). Contract law deals with what kinds of promises courts should\nenforce. For example, should courts enforce a contract where one of the parties was intoxicated,\nunderage, or insane? Should courts enforce a contract where one of the parties seemed to have\nan unfair advantage? What kind of contracts would have to be in writing to be enforced by\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n12\n\n\x0ccourts? Tort law deals with the types of cases that involve some kind of harm and or injury\nbetween the plaintiff and the defendant when no contract exists. Thus if you are libeled or a\ncompetitor lies about your product, your remedy would be in tort, not contract.\nThe thirteen original colonies had been using English common law for many years, and they\ncontinued to do so after independence from England. Early cases from the first states are full of\nreferences to already-decided English cases. As years went by, many precedents were\nestablished by US state courts, so that today a judicial opinion that refers to a seventeenth- or\neighteenth-century English common-law case is quite rare.\nCourts in one state may look to common-law decisions from the courts of other states where the\nreasoning in a similar case is persuasive. This will happen in \xe2\x80\x9ccases of first impression,\xe2\x80\x9d a fact\npattern or situation that the courts in one state have never seen before. But if the supreme court\nin a particular state has already ruled on a certain kind of case, lower courts in that state will\nalways follow the rule set forth by their highest court.\n\nState Courts and the Domain of State Law\nIn the early years of our nation, federal courts were not as active or important as state courts.\nStates had jurisdiction (the power to make and enforce laws) over the most important aspects of\nbusiness life. The power of state law has historically included governing the following kinds of\nissues and claims:\n\xe2\x80\xa2\n\nContracts, including sales, commercial paper, letters of credit, and secured transactions\n\n\xe2\x80\xa2\n\nTorts\n\n\xe2\x80\xa2\n\nProperty, including real property, bailments of personal property (such as when you check your\ncoat at a theater or leave your clothes with a dry cleaner), trademarks, copyrights, and the\nestates of decedents (dead people)\n\n\xe2\x80\xa2\n\nCorporations\n\n\xe2\x80\xa2\n\nPartnerships\n\n\xe2\x80\xa2\n\nDomestic matters, including marriage, divorce, custody, adoption, and visitation\n\n\xe2\x80\xa2\n\nSecurities law\n\n\xe2\x80\xa2\n\nEnvironmental law\n\n\xe2\x80\xa2\n\nAgency law, governing the relationship between principals and their agents.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n13\n\n\x0c\xe2\x80\xa2\n\nBanking\n\n\xe2\x80\xa2\n\nInsurance\nOver the past eighty years, however, federal law has become increasingly important in many of\nthese areas, including banking, securities, and environmental law.\n\nCivil versus Criminal Cases\nMost of the cases we will look at in this textbook are civil cases. Criminal cases are certainly of\ninterest to business, especially as companies may break criminal laws. A criminal case involves a\ngovernmental decision\xe2\x80\x94whether state or federal\xe2\x80\x94to prosecute someone (named as a defendant)\nfor violating society\xe2\x80\x99s laws. The law establishes a moral minimum and does so especially in the\narea of criminal laws; if you break a criminal law, you can lose your freedom (in jail) or your life\n(if you are convicted of a capital offense). In a civil action, you would not be sent to prison; in the\nworst case, you can lose property (usually money or other assets), such as when Ford Motor\nCompany lost a personal injury case and the judge awarded $295 million to the plaintiffs or\nwhen Pennzoil won a $10.54 billion verdict against Texaco (see Chapter 7 "Introduction to Tort\nLaw").\nSome of the basic differences between civil law and criminal law cases are illustrated in Table 1.1\n"Differences between Civil and Criminal Cases".\nTable 1.1 Differences between Civil and Criminal Cases\nCivil Cases\n\nCriminal Cases\n\nParties\n\nPlaintiff brings case; defendant must answer or\nlose by default\n\nProsecutor brings case; defendant may\nremain silent\n\nProof\n\nPreponderance of evidence\n\nBeyond a reasonable doubt\n\nReason\n\nTo settle disputes peacefully, usually between\nprivate parties\n\nTo maintain order in society\nTo punish the most blameworthy\nTo deter serious wrongdoing\n\nRemedies\n\nMoney damages (legal remedy)\n\nFines, jail, and forfeitures\n\nInjunctions (equitable remedy)\nSpecific performance (equity)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n14\n\n\x0cRegarding plaintiffs and prosecutors, you can often tell a civil case from a criminal case by\nlooking at the caption of a case going to trial. If the government appears first in the caption of\nthe case (e.g., U.S. v. Lieberman, it is likely that the United States is prosecuting on behalf of the\npeople. The same is true of cases prosecuted by state district attorneys (e.g., State v. Seidel). But\nthis is not a foolproof formula. Governments will also bring civil actions to collect debts from or\nsettle disputes with individuals, corporations, or other governments. Thus U.S. v. Mayer might\nbe a collection action for unpaid taxes, or U.S. v. Canada might be a boundary dispute in the\nInternational Court of Justice. Governments can be sued, as well; people occasionally sue their\nstate or federal government, but they can only get a trial if the government waives its sovereign\nimmunity and allows such suits. Warner v. U.S., for example, could be a claim for a tax refund\nwrongfully withheld or for damage caused to the Warner residence by a sonic boom from a US\nAir Force jet flying overhead.\n\nSubstance versus Procedure\nMany rules and regulations in law are substantive, and others are procedural. We are used to\nseeing laws as substantive; that is, there is some rule of conduct or behavior that is called for or\nsome action that is proscribed (prohibited). The substantive rules tell us how to act with one\nanother and with the government. For example, all of the following are substantive rules of law\nand provide a kind of command or direction to citizens:\n\xe2\x80\xa2\n\nDrive not more than fifty-five miles per hour where that speed limit is posted.\n\n\xe2\x80\xa2\n\nDo not conspire to fix prices with competitors in the US market.\n\n\xe2\x80\xa2\n\nDo not falsely represent the curative effects of your over-the-counter herbal remedy.\n\n\xe2\x80\xa2\n\nDo not drive your motor vehicle through an intersection while a red traffic signal faces the\ndirection you are coming from.\n\n\xe2\x80\xa2\n\nDo not discriminate against job applicants or employees on the basis of their race, sex, religion,\nor national origin.\n\n\xe2\x80\xa2\n\nDo not discharge certain pollutants into the river without first getting a discharge permit.\nIn contrast, procedural laws are the rules of courts and administrative agencies. They tell us how\nto proceed if there is a substantive-law problem. For example, if you drive fifty-three miles per\nhour in a forty mile-per-hour zone on Main Street on a Saturday night and get a ticket, you have\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n15\n\n\x0cbroken a substantive rule of law (the posted speed limit). Just how and what gets decided in\ncourt is a matter of procedural law. Is the police officer\xe2\x80\x99s word final, or do you get your say\nbefore a judge? If so, who goes first, you or the officer? Do you have the right to be represented\nby legal counsel? Does the hearing or trial have to take place within a certain time period? A\nweek? A month? How long can the state take to bring its case? What kinds of evidence will be\nrelevant? Radar? (Does it matter what kind of training the officer has had on the radar device?\nWhether the radar device had been tested adequately?) The officer\xe2\x80\x99s personal observation?\n(What kind of training has he had, how is he qualified to judge the speed of a car, and other\nquestions arise.) What if you unwisely bragged to a friend at a party recently that you went a\nhundred miles an hour on Main Street five years ago at half past three on a Tuesday morning?\n(If the prosecutor knows of this and the \xe2\x80\x9cfriend\xe2\x80\x9d is willing to testify, is it relevant to the charge of\nfifty-three in a forty-mile-per-hour zone?)\nIn the United States, all state procedural laws must be fair, since the due process clause of the\nFourteenth Amendment directs that no state shall deprive any citizen of \xe2\x80\x9clife, liberty, or\nproperty,\xe2\x80\x9d without due process of law. (The $200 fine plus court costs is designed to deprive you\nof property, that is, money, if you violate the speed limit.) Federal laws must also be fair,\nbecause the Fifth Amendment to the US Constitution has the exact same due process language\nas the Fourteenth Amendment. This suggests that some laws are more powerful or important\nthan others, which is true. The next section looks at various types of positive law and their\nrelative importance.\n\nKEY TAKEAWAY\n\nIn most legal systems, like that in the United States, there is a fairly firm distinction between\ncriminal law (for actions that are offenses against the entire society) and civil law (usually for\ndisputes between individuals or corporations). Basic ethical norms for promise-keeping and\nnot harming others are reflected in the civil law of contracts and torts. In the United States,\nboth the states and the federal government have roles to play, and sometimes these roles\nwill overlap, as in environmental standards set by both states and the federal government.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n16\n\n\x0c1. Jenna gets a ticket for careless driving after the police come to investigate a car accident she\nhad with you on Hanover Boulevard. Your car is badly damaged through no fault of your own.\nIs Jenna likely to face criminal charges, civil charges, or both?\n2. Jenna\xe2\x80\x99s ticket says that she has thirty days in which to respond to the charges against her.\nThe thirty days conforms to a state law that sets this time limit. Is the thirty-day limit\nprocedural law or substantive law?\n\n1.4 Sources of Law and Their Priority\nLEARNING OBJECTIVES\n\n1. Describe the different sources of law in the US legal system and the principal institutions that\ncreate those laws.\n2. Explain in what way a statute is like a treaty, and vice versa.\n3. Explain why the Constitution is \xe2\x80\x9cprior\xe2\x80\x9d and has priority over the legislative acts of a majority,\nwhether in the US Congress or in a state legislature.\n4. Describe the origins of the common-law system and what common law means.\n\nSources of Law\nIn the United States today, there are numerous sources of law. The main ones are (1)\nconstitutions\xe2\x80\x94both state and federal, (2) statutes and agency regulations, and (3) judicial\ndecisions. In addition, chief executives (the president and the various governors) can issue\nexecutive orders that have the effect of law.\nIn international legal systems, sources of law include treaties (agreements between states or\ncountries) and what is known as customary international law (usually consisting of judicial\ndecisions from national court systems where parties from two or more nations are in a dispute).\nAs you might expect, these laws sometimes conflict: a state law may conflict with a federal law,\nor a federal law might be contrary to an international obligation. One nation\xe2\x80\x99s law may provide\none substantive rule, while another nation\xe2\x80\x99s law may provide a different, somewhat contrary\nrule to apply. Not all laws, in other words, are created equal. To understand which laws have\npriority, it is essential to understand the relationships between the various kinds of law.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n17\n\n\x0cConstitutions\nConstitutions are the foundation for a state or nation\xe2\x80\x99s other laws, providing the country\xe2\x80\x99s\nlegislative, executive, and judicial framework. Among the nations of the world, the United States\nhas the oldest constitution still in use. It is difficult to amend, which is why there have only been\nseventeen amendments following the first ten in 1789; two-thirds of the House and Senate must\npass amendments, and three-fourths of the states must approve them.\nThe nation\xe2\x80\x99s states also have constitutions. Along with providing for legislative, executive, and\njudicial functions, state constitutions prescribe various rights of citizens. These rights may be\ndifferent from, and in addition to, rights granted by the US Constitution. Like statutes and\njudicial decisions, a constitution\xe2\x80\x99s specific provisions can provide people with a \xe2\x80\x9ccause of action\xe2\x80\x9d\non which to base a lawsuit (see Section 1.4.3 "Causes of Action, Precedent, and " on \xe2\x80\x9ccauses of\naction\xe2\x80\x9d). For example, California\xe2\x80\x99s constitution provides that the citizens of that state have a\nright of privacy. This has been used to assert claims against businesses that invade an\nemployee\xe2\x80\x99s right of privacy. In the case of Virginia Rulon-Miller, her employer, International\nBusiness Machines (IBM), told her to stop dating a former colleague who went to work for a\ncompetitor. When she refused, IBM terminated her, and a jury fined the company for $300,000\nin damages. As the California court noted, \xe2\x80\x9cWhile an employee sacrifices some privacy rights\nwhen he enters the workplace, the employee\xe2\x80\x99s privacy expectations must be balanced against the\nemployer\xe2\x80\x99s interests.\xe2\x80\xa6[T]he point here is that privacy, like the other unalienable rights listed\nfirst in our Constitution\xe2\x80\xa6is unquestionably a fundamental interest of our society.\xe2\x80\x9d [1]\n\nStatutes and Treaties in Congress\nIn Washington, DC, the federal legislature is known as Congress and has both a House of\nRepresentatives and a Senate. The House is composed of representatives elected every two years\nfrom various districts in each state. These districts are established by Congress according to\npopulation as determined every ten years by the census, a process required by the Constitution.\nEach state has at least one district; the most populous state (California) has fifty-two districts. In\nthe Senate, there are two senators from each state, regardless of the state\xe2\x80\x99s population. Thus\nDelaware has two senators and California has two senators, even though California has far more\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n18\n\n\x0cpeople. Effectively, less than 20 percent of the nation\xe2\x80\x99s population can send fifty senators to\nWashington.\nMany consider this to be antidemocratic. The House of Representatives, on the other hand, is\ndirectly proportioned by population, though no state can have less than one representative.\nEach Congressional legislative body has committees for various purposes. In these committees,\nproposed bills are discussed, hearings are sometimes held, and bills are either reported out\n(brought to the floor for a vote) or killed in committee. If a bill is reported out, it may be passed\nby majority vote. Because of the procedural differences between the House and the Senate, bills\nthat have the same language when proposed in both houses are apt to be different after approval\nby each body. A conference committee will then be held to try to match the two versions. If the\ntwo versions differ widely enough, reconciliation of the two differing versions into one\nacceptable to both chambers (House and Senate) is more difficult.\nIf the House and Senate can agree on identical language, the reconciled bill will be sent to the\npresident for signature or veto. The Constitution prescribes that the president will have veto\npower over any legislation. But the two bodies can override a presidential veto with a two-thirds\nvote in each chamber.\nIn the case of treaties, the Constitution specifies that only the Senate must ratify them. When the\nSenate ratifies a treaty, it becomes part of federal law, with the same weight and effect as a\nstatute passed by the entire Congress. The statutes of Congress are collected in codified form in\nthe US Code. The code is available online athttp://uscode.house.gov.\n\nDelegating Legislative Powers: Rules by Administrative Agencies\nCongress has found it necessary and useful to create government agencies to administer various\nlaws (see Chapter 5 "Administrative Law"). The Constitution does not expressly provide for\nadministrative agencies, but the US Supreme Court has upheld the delegation of power to create\nfederal agencies.\nExamples of administrative agencies would include the Occupational Safety and Health\nAdministration (OSHA), the Environmental Protection Agency (EPA), and the Federal Trade\nCommission (FTC).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n19\n\n\x0cIt is important to note that Congress does not have unlimited authority to delegate its\nlawmaking powers to an agency. It must delegate its authority with some guidelines for the\nagency and cannot altogether avoid its constitutional responsibilities (see Chapter 5\n"Administrative Law").\nAgencies propose rules in the Federal Register, published each working day of the year. Rules\nthat are formally adopted are published in the Code of Federal Regulations, or CFR, available\nonline at http://www.access.gpo.gov/nara/cfr/cfr-table-search.html.\n\nState Statutes and Agencies: Other Codified Law\nStatutes are passed by legislatures and provide general rules for society. States have legislatures\n(sometimes called assemblies), which are usually made up of both a senate and a house of\nrepresentatives. Like the federal government, state legislatures will agree on the provisions of a\nbill, which is then sent to the governor (acting like the president for that state) for signature.\nLike the president, governors often have a veto power. The process of creating and amending, or\nchanging, laws is filled with political negotiation and compromise.\nOn a more local level, counties and municipal corporations or townships may be authorized\nunder a state\xe2\x80\x99s constitution to create or adopt ordinances. Examples of ordinances include local\nbuilding codes, zoning laws, and misdemeanors or infractions such as skateboarding or\njaywalking. Most of the more unusual laws that are in the news from time to time are local\nordinances. For example, in Logan County, Colorado, it is illegal to kiss a sleeping woman; in\nIndianapolis, Indiana, and Eureka, Nebraska, it is a crime to kiss if you have a mustache. But\nreportedly, some states still have odd laws here and there. Kentucky law proclaims that every\nperson in the state must take a bath at least once a year, and failure to do so is illegal.\n\nJudicial Decisions: The Common Law\nCommon law consists of decisions by courts (judicial decisions) that do not involve\ninterpretation of statutes, regulations, treaties, or the Constitution. Courts make such\ninterpretations, but many cases are decided where there is no statutory or other codified law or\nregulation to be interpreted. For example, a state court deciding what kinds of witnesses are\nrequired for a valid will in the absence of a rule (from a statute) is making common law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n20\n\n\x0cUnited States law comes primarily from the tradition of English common law. By the time\nEngland\xe2\x80\x99s American colonies revolted in 1776, English common-law traditions were well\nestablished in the colonial courts. English common law was a system that gave written judicial\ndecisions the force of law throughout the country. Thus if an English court delivered an opinion\nas to what constituted the common-law crime of burglary, other courts would stick to that\ndecision, so that a common body of law developed throughout the country. Common law is\nessentially shorthand for the notion that a common body of law, based on past written decisions,\nis desirable and necessary.\nIn England and in the laws of the original thirteen states, common-law decisions defined crimes\nsuch as arson, burglary, homicide, and robbery. As time went on, US state legislatures either\nadopted or modified common-law definitions of most crimes by putting them in the form of\ncodes or statutes. This legislative ability\xe2\x80\x94to modify or change common law into judicial law\xe2\x80\x94\npoints to an important phenomenon: the priority of statutory law over common law. As we will\nsee in the next section, constitutional law will have priority over statutory law.\n\nPriority of Laws\nThe Constitution as Preemptive Force in US Law\nThe US Constitution takes precedence over all statutes and judicial decisions that are\ninconsistent. For example, if Michigan were to decide legislatively that students cannot speak ill\nof professors in state-sponsored universities, that law would be void, since it is inconsistent with\nthe state\xe2\x80\x99s obligation under the First Amendment to protect free speech. Or if the Michigan\ncourts were to allow a professor to bring a lawsuit against a student who had said something\nabout him that was derogatory but not defamatory, the state\xe2\x80\x99s judicial system would not be\nacting according to the First Amendment. (As we will see in Chapter 7 "Introduction to Tort\nLaw", free speech has its limits; defamation was a cause of action at the time the First\nAmendment was added to the Constitution, and it has been understood that the free speech\nrights in the First Amendment did not negate existing common law.)\n\nStatutes and Cases\nStatutes generally have priority, or take precedence, over case law (judicial decisions). Under\ncommon-law judicial decisions, employers could hire young children for difficult work, offer any\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n21\n\n\x0cwage they wanted, and not pay overtime work at a higher rate. But various statutes changed\nthat. For example, the federal Fair Labor Standards Act (1938) forbid the use of oppressive child\nlabor and established a minimum pay wage and overtime pay rules.\n\nTreaties as Statutes: The \xe2\x80\x9cLast in Time\xe2\x80\x9d Rule\nA treaty or convention is considered of equal standing to a statute. Thus when Congress ratified\nthe North American Free Trade Agreement (NAFTA), any judicial decisions or previous statutes\nthat were inconsistent\xe2\x80\x94such as quotas or limitations on imports from Mexico that were\nopposite to NAFTA commitments\xe2\x80\x94would no longer be valid. Similarly, US treaty obligations\nunder the General Agreement on Tariffs and Trade (GATT) and obligations made later through\nthe World Trade Organization (WTO) would override previous federal or state statutes.\nOne example of treaty obligations overriding, or taking priority over, federal statutes was the\ntuna-dolphin dispute between the United States and Mexico. The Marine Mammal Protection\nAct amendments in 1988 spelled out certain protections for dolphins in the Eastern Tropical\nPacific, and the United States began refusing to allow the importation of tuna that were caught\nusing \xe2\x80\x9cdolphin-unfriendly\xe2\x80\x9d methods (such as purse seining). This was challenged at a GATT\ndispute panel in Switzerland, and the United States lost. The discussion continued at the WTO\nunder its dispute resolution process. In short, US environmental statutes can be ruled contrary\nto US treaty obligations.\nUnder most treaties, the United States can withdraw, or take back, any voluntary limitation on\nits sovereignty; participation in treaties is entirely elective. That is, the United States may\n\xe2\x80\x9cunbind\xe2\x80\x9d itself whenever it chooses. But for practical purposes, some limitations on sovereignty\nmay be good for the nation. The argument goes something like this: if free trade in general helps\nthe United States, then it makes some sense to be part of a system that promotes free trade; and\ndespite some temporary setbacks, the WTO decision process will (it is hoped) provide far more\nbenefits than losses in the long run. This argument invokes utilitarian theory (that the best\npolicy does the greatest good overall for society) and David Ricardo\xe2\x80\x99s theory of comparative\nadvantage.\nUltimately, whether the United States remains a supporter of free trade and continues to\nparticipate as a leader in the WTO will depend upon citizens electing leaders who support the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n22\n\n\x0cprocess. Had Ross Perot been elected in 1992, for example, NAFTA would have been politically\n(and legally) dead during his term of office.\n\nCauses of Action, Precedent, and Stare Decisis\nNo matter how wrong someone\xe2\x80\x99s actions may seem to you, the only wrongs you can right in a\ncourt are those that can be tied to one or more causes of action. Positive law is full of cases,\ntreaties, statutes, regulations, and constitutional provisions that can be made into a cause of\naction. If you have an agreement with Harold Hill that he will purchase seventy-six trombones\nfrom you and he fails to pay for them after you deliver, you will probably feel wronged, but a\ncourt will only act favorably on your complaint if you can show that his behavior gives you a\ncause of action based on some part of your state\xe2\x80\x99s contract law. This case would give you a cause\nof action under the law of most states; unless Harold Hill had some legal excuse recognized by\nthe applicable state\xe2\x80\x99s contract law\xe2\x80\x94such as his legal incompetence, his being less than eighteen\nyears of age, his being drunk at the time the agreement was made, or his claim that the\ninstruments were trumpets rather than trombones or that they were delivered too late to be of\nuse to him\xe2\x80\x94you could expect to recover some compensation for his breaching of your agreement\nwith him.\nAn old saying in the law is that the law does not deal in trifles, or unimportant issues (in\nLatin, de minimis non curat lex). Not every wrong you may suffer in life will be a cause to bring\na court action. If you are stood up for a Saturday night date and feel embarrassed or humiliated,\nyou cannot recover anything in a court of law in the United States, as there is no cause of action\n(no basis in the positive law) that you can use in your complaint. If you are engaged to be\nmarried and your spouse-to-be bolts from the wedding ceremony, there are some states that do\nprovide a legal basis on which to bring a lawsuit. \xe2\x80\x9cBreach of promise to marry\xe2\x80\x9d is recognized in\nseveral states, but most states have abolished this cause of action, either by judicial decision or\nby legislation. Whether a runaway bride or groom gives rise to a valid cause of action in the\ncourts depends on whether the state courts still recognize and enforce this now-disappearing\ncause of action.\nYour cause of action is thus based on existing laws, including decided cases. How closely your\ncase \xe2\x80\x9cfits\xe2\x80\x9d with a prior decided case raises the question of precedent.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n23\n\n\x0cAs noted earlier in this chapter, the English common-law tradition placed great emphasis on\nprecedent and what is called stare decisis. A court considering one case would feel obliged to\ndecide that case in a way similar to previously decided cases. Written decisions of the most\nimportant cases had been spread throughout England (the common \xe2\x80\x9crealm\xe2\x80\x9d), and judges hoped\nto establish a somewhat predictable, consistent group of decisions.\nThe English legislature (Parliament) was not in the practice of establishing detailed statutes on\ncrimes, torts, contracts, or property. Thus definitions and rules were left primarily to the courts.\nBy their nature, courts could only decide one case at a time, but in doing so they would articulate\nholdings, or general rules, that would apply to later cases.\nSuppose that one court had to decide whether an employer could fire an employee for no reason\nat all. Suppose that there were no statutes that applied to the facts: there was no contract\nbetween the employer and the employee, but the employee had worked for the employer for\nmany years, and now a younger person was replacing him. The court, with no past guidelines,\nwould have to decide whether the employee had stated a \xe2\x80\x9ccause of action\xe2\x80\x9d against the employer.\nIf the court decided that the case was not legally actionable, it would dismiss the action. Future\ncourts would then treat similar cases in a similar way. In the process, the court might make a\nholding that employers could fire employees for any reason or for no reason. This rule could be\napplied in the future should similar cases come up.\nBut suppose that an employer fired an employee for not committing perjury (lying on the\nwitness stand in a court proceeding); the employer wanted the employee to cover up the\ncompany\'s criminal or unethical act. Suppose that, as in earlier cases, there were no applicable\nstatutes and no contract of employment. Courts relying on a holding or precedent that\n\xe2\x80\x9cemployers may fire employees for any reason or no reason\xe2\x80\x9d might rule against an employee\nseeking compensation for being fired for telling the truth on the witness stand. Or it might make\nan exception to the general rule, such as, \xe2\x80\x9cEmployers may generally discharge employees for any\nreason or for no reason without incurring legal liability; however, employers will incur legal\nliability for firing an employee who refuses to lie on behalf of the employer in a court\nproceeding.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n24\n\n\x0cIn each case (the general rule and its exception), the common-law tradition calls for the court to\nexplain the reasons for its ruling. In the case of the general rule, \xe2\x80\x9cfreedom of choice\xe2\x80\x9d might be\nthe major reason. In the case of the perjury exception, the efficiency of the judicial system and\nthe requirements of citizenship might be used as reasons. Because the court\xe2\x80\x99s \xe2\x80\x9creasons\xe2\x80\x9d will be\npersuasive to some and not to others, there is inevitably a degree of subjectivity to judicial\nopinions. That is, reasonable people will disagree as to the persuasiveness of the reasoning a\ncourt may offer for its decision.\nWritten judicial opinions are thus a good playing field for developing critical thinking skills by\nidentifying the issue in a case and examining the reasons for the court\xe2\x80\x99s previous decision(s), or\nholding. What has the court actually decided, and why? Remember that a court, especially the\nUS Supreme Court, is not only deciding one particular case but also setting down guidelines (in\nits holdings) for federal and state courts that encounter similar issues. Note that court cases\noften raise a variety of issues or questions to be resolved, and judges (and attorneys) will differ\nas to what the real issue in a case is. A holding is the court\xe2\x80\x99s complete answer to an issue that is\ncritical to deciding the case and thus gives guidance to the meaning of the case as a precedent for\nfuture cases.\nBeyond the decision of the court, it is in looking at the court\xe2\x80\x99s reasoning that you are most likely\nto understand what facts have been most significant to the court and what theories (schools of\nlegal thought) each trial or appellate judge believes in. Because judges do not always agree on\nfirst principles (i.e., they subscribe to different schools of legal thought), there are many divided\nopinions in appellate opinions and in each US Supreme Court term.\n\nKEY TAKEAWAY\n\nThere are different sources of law in the US legal system. The US Constitution is foundational;\nUS statutory and common law cannot be inconsistent with its provisions. Congress creates\nstatutory law (with the signature of the president), and courts will interpret constitutional\nlaw and statutory law. Where there is neither constitutional law nor statutory law, the courts\nfunction in the realm of common law. The same is true of law within the fifty states, each of\nwhich also has a constitution, or foundational law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n25\n\n\x0cBoth the federal government and the states have created administrative agencies. An agency\nonly has the power that the legislature gives it. Within the scope of that power, an agency\nwill often create regulations (see Chapter 5 "Administrative Law"), which have the same\nforce and effect as statutes. Treaties are never negotiated and concluded by states, as the\nfederal government has exclusive authority over relations with other nation-states. A treaty,\nonce ratified by the Senate, has the same force and effect as a statute passed by Congress\nand signed into law by the president.\nConstitutions, statutes, regulations, treaties, and court decisions can provide a legal basis in\nthe positive law. You may believe you have been wronged, but for you to have a right that is\nenforceable in court, you must have something in the positive law that you can point to that\nwill support a cause of action against your chosen defendant.\n\nEXERCISES\n\n1. Give one example of where common law was overridden by the passage of a federal statute.\n2. How does common law change or evolve without any action on the part of a legislature?\n3. Lindsey Paradise is not selected for her sorority of choice at the University of Kansas. She has\nspent all her time rushing that particular sorority, which chooses some of her friends but not\nher. She is disappointed and angry and wants to sue the sorority. What are her prospects of\nrecovery in the legal system? Explain.\n\n[1] Rulon-Miller v. International Business Machines Corp., 162 Cal. App.3d 241, 255 (1984).\n\n1.5 Legal and Political Systems of the World\nLEARNING OBJECTIVE\n\n1. Describe how the common-law system differs from the civil-law system.\nOther legal and political systems are very different from the US system, which came from\nEnglish common-law traditions and the framers of the US Constitution. Our legal and political\ntraditions are different both in what kinds of laws we make and honor and in how disputes are\nresolved in court.\n\nComparing Common-Law Systems with Other Legal Systems\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n26\n\n\x0cThe common-law tradition is unique to England, the United States, and former colonies of the\nBritish Empire. Although there are differences among common-law systems (e.g., most nations\ndo not permit their judiciaries to declare legislative acts unconstitutional; some nations use the\njury less frequently), all of them recognize the use of precedent in judicial cases, and none of\nthem relies on the comprehensive, legislative codes that are prevalent in civil-law systems.\n\nCivil-Law Systems\nThe main alternative to the common-law legal system was developed in Europe and is based in\nRoman and Napoleonic law. A civil-law or code-law system is one where all the legal rules are in\none or more comprehensive legislative enactments. During Napoleon\xe2\x80\x99s reign, a comprehensive\nbook of laws\xe2\x80\x94a code\xe2\x80\x94was developed for all of France. The code covered criminal law, criminal\nprocedure, noncriminal law and procedure, and commercial law. The rules of the code are still\nused today in France and in other continental European legal systems. The code is used to\nresolve particular cases, usually by judges without a jury. Moreover, the judges are not required\nto follow the decisions of other courts in similar cases. As George Cameron of the University of\nMichigan has noted, \xe2\x80\x9cThe law is in the code, not in the cases.\xe2\x80\x9d He goes on to note, \xe2\x80\x9cWhere\nseveral cases all have interpreted a provision in a particular way, the French courts may feel\nbound to reach the same result in future cases, under the doctrine ofjurisprudence\nconstante. The major agency for growth and change, however, is the legislature, not the courts.\xe2\x80\x9d\nCivil-law systems are used throughout Europe as well as in Central and South America. Some\nnations in Asia and Africa have also adopted codes based on European civil law. Germany,\nHolland, Spain, France, and Portugal all had colonies outside of Europe, and many of these\ncolonies adopted the legal practices that were imposed on them by colonial rule, much like the\noriginal thirteen states of the United States, which adopted English common-law practices.\nOne source of possible confusion at this point is that we have already referred to US civil law in\ncontrast to criminal law. But the European civil law covers both civil and criminal law.\nThere are also legal systems that differ significantly from the common-law and civil-law\nsystems. The communist and socialist legal systems that remain (e.g., in Cuba and North Korea)\noperate on very different assumptions than those of either English common law or European\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n27\n\n\x0ccivil law. Islamic and other religion-based systems of law bring different values and assumptions\nto social and commercial relations.\n\nKEY TAKEAWAY\n\nLegal systems vary widely in their aims and in the way they process civil and criminal cases.\nCommon-law systems use juries, have one judge, and adhere to precedent. Civil-law systems\ndecide cases without a jury, often use three judges, and often render shorter opinions\nwithout reference to previously decided cases.\n\nEXERCISE\n\n1. Use the Internet to identify some of the better-known nations with civil-law systems. Which\nAsian nations came to adopt all or part of civil-law traditions, and why?\n\n1.6 A Sample Case\nPreliminary Note to Students\nTitle VII of the Civil Rights Act of 1964 is a federal statute that applies to all employers whose\nworkforce exceeds fifteen people. The text of Title VII says that\n(a) it shall be an unlawful employment practice for an employer\xe2\x80\x94\n(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against\nany individual with respect to his compensation, terms, conditions, or privileges of employment,\nbecause of such individual\xe2\x80\x99s race, color, religion, sex, or natural origin.\nAt common law\xe2\x80\x94where judges decide cases without reference to statutory guidance\xe2\x80\x94employers\nwere generally free to hire and fire on any basis they might choose, and employees were\ngenerally free to work for an employer or quit an employer on any basis they might choose\n(unless the employer and the employee had a contract). This rule has been called \xe2\x80\x9cemployment\nat will.\xe2\x80\x9d State and federal statutes that prohibit discrimination on any basis (such as the\nprohibitions on discrimination because of race, color, religion, sex, or national origin in Title\nVII) are essentially legislative exceptions to the common-law employment-at-will rule.\nIn the 1970s, many female employees began to claim a certain kind of sex discrimination: sexual\nharassment. Some women were being asked to give sexual favors in exchange for continued\nemployment or promotion (quid pro quo sexual harassment) or found themselves in a working\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n28\n\n\x0cenvironment that put their chances for continued employment or promotion at risk. This form\nof sexual discrimination came to be called \xe2\x80\x9chostile working environment\xe2\x80\x9d sexual harassment.\nNotice that the statute itself says nothing about sexual harassment but speaks only in broad\nterms about discrimination \xe2\x80\x9cbecause of\xe2\x80\x9d sex (and four other factors). Having set the broad\npolicy, Congress left it to employees, employers, and the courts to fashion more specific rules\nthrough the process of civil litigation.\nThis is a case from our federal court system, which has a trial or hearing in the federal district\ncourt, an appeal to the Sixth Circuit Court of Appeals, and a final appeal to the US Supreme\nCourt. Teresa Harris, having lost at both the district court and the Sixth Circuit Court of\nAppeals, here has petitioned for a writ of certiorari (asking the court to issue an order to bring\nthe case to the Supreme Court), a petition that is granted less than one out of every fifty times.\nThe Supreme Court, in other words, chooses its cases carefully. Here, the court wanted to\nresolve a difference of opinion among the various circuit courts of appeal as to whether or not a\nplaintiff in a hostile-working-environment claim could recover damages without showing\n\xe2\x80\x9csevere psychological injury.\xe2\x80\x9d\nHarris v. Forklift Systems\n510 U.S. 17 (U.S. Supreme Court 1992)\nJUDGES: O\xe2\x80\x99CONNOR, J., delivered the opinion for a unanimous Court. SCALIA, J., and\nGINSBURG, J., filed concurring opinions.\nJUSTICE O\xe2\x80\x99CONNOR delivered the opinion of the Court.\nIn this case we consider the definition of a discriminatorily \xe2\x80\x9cabusive work environment\xe2\x80\x9d (also\nknown as a \xe2\x80\x9chostile work environment\xe2\x80\x9d) under Title VII of the Civil Rights Act of 1964, 78 Stat.\n253, as amended, 42 U.S.C. \xc2\xa7 2000e et seq. (1988 ed., Supp. III).\nI\nTeresa Harris worked as a manager at Forklift Systems, Inc., an equipment rental company,\nfrom April 1985 until October 1987. Charles Hardy was Forklift\xe2\x80\x99s president.\nThe Magistrate found that, throughout Harris\xe2\x80\x99 time at Forklift, Hardy often insulted her because\nof her gender and often made her the target of unwanted sexual innuendoes. Hardy told Harris\non several occasions, in the presence of other employees, \xe2\x80\x9cYou\xe2\x80\x99re a woman, what do you know\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n29\n\n\x0cand \xe2\x80\x9cWe need a man as the rental manager\xe2\x80\x9d; at least once, he told her she was \xe2\x80\x9ca dumbass\nwoman.\xe2\x80\x9d Again in front of others, he suggested that the two of them \xe2\x80\x9cgo to the Holiday Inn to\nnegotiate [Harris\xe2\x80\x99s] raise.\xe2\x80\x9d Hardy occasionally asked Harris and other female employees to get\ncoins from his front pants pocket. He threw objects on the ground in front of Harris and other\nwomen, and asked them to pick the objects up. He made sexual innuendoes about Harris\xe2\x80\x99 and\nother women\xe2\x80\x99s clothing.\nIn mid-August 1987, Harris complained to Hardy about his conduct. Hardy said he was\nsurprised that Harris was offended, claimed he was only joking, and apologized. He also\npromised he would stop, and based on this assurance Harris stayed on the job. But in early\nSeptember, Hardy began anew: While Harris was arranging a deal with one of Forklift\xe2\x80\x99s\ncustomers, he asked her, again in front of other employees, \xe2\x80\x9cWhat did you do, promise the\nguy\xe2\x80\xa6some [sex] Saturday night?\xe2\x80\x9d On October 1, Harris collected her paycheck and quit.\nHarris then sued Forklift, claiming that Hardy\xe2\x80\x99s conduct had created an abusive work\nenvironment for her because of her gender. The United States District Court for the Middle\nDistrict of Tennessee, adopting the report and recommendation of the Magistrate, found this to\nbe \xe2\x80\x9ca close case,\xe2\x80\x9d but held that Hardy\xe2\x80\x99s conduct did not create an abusive environment. The\ncourt found that some of Hardy\xe2\x80\x99s comments \xe2\x80\x9coffended [Harris], and would offend the\nreasonable woman,\xe2\x80\x9d but that they were not \xe2\x80\x9cso severe as to be expected to seriously affect\n[Harris\xe2\x80\x99s] psychological well-being. A reasonable woman manager under like circumstances\nwould have been offended by Hardy, but his conduct would not have risen to the level of\ninterfering with that person\xe2\x80\x99s work performance.\n\xe2\x80\x9cNeither do I believe that [Harris] was subjectively so offended that she suffered\ninjury.\xe2\x80\xa6Although Hardy may at times have genuinely offended [Harris], I do not believe that he\ncreated a working environment so poisoned as to be intimidating or abusive to [Harris].\xe2\x80\x9d\nIn focusing on the employee\xe2\x80\x99s psychological well-being, the District Court was following Circuit\nprecedent. See Rabidue v. Osceola Refining Co., 805 F.2d 611, 620 (CA6 1986), cert. denied, 481\nU.S. 1041, 95 L. Ed. 2d 823, 107 S. Ct. 1983 (1987). The United States Court of Appeals for the\nSixth Circuit affirmed in a brief unpublished decision\xe2\x80\xa6reported at 976 F.2d 733 (1992).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n30\n\n\x0cWe granted certiorari, 507 U.S. 959 (1993), to resolve a conflict among the Circuits on whether\nconduct, to be actionable as \xe2\x80\x9cabusive work environment\xe2\x80\x9d harassment (no quid pro quo\nharassment issue is present here), must \xe2\x80\x9cseriously affect [an employee\xe2\x80\x99s] psychological wellbeing\xe2\x80\x9d or lead the plaintiff to \xe2\x80\x9csuffer injury.\xe2\x80\x9d Compare Rabidue (requiring serious effect on\npsychological well-being); Vance v. Southern Bell Telephone & Telegraph Co., 863 F.2d 1503,\n1510 (CA11 1989) (same); and Downes v. FAA, 775 F.2d 288, 292 (CA Fed. 1985) (same), with\nEllison v. Brady, 924 F.2d 872, 877\xe2\x80\x93878 (CA9 1991) (rejecting such a requirement).\nII\nTitle VII of the Civil Rights Act of 1964 makes it \xe2\x80\x9can unlawful employment practice for an\nemployer\xe2\x80\xa6to discriminate against any individual with respect to his compensation, terms,\nconditions, or privileges of employment, because of such individual\xe2\x80\x99s race, color, religion, sex, or\nnational origin.\xe2\x80\x9d 42 U.S.C. \xc2\xa7 2000e-2(a)(1). As we made clear in Meritor Savings Bank, FSB v.\nVinson, 477 U.S. 57 (1986), this language \xe2\x80\x9cis not limited to \xe2\x80\x98economic\xe2\x80\x99 or \xe2\x80\x98tangible\xe2\x80\x99\ndiscrimination. The phrase \xe2\x80\x98terms, conditions, or privileges of employment\xe2\x80\x99 evinces a\ncongressional intent \xe2\x80\x98to strike at the entire spectrum of disparate treatment of men and women\xe2\x80\x99\nin employment,\xe2\x80\x9d which includes requiring people to work in a discriminatorily hostile or abusive\nenvironment. Id., at 64, quoting Los Angeles Dept. of Water and Power v. Manhart, 435 U.S.\n702, 707, n.13, 55 L. Ed. 2d 657, 98 S. Ct. 1370 (1978). When the workplace is permeated with\n\xe2\x80\x9cdiscriminatory intimidation, ridicule, and insult,\xe2\x80\x9d 477 U.S. at 65, that is \xe2\x80\x9csufficiently severe or\npervasive to alter the conditions of the victim\xe2\x80\x99s employment and create an abusive working\nenvironment,\xe2\x80\x9d Title VII is violated.\nThis standard, which we reaffirm today, takes a middle path between making actionable any\nconduct that is merely offensive and requiring the conduct to cause a tangible psychological\ninjury. As we pointed out in Meritor, \xe2\x80\x9cmere utterance of an\xe2\x80\xa6epithet which engenders offensive\nfeelings in an employee,\xe2\x80\x9d does not sufficiently affect the conditions of employment to implicate\nTitle VII. Conduct that is not severe or pervasive enough to create an objectively hostile or\nabusive work environment\xe2\x80\x94an environment that a reasonable person would find hostile or\nabusive\xe2\x80\x94is beyond Title VII\xe2\x80\x99s purview. Likewise, if the victim does not subjectively perceive the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n31\n\n\x0cenvironment to be abusive, the conduct has not actually altered the conditions of the victim\xe2\x80\x99s\nemployment, and there is no Title VII violation.\nBut Title VII comes into play before the harassing conduct leads to a nervous breakdown. A\ndiscriminatorily abusive work environment, even one that does not seriously affect employees\xe2\x80\x99\npsychological well-being, can and often will detract from employees\xe2\x80\x99 job performance,\ndiscourage employees from remaining on the job, or keep them from advancing in their careers.\nMoreover, even without regard to these tangible effects, the very fact that the discriminatory\nconduct was so severe or pervasive that it created a work environment abusive to employees\nbecause of their race, gender, religion, or national origin offends Title VII\xe2\x80\x99s broad rule of\nworkplace equality. The appalling conduct alleged in Meritor, and the reference in that case to\nenvironments \xe2\x80\x9c\xe2\x80\x98so heavily polluted with discrimination as to destroy completely the emotional\nand psychological stability of minority group workers,\xe2\x80\x99\xe2\x80\x9d Id., at 66, quoting Rogers v. EEOC, 454\nF.2d 234, 238 (CA5 1971), cert. denied, 406 U.S. 957,32 L. Ed. 2d 343, 92 S. Ct. 2058 (1972),\nmerely present some especially egregious examples of harassment. They do not mark the\nboundary of what is actionable.\nWe therefore believe the District Court erred in relying on whether the conduct \xe2\x80\x9cseriously\naffected plaintiff\xe2\x80\x99s psychological well-being\xe2\x80\x9d or led her to \xe2\x80\x9csuffer injury.\xe2\x80\x9d Such an inquiry may\nneedlessly focus the fact finder\xe2\x80\x99s attention on concrete psychological harm, an element Title VII\ndoes not require. Certainly Title VII bars conduct that would seriously affect a reasonable\nperson\xe2\x80\x99s psychological well-being, but the statute is not limited to such conduct. So long as the\nenvironment would reasonably be perceived, and is perceived, as hostile or abusive, Meritor,\nsupra, at 67, there is no need for it also to be psychologically injurious.\nThis is not, and by its nature cannot be, a mathematically precise test. We need not answer\ntoday all the potential questions it raises, nor specifically address the Equal Employment\nOpportunity Commission\xe2\x80\x99s new regulations on this subject, see 58 Fed. Reg. 51266 (1993)\n(proposed 29 CFR \xc2\xa7\xc2\xa7 1609.1, 1609.2); see also 29 CFR \xc2\xa7 1604.11 (1993). But we can say that\nwhether an environment is \xe2\x80\x9chostile\xe2\x80\x9d or \xe2\x80\x9cabusive\xe2\x80\x9d can be determined only by looking at all the\ncircumstances. These may include the frequency of the discriminatory conduct; its severity;\nwhether it is physically threatening or humiliating, or a mere offensive utterance; and whether it\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n32\n\n\x0cunreasonably interferes with an employee\xe2\x80\x99s work performance. The effect on the employee\xe2\x80\x99s\npsychological well-being is, of course, relevant to determining whether the plaintiff actually\nfound the environment abusive. But while psychological harm, like any other relevant factor,\nmay be taken into account, no single factor is required.\nIII\nForklift, while conceding that a requirement that the conduct seriously affect psychological wellbeing is unfounded, argues that the District Court nonetheless correctly applied the Meritor\nstandard. We disagree. Though the District Court did conclude that the work environment was\nnot \xe2\x80\x9cintimidating or abusive to [Harris],\xe2\x80\x9d it did so only after finding that the conduct was not \xe2\x80\x9cso\nsevere as to be expected to seriously affect plaintiff\xe2\x80\x99s psychological well-being,\xe2\x80\x9d and that Harris\nwas not \xe2\x80\x9csubjectively so offended that she suffered injury,\xe2\x80\x9d ibid. The District Court\xe2\x80\x99s application\nof these incorrect standards may well have influenced its ultimate conclusion, especially given\nthat the court found this to be a \xe2\x80\x9cclose case.\xe2\x80\x9d\nWe therefore reverse the judgment of the Court of Appeals, and remand the case for further\nproceedings consistent with this opinion.\nSo ordered.\nNote to Students\nThis was only the second time that the Supreme Court had decided a sexual harassment case.\nMany feminist legal studies scholars feared that the court would raise the bar and make hostileworking-environment claims under Title VII more difficult to win. That did not happen. When\nthe question to be decided is combined with the court\xe2\x80\x99s decision, we get the holding of the case.\nHere, the question that the court poses, plus its answer, yields a holding that \xe2\x80\x9cAn employee need\nnot prove severe psychological injury in order to win a Title VII sexual harassment claim.\xe2\x80\x9d This\nholding will be true until such time as the court revisits a similar question and answers it\ndifferently. This does happen, but happens rarely.\n\nCASE QUESTIONS\n\n1. Is this a criminal case or a civil-law case? How can you tell?\n2. Is the court concerned with making a procedural rule here, or is the court making a\nstatement about the substantive law?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n33\n\n\x0c3. Is this a case where the court is interpreting the Constitution, a federal statute, a state\nstatute, or the common law?\n4. In Harris v. Forklift, what if the trial judge does not personally agree that women should have\nany rights to equal treatment in the workplace? Why shouldn\xe2\x80\x99t that judge dismiss the case\neven before trial? Or should the judge dismiss the case after giving the female plaintiff her\nday in court?\n5. What was the employer\xe2\x80\x99s argument in this case? Do you agree or disagree with it? What if\nthose who legislated Title VII gave no thought to the question of seriousness of injury at all?\n\n1.7 Summary and Exercises\nSummary\n\nThere are differing conceptions of what law is and of what law should be. Laws and legal systems\ndiffer worldwide. The legal system in the United States is founded on the US Constitution, which\nis itself inspired by natural-law theory and the idea that people have rights that cannot be taken\nby government but only protected by government. The various functions of the law are done well\nor poorly depending on which nation-state you look at. Some do very well in terms of keeping\norder, while others do a better job of allowing civil and political freedoms. Social and political\nmovements within each nation greatly affect the nature and quality of the legal system within\nthat nation.\nThis chapter has familiarized you with a few of the basic schools of legal thought, such as natural\nlaw, positive law, legal realism, and critical legal studies. It has also given you a brief background\nin common law, including contracts, torts, and criminal law. The differences between civil and\ncriminal cases, substance and procedure, and the various sources of law have also been\nreviewed. Each source has a different level of authority, starting with constitutions, which are\nprimary and will negate any lower-court laws that are not consistent with its principles and\nprovisions. The basic differences between the common law and civil law (continental, or\nEuropean) systems of law are also discussed.\n\nEXERCISES\n\n1. What is the common law? Where do the courts get the authority to interpret it and to\nchange it?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n34\n\n\x0c2. After World War II ended in 1945, there was an international tribunal at Nuremberg that\nprosecuted various officials in Germany\xe2\x80\x99s Third Reich who had committed \xe2\x80\x9ccrimes against\nhumanity.\xe2\x80\x9d Many of them claim that they were simply \xe2\x80\x9cfollowing orders\xe2\x80\x9d of Adolf Hitler and\nhis chief lieutenants. What law, if any, have they violated?\n3. What does stare decisis mean, and why is it so basic to common-law legal tradition?\n4. In the following situations, which source of law takes priority, and why?\na.\n\nThe state statute conflicts with the common law of that state.\n\nb. A federal statute conflicts with the US Constitution.\nc. A common-law decision in one state conflicts with the US Constitution.\nd. A federal statute conflicts with a state constitution.\n\nSELF-TEST QUESTIONS\n\n1. The source of law that is foundational in the US legal system is\na.\n\nthe common law\n\nb. statutory law\nc. constitutional law\nd. administrative law\n\xe2\x80\x9cLaw is the command of a sovereign\xe2\x80\x9d represents what school of legal\nthought?\na.\n\ncivil law\n\nb. constitutional law\nc. natural law\nd. ecofeminist law\ne. positive law\nWhich of the following kinds of law are most often found in state law rather\nthan federal law?\na.\n\ntorts and contracts\n\nb. bankruptcy\nc. maritime law\nd. international law\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n35\n\n\x0cWhere was natural law discovered?\na.\n\nin nature\n\nb. in constitutions and statutes\nc. in the exercise of human reason\nd. in the Wall Street Journal\nWolfe is a state court judge in California. In the case of Riddick v. Clouse,\nwhich involves a contract dispute, Wolfe must follow precedent. She establishes a\nlogical relationship between the Riddick case and a case decided by the California\nSupreme Court, Zhu v. Patel Enterprises, Inc.She compares the facts of Riddick to\nthe facts in Zhu and to the extent the facts are similar, applies the same rule to\nreach her decision. This is\na.\n\ndeductive reasoning\n\nb. faulty reasoning\nc. linear reasoning\nd. reasoning by analogy\nMoore is a state court judge in Colorado. In the case of Cassidy v. Seawell,\nalso a contract dispute, there is no Colorado Supreme Court or court of appeals\ndecision that sets forth a rule that could be applied. However, the California case\nof Zhu v. Patel Enterprises, Inc. is \xe2\x80\x9cvery close\xe2\x80\x9d on the facts and sets forth a rule of\nlaw that could be applied to the Cassidy case. What process must Moore follow in\nconsidering whether to use the Zhu case as precedent?\na.\n\nMoore is free to decide the case any way he wants, but he may not look at\n\ndecisions and reasons in similar cases from other states.\nb. Moore must wait for the Colorado legislature and the governor to pass a law that\naddresses the issues raised in the Cassidy case.\nc. Moore must follow the California case if that is the best precedent.\nd. Moore may follow the California case if he believes that it offers the best\nreasoning for a similar case.\n\nSaylor URL: http://www.saylor.org/books\n\nSELF-TEST ANSWERS\nSaylor.org\n36\n\n\x0c1. c\n2. e\n3. a\n4. c\n5. d\n6. d\n\nChapter 2\nCorporate Social Responsibility and Business Ethics\nA great society is a society in which [leaders] of business think greatly about their functions.\nAlfred North Whitehead\n\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should be able to do the following:\n1. Define ethics and explain the importance of good ethics for business people and business\norganizations.\n2. Understand the principal philosophies of ethics, including utilitarianism, duty-based ethics,\nand virtue ethics.\n3. Distinguish between the ethical merits of various choices by using an ethical decision model.\n4. Explain the difference between shareholder and stakeholder models of ethical corporate\ngovernance.\n5. Explain why it is difficult to establish and maintain an ethical corporate culture in a business\norganization.\nFew subjects are more contentious or important as the role of business in society, particularly,\nwhether corporations have social responsibilities that are distinct from maximizing shareholder\nvalue. While the phrase \xe2\x80\x9cbusiness ethics\xe2\x80\x9d is not oxymoronic (i.e., a contradiction in terms), there\nis plenty of evidence that businesspeople and firms seek to look out primarily for themselves.\nHowever, business organizations ignore the ethical and social expectations of consumers,\nemployees, the media, nongovernment organizations (NGOs), government officials, and socially\nresponsible investors at their peril. Legal compliance alone no longer serves the long-term\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n37\n\n\x0cinterests of many companies, who find that sustainable profitability requires thinking about\npeople and the planet as well as profits.\nThis chapter has a fairly modest aim: to introduce potential businesspeople to the differences\nbetween legal compliance and ethical excellence by reviewing some of the philosophical\nperspectives that apply to business, businesspeople, and the role of business organizations in\nsociety.\n\n2.1 What Is Ethics?\n\nLEARNING OBJECTIVES\n\n1. Explain how both individuals and institutions can be viewed as ethical or unethical.\n2. Explain how law and ethics are different, and why a good reputation can be more important\nthan legal compliance.\nMost of those who write about ethics do not make a clear distinction between ethics and\nmorality. The question of what is \xe2\x80\x9cright\xe2\x80\x9d or \xe2\x80\x9cmorally correct\xe2\x80\x9d or \xe2\x80\x9cethically correct\xe2\x80\x9d or \xe2\x80\x9cmorally\ndesirable\xe2\x80\x9d in any situation is variously phrased, but all of the words and phrases are after the\nsame thing: what act is \xe2\x80\x9cbetter\xe2\x80\x9d in a moral or ethical sense than some other act? People\nsometimes speak of morality as something personal but view ethics as having wider social\nimplications. Others see morality as the subject of a field of study, that field being ethics. Ethics\nwould be morality as applied to any number of subjects, including journalistic ethics, business\nethics, or the ethics of professionals such as doctors, attorneys, and accountants. We will\nventure a definition of ethics, but for our purposes, ethics and morality will be used as\nequivalent terms.\nPeople often speak about the ethics or morality of individuals and also about the morality or\nethics of corporations and nations. There are clearly differences in the kind of moral\nresponsibility that we can fairly ascribe to corporations and nations; we tend to see individuals\nas having a soul, or at least a conscience, but there is no general agreement that nations or\ncorporations have either. Still, our ordinary use of language does point to something significant:\nif we say that some nations are \xe2\x80\x9cevil\xe2\x80\x9d and others are \xe2\x80\x9ccorrupt,\xe2\x80\x9d then we make moral judgments\nabout the quality of actions undertaken by the governments or people of that nation. For\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n38\n\n\x0cexample, if North Korea is characterized by the US president as part of an \xe2\x80\x9caxis of evil,\xe2\x80\x9d or if we\nconclude that WorldCom or Enron acted \xe2\x80\x9cunethically\xe2\x80\x9d in certain respects, then we are making\njudgments that their collective actions are morally deficient.\nIn talking about morality, we often use the word good; but that word can be confusing. If we say\nthat Microsoft is a \xe2\x80\x9cgood company,\xe2\x80\x9d we may be making a statement about the investment\npotential of Microsoft stock, or their preeminence in the market, or their ability to win lawsuits\nor appeals or to influence administrative agencies. Less likely, though possibly, we may be\nmaking a statement about the civic virtue and corporate social responsibility of Microsoft. In the\nfirst set of judgments, we use the word goodbut mean something other than ethical or moral;\nonly in the second instance are we using the word good in its ethical or moral sense.\nA word such as good can embrace ethical or moral values but also nonethical values. If I like\nDaniel and try to convince you what a \xe2\x80\x9cgood guy\xe2\x80\x9d he is, you may ask all sorts of questions: Is he\ngood-looking? Well-off? Fun to be with? Humorous? Athletic? Smart? I could answer all of\nthose questions with a yes, yet you would still not know any of his moral qualities. But if I said\nthat he was honest, caring, forthright, and diligent, volunteered in local soup kitchens, or tithed\nto the church, many people would see Daniel as having certain ethical or moral qualities. If I\nsaid that he keeps the Golden Rule as well as anyone I know, you could conclude that he is an\nethical person. But if I said that he is \xe2\x80\x9calways in control\xe2\x80\x9d or \xe2\x80\x9calways at the top of his game,\xe2\x80\x9d you\nwould probably not make inferences or assumptions about his character or ethics.\nThere are three key points here:\n1. Although morals and ethics are not precisely measurable, people generally have similar\nreactions about what actions or conduct can rightly be called ethical or moral.\n2. As humans, we need and value ethical people and want to be around them.\n3. Saying that someone or some organization is law-abiding does not mean the same as saying a\nperson or company is ethical.\nHere is a cautionary note: for individuals, it is far from easy to recognize an ethical problem,\nhave a clear and usable decision-making process to deal it, and then have the moral courage to\ndo what\xe2\x80\x99s right. All of that is even more difficult within a business organization, where corporate\nemployees vary in their motivations, loyalties, commitments, and character. There is no\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n39\n\n\x0cuniversally accepted way for developing an organization where employees feel valued, respected,\nand free to openly disagree; where the actions of top management are crystal clear; and where\nall the employees feel loyal and accountable to one another.\nBefore talking about how ethics relates to law, we can conclude that ethics is the study of\nmorality\xe2\x80\x94\xe2\x80\x9cright\xe2\x80\x9d and \xe2\x80\x9cwrong\xe2\x80\x9d\xe2\x80\x94in the context of everyday life, organizational behaviors, and\neven how society operates and is governed.\n\nHow Do Law and Ethics Differ?\nThere is a difference between legal compliance and moral excellence. Few would choose a\nprofessional service, health care or otherwise, because the provider had a record of perfect legal\ncompliance, or always following the letter of the law. There are many professional ethics codes,\nprimarily because people realize that law prescribes only a minimum of morality and does not\nprovide purpose or goals that can mean excellent service to customers, clients, or patients.\nBusiness ethicists have talked for years about the intersection of law and ethics. Simply put,\nwhat is legal is not necessarily ethical. Conversely, what is ethical is not necessarily legal. There\nare lots of legal maneuvers that are not all that ethical; the well-used phrase \xe2\x80\x9clegal loophole\xe2\x80\x9d\nsuggests as much.\nHere are two propositions about business and ethics. Consider whether they strike you as true or\nwhether you would need to know more in order to make a judgment.\n\xe2\x80\xa2\n\nIndividuals and organizations have reputations. (For an individual, moral reputation is most\noften tied to others\xe2\x80\x99 perceptions of his or her character: is the individual honest, diligent,\nreliable, fair, and caring? The reputation of an organization is built on the goodwill that\nsuppliers, customers, the community, and employees feel toward it. Although an organization is\nnot a person in the usual sense, the goodwill that people feel about the organization is based on\ntheir perception of its better qualities by a variety of stakeholders: customers or clients,\nsuppliers, investors, employees, government officials).\n\n\xe2\x80\xa2\n\nThe goodwill of an organization is to a great extent based on the actions it takes and on whether\nthe actions are favorably viewed. (This goodwill is usually specifically counted in the sale of a\nbusiness as an asset that the buyer pays for. While it is difficult to place a monetary value on\ngoodwill, a firm\xe2\x80\x99s good reputation will generally call for a higher evaluation in the final\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n40\n\n\x0caccounting before the sale. Legal troubles or a reputation for having legal troubles will only\nlessen the price for a business and will even lessen the value of the company\xe2\x80\x99s stock as bad legal\nnews comes to the public\xe2\x80\x99s attention.)\nAnother reason to think about ethics in connection with law is that the laws themselves are\nmeant to express some moral view. If there are legal prohibitions against cheating the Medicare\nprogram, it is because people (legislators or their agents) have collectively decided that cheating\nMedicare is wrong. If there are legal prohibitions against assisting someone to commit suicide, it\nis because there has been a group decision that doing so is immoral. Thus the law provides some\nimportant cues as to what society regards as right or wrong.\nFinally, important policy issues that face society are often resolved through law, but it is\nimportant to understand the moral perspectives that underlie public debate\xe2\x80\x94as, for example, in\nthe continuing controversies over stem-cell research, medical use of marijuana, and abortion.\nSome ethical perspectives focus on rights, some on social utility, some on virtue or character,\nand some on social justice. People consciously (or, more often, unconsciously) adopt one or\nmore of these perspectives, and even if they completely agree on the facts with an opponent,\nthey will not change their views. Fundamentally, the difference comes down to incompatible\nmoral perspectives, a clash of basic values. These are hot-button issues because society is\ndivided, not so much over facts, but over basic values. Understanding the varied moral\nperspectives and values in public policy debates is a clarifying benefit in following or\nparticipating in these important discussions.\n\nWhy Should an Individual or a Business Entity Be Ethical?\nThe usual answer is that good ethics is good business. In the long run, businesses that pay\nattention to ethics as well as law do better; they are viewed more favorably by customers. But\nthis is a difficult claim to measure scientifically, because \xe2\x80\x9cthe long run\xe2\x80\x9d is an indistinct period of\ntime and because there are as yet no generally accepted criteria by which ethical excellence can\nbe measured. In addition, life is still lived in the short run, and there are many occasions when\nsomething short of perfect conduct is a lot more profitable.\nSome years ago, Royal Dutch/Shell (one of the world\xe2\x80\x99s largest companies) found that it was in\ndeep trouble with the public for its apparent carelessness with the environment and human\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n41\n\n\x0crights. Consumers were boycotting and investors were getting frightened, so the company took a\nlong, hard look at its ethic of short-term profit maximization. Since then, changes have been\nmade. The CEO told one group of business ethicists that the uproar had taken them by surprise;\nthey thought they had done everything right, but it seemed there was a \xe2\x80\x9cghost in the machine.\xe2\x80\x9d\nThat ghost was consumers, NGOs, and the media, all of whom objected to the company\xe2\x80\x99s\nseeming lack of moral sensitivity.\nThe market does respond to unethical behavior. In Section 2.4 "Corporations and Corporate\nGovernance", you will read about the Sears Auto Centers case. The loss of goodwill toward Sears\nAuto Centers was real, even though the total amount of money lost cannot be clearly accounted\nfor. Years later, there are people who will not go near a Sears Auto Center; the customers who\nlost trust in the company will never return, and many of their children may avoid Sears Auto\nCenters as well.\nThe Arthur Andersen story is even more dramatic. A major accounting firm, Andersen worked\nclosely with Enron in hiding its various losses through creative accounting measures.\nSuspiciously, Andersen\xe2\x80\x99s Houston office also did some shredding around the clock, appearing to\ncover up what it was doing for Enron. A criminal case based on this shredding resulted in a\nconviction, later overturned by the Supreme Court. But it was too late. Even before the\nconviction, many clients had found other accounting firms that were not under suspicion, and\nthe Supreme Court\xe2\x80\x99s reversal came too late to save the company. Even without the conviction,\nAndersen would have lost significant market share.\nThe irony of Andersen as a poster child for overly aggressive accounting practices is that the\nman who founded the firm built it on integrity and straightforward practices. \xe2\x80\x9cThink straight,\ntalk straight\xe2\x80\x9d was the company\xe2\x80\x99s motto. Andersen established the company\xe2\x80\x99s reputation for\nintegrity over a hundred years ago by refusing to play numbers games for a potentially lucrative\nclient.\nMaximizing profits while being legally compliant is not a very inspiring goal for a business.\nPeople in an organization need some quality or excellence to strive for. By focusing on pushing\nthe edge of what is legal, by looking for loopholes in the law that would help create short-term\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n42\n\n\x0cfinancial gain, companies have often learned that in the long term they are not actually\nsatisfying the market, the shareholders, the suppliers, or the community generally.\n\nKEY TAKEAWAY\n\nLegal compliance is not the same as acting ethically. Your reputation, individually or\ncorporately, depends on how others regard your actions. Goodwill is hard to measure or\nquantify, but it is real nonetheless and can best be protected by acting ethically.\n\nEXERCISES\n\n1. Think of a person who did something morally wrong, at least to your way of thinking. What\nwas it? Explain to a friend of yours\xe2\x80\x94or a classmate\xe2\x80\x94why you think it was wrong. Does your\nfriend agree? Why or why not? What is the basic principle that forms the basis for your\njudgment that it was wrong?\n2. Think of a person who did something morally right, at least to your way of thinking. (This is\nnot a matter of finding something they did well, like efficiently changing a tire, but something\ngood.) What was it? Explain to a friend of yours\xe2\x80\x94or a classmate\xe2\x80\x94why you think it was right.\nDoes your friend agree? Why or why not? What is the basic principle that forms the basis for\nyour judgment that it was right?\n3. Think of an action by a business organization (sole proprietor, partnership, or corporation)\nthat was legal but still strikes you as wrong. What was it? Why do you think it was wrong?\n4. Think of an act by an individual or a corporation that is ethical but not legal. Compare your\nanswer with those of your classmates: were you more likely to find an example from\nindividual action or corporate action? Do you have any thoughts as to why?\n\n2.2 Major Ethical Perspectives\n\nLEARNING OBJECTIVES\n\n1. Describe the various major theories about ethics in human decision making.\n2. Begin considering how the major theories about ethics apply to difficult choices in life and\nbusiness.\nThere are several well-respected ways of looking at ethical issues. Some of them have been\naround for centuries. It is important to know that many who think a lot about business and\nethics have deeply held beliefs about which perspective is best. Others would recommend\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n43\n\n\x0cconsidering ethical problems from a variety of different perspectives. Here, we take a brief look\nat (1) utilitarianism, (2) deontology, (3) social justice and social contract theory, and (4) virtue\ntheory. We are leaving out some important perspectives, such as general theories of justice and\n\xe2\x80\x9crights\xe2\x80\x9d and feminist thought about ethics and patriarchy.\n\nUtilitarianism\nUtilitarianism is a prominent perspective on ethics, one that is well aligned with economics and\nthe free-market outlook that has come to dominate much current thinking about business,\nmanagement, and economics. Jeremy Bentham is often considered the founder of utilitarianism,\nthough John Stuart Mill (who wrote On Liberty and Utilitarianism) and others promoted it as a\nguide to what is good. Utilitarianism emphasizes not rules but results. An action (or set of\nactions) is generally deemed good or right if it maximizes happiness or pleasure throughout\nsociety. Originally intended as a guide for legislators charged with seeking the greatest good for\nsociety, the utilitarian outlook may also be practiced individually and by corporations.\nBentham believed that the most promising way to obtain agreement on the best policies for a\nsociety would be to look at the various policies a legislature could pass and compare the good\nand bad consequences of each. The right course of action from an ethical point of view would be\nto choose the policy that would produce the greatest amount of utility, or usefulness. In brief,\nthe utilitarian principle holds that an action is right if and only if the sum of utilities produced\nby that action is greater than the sum of utilities from any other possible act.\nThis statement describes \xe2\x80\x9cact utilitarianism\xe2\x80\x9d\xe2\x80\x94which action among various options will deliver\nthe greatest good to society? \xe2\x80\x9cRule utilitarianism\xe2\x80\x9d is a slightly different version; it asks, what\nrule or principle, if followed regularly, will create the greatest good?\nNotice that the emphasis is on finding the best possible results and that the assumption is that\nwe can measure the utilities involved. (This turns out to be more difficult that you might think.)\nNotice also that \xe2\x80\x9cthe sum total of utilities\xe2\x80\x9d clearly implies that in doing utilitarian analysis, we\ncannot be satisfied if an act or set of acts provides the greatest utility to us as individuals or to a\nparticular corporation; the test is, instead, whether it provides the greatest utility to society as a\nwhole. Notice that the theory does not tell us what kinds of utilities may be better than others or\nhow much better a good today is compared with a good a year from today.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n44\n\n\x0cWhatever its difficulties, utilitarian thinking is alive and well in US law and business. It is found\nin such diverse places as cost-benefit analysis in administrative and regulatory rules and\ncalculations, environmental impact studies, the majority vote, product comparisons for\nconsumer information, marketing studies, tax laws, and strategic planning. In management,\npeople will often employ a form of utility reasoning by projecting costs and benefits for plan X\nversus plan Y. But the issue in most of these cost-benefit analyses is usually (1) put exclusively in\nterms of money and (2) directed to the benefit of the person or organization doing the analysis\nand not to the benefit of society as a whole.\nAn individual or a company that consistently uses the test \xe2\x80\x9cWhat\xe2\x80\x99s the greatest good for me or\nthe company?\xe2\x80\x9d is not following the utilitarian test of the greatest good overall. Another common\nfailing is to see only one or two options that seem reasonable. The following are some frequent\nmistakes that people make in applying what they think are utilitarian principles in justifying\ntheir chosen course of action:\n1. Failing to come up with lots of options that seem reasonable and then choosing the one that has\nthe greatest benefit for the greatest number. Often, a decision maker seizes on one or two\nalternatives without thinking carefully about other courses of action. If the alternative does\nmore good than harm, the decision maker assumes it\xe2\x80\x99s ethically okay.\n2. Assuming that the greatest good for you or your company is in fact the greatest good for all\xe2\x80\x94that\nis, looking at situations subjectively or with your own interests primarily in mind.\n3. Underestimating the costs of a certain decision to you or your company. The now-classic Ford\nPinto case demonstrates how Ford Motor Company executives drastically underestimated the\nlegal costs of not correcting a feature on their Pinto models that they knew could cause death or\ninjury. General Motors was often taken to task by juries that came to understand that the\ncompany would not recall or repair known and dangerous defects because it seemed more\nprofitable not to. In 2010, Toyota learned the same lesson.\n4. Underestimating the cost or harm of a certain decision to someone else or some other group of\npeople.\n5. Favoring short-term benefits, even though the long-term costs are greater.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n45\n\n\x0c6. Assuming that all values can be reduced to money. In comparing the risks to human health or\nsafety against, say, the risks of job or profit losses, cost-benefit analyses will often try to compare\napples to oranges and put arbitrary numerical values on human health and safety.\n\nRules and Duty: Deontology\nIn contrast to the utilitarian perspective, the deontological view presented in the writings of\nImmanuel Kant purports that having a moral intent and following the right rules is a better path\nto ethical conduct than achieving the right results. A deontologist like Kant is likely to believe\nthat ethical action arises from doing one\xe2\x80\x99s duty and that duties are defined by rational thought.\nDuties, according to Kant, are not specific to particular kinds of human beings but are owed\nuniversally to all human beings. Kant therefore uses \xe2\x80\x9cuniversalizing\xe2\x80\x9c as a form of rational\nthought that assumes the inherent equality of all human beings. It considers all humans as\nequal, not in the physical, social, or economic sense, but equal before God, whether they are\nmale, female, Pygmy, Eskimoan, Islamic, Christian, gay, straight, healthy, sick, young, or old.\nFor Kantian thinkers, this basic principle of equality means that we should be able to\nuniversalize any particular law or action to determine whether it is ethical. For example, if you\nwere to consider misrepresenting yourself on a resume for a particular job you really wanted and\nyou were convinced that doing so would get you that job, you might be very tempted to do so.\n(What harm would it be? you might ask yourself. When I have the job, I can prove that I was\nperfect for it, and no one is hurt, while both the employer and I are clearly better off as a result!)\nKantian ethicists would answer that your chosen course of action should be a universal one\xe2\x80\x94a\ncourse of action that would be good for all persons at all times. There are two requirements for a\nrule of action to be universal: consistency and reversibility. Consider reversibility: if you make a\ndecision as though you didn\xe2\x80\x99t know what role or position you would have after the decision, you\nwould more likely make an impartial one\xe2\x80\x94you would more likely choose a course of action that\nwould be most fair to all concerned, not just you. Again, deontologyrequires that we put duty\nfirst, act rationally, and give moral weight to the inherent equality of all human beings.\nIn considering whether to lie on your resume, reversibility requires you to actively imagine both\nthat you were the employer in this situation and that you were another well-qualified applicant\nwho lost the job because someone else padded his resume with false accomplishments. If the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n46\n\n\x0cconsequences of such an exercise of the imagination are not appealing to you, your action is\nprobably not ethical.\nThe second requirement for an action to be universal is the search for consistency. This is more\nabstract. A deontologist would say that since you know you are telling a lie, you must be willing\nto say that lying, as a general, universal phenomenon, is acceptable. But if everyone lied, then\nthere would be no point to lying, since no one would believe anyone. It is only because honesty\nworks well for society as a whole and is generally practiced that lying even becomes possible!\nThat is, lying cannot be universalized, for it depends on the preexistence of honesty.\nSimilar demonstrations can be made for actions such as polluting, breaking promises, and\ncommitting most crimes, including rape, murder, and theft. But these are the easy cases for\nKantian thinkers. In the gray areas of life as it is lived, the consistency test is often difficult to\napply. If breaking a promise would save a life, then Kantian thought becomes difficult to apply.\nIf some amount of pollution can allow employment and the harm is minimal or distant, Kantian\nthinking is not all that helpful. Finally, we should note that the well-known Golden Rule, \xe2\x80\x9cDo\nunto others as you would have them do unto you,\xe2\x80\x9d emphasizes the easier of the two\nuniversalizing requirements: practicing reversibility (\xe2\x80\x9cHow would I like it if someone did this to\nme?\xe2\x80\x9d).\n\nSocial Justice Theory and Social Contract Theory\nSocial justice theorists worry about \xe2\x80\x9cdistributive justice\xe2\x80\x9d\xe2\x80\x94that is, what is the fair way to\ndistribute goods among a group of people? Marxist thought emphasizes that members of society\nshould be given goods to according to their needs. But this redistribution would require a\ngoverning power to decide who gets what and when. Capitalist thought takes a different\napproach, rejecting any giving that is not voluntary. Certain economists, such as the late Milton\nFriedman (see the sidebar in Section 2.4 "Corporations and Corporate Governance") also reject\nthe notion that a corporation has a duty to give to unmet needs in society, believing that the\ngovernment should play that role. Even the most dedicated free-market capitalist will often\nadmit the need for some government and some forms of welfare\xe2\x80\x94Social Security, Medicare,\nassistance to flood-stricken areas, help for AIDs patients\xe2\x80\x94along with some public goods (such as\ndefense, education, highways, parks, and support of key industries affecting national security).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n47\n\n\x0cPeople who do not see the need for public goods (including laws, court systems, and the\ngovernment goods and services just cited) often question why there needs to be a government at\nall. One response might be, \xe2\x80\x9cWithout government, there would be no corporations.\xe2\x80\x9d Thomas\nHobbes believed that people in a \xe2\x80\x9cstate of nature\xe2\x80\x9d would rationally choose to have some form of\ngovernment. He called this thesocial contract, where people give up certain rights to government\nin exchange for security and common benefits. In your own lives and in this course, you will see\nan ongoing balancing act between human desires for freedom and human desires for order; it is\nan ancient tension. Some commentators also see a kind of social contract between corporations\nand society; in exchange for perpetual duration and limited liability, the corporation has some\ncorresponding duties toward society. Also, if a corporation is legally a \xe2\x80\x9cperson,\xe2\x80\x9d as the Supreme\nCourt reaffirmed in 2010, then some would argue that if this corporate person commits three\nfelonies, it should be locked up for life and its corporate charter revoked!\nModern social contract theorists, such as Thomas Donaldson and Thomas Dunfee (Ties that\nBind, 1999), observe that various communities, not just nations, make rules for the common\ngood. Your college or school is a community, and there are communities within the school\n(fraternities, sororities, the folks behind the counter at the circulation desk, the people who work\ntogether at the university radio station, the sports teams, the faculty, the students generally, the\ngay and lesbian alliance) that have rules, norms, or standards that people can buy into or not. If\nnot, they can exit from that community, just as we are free (though not without cost) to reject US\ncitizenship and take up residence in another country.\nDonaldson and Dunfee\xe2\x80\x99s integrative social contracts theory stresses the importance of studying\nthe rules of smaller communities along with the larger social contracts made in states (such as\nColorado or California) and nation-states (such as the United States or Germany). Our\nConstitution can be seen as a fundamental social contract.\nIt is important to realize that a social contract can be changed by the participants in a\ncommunity, just as the US Constitution can be amended. Social contract theory is thus\ndynamic\xe2\x80\x94it allows for structural and organic changes. Ideally, the social contract struck by\ncitizens and the government allows for certain fundamental rights such as those we enjoy in the\nUnited States, but it need not. People can give up freedom-oriented rights (such as the right of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n48\n\n\x0cfree speech or the right to be free of unreasonable searches and seizures) to secure order\n(freedom from fear, freedom from terrorism). For example, many citizens in Russia now miss\nthe days when the Kremlin was all powerful; there was less crime and more equality and\npredictability to life in the Soviet Union, even if there was less freedom.\nThus the rights that people have\xe2\x80\x94in positive law\xe2\x80\x94come from whatever social contract exists in\nthe society. This view differs from that of the deontologists and that of the natural-law thinkers\nsuch as Gandhi, Jesus, or Martin Luther King Jr., who believed that rights come from God or, in\nless religious terms, from some transcendent moral order.\nAnother important movement in ethics and society is the communitarian outlook.\nCommunitarians emphasize that rights carry with them corresponding duties; that is, there\ncannot be a right without a duty. Interested students may wish to explore the work of Amitai\nEtzioni. Etzioni was a founder of the Communitarian Network, which is a group of individuals\nwho have come together to bolster the moral, social, and political environment. It claims to be\nnonsectarian, nonpartisan, and international in scope.\nThe relationship between rights and duties\xe2\x80\x94in both law and ethics\xe2\x80\x94calls for some explanations:\n1. If you have a right of free expression, the government has a duty to respect that right but can put\nreasonable limits on it. For example, you can legally say whatever you want about the US\npresident, but you can\xe2\x80\x99t get away with threatening the president\xe2\x80\x99s life. Even if your criticisms are\nstrong and insistent, you have the right (and our government has the duty to protect your right)\nto speak freely. In Singapore during the 1990s, even indirect criticisms\xe2\x80\x94mere hints\xe2\x80\x94of the\npolitical leadership were enough to land you in jail or at least silence you with a libel suit.\n2. Rights and duties exist not only between people and their governments but also between\nindividuals. Your right to be free from physical assault is protected by the law in most states, and\nwhen someone walks up to you and punches you in the nose, your rights\xe2\x80\x94as set forth in the\npositive law of your state\xe2\x80\x94have been violated. Thus other people have a duty to respect your\nrights and to not punch you in the nose.\n3. Your right in legal terms is only as good as your society\xe2\x80\x99s willingness to provide legal remedies\nthrough the courts and political institutions of society.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n49\n\n\x0cA distinction between basic rights and nonbasic rights may also be important. Basic rights may\ninclude such fundamental elements as food, water, shelter, and physical safety. Another\ndistinction is between positive rights (the right to bear arms, the right to vote, the right of\nprivacy) and negative rights (the right to be free from unreasonable searches and seizures, the\nright to be free of cruel or unusual punishments). Yet another is between economic or social\nrights (adequate food, work, and environment) and political or civic rights (the right to vote, the\nright to equal protection of the laws, the right to due process).\n\nAristotle and Virtue Theory\nVirtue theory, or virtue ethics, has received increasing attention over the past twenty years,\nparticularly in contrast to utilitarian and deontological approaches to ethics. Virtue theory\nemphasizes the value of virtuous qualities rather than formal rules or useful results. Aristotle is\noften recognized as the first philosopher to advocate the ethical value of certain qualities, or\nvirtues, in a person\xe2\x80\x99s character. As LaRue Hosmer has noted, Aristotle saw the goal of human\nexistence as the active, rational search for excellence, and excellence requires the personal\nvirtues of honesty, truthfulness, courage, temperance, generosity, and high-mindedness. This\npursuit is also termed \xe2\x80\x9cknowledge of the good\xe2\x80\x9d in Greek philosophy. [1]\nAristotle believed that all activity was aimed at some goal or perceived good and that there must\nbe some ranking that we do among those goals or goods. Happiness may be our ultimate goal,\nbut what does that mean, exactly? Aristotle rejected wealth, pleasure, and fame and embraced\nreason as the distinguishing feature of humans, as opposed to other species. And since a human\nis a reasoning animal, happiness must be associated with reason. Thus happiness is living\naccording to the active (rather than passive) use of reason. The use of reason leads to excellence,\nand so happiness can be defined as the active, rational pursuit of personal excellence, or virtue.\nAristotle named fourteen virtues: (1) courage, particularly in battle; (2) temperance, or\nmoderation in eating and drinking; (3) liberality, or spending money well; (4) magnificence, or\nliving well; (5) pride, or taking pleasure in accomplishments and stature; (6) high-mindedness,\nor concern with the noble rather than the petty; (7) unnamed virtue, which is halfway between\nambition and total lack of effort; (8) gentleness, or concern for others; (9) truthfulness; (10) wit,\nor pleasure in group discussions; (11) friendliness, or pleasure in personal conduct; (12)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n50\n\n\x0cmodesty, or pleasure in personal conduct; (13) righteous indignation, or getting angry at the\nright things and in the right amounts; and (14) justice.\nFrom a modern perspective, some of these virtues seem old-fashioned or even odd.\nMagnificence, for example, is not something we commonly speak of. Three issues emerge: (1)\nHow do we know what a virtue is these days? (2) How useful is a list of agreed-upon virtues\nanyway? (3) What do virtues have to do with companies, particularly large ones where various\ngroups and individuals may have little or no contact with other parts of the organization?\nAs to the third question, whether corporations can \xe2\x80\x9chave\xe2\x80\x9d virtues or values is a matter of lively\ndebate. A corporation is obviously not the same as an individual. But there seems to be growing\nagreement that organizations do differ in their practices and that these practices are value\ndriven. If all a company cares about is the bottom line, other values will diminish or disappear.\nQuite a few books have been written in the past twenty years that emphasize the need for\nbusinesses to define their values in order to be competitive in today\xe2\x80\x99s global economy. [2]\nAs to the first two questions regarding virtues, a look at Michael Josephson\xe2\x80\x99s core values may\nprove helpful.\n\nJosephson\xe2\x80\x99s Core Values Analysis and Decision Process\nMichael Josephson, a noted American ethicist, believes that a current set of core valueshas been\nidentified and that the values can be meaningfully applied to a variety of personal and corporate\ndecisions.\nTo simplify, let\xe2\x80\x99s say that there are ethical and nonethical qualities among people in the United\nStates. When you ask people what kinds of qualities they admire in others or in themselves, they\nmay say wealth, power, fitness, sense of humor, good looks, intelligence, musical ability, or some\nother quality. They may also value honesty, caring, fairness, courage, perseverance, diligence,\ntrustworthiness, or integrity. The qualities on the second list have something in common\xe2\x80\x94they\nare distinctively ethical characteristics. That is, they are commonly seen as moral or ethical\nqualities, unlike the qualities on the first list. You can be, like the Athenian Alcibiades, brilliant\nbut unprincipled, or, like some political leaders today, powerful but dishonest, or wealthy but\nuncaring. You can, in short, have a number of admirable qualities (brilliance, power, wealth)\nthat are not per se virtuous. Just because Harold is rich or good-looking or has a good sense of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n51\n\n\x0chumor does not mean that he is ethical. But if Harold is honest and caring (whether he is rich or\npoor, humorous or humorless), people are likely to see him as ethical.\nAmong the virtues, are any especially important? Studies from the Josephson Institute of Ethics\nin Marina del Rey, California, have identified six core values in our society, values that almost\neveryone agrees are important to them. When asked what values people hold dear, what values\nthey wish to be known by, and what values they wish others would exhibit in their actions, six\nvalues consistently turn up: (1) trustworthiness, (2) respect, (3) responsibility, (4) fairness, (5)\ncaring, and (6) citizenship.\nNote that these values are distinctly ethical. While many of us may value wealth, good looks, and\nintelligence, having wealth, good looks, and intelligence does not automatically make us\nvirtuous in our character and habits. But being more trustworthy (by being honest and by\nkeeping promises) does make us more virtuous, as does staying true to the other five core\nvalues.\nNotice also that these six core values share something in common with other ethical values that\nare less universally agreed upon. Many values taught in the family or in places of worship are\nnot generally agreed on, practiced, or admired by all. Some families and individuals believe\nstrongly in the virtue of saving money or in abstaining from alcohol or sex prior to marriage.\nOthers clearly do not, or at least don\xe2\x80\x99t act on their beliefs. Moreover, it is possible to have and\npractice core ethical values even if you take on heavy debt, knock down several drinks a night, or\nhave frequent premarital sex. Some would dispute this, saying that you can\xe2\x80\x99t really lead a\nvirtuous life if you get into debt, drink heavily, or engage in premarital sex. But the point here is\nthat since people do disagree in these areas, the ethical traits of thrift, temperance, and sexual\nabstinence do not have the unanimity of approval that the six core values do.\nThe importance of an individual\xe2\x80\x99s having these consistent qualities of character is well known.\nOften we remember the last bad thing a person did far more than any or all previous good acts.\nFor example, Eliot Spitzer and Bill Clinton are more readily remembered by people for their last,\nworst acts than for any good they accomplished as public servants. As for a company, its good\nreputation also has an incalculable value that when lost takes a great deal of time and work to\nrecover. Shell, Nike, and other companies have discovered that there is a market for morality,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n52\n\n\x0chowever difficult to measure, and that not paying attention to business ethics often comes at a\nserious price. In the past fifteen years, the career of ethics and compliance officer has emerged,\npartly as a result of criminal proceedings against companies but also because major companies\nhave found that reputations cannot be recovered retroactively but must be pursued proactively.\nFor individuals, Aristotle emphasized the practice of virtue to the point where virtue becomes a\nhabit. Companies are gradually learning the same lesson.\n\nKEY TAKEAWAY\n\nThroughout history, people have pondered what it means \xe2\x80\x9cto do what is right.\xe2\x80\x9d Some of the\nmain answers have come from the differing perspectives of utilitarian thought; duty-based,\nor deontological, thought; social contract theory; and virtue ethics.\n\nEXERCISES\n\nXYZ Motor Corporation begins to get customer complaints about two models of its\nautomobiles. Customers have had near-death experiences from sudden acceleration; they\nwould be driving along a highway at normal speed when suddenly the car would begin to\naccelerate, and efforts to stop the acceleration by braking fail to work. Drivers could turn off\nthe ignition and come to a safe stop, but XYZ does not instruct buyers of its cars to do so, nor\nis this a common reaction among drivers who experience sudden acceleration.\nInternal investigations of half a dozen accidents in US locations come to the conclusion that\nthe accidents are not being caused by drivers who mistake the gas pedal for the brake pedal.\nIn fact, there appears to be a possible flaw in both models, perhaps in a semiconductor chip,\nthat makes sudden acceleration happen. Interference by floor mats and poorly designed gas\npedals do not seem to be the problem.\nIt is voluntary to report these incidents to the National Highway Traffic and Safety\nAdministration (NHTSA), but the company decides that it will wait awhile and see if there are\nmore complaints. Recalling the two models so that local dealers and their mechanics could\nexamine them is also an option, but it would be extremely costly. Company executives are\naware that quarterly and annual profit-and-loss statements, on which their bonuses depend,\ncould be decisively worse with a recall. They decide that on a cost-benefit basis, it makes\nmore sense to wait until there are more accidents and more data. After a hundred or more\naccidents and nearly fifteen fatalities, the company institutes a selective recall, still not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n53\n\n\x0cnotifying NHTSA, which has its own experts and the authority to order XYZ to do a full recall\nof all affected models.\nExperts have advised XYZ that standard failure-analysis methodology requires that the\ncompany obtain absolutely every XYZ vehicle that has experienced sudden acceleration,\nusing microscopic analysis of all critical components of the electronic system. The company\ndoes not wish to take that advice, as it would be\xe2\x80\x94as one top executive put it\xe2\x80\x94\xe2\x80\x9ctoo timeconsuming and expensive.\xe2\x80\x9d\n1. Can XYZ\xe2\x80\x99s approach to this problem be justified under utilitarian theory? If so, how? If not,\nwhy not?\n2. What would Kant advise XYZ to do? Explain.\n3. What would the \xe2\x80\x9cvirtuous\xe2\x80\x9d approach be for XYZ in this situation?\n\n[1] LaRue Tone Hosmer, Moral Leadership in Business (Chicago: Irwin Professional Publishing, 1994), 72.\n[2] James O\xe2\x80\x99Toole and Don Mayer, eds., Good Business: Exercising Effective and Ethical\nLeadership (London: Routledge, 2010).\n\n2.3 An Ethical Decision Model\n\nLEARNING OBJECTIVE\n\n1. Understand one model for ethical decision making: a process to arrive at the most ethical\noption for an individual or a business organization, using a virtue ethics approach combined\nwith some elements of stakeholder analysis and utilitarianism.\n\nJosephson\xe2\x80\x99s Core Values Model\nOnce you recognize that there is a decision that involves ethical judgment, Michael Josephson\nwould first have you ask as many questions as are necessary to get a full background on the\nrelevant facts. Then, assuming you have all the needed information, the decision process is as\nfollows:\n1. Identify the stakeholders. That is, who are the potential gainers and losers in the various\ndecisions that might be made here?\n2. Identify several likely or reasonable decisions that could be made.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n54\n\n\x0c3. Consider which stakeholders gain or lose with each decision.\n4. Determine which decision satisfies the greatest number of core values.\n5. If there is no decision that satisfies the greatest number of core values, try to determine which\ndecision delivers the greatest good to the various stakeholders.\nIt is often helpful to identify who (or what group) is the most important stakeholder, and why.\nIn Milton Friedman\xe2\x80\x99s view, it will always be the shareholders. In the view of John Mackey, the\nCEO of Whole Foods Market, the long-term viability and profitability of the organization may\nrequire that customers come first, or, at times, some other stakeholder group (see \xe2\x80\x9cConscious\nCapitalism\xe2\x80\x9d in Section 2.4 "Corporations and Corporate Governance").\n\nThe Core Values\n\nHere are the core values and their subcomponents as developed by the Josephson Institute of\nEthics.\nTrustworthiness: Be honest\xe2\x80\x94tell the truth, the whole truth, and nothing but the truth; be\nsincere, forthright; don\xe2\x80\x99t deceive, mislead, or be tricky with the truth; don\xe2\x80\x99t cheat or steal, and\ndon\xe2\x80\x99t betray a trust. Demonstrate integrity\xe2\x80\x94stand up for what you believe, walk the walk as well\nas talking the talk; be what you seem to be; show commitment and courage. Be loyal\xe2\x80\x94stand by\nyour family, friends, co-workers, community, and nation; be discreet with information that\ncomes into your hands; don\xe2\x80\x99t spread rumors or engage in harmful gossip; don\xe2\x80\x99t violate your\nprinciples just to win friendship or approval; don\xe2\x80\x99t ask a friend to do something that is\nwrong. Keep promises\xe2\x80\x94keep your word, honor your commitments, and pay your debts; return\nwhat you borrow.\nRespect: Judge people on their merits, not their appearance; be courteous, polite, appreciative,\nand accepting of differences; respect others\xe2\x80\x99 right to make decisions about their own lives; don\xe2\x80\x99t\nabuse, demean, mistreat anyone; don\xe2\x80\x99t use, manipulate, exploit, or take advantage of others.\nResponsibility: Be accountable\xe2\x80\x94think about the consequences on yourself and others likely to\nbe affected before you act; be reliable; perform your duties; take responsibility for the\nconsequences of your choices; set a good example and don\xe2\x80\x99t make excuses or take credit for\nother people\xe2\x80\x99s work. Pursue excellence: Do your best, don\xe2\x80\x99t quit easily, persevere, be diligent,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n55\n\n\x0cmake all you do worthy of pride. Exercise self-restraint\xe2\x80\x94be disciplined, know the difference\nbetween what you have a right to do and what is right to do.\nFairness: Treat all people fairly, be open-minded; listen; consider opposing viewpoints; be\nconsistent; use only appropriate considerations; don\xe2\x80\x99t let personal feelings improperly interfere\nwith decisions; don\xe2\x80\x99t take unfair advantage of mistakes; don\xe2\x80\x99t take more than your fair share.\nCaring: Show you care about others through kindness, caring, sharing, compassion, and\nempathy; treat others the way you want to be treated; don\xe2\x80\x99t be selfish, mean, cruel, or insensitive\nto others\xe2\x80\x99 feelings.\nCitizenship: Play by the rules, obey laws; do your share, respect authority, stay informed, vote,\nprotect your neighbors, pay your taxes; be charitable, help your community; protect the\nenvironment, conserve resources.\nWhen individuals and organizations confront ethical problems, the core values decision model\noffered by Josephson generally works well (1) to clarify the gains and losses of the various\nstakeholders, which then raises ethical awareness on the part of the decision maker and (2) to\nprovide a fairly reliable guide as to what the most ethical decision would be. In nine out of ten\ncases, step 5 in the decision process is not needed.\nThat said, it does not follow that students (or managers) would necessarily act in accord with the\nresults of the core values decision process. There are many psychological pressures and\norganizational constraints that place limits on people both individually and in organizations.\nThese pressures and constraints tend to compromise ideal or the most ethical solutions for\nindividuals and for organizations. For a business, one essential problem is that ethics can cost\nthe organization money or resources, at least in the short term. Doing the most ethical thing will\noften appear to be something that fails to maximize profits in the short term or that may seem\npointless because if you or your organization acts ethically, others will not, and society will be no\nbetter off, anyway.\n\nKEY TAKEAWAY\n\nHaving a step-by-step process to analyze difficult moral dilemmas is useful. One such process\nis offered here, based on the core values of trustworthiness, caring, respect, fairness,\nresponsibility, and citizenship.\n\nSaylor URL: http://www.saylor.org/books\n\nEXERCISE\nSaylor.org\n56\n\n\x0c1. Consider XYZ in the exercises for Section 2.2.5 "Josephson\xe2\x80\x99s Core Values Analysis and\nDecision Process" and use the core values decision-making model. What are XYZ\xe2\x80\x99s options\nwhen they first notice that two of their models are causing sudden acceleration incidents\nthat put their customers at risk? Who are the stakeholders? What options most clearly meet\nthe criteria for each of the core values?\n\n2.4 Corporations and Corporate Governance\nLEARNING OBJECTIVES\n\n1. Explain the basic structure of the typical corporation and how the shareholders own the\ncompany and elect directors to run it.\n2. Understand how the shareholder profit-maximization model is different from stakeholder\ntheory.\n3. Discern and describe the ethical challenges for corporate cultures.\n4. Explain what conscious capitalism is and how it differs from stakeholder theory.\n\nLegal Organization of the Corporation\nFigure 2.1 Corporate Legal Structure\n\nFigure 2.1 "Corporate Legal Structure", though somewhat oversimplified, shows the basic legal\nstructure of a corporation under Delaware law and the laws of most other states in the United\nStates. Shareholders elect directors, who then hire officers to manage the company. From this\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n57\n\n\x0cstructure, some very basic realities follow. Because the directors of a corporation do not meet\nthat often, it\xe2\x80\x99s possible for the officers hired (top management, or the \xe2\x80\x9cC-suite\xe2\x80\x9d) to be selective of\nwhat the board knows about, and directors are not always ready and able to provide the\noversight that the shareholders would like. Nor does the law require officers to be shareholders,\nso that officers\xe2\x80\x99 motivations may not align with the best interests of the company. This is the\n\xe2\x80\x9cagency problem\xe2\x80\x9d often discussed in corporate governance: how to get officers and other top\nmanagement to align their own interests with those of the shareholders. For example, a CEO\nmight trade insider information to the detriment of the company\xe2\x80\x99s shareholders. Even board\nmembers are susceptible to misalignment of interets; for example, board members might resist\nhostile takeover bids because they would likely lose their perks (short for perquisites) as\ndirectors, even though the tender offer would benefit stockholders. Among other attempted\nrealignments, the use of stock options was an attempt to make managers more attentive to the\nvalue of company stock, but the law of unintended consequences was in full force; managers\ntweaked and managed earnings in the bubble of the 1990s bull market, and \xe2\x80\x9cmanaging by\nnumbers\xe2\x80\x9d became an epidemic in corporations organized under US corporate law. The rights of\nshareholders can be bolstered by changes in state and federal law, and there have been some\nattempts to do that since the late 1990s. But as owners, shareholders have the ultimate power to\nreplace nonperforming or underperforming directors, which usually results in changes at the Csuite level as well.\n\nShareholders and Stakeholders\nThere are two main views about what the corporation\xe2\x80\x99s duties are. The first view\xe2\x80\x94maximizing\nprofits\xe2\x80\x94is the prevailing view among business managers and in business schools. This view\nlargely follows the idea of Milton Friedman that the duty of a manager is to maximize return on\ninvestment to the owners. In essence, managers\xe2\x80\x99 legally prescribed duties are those that make\ntheir employment possible. In terms of the legal organization of the corporation, the\nshareholders elect directors who hire managers, who have legally prescribed duties toward both\ndirectors and shareholders. Those legally prescribed duties are a reflection of the fact that\nmanagers are managing other people\xe2\x80\x99s money and have a moral duty to act as a responsible\nagent for the owners. In law, this is called the manager\xe2\x80\x99s fiduciary duty. Directors have the same\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n58\n\n\x0cduties toward shareholders. Friedman emphasized the primacy of this duty in his writings about\ncorporations and social responsibility.\n\nMaximizing Profits: Milton Friedman\nEconomist Milton Friedman is often quoted as having said that the only moral duty a\ncorporation has is to make the most possible money, or to maximize profits, for its stockholders.\nFriedman\xe2\x80\x99s beliefs are noted at length (see sidebar on Friedman\xe2\x80\x99s article from the New York\nTimes), but he asserted in a now-famous 1970 article that in a free society, \xe2\x80\x9cthere is one and only\none social responsibility of business: to use its resources and engage in activities designed to\nincrease its profits as long as it stays within the rules of the game, which is to say, engages in\nopen and free competition without deception and fraud.\xe2\x80\x9d What follows is a major portion of\nwhat Friedman had to say in 1970.\n\n\xe2\x80\x9cThe Social Responsibility of Business Is to Increase Its Profits\xe2\x80\x9d\nMilton Friedman, New York Times Magazine, September 13, 1970\nWhat does it mean to say that \xe2\x80\x9cbusiness\xe2\x80\x9d has responsibilities? Only people can have\nresponsibilities. A corporation is an artificial person and in this sense may have artificial\nresponsibilities, but \xe2\x80\x9cbusiness\xe2\x80\x9d as a whole cannot be said to have responsibilities, even in this\nvague sense.\xe2\x80\xa6\nPresumably, the individuals who are to be responsible are businessmen, which means individual\nproprietors or corporate executives.\xe2\x80\xa6In a free enterprise, private-property system, a corporate\nexecutive is an employee of the owners of the business. He has direct responsibility to his\nemployers. That responsibility is to conduct the business in accordance with their desires, which\ngenerally will be to make as much money as possible while conforming to the basic rules of the\nsociety, both those embodied in law and those embodied in ethical custom.\xe2\x80\xa6\n\xe2\x80\xa6[T]he manager is that agent of the individuals who own the corporation or establish the\neleemosynary institution, and his primary responsibility is to them\xe2\x80\xa6\nOf course, the corporate executive is also a person in his own right. As a person, he may have\nother responsibilities that he recognizes or assumes voluntarily\xe2\x80\x94to his family, his conscience,\nhis feeling of charity, his church, his clubs, his city, his country. He may feel impelled by these\nresponsibilities to devote part of his income to causes he regards as worthy, to refuse to work for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n59\n\n\x0cparticular corporations, even to leave his job\xe2\x80\xa6But in these respects he is acting as a principal,\nnot an agent; he is spending his own money or time or energy, not the money of his employers\nor the time or energy he has contracted to devote to their purposes. If these are \xe2\x80\x9csocial\nresponsibilities,\xe2\x80\x9d they are the social responsibilities of individuals, not of business.\nWhat does it mean to say that the corporate executive has a \xe2\x80\x9csocial responsibility\xe2\x80\x9d in his capacity\nas businessman? If this statement is not pure rhetoric, it must mean that he has to act in some\nway that is not in the interest of his employers. For example, that he is to refrain from increasing\nthe price of the product in order to contribute to the social objective of preventing inflation, even\nthough a price increase would be in the best interests of the corporation. Or that he is to make\nexpenditures on reducing pollution beyond the amount that is in the best interests of the\ncorporation or that is required by law in order to contribute to the social objective of improving\nthe environment. Or that, at the expense of corporate profits, he is to hire \xe2\x80\x9chardcore\xe2\x80\x9d\nunemployed instead of better qualified available workmen to contribute to the social objective of\nreducing poverty.\nIn each of these cases, the corporate executive would be spending someone else\xe2\x80\x99s money for a\ngeneral social interest. Insofar as his actions\xe2\x80\xa6reduce returns to stockholders, he is spending\ntheir money. Insofar as his actions raise the price to customers, he is spending the customers\xe2\x80\x99\nmoney. Insofar as his actions lower the wages of some employees, he is spending their money.\nThis process raises political questions on two levels: principle and consequences. On the level of\npolitical principle, the imposition of taxes and the expenditure of tax proceeds are governmental\nfunctions. We have established elaborate constitutional, parliamentary, and judicial provisions\nto control these functions, to assure that taxes are imposed so far as possible in accordance with\nthe preferences and desires of the public.\xe2\x80\xa6\nOthers have challenged the notion that corporate managers have no real duties except toward\nthe owners (shareholders). By changing two letters in shareholder, stakeholder theorists\nwidened the range of people and institutions that a corporation should pay moral consideration\nto. Thus they contend that a corporation, through its management, has a set of responsibilities\ntoward nonshareholder interests.\n\nStakeholder Theory\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n60\n\n\x0cStakeholders of a corporation include its employees, suppliers, customers, and the community.\nStakeholder is a deliberate play on the word shareholder, to emphasize that corporations have\nobligations that extend beyond the bottom-line aim of maximizing profits. A stakeholder is\nanyone who most would agree is significantly affected (positively or negatively) by the decision\nof another moral agent.\nThere is one vital fact about corporations: the corporation is a creation of the law. Without law\n(and government), corporations would not have existence. The key concept for corporations is\nthe legal fact of limited liability. The benefit of limited liability for shareholders of a corporation\nmeant that larger pools of capital could be aggregated for larger enterprises; shareholders could\nonly lose their investments should the venture fail in any way, and there would be no personal\nliability and thus no potential loss of personal assets other than the value of the corporate stock.\nBefore New Jersey and Delaware competed to make incorporation as easy as possible and\nbeneficial to the incorporators and founders, those who wanted the benefits of incorporation\nhad to go to legislatures\xe2\x80\x94usually among the states\xe2\x80\x94to show a public purpose that the company\nwould serve.\nIn the late 1800s, New Jersey and Delaware changed their laws to make incorporating relatively\neasy. These two states allowed incorporation \xe2\x80\x9cfor any legal purpose,\xe2\x80\x9d rather than requiring some\npublic purpose. Thus it is government (and its laws) that makes limited liability happen through\nthe corporate form. That is, only through the consent of the state and armed with the charter\ngranted by the state can a corporation\xe2\x80\x99s shareholders have limited liability. This is a right\ngranted by the state, a right granted for good and practical reasons for encouraging capital and\ninnovation. But with this right comes a related duty, not clearly stated at law, but assumed when\na charter is granted by the state: that the corporate form of doing business is legal because the\ngovernment feels that it socially useful to do so.\nImplicitly, then, there is a social contract between governments and corporations: as long as\ncorporations are considered socially useful, they can exist. But do they have explicit social\nresponsibilities? Milton Friedman\xe2\x80\x99s position suggests that having gone along with legal duties,\nthe corporation can ignore any other social obligations. But there are others (such as advocates\nof stakeholder theory) who would say that a corporation\xe2\x80\x99s social responsibilities go beyond just\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n61\n\n\x0cstaying within the law and go beyond the corporation\xe2\x80\x99s shareholders to include a number of\nother important stakeholders, those whose lives can be affected by corporate decisions.\nAccording to stakeholder theorists, corporations (and other business organizations) must pay\nattention not only to the bottom line but also to their overall effect on the community. Public\nperception of a company\xe2\x80\x99s unfairness, uncaring, disrespect, or lack of trustworthiness often\nleads to long-term failure, whatever the short-term successes or profits may be. A socially\nresponsible corporation is likely to consider the impact of its decisions on a wide range of\nstakeholders, not just shareholders. As Table 2.1 "The Stakes of Various Stakeholders" indicates,\nstakeholders have very different kinds of interests (\xe2\x80\x9cstakes\xe2\x80\x9d) in the actions of a corporation.\nTable 2.1 The Stakes of Various Stakeholders\nManagers\nDirectors who\nown stock\nOwnership\n\nThe value of the organization has a direct impact on the\nwealth of these stakeholders.\n\nShareholders\n\nSalaried\nmanagers\nCreditors\nSuppliers\nEmployees\nEconomic\nDependence\n\nStakeholders can be economically dependent without\nhaving ownership. Each of these stakeholders relies on\nthe corporation in some way for financial well-being.\n\nLocal\ncommunities\nCommunities\n\nSocial\nInterests\n\nThese stakeholders are not directly linked to the\norganization but have an interest in making sure the\norganization acts in a socially responsible manner.\n\nGovernment\nMedia\n\nCorporate Culture and Codes of Ethics\nA corporation is a \xe2\x80\x9cperson\xe2\x80\x9d capable of suing, being sued, and having rights and duties in our\nlegal system. (It is a legal or juridical person, not a natural person, according to our Supreme\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n62\n\n\x0cCourt.) Moreover, many corporations have distinct cultures and beliefs that are lived and\nbreathed by its members. Often, the culture of a corporation is the best defense against\nindividuals within that firm who may be tempted to break the law or commit serious ethical\nmisdeeds.\nWhat follows is a series of observations about corporations, ethics, and corporate culture.\n\nEthical Leadership Is Top-Down\nPeople in an organization tend to watch closely what the top managers do and say. Regardless of\nmanagers\xe2\x80\x99 talk about ethics, employees quickly learn what speech or actions are in fact\nrewarded. If the CEO is firm about acting ethically, others in the organization will take their cues\nfrom him or her. People at the top tend to set the target, the climate, the beliefs, and the\nexpectations that fuel behavior.\n\nAccountability Is Often Weak\nClever managers can learn to shift blame to others, take credit for others\xe2\x80\x99 work, and move on\nbefore \xe2\x80\x9cfunny numbers\xe2\x80\x9d or other earnings management tricks come to light. [1]Again, we see that\nthe manager is often an agent for himself or herself and will often act more in his or her selfinterest than for the corporate interest.\n\nKilling the Messenger\nWhere organizations no longer function, inevitably some employees are unhappy. If they call\nattention to problems that are being covered up by coworkers or supervisors, they bring bad\nnews. Managers like to hear good news and discourage bad news. Intentionally or not, those\nwho told on others, or blew the whistle, have rocked the boat and become unpopular with those\nwhose defalcations they report on and with the managers who don\xe2\x80\x99t really want to hear the bad\nnews. In many organizations, \xe2\x80\x9ckilling the messenger\xe2\x80\x9d solves the problem. Consider James\nAlexander at Enron Corporation, who was deliberately shut out after bringing problems to CEO\nKen Lay\xe2\x80\x99s attention. [2]When Sherron Watkins sent Ken Lay a letter warning him about Enron\xe2\x80\x99s\naccounting practices, CFO Andrew Fastow tried to fire her. [3]\n\nEthics Codes\nWithout strong leadership and a willingness to listen to bad news as well as good news,\nmanagers do not have the feedback necessary to keep the organization healthy. Ethics codes\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n63\n\n\x0chave been put in place\xe2\x80\x94partly in response to federal sentencing guidelines and partly to\nencourage feedback loops to top management. The best ethics codes are aspirational, or having\nan ideal to be pursued, not legalistic or compliance driven. The Johnson & Johnson ethics code\npredated the Tylenol scare and the company\xe2\x80\x99s oft-celebrated corporate response. [4] The\ncorporate response was consistent with that code, which was lived and modeled by the top of the\norganization.\nIt\xe2\x80\x99s often noted that a code of ethics is only as important as top management is willing to make\nit. If the code is just a document that goes into a drawer or onto a shelf, it will not effectively\nencourage good conduct within the corporation. The same is true of any kind of training that the\ncompany undertakes, whether it be in racial sensitivity or sexual harassment. If the message is\nnot continuously reinforced, or (worse yet) if the message is undermined by management\xe2\x80\x99s\nactions, the real message to employees is that violations of the ethics code will not be taken\nseriously, or that efforts to stop racial discrimination or sexual harassment are merely token\nefforts, and that the important things are profits and performance. The ethics code at Enron\nseems to have been one of those \xe2\x80\x9c3-P\xe2\x80\x9d codes that wind up sitting on shelves\xe2\x80\x94\xe2\x80\x9cPrint, Post, and\nPray.\xe2\x80\x9d Worse, the Enron board twice suspended the code in 1999 to allow outside partnerships\nto be led by a top Enron executive who stood to gain financially from them. [5]\n\nEthics Hotlines and Federal Sentencing Guidelines\nThe federal sentencing guidelines were enacted in 1991. The original idea behind these\nguidelines was for Congress to correct the lenient treatment often given to white-collar, or\ncorporate, criminals. The guidelines require judges to consider \xe2\x80\x9caggravating and mitigating\xe2\x80\x9d\nfactors in determining sentences and fines. (While corporations cannot go to jail, its officers and\nmanagers certainly can, and the corporation itself can be fined. Many companies will claim that\nit is one bad apple that has caused the problem; the guidelines invite these companies to show\nthat they are in fact tending their orchard well. They can show this by providing evidence that\nthey have (1) a viable, active code of ethics; (2) a way for employees to report violations of law or\nthe ethics code; and (3) an ethics ombudsman, or someone who oversees the code.\nIn short, if a company can show that it has an ongoing process to root out wrongdoing at all\nlevels of the company, the judge is allowed to consider this as a major mitigating factor in the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n64\n\n\x0cfines the company will pay. Most Fortune 500 companies have ethics hotlines and processes in\nplace to find legal and ethical problems within the company.\n\nManaging by the Numbers\nIf you manage by the numbers, there is a temptation to lie about those numbers, based on the\nneed to get stock price ever higher. At Enron, \xe2\x80\x9c15 percent a year or better earnings growth\xe2\x80\x9d was\nthe mantra. Jeffrey Pfeffer, professor of organizational behavior at Stanford University, observes\nhow the belief that \xe2\x80\x9cstock price is all that matters\xe2\x80\x9d has been hardwired into the corporate\npsyche. It dictates not only how people judge the worth of their company but also how they feel\nabout themselves and the work that they are doing. And, over time, it has clouded judgments\nabout what is acceptable corporate behavior. [6]\n\nManaging by Numbers: The Sears Auto Center Story\nIf winning is the most important thing in your life, then you must be prepared to do anything to\nwin.\n\xe2\x80\x94Michael Josephson\nMost people want to be winners or associate with winners. As humans, our desire to associate\nwith those who have status provides plenty of incentive to glorify winners and ignore losers. But\nif an individual, a team, or a company does whatever it takes to win, then all other values are\nthrown out in the goal to win at all costs. The desire of some people within Sears & Roebuck\nCompany\xe2\x80\x99s auto repair division to win by gaining higher profits resulted in the situation\nportrayed here.\nSears Roebuck & Company has been a fixture in American retailing throughout the twentieth\ncentury. At one time, people in rural America could order virtually anything (including a house)\nfrom Sears. Not without some accuracy, the company billed itself as \xe2\x80\x9cthe place where Americans\nshop.\xe2\x80\x9d But in 1992, Sears was charged by California authorities with gross and deliberate fraud\nin many of its auto centers.\nThe authorities were alerted by a 50 percent increase in consumer complaints over a three-year\nperiod. New Jersey\xe2\x80\x99s division of consumer affairs also investigated Sears Auto Centers and\nfound that all six visited by investigators had recommended unnecessary repairs. California\xe2\x80\x99s\ndepartment of consumer affairs found that Sears had systematically overcharged by an average\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n65\n\n\x0cof $223 for repairs and routinely billed for work that was not done. Sears Auto Centers were the\nlargest providers of auto repair services in the state.\nThe scam was a variant on the old bait-and-switch routine. Customers received coupons in the\nmail inviting them to take advantage of hefty discounts on brake jobs. When customers came in\nto redeem their coupons, sales staffers would convince them to authorize additional repairs. As a\nmanagement tool, Sears had also established quotas for each of their sales representatives to\nmeet.\nUltimately, California got Sears to settle a large number of lawsuits against it by threatening to\nrevoke Sears\xe2\x80\x99 auto repair license. Sears agreed to distribute $50 coupons to nearly a million\ncustomers nationwide who had obtained certain services between August 1, 1990, and January\n31, 1992. Sears also agreed to pay $3.5 million to cover the costs of various government\ninvestigations and to contribute $1.5 million annually to conduct auto mechanic training\nprograms. It also agreed to abandon its repair service quotas. The entire settlement cost Sears\n$30 million. Sears Auto Center sales also dropped about 15 to 20 percent after news of the\nscandal broke.\nNote that in boosting sales by performing unnecessary services, Sears suffered very bad\npublicity. Losses were incalculable. The short-term gains were easy to measure; long-term\nconsequences seldom are. The case illustrates a number of important lessons:\n\xe2\x80\xa2\n\nPeople generally choose short-term gains over potential long-term losses.\n\n\xe2\x80\xa2\n\nPeople often justify the harm to others as being minimal or \xe2\x80\x9cnecessary\xe2\x80\x9d to achieve the desired\nsales quota or financial goal.\n\n\xe2\x80\xa2\n\nIn working as a group, we often form an \xe2\x80\x9cus versus them\xe2\x80\x9d mentality. In the Sears case, it is likely\nthat Sears \xe2\x80\x9cinsiders\xe2\x80\x9d looked at customers as \xe2\x80\x9coutsiders,\xe2\x80\x9d effectively treating them (in Kantian\nterms) as means rather than ends in themselves. In short, outsiders were used for the benefit of\ninsiders.\n\n\xe2\x80\xa2\n\nThe long-term losses to Sears are difficult to quantify, while the short-term gains were easy to\nmeasure and (at least for a brief while) quite satisfying financially.\n\n\xe2\x80\xa2\n\nSears\xe2\x80\x99 ongoing rip-offs were possible only because individual consumers lacked the relevant\ninformation about the service being offered. This lack of information is a market failure, since\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n66\n\n\x0cmany consumers were demanding more of Sears Auto Center services than they would have\n(and at a higher price) if relevant information had been available to them earlier. Sears, like\nother sellers of goods and services, took advantage of a market system, which, in its ideal form,\nwould not permit such information distortions.\n\xe2\x80\xa2\n\nPeople in the organization probably thought that the actions they took were necessary.\nNoting this last point, we can assume that these key people were motivated by maximizing\nprofits and had lost sight of other goals for the organization.\nThe emphasis on doing whatever is necessary to win is entirely understandable, but it is not\nethical. The temptation will always exist\xe2\x80\x94for individuals, companies, and nations\xe2\x80\x94to dominate\nor to win and to write the history of their actions in a way that justifies or overlooks the harm\nthat has been done. In a way, this fits with the notion that \xe2\x80\x9cmight makes right,\xe2\x80\x9d or that power is\nthe ultimate measure of right and wrong.\n\nConscious Capitalism\nOne effort to integrate the two viewpoints of stakeholder theory and shareholder primacy is the\nconscious capitalism movement. Companies that practiceconscious capitalism embrace the idea\nthat profit and prosperity can and must go hand in hand with social justice and environmental\nstewardship. They operate with a holistic or systems view. This means that they understand that\nall stakeholders are connected and interdependent. They reject false trade-offs between\nstakeholder interests and strive for creative ways to achieve win-win-win outcomes for all. [7]\nThe \xe2\x80\x9cconscious business\xe2\x80\x9d has a purpose that goes beyond maximizing profits. It is designed to\nmaximize profits but is focused more on its higher purpose and does not fixate solely on the\nbottom line. To do so, it focuses on delivering value to all its stakeholders, harmonizing as best it\ncan the interests of consumers, partners, investors, the community, and the environment. This\nrequires that company managers take a \xe2\x80\x9cservant leadership\xe2\x80\x9d role, serving as stewards to the\ncompany\xe2\x80\x99s deeper purpose and to the company\xe2\x80\x99s stakeholders.\nConscious business leaders serve as such stewards, focusing on fulfilling the company\xe2\x80\x99s purpose,\ndelivering value to its stakeholders, and facilitating a harmony of interests, rather than on\npersonal gain and self-aggrandizement. Why is this refocusing needed? Within the standard\nprofit-maximizing model, corporations have long had to deal with the \xe2\x80\x9cagency problem.\xe2\x80\x9d Actions\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n67\n\n\x0cby top-level managers\xe2\x80\x94acting on behalf of the company\xe2\x80\x94should align with the shareholders,\nbut in a culture all about winning and money, managers sometimes act in ways that are selfaggrandizing and that do not serve the interests of shareholders. Laws exist to limit such selfaggrandizing, but the remedies are often too little and too late and often catch only the most\negregious overreaching. Having a culture of servant leadership is a much better way to see that a\ncompany\xe2\x80\x99s top management works to ensure a harmony of interests.\n\n[1] See Robert Jackall, Moral Mazes: The World of Corporate Managers (New York: Oxford University\nPress, 1988).\n[2] John Schwartz, \xe2\x80\x9cAn Enron Unit Chief Warned, and Was Rebuffed,\xe2\x80\x9d New York Times, February 20,\n2002.\n[3] Warren Bennis, \xe2\x80\x9cA Corporate Fear of Too Much Truth,\xe2\x80\x9d New York Times, February 17, 2002.\n[4] University of Oklahoma Department of Defense Joint Course in Communication, Case Study: The\nJohnson & Johnson Tylenol Crisis, accessed April 5, 2011.\n[5] FindLaw, Report of Investigation by the Special Investigative Committee of the Board of Directors of\nEnron Corp., February 1, 2002, accessed April 5,\n2011,http://news.findlaw.com/wsj/docs/enron/sicreport.\n[6] Steven Pearlstein, \xe2\x80\x9cDebating the Enron Effect,\xe2\x80\x9d Washington Post, February 17, 2002.\n[7] Milton Friedman, John Mackey, and T. J. Rodgers, \xe2\x80\x9cRethinking the Social Responsibility of Business,\xe2\x80\x9d\nReason.com, October 2005, http://reason.com/archives/2005/10/01/rethinking-the-social-responsi.\n\n2.5 Summary and Exercises\nSummary\n\nDoing good business requires attention to ethics as well as law. Understanding the longstanding perspectives on ethics\xe2\x80\x94utilitarianism, deontology, social contract, and virtue ethics\xe2\x80\x94is\nhelpful in sorting out the ethical issues that face us as individuals and businesses. Each business\nneeds to create or maintain a culture of ethical excellence, where there is ongoing dialogue not\nonly about the best technical practices but also about the company\xe2\x80\x99s ethical challenges and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n68\n\n\x0cpractices. A firm that has purpose and passion beyond profitability is best poised to meet the\nneeds of diverse stakeholders and can best position itself for long-term, sustainable success for\nshareholders and other stakeholders as well.\n\nEXERCISES\n\n1. Consider again Milton Friedman\xe2\x80\x99s article.\na.\n\nWhat does Friedman mean by \xe2\x80\x9cethical custom\xe2\x80\x9d?\n\nb.\n\nIf the laws of the society are limiting the company\xe2\x80\x99s profitability, would the\n\ncompany be within its rights to disobey the law?\nc.\n\nWhat if the law is \xe2\x80\x9con the books,\xe2\x80\x9d but the company could count on a lack of\n\nenforcement from state officials who were overworked and underpaid? Should the\ncompany limit its profits? Suppose that it could save money by discharging a pollutant into a\nnearby river, adversely affecting fish and, potentially, drinking water supplies for\ndownstream municipalities. In polluting against laws that aren\xe2\x80\x99t enforced, is it still acting\n\xe2\x80\x9cwithin the rules of the game\xe2\x80\x9d? What if almost all other companies in the industry were\nsaving money by doing similar acts?\nConsider again the Harris v. Forklift case at the end of Chapter 1\n"Introduction to Law and Legal Systems". The Supreme Court ruled that Ms. Harris\nwas entitled to be heard again by the federal district court, which means that\nthere would be a trial on her claim that Mr. Hardy, owner of Forklift Systems, had\ncreated a \xe2\x80\x9chostile working environment\xe2\x80\x9d for Ms. Harris. Apart from the legal\naspects, did he really do anything unethical? How can you tell?\na.\n\nWhich of his actions, if any, were contrary to utilitarian thinking?\n\nb.\n\nIf Kant were his second-in-command and advising him on ethical matters,\n\nwould he have approved of Mr. Hardy\xe2\x80\x99s behavior? Why or why not?\nConsider the behaviors alleged by Ms. Harris and assume for a moment that they are all\ntrue. In terms of core values, which of these behaviors are not consistent with the core\nvalues Josephson points to? Be specific.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n69\n\n\x0cAssume that Forklift Systems is a large public corporation and that the CEO engages in\nthese kinds of behaviors. Assume also that the board of directors knows about it. What\naction should the board take, and why?\nAssume that the year is 1963, prior to the passage of the Civil Rights Act of\n1964 and the Title VII provisions regarding equal employment opportunity that\nprohibit discrimination based on sex. So, Mr. Hardy\xe2\x80\x99s actions are not illegal,\nfraudulent, or deceitful. Assume also that he heads a large public company and\nthat there is a large amount of turnover and unhappiness among the women who\nwork for the company. No one can sue him for being sexist or lecherous, but are\nhis actions consistent with maximizing shareholder returns? Should the board be\nconcerned?\nNotice that this question is really a stand-in for any situation faced by a company\ntoday regarding its CEO where the actions are not illegal but are ethically\nquestionable. What would conscious capitalism tell a CEO or a board to do where\nsome group of its employees are regularly harassed or disadvantaged by top\nmanagement?\n\nSELF-TEST QUESTIONS\n\n1. Milton Friedman would have been most likely to agree to which of the following\nstatements?\na.\n\nThe purpose of the corporation is to find a path to sustainable corporate profits by\n\npaying careful attention to key stakeholders.\nb.\n\nThe business of business is business.\n\nc.\n\nThe CEO and the board should have a single-minded focus on delivering maximum\n\nvalue to shareholders of the business.\nd.\n\nAll is fair in love, war, and business.\nMilton Friedman meant (using the material quoted in this chapter) that\ncompanies should\n\na.\n\nFind a path to sustainable profits by looking at the interconnected needs and\n\ndesires of all the stakeholders.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n70\n\n\x0cb.\n\nAlways remember that the business of business is business.\n\nc.\n\nRemind the CEO that he or she has one duty: to maximize shareholder wealth by\n\nany means possible.\nd.\n\nMaximize shareholder wealth by engaging in open competition without fraud or\n\ndeceit.\nWhat are some key drawbacks to utilitarian thinking at the corporate level?\na.\n\nThe corporation may do a cost-benefit analysis that puts the greatest good of the\n\nfirm above all other considerations.\nb.\n\nIt is difficult to predict future consequences; decision makers in for-profit\n\norganizations will tend to overestimate the upside of certain decisions and underestimate\nthe downside.\nc.\n\nShort-term interests will be favored over long-term consequences.\n\nd.\n\nall of the above\n\ne.\n\na and b only\nWhich ethical perspective would allow that under certain circumstances, it\nmight be ethical to lie to a liar?\n\na.\n\ndeontology\n\nb.\n\nvirtue ethics\n\nc.\n\nutilitarianism\n\nd.\n\nall of the above\nUnder conscious capitalism,\na.\n\nVirtue ethics is ignored.\n\nb.\n\nShareholders, whether they be traders or long-term investors, are always\n\nthe first and last consideration for the CEO and the board.\nc.\n\nMaximizing profits comes from a focus on higher purposes and harmonizing\n\nthe interests of various stakeholders.\nd.\n\nKantian duties take precedence over cost-benefit analyses.\n\nSELF-TEST ANSWERS\n\n1. c\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n71\n\n\x0c2. d\n3. d\n4. c\n5. c\n\nChapter 3\nCourts and the Legal Process\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should be able to do the following:\n1. Describe the two different court systems in the United States, and explain why some cases\ncan be filed in either court system.\n2. Explain the importance of subject matter jurisdiction and personal jurisdiction and know the\ndifference between the two.\n3. Describe the various stages of a civil action: from pleadings, to discovery, to trial, and to\nappeals.\n4. Describe two alternatives to litigation: mediation and arbitration.\nIn the United States, law and government are interdependent. The Constitution establishes the\nbasic framework of government and imposes certain limitations on the powers of government.\nIn turn, the various branches of government are intimately involved in making, enforcing, and\ninterpreting the law. Today, much of the law comes from Congress and the state legislatures. But\nit is in the courts that legislation is interpreted and prior case law is interpreted and applied.\nAs we go through this chapter, consider the case of Harry and Kay Robinson. In which court\nshould the Robinsons file their action? Can the Oklahoma court hear the case and make a\njudgment that will be enforceable against all of the defendants? Which law will the court use to\ncome to a decision? Will it use New York law, Oklahoma law, federal law, or German law?\n\nRobinson v. Audi\n\nHarry and Kay Robinson purchased a new Audi automobile from Seaway Volkswagen, Inc.\n(Seaway), in Massena, New York, in 1976. The following year the Robinson family, who resided\nin New York, left that state for a new home in Arizona. As they passed through Oklahoma,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n72\n\n\x0canother car struck their Audi in the rear, causing a fire that severely burned Kay Robinson and\nher two children. Later on, the Robinsons brought a products-liability action in the District\nCourt for Creek County, Oklahoma, claiming that their injuries resulted from the defective\ndesign and placement of the Audi\xe2\x80\x99s gas tank and fuel system. They sued numerous defendants,\nincluding the automobile\xe2\x80\x99s manufacturer, Audi NSU Auto Union Aktiengesellschaft (Audi); its\nimporter, Volkswagen of America, Inc. (Volkswagen); its regional distributor, World-Wide\nVolkswagen Corp. (World-Wide); and its retail dealer, Seaway.\nShould the Robinsons bring their action in state court or in federal court? Over which of the\ndefendants will the court have personal jurisdiction?\n\n3.1 The Relationship between State and Federal Court\nSystems in the United States\nLEARNING OBJECTIVES\n\n1. Understand the different but complementary roles of state and federal court systems.\n2. Explain why it makes sense for some courts to hear and decide only certain kinds of cases.\n3. Describe the difference between a trial court and an appellate court.\nAlthough it is sometimes said that there are two separate court systems, the reality is more\ncomplex. There are, in fact, fifty-two court systems: those of the fifty states, the local court\nsystem in the District of Columbia, and the federal court system. At the same time, these are not\nentirely separate; they all have several points of contact.\nState and local courts must honor both federal law and the laws of the other states. First, state\ncourts must honor federal law where state laws are in conflict with federal laws (under the\nsupremacy clause of the Constitution; see Chapter 4 "Constitutional Law and US Commerce").\nSecond, claims arising under federal statutes can often be tried in the state courts, where the\nConstitution or Congress has not explicitly required that only federal courts can hear that kind\nof claim. Third, under the full faith and credit clause, each state court is obligated to respect the\nfinal judgments of courts in other states. Thus a contract dispute resolved by an Arkansas court\ncannot be relitigated in North Dakota when the plaintiff wants to collect on the Arkansas\njudgment in North Dakota. Fourth, state courts often must consider the laws of other states in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n73\n\n\x0cdeciding cases involving issues where two states have an interest, such as when drivers from two\ndifferent states collide in a third state. Under these circumstances, state judges will consult their\nown state\xe2\x80\x99s case decisions involving conflicts of laws and sometimes decide that they must apply\nanother state\xe2\x80\x99s laws to decide the case (see Table 3.1 "Sample Conflict-of-Law Principles").\nAs state courts are concerned with federal law, so federal courts are often concerned with state\nlaw and with what happens in state courts. Federal courts will consider state-law-based claims\nwhen a case involves claims using both state and federal law. Claims based on federal laws will\npermit the federal court to take jurisdiction over the whole case, including any state issues\nraised. In those cases, the federal court is said to exercise \xe2\x80\x9cpendent jurisdiction\xe2\x80\x9d over the state\nclaims. Also, the Supreme Court will occasionally take appeals from a state supreme court where\nstate law raises an important issue of federal law to be decided. For example, a convict on death\nrow may claim that the state\xe2\x80\x99s chosen method of execution using the injection of drugs is\nunusually painful and involves \xe2\x80\x9ccruel and unusual punishment,\xe2\x80\x9d raising an Eighth Amendment\nissue.\nThere is also a broad category of cases heard in federal courts that concern only state legal\nissues\xe2\x80\x94namely, cases that arise between citizens of different states. The federal courts are\npermitted to hear these cases under their so-calleddiversity of citizenship jurisdiction (or\ndiversity jurisdiction). A citizen of New Jersey may sue a citizen of New York over a contract\ndispute in federal court, but if both were citizens of New Jersey, the plaintiff would be limited to\nthe state courts. The Constitution established diversity jurisdiction because it was feared that\nlocal courts would be hostile toward people from other states and that they would need separate\ncourts. In 2009, nearly a third of all lawsuits filed in federal court were based on diversity of\ncitizenship. In these cases, the federal courts were applying state law, rather than\ntaking federal question jurisdiction, where federal law provided the basis for the lawsuit or\nwhere the United States was a party (as plaintiff or defendant).\nWhy are there so many diversity cases in federal courts? Defense lawyers believe that there is\nsometimes a \xe2\x80\x9chome-court advantage\xe2\x80\x9d for an in-state plaintiff who brings a lawsuit against a\nnonresident in his local state court. The defense attorney is entitled to ask for removal to a\nfederal court where there is diversity. This fits with the original reason for diversity jurisdiction\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n74\n\n\x0cin the Constitution\xe2\x80\x94the concern that judges in one state court would favor the in-state plaintiff\nrather than a nonresident defendant. Another reason there are so many diversity cases is that\nplaintiffs\xe2\x80\x99 attorneys know that removal is common and that it will move the case along faster by\nfiling in federal court to begin with. Some plaintiffs\xe2\x80\x99 attorneys also find advantages in pursuing a\nlawsuit in federal court. Federal court procedures are often more efficient than state court\nprocedures, so that federal dockets are often less crowded. This means a case will get to trial\nfaster, and many lawyers enjoy the higher status that comes in practicing before the federal\nbench. In some federal districts, judgments for plaintiffs may be higher, on average, than in the\nlocal state court. In short, not only law but also legal strategy factor into the popularity of\ndiversity cases in federal courts.\n\nState Court Systems\nThe vast majority of civil lawsuits in the United States are filed in state courts. Two aspects of\ncivil lawsuits are common to all state courts: trials and appeals. A court exercising a trial\nfunction has original jurisdiction\xe2\x80\x94that is, jurisdiction to determine the facts of the case and\napply the law to them. A court that hears appeals from the trial court is said to\nhave appellate jurisdiction\xe2\x80\x94it must accept the facts as determined by the trial court and limit its\nreview to the lower court\xe2\x80\x99s theory of the applicable law.\n\nLimited Jurisdiction Courts\nIn most large urban states and many smaller states, there are four and sometimes five levels of\ncourts. The lowest level is that of the limited jurisdiction courts. These are usually county or\nmunicipal courts with original jurisdiction to hear minor criminal cases (petty assaults, traffic\noffenses, and breach of peace, among others) and civil cases involving monetary amounts up to a\nfixed ceiling (no more than $10,000 in most states and far less in many states). Most disputes\nthat wind up in court are handled in the 18,000-plus limited jurisdiction courts, which are\nestimated to hear more than 80 percent of all cases.\nOne familiar limited jurisdiction court is the small claims court, with jurisdiction to hear civil\ncases involving claims for amounts ranging between $1,000 and $5,000 in about half the states\nand for considerably less in the other states ($500 to $1,000). The advantage of the small claims\ncourt is that its procedures are informal, it is often located in a neighborhood outside the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n75\n\n\x0cbusiness district, it is usually open after business hours, and it is speedy. Lawyers are not\nnecessary to present the case and in some states are not allowed to appear in court.\n\nGeneral Jurisdiction Courts\nAll other civil and criminal cases are heard in the general trial courts, or courts of general\njurisdiction. These go by a variety of names: superior, circuit, district, or common pleas court\n(New York calls its general trial court the supreme court). These are the courts in which people\nseek redress for incidents such as automobile accidents and injuries, or breaches of contract.\nThese state courts also prosecute those accused of murder, rape, robbery, and other serious\ncrimes. The fact finder in these general jurisdiction courts is not a judge, as in the lower courts,\nbut a jury of citizens.\nAlthough courts of general jurisdiction can hear all types of cases, in most states more than half\ninvolve family matters (divorce, child custody disputes, and the like). A third were commercial\ncases, and slightly over 10 percent were devoted to car accident cases and other torts (as\ndiscussed in Chapter 7 "Introduction to Tort Law").\nMost states have specialized courts that hear only a certain type of case, such as landlord-tenant\ndisputes or probate of wills. Decisions by judges in specialized courts are usually final, although\nany party dissatisfied with the outcome may be able to get a new trial in a court of general\njurisdiction. Because there has been one trial already, this is known as a trial de novo. It is not\nan appeal, since the case essentially starts over.\n\nAppellate Courts\nThe losing party in a general jurisdiction court can almost always appeal to either one or two\nhigher courts. These intermediate appellate courts\xe2\x80\x94usually called courts of appeal\xe2\x80\x94have been\nestablished in forty states. They do not retry the evidence, but rather determine whether the trial\nwas conducted in a procedurally correct manner and whether the appropriate law was applied.\nFor example, the appellant (the losing party who appeals) might complain that the judge\nwrongly instructed the jury on the meaning of the law, or improperly allowed testimony of a\nparticular witness, or misconstrued the law in question. The appellee (who won in the lower\ncourt) will ask that the appellant be denied\xe2\x80\x94usually this means that the appellee wants the\nlower-court judgment affirmed. The appellate court has quite a few choices: it can affirm,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n76\n\n\x0cmodify, reverse, or reverse and remand the lower court (return the case to the lower court for\nretrial).\nThe last type of appeal within the state courts system is to the highest court, the state supreme\ncourt, which is composed of a single panel of between five and nine judges and is usually located\nin the state capital. (The intermediate appellate courts are usually composed of panels of three\njudges and are situated in various locations around the state.) In a few states, the highest court\ngoes by a different name: in New York, it is known as the court of appeals. In certain cases,\nappellants to the highest court in a state have the right to have their appeals heard, but more\noften the supreme court selects the cases it wishes to hear. For most litigants, the ruling of the\nstate supreme court is final. In a relatively small class of cases\xe2\x80\x94those in which federal\nconstitutional claims are made\xe2\x80\x94appeal to the US Supreme Court to issue\na writ of certiorariremains a possibility.\n\nThe Federal Court System\nDistrict Courts\nThe federal judicial system is uniform throughout the United States and consists of three levels.\nAt the first level are the federal district courts, which are the trial courts in the federal system.\nEvery state has one or more federal districts; the less populous states have one, and the more\npopulous states (California, Texas, and New York) have four. The federal court with the heaviest\ncommercial docket is the US District Court for the Southern District of New York (Manhattan).\nThere are forty-four district judges and fifteen magistrates in this district. The district judges\nthroughout the United States commonly preside over all federal trials, both criminal and civil.\n\nCourts of Appeal\nCases from the district courts can then be appealed to the circuit courts of appeal, of which there\nare thirteen (Figure 3.1 "The Federal Judicial Circuits"). Each circuit oversees the work of the\ndistrict courts in several states. For example, the US Court of Appeals for the Second Circuit\nhears appeals from district courts in New York, Connecticut, and Vermont. The US Court of\nAppeals for the Ninth Circuit hears appeals from district courts in California, Oregon, Nevada,\nMontana, Washington, Idaho, Arizona, Alaska, Hawaii, and Guam. The US Court of Appeals for\nthe District of Columbia Circuit hears appeals from the district court in Washington, DC, as well\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n77\n\n\x0cas from numerous federal administrative agencies (see Chapter 5 "Administrative Law"). The US\nCourt of Appeals for the Federal Circuit, also located in Washington, hears appeals in patent and\ncustoms cases. Appeals are usually heard by three-judge panels, but sometimes there will be a\nrehearing at the court of appeals level, in which case all judges sit to hear the case \xe2\x80\x9cen banc.\xe2\x80\x9d\nThere are also several specialized courts in the federal judicial system. These include the US Tax\nCourt, the Court of Customs and Patent Appeals, and the Court of Claims.\n\nUnited States Supreme Court\nOverseeing all federal courts is the US Supreme Court, in Washington, DC. It consists of nine\njustices\xe2\x80\x94the chief justice and eight associate justices. (This number is not constitutionally\nrequired; Congress can establish any number. It has been set at nine since after the Civil War.)\nThe Supreme Court has selective control over most of its docket. By law, the cases it hears\nrepresent only a tiny fraction of the cases that are submitted. In 2008, the Supreme Court had\nnumerous petitions (over 7,000, not including thousands of petitions from prisoners) but heard\narguments in only 87 cases. The Supreme Court does not sit in panels. All the justices hear and\nconsider each case together, unless a justice has a conflict of interest and must withdraw from\nhearing the case.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n78\n\n\x0cFigure 3.1 The Federal Judicial Circuits\n\nFederal judges\xe2\x80\x94including Supreme Court justices\xe2\x80\x94are nominated by the president and must be\nconfirmed by the Senate. Unlike state judges, who are usually elected and preside for a fixed\nterm of years, federal judges sit for life unless they voluntarily retire or are impeached.\n\nKEY TAKEAWAY\n\nTrial courts and appellate courts have different functions. State trial courts sometimes hear\ncases with federal law issues, and federal courts sometimes hear cases with state law issues.\nWithin both state and federal court systems, it is useful to know the different kinds of courts\nand what cases they can decide.\n\nEXERCISES\n\n1. Why all of this complexity? Why don\xe2\x80\x99t state courts hear only claims based on state law, and\nfederal courts only federal-law-based claims?\n2. Why would a plaintiff in Iowa with a case against a New Jersey defendant prefer to have the\ncase heard in Iowa?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n79\n\n\x0c3. James, a New Jersey resident, is sued by Jonah, an Iowa resident. After a trial in which James\nappears and vigorously defends himself, the Iowa state court awards Jonah $136,750 dollars\nin damages for his tort claim. In trying to collect from James in New Jersey, Jonah must have\nthe New Jersey court certify the Iowa judgment. Why, ordinarily, must the New Jersey court\ndo so?\n\n3.2 The Problem of Jurisdiction\n\nLEARNING OBJECTIVES\n\n1. Explain the concept of subject matter jurisdiction and distinguish it from personal\njurisdiction.\n2. Understand how and where the US Constitution provides a set of instructions as to what\nfederal courts are empowered by law to do.\n3. Know which kinds of cases must be heard in federal courts only.\n4. Explain diversity of citizenship jurisdiction and be able to decide whether a case is eligible for\ndiversity jurisdiction in the federal courts.\nJurisdiction is an essential concept in understanding courts and the legal system. Jurisdiction is\na combination of two Latin words: juris (law) and diction (to speak). Which court has the power\n\xe2\x80\x9cto speak the law\xe2\x80\x9d is the basic question of jurisdiction.\nThere are two questions about jurisdiction in each case that must be answered before a judge\nwill hear a case: the question of subject matter jurisdiction and the question of personal\njurisdiction. We will consider the question of subject matter jurisdiction first, because judges do;\nif they determine, on the basis of the initial documents in the case (the \xe2\x80\x9cpleadings\xe2\x80\x9d), that they\nhave no power to hear and decide that kind of case, they will dismiss it.\n\nThe Federal-State Balance: Federalism\nState courts have their origins in colonial era courts. After the American Revolution, state courts\nfunctioned (with some differences) much like they did in colonial times. The big difference after\n1789 was that state courts coexisted with federal courts.Federalism was the system devised by\nthe nation\xe2\x80\x99s founders in which power is shared between states and the federal government. This\nsharing requires a division of labor between the states and the federal government. It is Article\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n80\n\n\x0cIII of the US Constitution that spells out the respective spheres of authority (jurisdiction)\nbetween state and federal courts.\nTake a close look at Article III of the Constitution. (You can find a printable copy of the\nConstitution at http://www.findlaw.com.) Article III makes clear that federal courts are courts\nof limited power or jurisdiction. Notice that the only kinds of cases federal courts are authorized\nto deal with have strong federal connections. For example, federal courts have jurisdiction when\na federal law is being used by the plaintiff or prosecutor (a \xe2\x80\x9cfederal question\xe2\x80\x9d case) or the case\narises \xe2\x80\x9cin admiralty\xe2\x80\x9d (meaning that the problem arose not on land but on sea, beyond the\nterritorial jurisdiction of any state, or in navigable waters within the United States). Implied in\nthis list is the clear notion that states would continue to have their own laws, interpreted by their\nown courts, and that federal courts were needed only where the issues raised by the parties had\na clear federal connection. The exception to this is diversity jurisdiction, discussed later.\nThe Constitution was constructed with the idea that state courts would continue to deal with\nbasic kinds of claims such as tort, contract, or property claims. Since states sanction marriages\nand divorce, state courts would deal with \xe2\x80\x9cdomestic\xe2\x80\x9d (family) issues. Since states deal with birth\nand death records, it stands to reason that paternity suits, probate disputes, and the like usually\nwind up in state courts. You wouldn\xe2\x80\x99t go to the federal building or courthouse to get a marriage\nlicense, ask for a divorce, or probate a will: these matters have traditionally been dealt with by\nthe states (and the thirteen original colonies before them). Matters that historically get raised\nand settled in state court under state law include not only domestic and probate matters but also\nlaw relating to corporations, partnerships, agency, contracts, property, torts, and commercial\ndealings generally. You cannot get married or divorced in federal court, because federal courts\nhave no jurisdiction over matters that are historically (and are still) exclusively within the\ndomain of state law.\nIn terms of subject matter jurisdiction, then, state courts will typically deal with the kinds of\ndisputes just cited. Thus if you are Michigan resident and have an auto accident in Toledo with\nan Ohio resident and you each blame each other for the accident, the state courts would\nordinarily resolve the matter if the dispute cannot otherwise be settled. Why state courts?\nBecause when you blame one another and allege that it\xe2\x80\x99s the other person\xe2\x80\x99s fault, you have the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n81\n\n\x0cbeginnings of a tort case, with negligence as a primary element of the claim, and state courts\nhave routinely dealt with this kind of claim, from British colonial times through Independence\nand to the present. (See alsoChapter 7 "Introduction to Tort Law" of this text.) People have had a\nneed to resolve this kind of dispute long before our federal courts were created, and you can tell\nfrom Article III that the founders did not specify that tort or negligence claims should be\nhandled by the federal courts. Again, federal courts are courts of limited jurisdiction, limited to\nthe kinds of cases specified in Article III. If the case before the federal court does not fall within\none of those categories, the federal court cannot constitutionally hear the case because it does\nnot have subject matter jurisdiction.\nAlways remember: a court must have subject matter jurisdiction to hear and decide a case.\nWithout it, a court cannot address the merits of the controversy or even take the next\njurisdictional step of figuring out which of the defendants can be sued in that court. The\nquestion of which defendants are appropriately before the court is a question\nof personal jurisdiction.\nBecause there are two court systems, it is important for a plaintiff to file in the right court to\nbegin with. The right court is the one that has subject matter jurisdiction over the case\xe2\x80\x94that is,\nthe power to hear and decide the kind of case that is filed. Not only is it a waste of time to file in\nthe wrong court system and be dismissed, but if the dismissal comes after the filing period\nimposed by the applicable statute of limitations, it will be too late to refile in the correct court\nsystem. Such cases will be routinely dismissed, regardless of how deserving the plaintiff might\nbe in his quest for justice. (The plaintiff\xe2\x80\x99s only remedy at that point would be to sue his lawyer\nfor negligence for failing to mind the clock and get to the right court in time!)\n\nExclusive Jurisdiction in Federal Courts\nWith two court systems, a plaintiff (or the plaintiff\xe2\x80\x99s attorney, most likely) must decide whether\nto file a case in the state court system or the federal court system. Federal courts have exclusive\njurisdiction over certain kinds of cases. The reason for this comes directly from the Constitution.\nArticle III of the US Constitution provides the following:\nThe judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution,\nthe Laws of the United States, and Treaties made, or which shall be made, under their Authority;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n82\n\n\x0cto all Cases affecting Ambassadors, other public Ministers and Consuls; to all Cases of admiralty\nand maritime Jurisdiction; to Controversies to which the United States shall be a Party; to\nControversies between two or more States; between a State and Citizens of another State;\nbetween Citizens of different States; between Citizens of the same State claiming Lands under\nGrants of different States, and between a State, or the Citizens thereof, and foreign States,\nCitizens or Subjects.\nBy excluding diversity cases, we can assemble a list of the kinds of cases that can only be heard\nin federal courts. The list looks like this:\n1. Suits between states. Cases in which two or more states are a party.\n2. Cases involving ambassadors and other high-ranking public figures. Cases arising between\nforeign ambassadors and other high-ranking public officials.\n3. Federal crimes. Crimes defined by or mentioned in the US Constitution or those defined or\npunished by federal statute. Such crimes include treason against the United States, piracy,\ncounterfeiting, crimes against the law of nations, and crimes relating to the federal government\xe2\x80\x99s\nauthority to regulate interstate commerce. However, most crimes are state matters.\n4. Bankruptcy. The statutory procedure, usually triggered by insolvency, by which a person is\nrelieved of most debts and undergoes a judicially supervised reorganization or liquidation for\nthe benefit of the person\xe2\x80\x99s creditors.\n5. Patent, copyright, and trademark cases\na.\n\nPatent. The exclusive right to make, use, or sell an invention for a specified period\n\n(usually seventeen years), granted by the federal government to the inventor if the device or\nprocess is novel, useful, and nonobvious.\nb.\n\nCopyright. The body of law relating to a property right in an original work of authorship\n\n(such as a literary, musical, artistic, photographic, or film work) fixed in any tangible medium of\nexpression, giving the holder the exclusive right to reproduce, adapt, distribute, perform, and\ndisplay the work.\nc.\n\nTrademark. A word, phrase, logo, or other graphic symbol used by a manufacturer or\n\nseller to distinguish its product or products from those of others.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n83\n\n\x0cAdmiralty. The system of laws that has grown out of the practice of admiralty courts:\ncourts that exercise jurisdiction over all maritime contracts, torts, injuries, and offenses.\nAntitrust. Federal laws designed to protect trade and commerce from restraining\nmonopolies, price fixing, and price discrimination.\nSecurities and banking regulation. The body of law protecting the public by regulating\nthe registration, offering, and trading of securities and the regulation of banking practices.\nOther cases specified by federal statute. Any other cases specified by a federal statute\nwhere Congress declares that federal courts will have exclusive jurisdiction.\n\nConcurrent Jurisdiction\nWhen a plaintiff takes a case to state court, it will be because state courts typically hear that kind\nof case (i.e., there is subject matter jurisdiction). If the plaintiff\xe2\x80\x99s main cause of action comes\nfrom a certain state\xe2\x80\x99s constitution, statutes, or court decisions, the state courts have subject\nmatter jurisdiction over the case. If the plaintiff\xe2\x80\x99s main cause of action is based on federal law\n(e.g., Title VII of the Civil Rights Act of 1964), the federal courts have subject matter jurisdiction\nover the case. But federal courts will also have subject matter jurisdiction over certain cases that\nhave only a state-based cause of action; those cases are ones in which the plaintiff(s) and the\ndefendant(s) are from different states and the amount in controversy is more than $75,000.\nState courts can have subject matter jurisdiction over certain cases that have only a federalbased cause of action. The Supreme Court has now made clear that state courts\nhaveconcurrent jurisdiction of any federal cause of action unless Congress has given exclusive\njurisdiction to federal courts.\nIn short, a case with a federal question can be often be heard in either state or federal court, and\na case that has parties with a diversity of citizenship can be heard in state courts or in federal\ncourts where the tests of complete diversity and amount in controversy are met. (See Note 3.18\n"Summary of Rules on Subject Matter Jurisdiction".)\nWhether a case will be heard in a state court or moved to a federal court will depend on the\nparties. If a plaintiff files a case in state trial court where concurrent jurisdiction applies, a\ndefendant may (or may not) ask that the case be removed to federal district court.\n\nSummary of Rules on Subject Matter Jurisdiction\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n84\n\n\x0c1. A court must always have subject matter jurisdiction, and personal jurisdiction over at least one\ndefendant, to hear and decide a case.\n2. A state court will have subject matter jurisdiction over any case that is not required to be\nbrought in a federal court.\nSome cases can only be brought in federal court, such as bankruptcy cases, cases involving\nfederal crimes, patent cases, and Internal Revenue Service tax court claims. The list of cases for\nexclusive federal jurisdiction is fairly short. That means that almost any state court will have\nsubject matter jurisdiction over almost any kind of case. If it\xe2\x80\x99s a case based on state law, a state\ncourt will always have subject matter jurisdiction.\n3. A federal court will have subject matter jurisdiction over any case that is either based on a\nfederal law (statute, case, or US Constitution)\nOR\nA federal court will have subject matter jurisdiction over any case based on state law where the\nparties are (1) from different states and (2) the amount in controversy is at least $75,000.\n(1) The different states requirement means that no plaintiff can have permanent residence in a\nstate where any defendant has permanent residence\xe2\x80\x94there must be complete diversity of\ncitizenship as between all plaintiffs and defendants.\n(2) The amount in controversy requirement means that a good-faith estimate of the amount the\nplaintiff may recover is at least $75,000.\nNOTE: For purposes of permanent residence, a corporation is considered a resident where it is\nincorporated AND where it has a principal place of business.\n4. In diversity cases, the following rules apply.\n(1) Federal civil procedure rules apply to how the case is conducted before and during trial and\nany appeals, but\n(2) State law will be used as the basis for a determination of legal rights and responsibilities.\n(a) This \xe2\x80\x9cchoice of law\xe2\x80\x9d process is interesting but complicated. Basically, each state has its own\nset of judicial decisions that resolve conflict of laws. For example, just because A sues B in a\nTexas court, the Texas court will not necessarily apply Texas law. Anna and Bobby collide and\nsuffer serious physical injuries while driving their cars in Roswell, New Mexico. Both live in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n85\n\n\x0cAustin, and Bobby files a lawsuit in Austin. The court there could hear it (having subject matter\njurisdiction and personal jurisdiction over Bobby) but would apply New Mexico law, which\ngoverns motor vehicle laws and accidents in New Mexico. Why would the Texas judge do that?\n(b) The Texas judge knows that which state\xe2\x80\x99s law is chosen to apply to the case can make a\ndecisive difference in the case, as different states have different substantive law standards. For\nexample, in a breach of contract case, one state\xe2\x80\x99s version of the Uniform Commercial Code may\nbe different from another\xe2\x80\x99s, and which one the court decides to apply is often exceedingly good\nfor one side and dismal for the other. In Anna v. Bobby, if Texas has one kind of comparative\nnegligence statute and New Mexico has a different kind of comparative negligence statute, who\nwins or loses, or how much is awarded, could well depend on which law applies. Because both\nwere under the jurisdiction of New Mexico\xe2\x80\x99s laws at the time, it makes sense to apply New\nMexico law.\n(3) Why do some nonresident defendants prefer to be in federal court?\n(a) In the state court, the judge is elected, and the jury may be familiar with or sympathetic to\nthe \xe2\x80\x9clocal\xe2\x80\x9d plaintiff.\n(b) The federal court provides a more neutral forum, with an appointed, life-tenured judge and a\nwider pool of potential jurors (drawn from a wider geographical area).\n(4) If a defendant does not want to be in state court and there is diversity, what is to be done?\n(a) Make a motion for removal to the federal court.\n(b) The federal court will not want to add to its caseload, or docket, but must take the case\nunless there is not complete diversity of citizenship or the amount in controversy is less\nthan $75,000.\nTo better understand subject matter jurisdiction in action, let\xe2\x80\x99s take an example. Wile E. Coyote\nwants a federal judge to hear his products-liability action against Acme, Inc., even though the\naction is based on state law. Mr. Coyote\xe2\x80\x99s attorney wants to \xe2\x80\x9cmake a federal case\xe2\x80\x9d out of it,\nthinking that the jurors in the federal district court\xe2\x80\x99s jury pool will understand the case better\nand be more likely to deliver a \xe2\x80\x9chigh value\xe2\x80\x9d verdict for Mr. Coyote. Mr. Coyote resides in\nArizona, and Acme is incorporated in the state of Delaware and has its principal place of\nbusiness in Chicago, Illinois. The federal court in Arizona can hear and decide Mr. Coyote\xe2\x80\x99s case\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n86\n\n\x0c(i.e., it has subject matter jurisdiction over the case) because of diversity of citizenship. If Mr.\nCoyote was injured by one of Acme\xe2\x80\x99s defective products while chasing a roadrunner in Arizona,\nthe federal district court judge would hear his action\xe2\x80\x94using federal procedural law\xe2\x80\x94and decide\nthe case based on the substantive law of Arizona on product liability.\nBut now change the facts only slightly: Acme is incorporated in Delaware but has its principal\nplace of business in Phoenix, Arizona. Unless Mr. Coyote has a federal law he is using as a basis\nfor his claims against Acme, his attempt to get a federal court to hear and decide the case will\nfail. It will fail because there is not complete diversity of citizenship between the plaintiff and the\ndefendant.\n\nRobinson v. Audi\nNow consider Mr. and Mrs. Robinson and their products-liability claim against Seaway\nVolkswagen and the other three defendants. There is no federal products-liability law that could\nbe used as a cause of action. They are most likely suing the defendants using products-liability\nlaw based on common-law negligence or common-law strict liability law, as found in state court\ncases. They were not yet Arizona residents at the time of the accident, and their accident does\nnot establish them as Oklahoma residents, either. They bought the vehicle in New York from a\nNew York\xe2\x80\x93based retailer. None of the other defendants is from Oklahoma.\nThey file in an Oklahoma state court, but how will they (their attorney or the court) know if the\nstate court has subject matter jurisdiction? Unless the case is requiredto be in a federal court\n(i.e., unless the federal courts have exclusive jurisdiction over this kind of case), any state court\nsystem will have subject matter jurisdiction, including Oklahoma\xe2\x80\x99s state court system. But if\ntheir claim is for a significant amount of money, they cannot file in small claims court, probate\ncourt, or any court in Oklahoma that does not have statutory jurisdiction over their claim. They\nwill need to file in a court of general jurisdiction. In short, even filing in the right court system\n(state versus federal), the plaintiff must be careful to find the court that has subject matter\njurisdiction.\nIf they wish to go to federal court, can they? There is no federal question presented here (the\nclaim is based on state common law), and the United States is not a party, so the only basis for\nfederal court jurisdiction would be diversity jurisdiction. If enough time has elapsed since the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n87\n\n\x0caccident and they have established themselves as Arizona residents, they could sue in federal\ncourt in Oklahoma (or elsewhere), but only if none of the defendants\xe2\x80\x94the retailer, the regional\nVolkswagen company, Volkswagen of North America, or Audi (in Germany) are incorporated in\nor have a principal place of business in Arizona. The federal judge would decide the case using\nfederal civil procedure but would have to make the appropriate choice of state law. In this case,\nthe choice of conflicting laws would most likely be Oklahoma, where the accident happened, or\nNew York, where the defective product was sold.\nTable 3.1 Sample Conflict-of-Law Principles\nSubstantive Law Issue\n\nLaw to be Applied\n\nLiability for injury caused by tortious conduct\n\nState in which the injury was inflicted\n\nReal property\n\nState where the property is located\n\nPersonal Property: inheritance\n\nDomicile of deceased (not location of property)\n\nContract: validity\n\nState in which contract was made\n\nContract: breach\n\nState in which contract was to be performed*\n\n*Or, in many states, the state with the most significant contacts with the contractual activities\nNote: Choice-of-law clauses in a contract will ordinarily be honored by judges in state and federal\ncourts.\n\nLegal Procedure, Including Due Process and Personal Jurisdiction\nIn this section, we consider how lawsuits are begun and how the court knows that it has both\nsubject matter jurisdiction and personal jurisdiction over at least one of the named defendants.\nThe courts are not the only institutions that can resolve disputes. In Section 3.8 "Alternative\nMeans of Resolving Disputes", we will discuss other dispute-resolution forums, such as\narbitration and mediation. For now, let us consider how courts make decisions in civil disputes.\nJudicial decision making in the context of litigation (civil lawsuits) is a distinctive form of\ndispute resolution.\nFirst, to get the attention of a court, the plaintiff must make a claim based on existing laws.\nSecond, courts do not reach out for cases. Cases are brought to them, usually when an attorney\nfiles a case with the right court in the right way, following the various laws that govern all civil\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n88\n\n\x0cprocedures in a state or in the federal system. (Most US states\xe2\x80\x99 procedural laws are similar to the\nfederal procedural code.)\nOnce at the court, the case will proceed through various motions (motions to dismiss for lack of\njurisdiction, for example, or insufficient service of process), the proofs (submission of evidence),\nand the arguments (debate about the meaning of the evidence and the law) of contesting parties.\nThis is at the heart of the adversary system, in which those who oppose each other may attack\nthe other\xe2\x80\x99s case through proofs and cross-examination. Every person in the United States who\nwishes to take a case to court is entitled to hire a lawyer. The lawyer works for his client, not the\ncourt, and serves him as an advocate, or supporter. The client\xe2\x80\x99s goal is to persuade the court of\nthe accuracy and justness of his position. The lawyer\xe2\x80\x99s duty is to shape the evidence and the\nargument\xe2\x80\x94the line of reasoning about the evidence\xe2\x80\x94to advance his client\xe2\x80\x99s cause and persuade\nthe court of its rightness. The lawyer for the opposing party will be doing the same thing, of\ncourse, for her client. The judge (or, if one is sitting, the jury) must sort out the facts and reach a\ndecision from this cross-fire of evidence and argument.\nThe method of adjudication\xe2\x80\x94the act of making an order or judgment\xe2\x80\x94has several important\nfeatures. First, it focuses the conflicting issues. Other, secondary concerns are minimized or\nexcluded altogether. Relevance is a key concept in any trial. The judge is required to decide the\nquestions presented at the trial, not to talk about related matters. Second, adjudication requires\nthat the judge\xe2\x80\x99s decision be reasoned, and that is why judges write opinions explaining their\ndecisions (an opinion may be omitted when the verdict comes from a jury). Third, the judge\xe2\x80\x99s\ndecision must not only be reasoned but also be responsive to the case presented: the judge is not\nfree to say that the case is unimportant and that he therefore will ignore it. Unlike other\nbranches of government that are free to ignore problems pressing upon them,\njudges must decide cases. (For example, a legislature need not enact a law, no matter how many\npeople petition it to do so.) Fourth, the court must respond in a certain way. The judge must pay\nattention to the parties\xe2\x80\x99 arguments and his decision must result from their proofs and\narguments. Evidence that is not presented and legal arguments that are not made cannot be the\nbasis for what the judge decides. Also, judges are bound by standards of weighing evidence: the\nburden of proof in a civil case is generally a \xe2\x80\x9cpreponderance of the evidence.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n89\n\n\x0cIn all cases, the plaintiff\xe2\x80\x94the party making a claim and initiating the lawsuit (in a criminal case\nthe plaintiff is the prosecution)\xe2\x80\x94has the burden of proving his case. If he fails to prove it, the\ndefendant\xe2\x80\x94the party being sued or prosecuted\xe2\x80\x94will win.\nCriminal prosecutions carry the most rigorous burden of proof: the government must prove its\ncase against the defendant beyond a reasonable doubt. That is, even if it seems very likely that\nthe defendant committed the crime, as long as there remains some reasonable doubt\xe2\x80\x94perhaps\nhe was not clearly identified as the culprit, perhaps he has an alibi that could be legitimate\xe2\x80\x94the\njury must vote to acquit rather than convict.\nBy contrast, the burden of proof in ordinary civil cases\xe2\x80\x94those dealing with contracts, personal\ninjuries, and most of the cases in this book\xe2\x80\x94is a preponderance of the evidence, which means\nthat the plaintiff\xe2\x80\x99s evidence must outweigh whatever evidence the defendant can muster that\ncasts doubts on the plaintiff\xe2\x80\x99s claim. This is not merely a matter of counting the number of\nwitnesses or of the length of time that they talk: the judge in a trial without a jury (a bench trial),\nor the jury where one is impaneled, must apply the preponderance of evidence test by\ndetermining which side has the greater weight of credible, relevant evidence.\nAdjudication and the adversary system imply certain other characteristics of courts. Judges\nmust be impartial; those with a personal interest in a matter must refuse to hear it. The ruling of\na court, after all appeals are exhausted, is final. This principle is known as res judicata (Latin for\n\xe2\x80\x9cthe thing is decided\xe2\x80\x9d), and it means that the same parties may not take up the same dispute in\nanother court at another time. Finally, a court must proceed according to a public set of formal\nprocedural rules; a judge cannot make up the rules as he goes along. To these rules we now turn.\n\nHow a Case Proceeds\nComplaint and Summons\nBeginning a lawsuit is simple and is spelled out in the rules of procedure by which each court\nsystem operates. In the federal system, the plaintiff begins a lawsuit by filing a complaint\xe2\x80\x94a\ndocument clearly explaining the grounds for suit\xe2\x80\x94with the clerk of the court. The court\xe2\x80\x99s agent\n(usually a sheriff, for state trial courts, or a US deputy marshal, in federal district courts) will\nthen serve the defendant with the complaint and a summons. The summons is a court document\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n90\n\n\x0cstating the name of the plaintiff and his attorney and directing the defendant to respond to the\ncomplaint within a fixed time period.\nThe timing of the filing can be important. Almost every possible legal complaint is governed by a\nfederal or state statute of limitations, which requires a lawsuit to be filed within a certain period\nof time. For example, in many states a lawsuit for injuries resulting from an automobile accident\nmust be filed within two years of the accident or the plaintiff forfeits his right to proceed. As\nnoted earlier, making a correct initial filing in a court that has subject matter jurisdiction is\ncritical to avoiding statute of limitations problems.\n\nJurisdiction and Venue\nThe place of filing is equally important, and there are two issues regarding location. The first is\nsubject matter jurisdiction, as already noted. A claim for breach of contract, in which the\namount at stake is $1 million, cannot be brought in a local county court with jurisdiction to hear\ncases involving sums of up to only $1,000. Likewise, a claim for copyright violation cannot be\nbrought in a state superior court, since federal courts have exclusive jurisdiction over copyright\ncases.\nThe second consideration is venue\xe2\x80\x94the proper geographic location of the court. For example,\nevery county in a state might have a superior court, but the plaintiff is not free to pick any\ncounty. Again, a statute will spell out to which court the plaintiff must go (e.g., the county in\nwhich the plaintiff resides or the county in which the defendant resides or maintains an office).\n\nService of Process and Personal Jurisdiction\nThe defendant must be \xe2\x80\x9cserved\xe2\x80\x9d\xe2\x80\x94that is, must receive notice that he has been sued. Service can\nbe done by physically presenting the defendant with a copy of the summons and complaint. But\nsometimes the defendant is difficult to find (or deliberately avoids the marshal or other process\nserver). The rules spell out a variety of ways by which individuals and corporations can be\nserved. These include using US Postal Service certified mail or serving someone already\ndesignated to receive service of process. A corporation or partnership, for example, is often\nrequired by state law to designate a \xe2\x80\x9cregistered agent\xe2\x80\x9d for purposes of getting public notices or\nreceiving a summons and complaint.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n91\n\n\x0cOne of the most troublesome problems is service on an out-of-state defendant. The personal\njurisdiction of a state court over persons is clear for those defendants found within the state. If\nthe plaintiff claims that an out-of-state defendant injured him in some way, must the plaintiff go\nto the defendant\xe2\x80\x99s home state to serve him? Unless the defendant had some significant contact\nwith the plaintiff\xe2\x80\x99s state, the plaintiff may indeed have to. For instance, suppose a traveler from\nMaine stopped at a roadside diner in Montana and ordered a slice of homemade pie that was\ntainted and caused him to be sick. The traveler may not simply return home and mail the diner a\nnotice that he is suing it in a Maine court. But if out-of-state defendants have some contact with\nthe plaintiff\xe2\x80\x99s state of residence, there might be grounds to bring them within the jurisdiction of\nthe plaintiff\xe2\x80\x99s state courts. In Burger King v. Rudzewicz, Section 3.9 "Cases", the federal court in\nFlorida had to consider whether it was constitutionally permissible to exercise personal\njurisdiction over a Michigan franchisee.\nAgain, recall that even if a court has subject matter jurisdiction, it must also have personal\njurisdiction over each defendant against whom an enforceable judgment can be made. Often this\nis not a problem; you might be suing a person who lives in your state or regularly does business\nin your state. Or a nonresident may answer your complaint without objecting to the court\xe2\x80\x99s \xe2\x80\x9cin\npersonam\xe2\x80\x9d (personal) jurisdiction. But many defendants who do not reside in the state where\nthe lawsuit is filed would rather not be put to the inconvenience of contesting a lawsuit in a\ndistant forum. Fairness\xe2\x80\x94and the due process clause of the Fourteenth Amendment\xe2\x80\x94dictates\nthat nonresidents should not be required to defend lawsuits far from their home base, especially\nwhere there is little or no contact or connection between the nonresident and the state where a\nlawsuit is brought.\n\nSummary of Rules on Personal Jurisdiction\n1. Once a court determines that it has subject matter jurisdiction, it must find at least one\ndefendant over which it is \xe2\x80\x9cfair\xe2\x80\x9d (i.e., in accord with due process) to exercise personal\njurisdiction.\n2. If a plaintiff sues five defendants and the court has personal jurisdiction over just one, the case\ncan be heard, but the court cannot make a judgment against the other four.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n92\n\n\x0c1. But if the plaintiff loses against defendant 1, he can go elsewhere (to another state or states) and\nsue defendants 2, 3, 4, or 5.\n2. The court\xe2\x80\x99s decision in the first lawsuit (against defendant 1) does not determine the liability of\nthe nonparticipating defendants.\nThis involves the principle of res judicata, which means that you can\xe2\x80\x99t bring the same action\nagainst the same person (or entity) twice. It\xe2\x80\x99s like the civil side of double jeopardy. Res means\n\xe2\x80\x9cthing,\xe2\x80\x9d and judicata means \xe2\x80\x9cadjudicated.\xe2\x80\x9d Thus the \xe2\x80\x9cthing\xe2\x80\x9d has been \xe2\x80\x9cadjudicated\xe2\x80\x9d and should\nnot be judged again. But, as to nonparticipating parties, it is not over. If you have\na different case against the same defendant\xe2\x80\x94one that arises out of a completely different\nsituation\xe2\x80\x94that case is not barred by res judicata.\n3. Service of process is a necessary (but not sufficient) condition for getting personal jurisdiction\nover a particular defendant (see rule 4).\n1. In order to get a judgment in a civil action, the plaintiff must serve a copy of the complaint and a\nsummons on the defendant.\n2. There are many ways to do this.\n\xef\x82\xa7\n\nThe process server personally serves a complaint on the defendant.\n\n\xef\x82\xa7\n\nThe process server leaves a copy of the summons and complaint at the residence of the\ndefendant, in the hands of a competent person.\n\n\xef\x82\xa7\n\nThe process server sends the summons and complaint by certified mail, return receipt\nrequested.\n\n\xef\x82\xa7\n\nThe process server, if all other means are not possible, notifies the defendant by publication in a\nnewspaper having a minimum number of readers (as may be specified by law).\n\n4. In addition to successfully serving the defendant with process, a plaintiff must convince the\ncourt that exercising personal jurisdiction over the defendant is consistent with due process and\nany statutes in that state that prescribe the jurisdictional reach of that state (the so-called longarm statutes). The Supreme Court has long recognized various bases for judging whether such\nprocess is fair.\n1. Consent. The defendant agrees to the court\xe2\x80\x99s jurisdiction by coming to court, answering the\ncomplaint, and having the matter litigated there.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n93\n\n\x0c2. Domicile. The defendant is a permanent resident of that state.\n3. Event. The defendant did something in that state, related to the lawsuit, that makes it fair for the\nstate to say, \xe2\x80\x9cCome back and defend!\xe2\x80\x9d\n4. Service of process within the state will effectively provide personal jurisdiction over the\nnonresident.\nAgain, let\xe2\x80\x99s consider Mrs. Robinson and her children in the Audi accident. She could file a\nlawsuit anywhere in the country. She could file a lawsuit in Arizona after she establishes\nresidency there. But while the Arizona court would have subject matter jurisdiction over any\nproducts-liability claim (or any claim that was not required to be heard in a federal court), the\nArizona court would face an issue of \xe2\x80\x9cin personamjurisdiction,\xe2\x80\x9d or personal jurisdiction: under\nthe due process clause of the Fourteenth Amendment, each state must extend due process to\ncitizens of all of the other states. Because fairness is essential to due process, the court must\nconsider whether it is fair to require an out-of-state defendant to appear and defend against a\nlawsuit that could result in a judgment against that defendant.\nAlmost every state in the United States has a statute regarding personal jurisdiction, instructing\njudges when it is permissible to assert personal jurisdiction over an out-of-state resident. These\nare called long-arm statutes. But no state can reach out beyond the limits of what is\nconstitutionally permissible under the Fourteenth Amendment, which binds the states with its\nproviso to guarantee the due process rights of the citizens of every state in the union. The\n\xe2\x80\x9cminimum contacts\xe2\x80\x9d test in Burger King v. Rudzewicz(Section 3.9 "Cases") tries to make the\nfairness mandate of the due process clause more specific. So do other tests articulated in the\ncase (such as \xe2\x80\x9cdoes not offend traditional notions of fair play and substantial justice\xe2\x80\x9d). These\ntests are posed by the Supreme Court and heeded by all lower courts in order to honor the\nprovisions of the Fourteenth Amendment\xe2\x80\x99s due process guarantees. These tests are in addition\nto any state long-arm statute\xe2\x80\x99s instructions to courts regarding the assertion of personal\njurisdiction over nonresidents.\n\nChoice of Law and Choice of Forum Clauses\nIn a series of cases, the Supreme Court has made clear that it will honor contractual choices of\nparties in a lawsuit. Suppose the parties to a contract wind up in court arguing over the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n94\n\n\x0capplication of the contract\xe2\x80\x99s terms. If the parties are from two different states, the judge may\nhave difficulty determining which law to apply (see Table 3.1 "Sample Conflict-of-Law\nPrinciples"). But if the contract says that a particular state\xe2\x80\x99s law will be applied if there is a\ndispute, then ordinarily the judge will apply that state\xe2\x80\x99s law as a rule of decision in the case. For\nexample, Kumar Patel (a Missouri resident) opens a brokerage account with Goldman, Sachs\nand Co., and the contractual agreement calls for \xe2\x80\x9cany disputes arising under this agreement\xe2\x80\x9d to\nbe determined \xe2\x80\x9caccording to the laws of the state of New York.\xe2\x80\x9d When Kumar claims in a\nMissouri court that his broker is \xe2\x80\x9cchurning\xe2\x80\x9d his account, and, on the other hand, Goldman,\nSachs claims that Kumar has failed to meet his margin call and owes $38,568.25 (plus interest\nand attorney\xe2\x80\x99s fees), the judge in Missouri will apply New York law based on the contract\nbetween Kumar and Goldman, Sachs.\nOrdinarily, a choice-of-law clause will be accompanied by a choice-of-forum clause. In a choiceof-forum clause, the parties in the contract specify which court they will go to in the event of a\ndispute arising under the terms of contract. For example, Harold (a resident of Virginia) rents a\ncar from Alamo at the Denver International Airport. He does not look at the fine print on the\ncontract. He also waives all collision and other insurance that Alamo offers at the time of his\nrental. While driving back from Telluride Bluegrass Festival, he has an accident in Idaho\nSprings, Colorado. His rented Nissan Altima is badly damaged. On returning to Virginia, he\nwould like to settle up with Alamo, but his insurance company and Alamo cannot come to terms.\nHe realizes, however, that he has agreed to hear the dispute with Alamo in a specific court in San\nAntonio, Texas. In the absence of fraud or bad faith, any court in the United States is likely to\nuphold the choice-of-form clause and require Harold (or his insurance company) to litigate in\nSan Antonio, Texas.\n\nKEY TAKEAWAY\nThere are two court systems in the United States. It is important to know which system\xe2\x80\x94the\nstate court system or the federal court system\xe2\x80\x94has the power to hear and decide a\nparticular case. Once that is established, the Constitution compels an inquiry to make sure\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n95\n\n\x0cthat no court extends its reach unfairly to out-of-state residents. The question of personal\njurisdiction is a question of fairness and due process to nonresidents.\n\nEXERCISES\n\n1. The Constitution specifies that federal courts have exclusive jurisdiction over admiralty\nclaims. Mr. and Mrs. Shute have a claim against Carnival Cruise lines for the negligence of the\ncruise line. Mrs. Shute sustained injuries as a result of the company\xe2\x80\x99s negligence. Mr. and\nMrs. Shute live in the state of Washington. Can they bring their claim in state court? Must\nthey bring their claim in federal court?\n2. Congress passed Title VII of the Civil Rights Act of 1964. In Title VII, employers are required\nnot to discriminate against employees on the basis of race, color, sex, religion, or national\norigin. In passing Title VII, Congress did not require plaintiffs to file only in federal courts.\nThat is, Congress made no statement in Title VII that federal courts had \xe2\x80\x9cexclusive\njurisdiction\xe2\x80\x9d over Title VII claims. Mrs. Harris wishes to sue Forklift Systems, Inc. of Nashville,\nTennessee, for sexual harassment under Title VII. She has gone through the Equal\nEmployment Opportunity Commission process and has a right-to-sue letter, which is required\nbefore a Title VII action can be brought to court. Can she file a complaint that will be heard\nby a state court?\n3. Mrs. Harris fails to go to the Equal Employment Opportunity Commission to get her right-tosue letter against Forklift Systems, Inc. She therefore does not have a viable Title VII cause of\naction against Forklift. She does, however, have her rights under Tennessee\xe2\x80\x99s equal\nemployment statute and various court decisions from Tennessee courts regarding sexual\nharassment. Forklift is incorporated in Tennessee and has its principal place of business in\nNashville. Mrs. Harris is also a citizen of Tennessee. Explain why, if she brings her\nemployment discrimination and sexual harassment lawsuit in a federal court, her lawsuit will\nbe dismissed for lack of subject matter jurisdiction.\n4. Suppose Mr. and Mrs. Robinson find in the original paperwork with Seaway Volkswagen that\nthere is a contractual agreement with a provision that says \xe2\x80\x9call disputes arising between\nbuyer and Seaway Volkswagen will be litigated, if at all, in the county courts of Westchester\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n96\n\n\x0cCounty, New York.\xe2\x80\x9d Will the Oklahoma court take personal jurisdiction over Seaway\nVolkswagen, or will it require the Robinsons to litigate their claim in New York?\n\n3.3 Motions and Discovery\n\nLEARNING OBJECTIVES\n\n1. Explain how a lawsuit can be dismissed prior to any trial.\n2. Understand the basic principles and practices of discovery before a trial.\nThe early phases of a civil action are characterized by many different kinds of motions and a\ncomplex process of mutual fact-finding between the parties that is known as discovery. A lawsuit\nwill start with the pleadings (complaint and answer in every case, and in some cases a\ncounterclaim by the defendant against the plaintiff and the plaintiff\xe2\x80\x99s reply to the defendant\xe2\x80\x99s\ncounterclaim). After the pleadings, the parties may make various motions, which are requests to\nthe judge. Motions in the early stages of a lawsuit usually aim to dismiss the lawsuit, to have it\nmoved to another venue, or to compel the other party to act in certain ways during the discovery\nprocess.\n\nInitial Pleadings, and Motions to Dismiss\nThe first papers filed in a lawsuit are called the pleadings. These include the plaintiff\xe2\x80\x99s complaint\nand then (usually after thirty or more days) the answer or response from the defendant. The\nanswer may be coupled with a counterclaim against the plaintiff. (In effect, the defendant\nbecomes the plaintiff for the claims she has against the original plaintiff.) The plaintiff may reply\nto any counterclaim by the defendant.\nState and federal rules of civil procedure require that the complaint must state the nature of the\nplaintiff\xe2\x80\x99s claim, the jurisdiction of the court, and the nature of the relief that is being asked for\n(usually an award of money, but sometimes an injunction, or a declaration of legal rights). In an\nanswer, the defendant will often deny all the allegations of the complaint or will admit to certain\nof its allegations and deny others.\nA complaint and subsequent pleadings are usually quite general and give little detail. Cases can\nbe decided on the pleadings alone in the following situations: (1) If the defendant fails to answer\nthe complaint, the court can enter a default judgment, awarding the plaintiff what he seeks. (2)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n97\n\n\x0cThe defendant can move to dismiss the complaint on the grounds that the plaintiff failed to\n\xe2\x80\x9cstate a claim on which relief can be granted,\xe2\x80\x9d or on the basis that there is no subject matter\njurisdiction for the court chosen by the plaintiff, or on the basis that there is no personal\njurisdiction over the defendant. The defendant is saying, in effect, that even if all the plaintiff\xe2\x80\x99s\nallegations are true, they do not amount to a legal claim that can be heard by the court. For\nexample, a claim that the defendant induced a woman to stop dating the plaintiff (a so-called\nalienation of affections cause of action) is no longer actionable in US state courts, and any court\nwill dismiss the complaint without any further proceedings. (This type of dismissal is\noccasionally still called a demurrer.)\nA third kind of dismissal can take place on a motion for summary judgment. If there is no triable\nquestion of fact or law, there is no reason to have a trial. For example, the plaintiff sues on a\npromissory note and, at deposition (an oral examination under oath), the defendant admits\nhaving made no payment on the note and offers no excuse that would be recognizable as a\nreason not to pay. There is no reason to have a trial, and the court should grant summary\njudgment.\n\nDiscovery\nIf there is a factual dispute, the case will usually involve some degree of discovery, where each\nparty tries to get as much information out of the other party as the rules allow. Until the 1940s,\nwhen discovery became part of civil procedure rules, a lawsuit was frequently a game in which\neach party hid as much information as possible and tried to surprise the other party in court.\nBeginning with a change in the Federal Rules of Civil Procedure adopted by the Supreme Court\nin 1938 and subsequently followed by many of the states, the parties are entitled to learn the\nfacts of the case before trial. The basic idea is to help the parties determine what the evidence\nmight be, who the potential witnesses are, and what specific issues are relevant. Discovery can\nproceed by several methods. A party may serve an interrogatory on his adversary\xe2\x80\x94a written\nrequest for answers to specific questions. Or a party may depose the other party or a witness. A\ndeposition is a live question-and-answer session at which the witness answers questions put to\nhim by one of the parties\xe2\x80\x99 lawyers. His answers are recorded verbatim and may be used at trial.\nEach party is also entitled to inspect books, documents, records, and other physical items in the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n98\n\n\x0cpossession of the other. This is a broad right, as it is not limited to just evidence that is\nadmissible at trial. Discovery of physical evidence means that a plaintiff may inspect a\ncompany\xe2\x80\x99s accounts, customer lists, assets, profit-and-loss statements, balance sheets,\nengineering and quality-control reports, sales reports, and virtually any other document.\nThe lawyers, not the court, run the discovery process. For example, one party simply makes a\nwritten demand, stating the time at which the deposition will take place or the type of\ndocuments it wishes to inspect and make copies of. A party unreasonably resisting discovery\nmethods (whether depositions, written interrogatories, or requests for documents) can be\nchallenged, however, and judges are often brought into the process to push reluctant parties to\nmake more disclosure or to protect a party from irrelevant or unreasonable discovery requests.\nFor example, the party receiving the discovery request can apply to the court for a protective\norder if it can show that the demand is for privileged material (e.g., a party\xe2\x80\x99s lawyers\xe2\x80\x99 records are\nnot open for inspection) or that the demand was made to harass the opponent. In complex cases\nbetween companies, the discovery of documents can run into tens of millions of pages and can\ntake years. Depositions can consume days or even weeks of an executive\xe2\x80\x99s time.\n\nKEY TAKEAWAY\n\nMany cases never get to trial. They are disposed of by motions to dismiss or are settled after\nextensive discovery makes clear to the parties the strengths and weaknesses of the parties to\nthe dispute.\n\nEXERCISES\n\n1. Mrs. Robinson (in the Volkswagen Audi case) never establishes residency in Arizona, returns\nto New York, and files her case in federal district court in New York, alleging diversity\njurisdiction. Assume that the defendants do not want to have the case heard in federal court.\nWhat motion will they make?\n2. Under contributory negligence, the negligence of any plaintiff that causes or contributes to\nthe injuries a plaintiff complains of will be grounds for dismissal. Suppose that in discovery,\nMr. Ferlito in Ferlito v. Johnson & Johnson (Section 3.9 "Cases") admits that he brought the\ncigarette lighter dangerously close to his costume, saying, \xe2\x80\x9cYes, you could definitely say I was\nbeing careless; I had a few drinks under my belt.\xe2\x80\x9d Also, Mrs. Ferlito admits that she never\nreads product instructions from manufacturers. If the case is brought in a state where\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n99\n\n\x0ccontributory negligence is the law, on what basis can Johnson & Johnson have the case\ndismissed before trial?\n\n3.4 The Pretrial and Trial Phase\n\nLEARNING OBJECTIVES\n\n1. Understand how judges can push parties into pretrial settlement.\n2. Explain the meaning and use of directed verdicts.\n3. Distinguish a directed verdict from a judgment n.o.v. (\xe2\x80\x9cnotwithstanding the verdict\xe2\x80\x9d).\nAfter considerable discovery, one of the parties may believe that there is no triable issue of law\nor fact for the court to consider and may file a motion with the court for summary judgment.\nUnless it is very clear, the judge will deny a summary judgment motion, because that ends the\ncase at the trial level; it is a \xe2\x80\x9cfinal order\xe2\x80\x9d in the case that tells the plaintiff \xe2\x80\x9cno\xe2\x80\x9d and leaves no\nroom to bring another lawsuit against the defendant for that particular set of facts (res judicata).\nIf the plaintiff successfully appeals a summary judgment motion, the case will come back to the\ntrial court.\nPrior to the trial, the judge may also convene the parties in an effort to investigate the\npossibilities of settlement. Usually, the judge will explore the strengths and weaknesses of each\nparty\xe2\x80\x99s case with the attorneys. The parties may decide that it is more prudent or efficient to\nsettle than to risk going to trial.\n\nPretrial Conference\nAt various times during the discovery process, depending on the nature and complexity of the\ncase, the court may hold a pretrial conference to clarify the issues and establish a timetable. The\ncourt may also hold a settlement conference to see if the parties can work out their differences\nand avoid trial altogether. Once discovery is complete, the case moves on to trial if it has not\nbeen settled. Most cases are settled before this stage; perhaps 85 percent of all civil cases end\nbefore trial, and more than 90 percent of criminal prosecutions end with a guilty plea.\n\nTrial\nAt trial, the first order of business is to select a jury. (In a civil case of any consequence, either\nparty can request one, based on the Sixth Amendment to the US Constitution.) The judge and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n100\n\n\x0csometimes the lawyers are permitted to question the jurors to be sure that they are unbiased.\nThis questioning is known as the voir dire (pronounced vwahr-DEER). This is an important\nprocess, and a great deal of thought goes into selecting the jury, especially in high-profile cases.\nA jury panel can be as few as six persons, or as many as twelve, with alternates selected and\nsitting in court in case one of the jurors is unable to continue. In a long trial, having alternates is\nessential; even in shorter trials, most courts will have at least two alternate jurors.\nIn both criminal and civil trials, each side has opportunities to challenge potential jurors for\ncause. For example, in the Robinsons\xe2\x80\x99 case against Audi, the attorneys representing Audi will\nwant to know if any prospective jurors have ever owned an Audi, what their experience has\nbeen, and if they had a similar problem (or worse) with their Audi that was not resolved to their\nsatisfaction. If so, the defense attorney could well believe that such a juror has a potential for a\nbias against her client. In that case, she could use a challenge for cause, explaining to the judge\nthe basis for her challenge. The judge, at her discretion, could either accept the for-cause reason\nor reject it.\nEven if an attorney cannot articulate a for-cause reason acceptable to the judge, he may use one\nof several peremptory challenges that most states (and the federal system) allow. A trial attorney\nwith many years of experience may have a sixth sense about a potential juror and, in\nconsultation with the client, may decide to use a peremptory challenge to avoid having that juror\non the panel.\nAfter the jury is sworn and seated, the plaintiff\xe2\x80\x99s lawyer makes an opening statement, laying out\nthe nature of the plaintiff\xe2\x80\x99s claim, the facts of the case as the plaintiff sees them, and the\nevidence that the lawyer will present. The defendant\xe2\x80\x99s lawyer may also make an opening\nstatement or may reserve his right to do so at the end of the plaintiff\xe2\x80\x99s case.\nThe plaintiff\xe2\x80\x99s lawyer then calls witnesses and presents the physical evidence that is relevant to\nher proof. The direct testimony at trial is usually far from a smooth narration. The rules of\nevidence (that govern the kinds of testimony and documents that may be introduced at trial)\nand the question-and-answer format tend to make the presentation of evidence choppy and\ndifficult to follow.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n101\n\n\x0cAnyone who has watched an actual televised trial or a television melodrama featuring a trial\nscene will appreciate the nature of the trial itself: witnesses are asked questions about a number\nof issues that may or may not be related, the opposing lawyer will frequently object to the\nquestion or the form in which it is asked, and the jury may be sent from the room while the\nlawyers argue at the bench before the judge.\nAfter direct testimony of each witness is over, the opposing lawyer may conduct crossexamination. This is a crucial constitutional right; in criminal cases it is preserved in the\nConstitution\xe2\x80\x99s Sixth Amendment (the right to confront one\xe2\x80\x99s accusers in open court). The formal\nrules of direct testimony are then relaxed, and the cross-examiner may probe the witness more\ninformally, asking questions that may not seem immediately relevant. This is when the opposing\nattorney may become harsh, casting doubt on a witness\xe2\x80\x99s credibility, trying to trip her up and\nshow that the answers she gave are false or not to be trusted. This use of cross-examination,\nalong with the requirement that the witness must respond to questions that are at all relevant to\nthe questions raised by the case, distinguishes common-law courts from those of authoritarian\nregimes around the world.\nFollowing cross-examination, the plaintiff\xe2\x80\x99s lawyer may then question the witness again: this is\ncalled redirect examination and is used to demonstrate that the witness\xe2\x80\x99s original answers were\naccurate and to show that any implications otherwise, suggested by the cross-examiner, were\nunwarranted. The cross-examiner may then engage the witness in re-cross-examination, and so\non. The process usually stops after cross-examination or redirect.\nDuring the trial, the judge\xe2\x80\x99s chief responsibility is to see that the trial is fair to both sides. One\nbig piece of that responsibility is to rule on the admissibility of evidence. A judge may rule that a\nparticular question is out of order\xe2\x80\x94that is, not relevant or appropriate\xe2\x80\x94or that a given\ndocument is irrelevant. Where the attorney is convinced that a particular witness, a particular\nquestion, or a particular document (or part thereof) is critical to her case, she may preserve an\nobjection to the court\xe2\x80\x99s ruling by saying \xe2\x80\x9cexception,\xe2\x80\x9d in which case the court stenographer will\nnote the exception; on appeal, the attorney may cite any number of exceptions as adding up to\nthe lack of a fair trial for her client and may request a court of appeals to order a retrial.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n102\n\n\x0cFor the most part, courts of appeal will not reverse and remand for a new trial unless the trial\ncourt judge\xe2\x80\x99s errors are \xe2\x80\x9cprejudicial,\xe2\x80\x9d or \xe2\x80\x9can abuse of discretion.\xe2\x80\x9d In short, neither party is\nentitled to a perfect trial, but only to a fair trial, one in which the trial judge has made only\n\xe2\x80\x9charmless errors\xe2\x80\x9d and not prejudicial ones.\nAt the end of the plaintiff\xe2\x80\x99s case, the defendant presents his case, following the same procedure\njust outlined. The plaintiff is then entitled to present rebuttal witnesses, if necessary, to deny or\nargue with the evidence the defendant has introduced. The defendant in turn may present\n\xe2\x80\x9csurrebuttal\xe2\x80\x9d witnesses.\nWhen all testimony has been introduced, either party may ask the judge for adirected verdict\xe2\x80\x94a\nverdict decided by the judge without advice from the jury. This motion may be granted if the\nplaintiff has failed to introduce evidence that is legally sufficient to meet her burden of proof or\nif the defendant has failed to do the same on issues on which she has the burden of proof. (For\nexample, the plaintiff alleges that the defendant owes him money and introduces a signed\npromissory note. The defendant cannot show that the note is invalid. The defendant must lose\nthe case unless he can show that the debt has been paid or otherwise discharged.)\nThe defendant can move for a directed verdict at the close of the plaintiff\xe2\x80\x99s case, but the judge\nwill usually wait to hear the entire case until deciding whether to do so. Directed verdicts are not\nusually granted, since it is the jury\xe2\x80\x99s job to determine the facts in dispute.\nIf the judge refuses to grant a directed verdict, each lawyer will then present a closing argument\nto the jury (or, if there is no jury, to the judge alone). The closing argument is used to tie up the\nloose ends, as the attorney tries to bring together various seemingly unrelated facts into a story\nthat will make sense to the jury.\nAfter closing arguments, the judge will instruct the jury. The purpose of jury instruction is to\nexplain to the jurors the meaning of the law as it relates to the issues they are considering and to\ntell the jurors what facts they must determine if they are to give a verdict for one party or the\nother. Each lawyer will have prepared a set of written instructions that she hopes the judge will\ngive to the jury. These will be tailored to advance her client\xe2\x80\x99s case. Many a verdict has been\noverturned on appeal because a trial judge has wrongly instructed the jury. The judge will\ncarefully determine which instructions to give and often will use a set of pattern instructions\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n103\n\n\x0cprovided by the state bar association or the supreme court of the state. These pattern jury\ninstructions are often safer because they are patterned after language that appellate courts have\nused previously, and appellate courts are less likely to find reversible error in the instructions.\nAfter all instructions are given, the jury will retire to a private room and discuss the case and the\nanswers requested by the judge for as long as it takes to reach a unanimous verdict. Some minor\ncases do not require a unanimous verdict. If the jury cannot reach a decision, this is called a\nhung jury, and the case will have to be retried. When a jury does reach a verdict, it delivers it in\ncourt with both parties and their lawyers present. The jury is then discharged, and control over\nthe case returns to the judge. (If there is no jury, the judge will usually announce in a written\nopinion his findings of fact and how the law applies to those facts. Juries just announce their\nverdicts and do not state their reasons for reaching them.)\n\nPosttrial Motions\nThe losing party is allowed to ask the judge for a new trial or for a judgment notwithstanding the\nverdict (often called a judgment n.o.v., from the Latin non obstante veredicto). A judge who\ndecides that a directed verdict is appropriate will usually wait to see what the jury\xe2\x80\x99s verdict is. If\nit is favorable to the party the judge thinks should win, she can rely on that verdict. If the verdict\nis for the other party, he can grant the motion for judgment n.o.v. This is a safer way to proceed\nbecause if the judge is reversed on appeal, a new trial is not necessary. The jury\xe2\x80\x99s verdict always\ncan be restored, whereas without a jury verdict (as happens when a directed verdict is granted\nbefore the case goes to the jury), the entire case must be presented to a new jury.Ferlito v.\nJohnson & Johnson (Section 3.9 "Cases") illustrates the judgment n.o.v. process in a case where\nthe judge allowed the case to go to a jury that was overly sympathetic to the plaintiffs.\nRule 50(b) of the Federal Rules of Civil Procedure provides the authorization for federal judges\nmaking a judgment contrary to the judgment of the jury. Most states have a similar rule.\nRule 50(b) says,\nWhenever a motion for a directed verdict made at the close of all the evidence is denied or for\nany reason is not granted, the court is deemed to have submitted the action to the jury subject to\na later determination of the legal questions raised by the motion. Not later than 10 days after\nentry of judgment, a party who has moved for a directed verdict may move to have the verdict\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n104\n\n\x0cand any judgment entered thereon set aside and to have judgment entered in accordance with\nthe party\xe2\x80\x99s motion for a directed verdict.\xe2\x80\xa6[A] new trial may be prayed for in the alternative. If a\nverdict was returned the court may allow the judgment to stand or may reopen the judgment\nand either order a new trial or direct the entry of judgment as if the requested verdict had been\ndirected.\n\nKEY TAKEAWAY\n\nThe purpose of a trial judge is to ensure justice to all parties to the lawsuit. The judge\npresides, instructs the jury, and may limit who testifies and what they testify about what. In\nall of this, the judge will usually commit some errors; occasionally these will be the kinds of\nerrors that seriously compromise a fair trial for both parties. Errors that do seriously\ncompromise a fair trial for both parties are prejudicial, as opposed to harmless. The appeals\ncourt must decide whether any errors of the trial court judge are prejudicial or not.\nIf a judge directs a verdict, that ends the case for the party who hasn\xe2\x80\x99t asked for one; if a\njudge grants judgment n.o.v., that will take away a jury verdict that one side has worked very\nhard to get. Thus a judge must be careful not to unduly favor one side or the other,\nregardless of his or her sympathies.\n\nEXERCISES\n\n1. What if there was not a doctrine of res judicata? What would the legal system be like?\n2. Why do you think cross-examination is a \xe2\x80\x9cright,\xe2\x80\x9d as opposed to a \xe2\x80\x9cgood thing\xe2\x80\x9d? What kind of\njudicial system would not allow cross-examination of witnesses as a matter of right?\n\n3.5 Judgment, Appeal, and Execution\nLEARNING OBJECTIVES\n\n1. Understand the posttrial process\xe2\x80\x94how appellate courts process appeals.\n2. Explain how a court\xe2\x80\x99s judgment is translated into relief for the winning party.\n\nJudgment or Order\nAt the end of a trial, the judge will enter an order that makes findings of fact (often with the help\nof a jury) and conclusions of law. The judge will also make a judgment as to what relief or\nremedy should be given. Often it is an award of money damages to one of the parties. The losing\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n105\n\n\x0cparty may ask for a new trial at this point or within a short period of time following. Once the\ntrial judge denies any such request, the judgment\xe2\x80\x94in the form of the court\xe2\x80\x99s order\xe2\x80\x94is final.\n\nAppeal\nIf the loser\xe2\x80\x99s motion for a new trial or a judgment n.o.v. is denied, the losing party may appeal\nbut must ordinarily post a bond sufficient to ensure that there are funds to pay the amount\nawarded to the winning party. In an appeal, the appellant aims to show that there was some\nprejudicial error committed by the trial judge. There will be errors, of course, but the errors\nmust be significant (i.e., not harmless). The basic idea is for an appellate court to ensure that a\nreasonably fair trial was provided to both sides. Enforcement of the court\xe2\x80\x99s judgment\xe2\x80\x94an award\nof money, an injunction\xe2\x80\x94is usually stayed (postponed) until the appellate court has ruled. As\nnoted earlier, the party making the appeal is called the appellant, and the party defending the\njudgment is the appellee (or in some courts, the petitioner and the respondent).\nDuring the trial, the losing party may have objected to certain procedural decisions by the judge.\nIn compiling a record on appeal, the appellant needs to show the appellate court some examples\nof mistakes made by the judge\xe2\x80\x94for example, having erroneously admitted evidence, having\nfailed to admit proper evidence that should have been admitted, or having wrongly instructed\nthe jury. The appellate court must determine if those mistakes were serious enough to amount\nto prejudicial error.\nAppellate and trial procedures are different. The appellate court does not hear witnesses or\naccept evidence. It reviews the record of the case\xe2\x80\x94the transcript of the witnesses\xe2\x80\x99 testimony and\nthe documents received into evidence at trial\xe2\x80\x94to try to find a legal error on a specific request of\none or both of the parties. The parties\xe2\x80\x99 lawyers prepare briefs (written statements containing the\nfacts in the case), the procedural steps taken, and the argument or discussion of the meaning of\nthe law and how it applies to the facts. After reading the briefs on appeal, the appellate court\nmay dispose of the appeal without argument, issuing a written opinion that may be very short or\nmany pages. Often, though, the appellate court will hear oral argument. (This can be months, or\neven more than a year after the briefs are filed.) Each lawyer is given a short period of time,\nusually no more than thirty minutes, to present his client\xe2\x80\x99s case. The lawyer rarely gets a chance\nfor an extended statement because he is usually interrupted by questions from the judges.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n106\n\n\x0cThrough this exchange between judges and lawyers, specific legal positions can be tested and\ntheir limits explored.\nDepending on what it decides, the appellate court will affirm the lower court\xe2\x80\x99s\njudgment, modify it, reverse it, or remand it to the lower court for retrial or other action\ndirected by the higher court. The appellate court itself does not take specific action in the case; it\nsits only to rule on contested issues of law. The lower court must issue the final judgment in the\ncase. As we have already seen, there is the possibility of appealing from an intermediate\nappellate court to the state supreme court in twenty-nine states and to the US Supreme Court\nfrom a ruling from a federal circuit court of appeal. In cases raising constitutional issues, there is\nalso the possibility of appeal to the Supreme Court from the state courts.\nLike trial judges, appellate judges must follow previous decisions, or precedent. But not every\nprevious case is a precedent for every court. Lower courts must respect appellate court\ndecisions, and courts in one state are not bound by decisions of courts in other states. State\ncourts are not bound by decisions of federal courts, except on points of federal law that come\nfrom federal courts within the state or from a federal circuit in which the state court sits. A state\nsupreme court is not bound by case law in any other state. But a supreme court in one state with\na type of case it has not previously dealt with may find persuasive reasoning in decisions of other\nstate supreme courts.\nFederal district courts are bound by the decisions of the court of appeals in their circuit, but\ndecisions by one circuit court are not precedents for courts in other circuits. Federal courts are\nalso bound by decisions of the state supreme courts within their geographic territory in diversity\njurisdiction cases. All courts are bound by decisions of the US Supreme Court, except the\nSupreme Court itself, which seldom reverses itself but on occasion has overturned its own\nprecedents.\nNot everything a court says in an opinion is a precedent. Strictly speaking, only the exact holding\nis binding on the lower courts. A holding is the theory of the law that applies to the particular\ncircumstances presented in a case. The courts may sometimes declare what they believe to be\nthe law with regard to points that are not central to the case being decided. These declarations\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n107\n\n\x0care called dicta (the singular, dictum), and the lower courts do not have to give them the same\nweight as holdings.\n\nJudgment and Order\nWhen a party has no more possible appeals, it usually pays up voluntarily. If not voluntarily,\nthen the losing party\xe2\x80\x99s assets can be seized or its wages or other income garnished to satisfy the\njudgment. If the final judgment is an injunction, failure to follow its dictates can lead to a\ncontempt citation, with a fine or jail time imposed.\n\nKEY TAKEAWAY\n\nThe process of conducting a civil trial has many aspects, starting with pleadings and\ncontinuing with motions, discovery, more motions, pretrial conferences, and finally the trial\nitself. At all stages, the rules of civil procedure attempt to give both sides plenty of notice,\nopportunity to be heard, discovery of relevant information, cross-examination, and the\npreservation of procedural objections for purposes of appeal. All of these rules and\nprocedures are intended to provide each side with a fair trial.\n\nEXERCISES\n\n1. Mrs. Robinson has a key witness on auto safety that the judge believes is not qualified as an\nexpert. The judge examines the witness while the jury is in the jury room and disqualifies him\nfrom testifying. The jury does not get to hear this witness. Her attorney objects. She loses her\ncase. What argument would you expect Mrs. Robinson\xe2\x80\x99s attorney to make in an appeal?\n2. Why don\xe2\x80\x99t appellate courts need a witness box for witnesses to give testimony under oath?\n3. A trial judge in Nevada is wondering whether to enforce a surrogate motherhood\ncontract. Penelope Barr, of Reno, Nevada, has contracted with Reuben and Tina\nGoldberg to bear the in vitro fertilized egg of Mrs. Goldberg. After carrying the\nchild for nine months, Penelope gives birth, but she is reluctant to give up the\nchild, even though she was paid $20,000 at the start of the contract and will earn\nan additional $20,000 on handing over the baby to the Goldbergs. (Barr was an\nespecially good candidate for surrogate motherhood: she had borne two perfect\nchildren and at age 28 drinks no wine, does not smoke or use drugs of any kind,\npractices yoga, and maintains a largely vegetarian diet with just enough meat to\nmeet the needs of the fetus within.)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n108\n\n\x0cThe Goldbergs have asked the judge for an order compelling Penelope to give up\nthe baby, who was five days old when the lawsuit was filed. The baby is now a\nmonth old as the judge looks in vain for guidance from any Nevada statute,\nfederal statute, or any prior case in Nevada that addressed the issue of surrogate\nmotherhood. He does find several well-reasoned cases, one from New Jersey, one\nfrom Michigan, and one from Oregon. Are any of these \xe2\x80\x9cprecedent\xe2\x80\x9d that he must\nfollow? May he adopt the reasoning of any of these courts, if he should find that\nreasoning persuasive?\n\n3.6 When Can Someone Bring a Lawsuit?\nLEARNING OBJECTIVES\n\n1. Explain the requirements for standing to bring a lawsuit in US courts.\n2. Describe the process by which a group or class of plaintiffs can be certified to file a class\naction case.\nAlmost anyone can bring a lawsuit, assuming they have the filing fee and the help of an attorney.\nBut the court may not hear it, for a number of reasons. There may be no case or controversy,\nthere may be no law to support the plaintiff\xe2\x80\x99s claim, it may be in the wrong court, too much time\nmight have lapsed (a statute of limitations problem), or the plaintiff may not have standing.\n\nCase or Controversy: Standing to Sue\nArticle III of the US Constitution provides limits to federal judicial power. For some cases, the\nSupreme Court has decided that it has no power to adjudicate because there is no \xe2\x80\x9ccase or\ncontroversy.\xe2\x80\x9d For example, perhaps the case has settled or the \xe2\x80\x9creal parties in interest\xe2\x80\x9d are not\nbefore the court. In such a case, a court might dismiss the case on the grounds that the plaintiff\ndoes not have \xe2\x80\x9cstanding\xe2\x80\x9d to sue.\nFor example, suppose you see a sixteen-wheel moving van drive across your neighbor\xe2\x80\x99s flower\nbed, destroying her beloved roses. You have enjoyed seeing her roses every summer, for years.\nShe is forlorn and tells you that she is not going to raise roses there anymore. She also tells you\nthat she has decided not to sue, because she has made the decision to never deal with lawyers if\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n109\n\n\x0cat all possible. Incensed, you decide to sue on her behalf. But you will not have standing to sue\nbecause your person or property was not directly injured by the moving van. Standing means\nthat only the person whose interests are directly affected has the legal right to sue.\nThe standing doctrine is easy to understand in straightforward cases such as this but is often a\nfairly complicated matter. For example, can fifteen or more state attorneys general bring a\nlawsuit for a declaratory judgment that the health care legislation passed in 2010 is\nunconstitutional? What particular injury have they (or the states) suffered? Are they the best set\nof plaintiffs to raise this issue? Time\xe2\x80\x94and the Supreme Court\xe2\x80\x94will tell.\n\nClass Actions\nMost lawsuits concern a dispute between two people or between a person and a company or\nother organization. But it can happen that someone injures more than one person at the same\ntime. A driver who runs a red light may hit another car carrying one person or many people. If\nseveral people are injured in the same accident, they each have the right to sue the driver for the\ndamage that he caused them. Could they sue as a group? Usually not, because the damages\nwould probably not be the same for each person, and different facts would have to be proved at\nthe trial. Plus, the driver of the car that was struck might have been partially to blame, so the\ndefendant\xe2\x80\x99s liability toward him might be different from his liability toward the passengers.\nIf, however, the potential plaintiffs were all injured in the same way and their injuries were\nidentical, a single lawsuit might be a far more efficient way of determining liability and deciding\nfinancial responsibility than many individual lawsuits.\nHow could such a suit be brought? All the injured parties could hire the same lawyer, and she\ncould present a common case. But with a group numbering more than a handful of people, it\ncould become overwhelmingly complicated. So how could, say, a million stockholders who\nbelieved they were cheated by a corporation ever get together to sue?\nBecause of these types of situations, there is a legal procedure that permits one person or a small\ngroup of people to serve as representatives for all others. This is the class action. The class action\nis provided for in the Federal Rules of Civil Procedure (Rule 23) and in the separate codes of\ncivil procedure in the states. These rules differ among themselves and are often complex, but in\ngeneral anyone can file a class action in an appropriate case, subject to approval of the court.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n110\n\n\x0cOnce the class is \xe2\x80\x9ccertified,\xe2\x80\x9d or judged to be a legally adequate group with common injuries, the\nlawyers for the named plaintiffs become, in effect, lawyers for the entire class.\nUsually a person who doesn\xe2\x80\x99t want to be in the class can decide to leave. If she does, she will not\nbe included in an eventual judgment or settlement. But a potential plaintiff who is included in\nthe class cannot, after a final judgment is awarded, seek to relitigate the issue if she is\ndissatisfied with the outcome, even though she did not participate at all in the legal proceeding.\n\nKEY TAKEAWAY\n\nAnyone can file a lawsuit, with or without the help of an attorney, but only those lawsuits\nwhere a plaintiff has standing will be heard by the courts. Standing has become a\ncomplicated question and is used by the courts to ensure that civil cases heard are being\npursued by those with tangible and particular injuries. Class actions are a way of aggregating\nclaims that are substantially similar and arise out of the same facts and circumstances.\n\nEXERCISE\n\n1. Fuchs Funeral Home is carrying the body of Charles Emmenthaler to its resting place\nat Forest Lawn Cemetery. Charles\xe2\x80\x99s wife, Chloe, and their two children, Chucky\nand Clarice, are following the hearse when the coffin falls on the street, opens,\nand the body of Charles Emmenthaler falls out. The wife and children are shocked\nand aggrieved and later sue in civil court for damages. Assume that this is a viable\ncause of action based on \xe2\x80\x9cnegligent infliction of emotional distress\xe2\x80\x9d in the state of\nCalifornia and that Charles\xe2\x80\x99s brother, sister-in-law, and multiple cousins also were\nin the funeral procession and saw what happened. The brother of Charles,\nKingston Emmenthaler, also sees his brother\xe2\x80\x99s body on the street, but his wife,\ntheir three children, and some of Charles\xe2\x80\x99s other cousins do not.\nCharles was actually emotionally closest to Kingston\xe2\x80\x99s oldest son, Nestor, who was\nstudying abroad at the time of the funeral and could not make it back in time. He\nis as emotionally distraught at his uncle\xe2\x80\x99s passing as anyone else in the family and\nis especially grieved over the description of the incident and the grainy video shot\nby one of the cousins on his cell phone. Who has standing to sue Fuchs Funeral\nHome, and who does not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n111\n\n\x0c3.7 Relations with Lawyers\n\nLEARNING OBJECTIVES\n\n1. Understand the various ways that lawyers charge for services.\n2. Describe the contingent fee system in the United States.\n3. Know the difference between the American rule and the British rule with regard to who pays\nattorneys\xe2\x80\x99 fees.\n\nLegal Fees\nLawyers charge for their services in one of three different ways: flat rate, hourly rate, and\ncontingent fee. A flat rate is used usually when the work is relatively routine and the lawyer\nknows in advance approximately how long it will take her to do the job. Drawing a will or doing\na real estate closing are examples of legal work that is often paid a flat rate. The rate itself may\nbe based on a percentage of the worth of the matter\xe2\x80\x94say, 1 percent of a home\xe2\x80\x99s selling price.\nLawyers generally charge by the hour for courtroom time and for ongoing representation in\ncommercial matters. Virtually every sizable law firm bills its clients by hourly rates, which in\nlarge cities can range from $300 for an associate\xe2\x80\x99s time to $500 and more for a senior partner\xe2\x80\x99s\ntime.\nA contingent fee is one that is paid only if the lawyer wins\xe2\x80\x94that is, it is contingent, or depends\nupon, the success of the case. This type of fee arrangement is used most often in personal injury\ncases (e.g., automobile accidents, products liability, and professional malpractice). Although\nused quite often, the contingent fee is controversial. Trial lawyers justify it by pointing to the\nhigh cost of preparing for such lawsuits. A typical automobile accident case can cost at least ten\nthousand dollars to prepare, and a complicated products-liability case can cost tens of\nthousands of dollars. Few people have that kind of money or would be willing to spend it on the\nchance that they might win a lawsuit. Corporate and professional defendants complain that the\ncontingent fee gives lawyers a license to go big game hunting, or to file suits against those with\ndeep pockets in the hopes of forcing them to settle.\nTrial lawyers respond that the contingent fee arrangement forces them to screen cases and weed\nout cases that are weak, because it is not worth their time to spend the hundreds of hours\nnecessary on such cases if their chances of winning are slim or nonexistent.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n112\n\n\x0cCosts\nIn England and in many other countries, the losing party must pay the legal expenses of the\nwinning party, including attorneys\xe2\x80\x99 fees. That is not the general rule in this country. Here, each\nparty must pay most of its own costs, including (and especially) the fees of lawyers. (Certain\nrelatively minor costs, such as filing fees for various documents required in court, are chargeable\nto the losing side, if the judge decides it.) This type of fee structure is known as the American\nrule (in contrast to the British rule).\nThere are two types of exceptions to the American rule. By statute, Congress and the state\nlegislatures have provided that the winning party in particular classes of cases may recover its\nfull legal costs from the loser\xe2\x80\x94for example, the federal antitrust laws so provide and so does the\nfederal Equal Access to Justice Act. The other exception applies to litigants who either initiate\nlawsuits in bad faith, with no expectation of winning, or who defend them in bad faith, in order\nto cause the plaintiff great expense. Under these circumstances, a court has the discretion to\naward attorneys\xe2\x80\x99 fees to the winner. But this rule is not infinitely flexible, and courts do not have\ncomplete freedom to award attorneys\xe2\x80\x99 fees in any amount, but only "reasonable" attorney\'s fees.\n\nKEY TAKEAWAY\n\nLitigation is expensive. Getting a lawyer can be costly, unless you get a lawyer on a\ncontingent fee. Not all legal systems allow contingent fees. In many legal systems, the loser\npays attorneys\xe2\x80\x99 fees for both parties.\n\nEXERCISES\n\n1. Mrs. Robinson\xe2\x80\x99s attorney estimates that they will recover a million dollars from Volkswagen\nin the Audi lawsuit. She has Mrs. Robinson sign a contract that gives her firm one-third of any\nrecovery after the firm\xe2\x80\x99s expenses are deducted. The judge does in fact award a million\ndollars, and the defendant pays. The firm\xe2\x80\x99s expenses are $100,000. How much does Mrs.\nRobinson get?\n2. Harry Potter brings a lawsuit against Draco Malfoy in Chestershire, England, for slander, a\nform of defamation. Potter alleges that Malfoy insists on calling him a mudblood. Ron\nWeasley testifies, as does Neville Chamberlain. But Harry loses, because the court has no\nconception of wizardry and cannot make sense of the case at all. In dismissing the case,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n113\n\n\x0chowever, who (under English law) will bear the costs of the attorneys who have brought the\ncase for Potter and defended the matter for Malfoy?\n\n3.8 Alternative Means of Resolving Disputes\nLEARNING OBJECTIVES\n\n1. Understand how arbitration and mediation are frequently used alternatives to litigation.\n2. Describe the differences between arbitration and mediation.\n3. Explain why arbitration is final and binding.\nDisputes do not have to be settled in court. No law requires parties who have a legal dispute to\nseek judicial resolution if they can resolve their disagreement privately or through some other\npublic forum. In fact, the threat of a lawsuit can frequently motivate parties toward private\nnegotiation. Filing a lawsuit may convince one party that the other party is serious. Or the\nparties may decide that they will come to terms privately rather than wait the three or four years\nit can frequently take for a case to move up on the court calendar.\n\nArbitration\nBeginning around 1980, a movement toward alternative dispute resolution began to gain force\nthroughout the United States. Bar associations, other private groups, and the courts themselves\nwanted to find quicker and cheaper ways for litigants and potential litigants to settle certain\ntypes of quarrels than through the courts. As a result, neighborhood justice centers or dispute\nresolution centers have sprung up in communities. These are where people can come for help in\nsettling disputes, of both civil and criminal nature, that should not consume the time and money\nof the parties or courts in lengthy proceedings.\nThese alternative forums use a variety of methods, including arbitration, mediation, and\nconciliation, to bring about agreement or at least closure of the dispute. These methods are not\nall alike, and their differences are worth noting.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n114\n\n\x0cArbitration is a type of adjudication. The parties use a private decision maker, the arbitrator,\nand the rules of procedure are considerably more relaxed than those that apply in the\ncourtroom. Arbitrators might be retired judges, lawyers, or anyone with the kind of specialized\nknowledge and training that would be useful in making a final, binding decision on the dispute.\nIn a contractual relationship, the parties can decide even before a dispute arises to use\narbitration when the time comes. Or parties can decide after a dispute arises to use arbitration\ninstead of litigation. In a predispute arbitration agreement (often part of a larger contract), the\nparties can spell out the rules of procedure to be used and the method for choosing the\narbitrator. For example, they may name the specific person or delegate the responsibility of\nchoosing to some neutral person, or they may each designate a person and the two designees\nmay jointly pick a third arbitrator.\nMany arbitrations take place under the auspices of the American Arbitration Association, a\nprivate organization headquartered in New York, with regional offices in many other cities. The\nassociation uses published sets of rules for various types of arbitration (e.g., labor arbitration or\ncommercial arbitration); parties who provide in contracts for arbitration through the association\nare agreeing to be bound by the association\xe2\x80\x99s rules. Similarly, the National Association of\nSecurities Dealers provides arbitration services for disputes between clients and brokerage\nfirms. International commercial arbitration often takes place through the auspices of the\nInternational Chamber of Commerce. A multilateral agreement known as the Convention on the\nRecognition and Enforcement of Arbitral Awards provides that agreements to arbitrate\xe2\x80\x94and\narbitral awards\xe2\x80\x94will be enforced across national boundaries.\nArbitration has two advantages over litigation. First, it is usually much quicker, because the\narbitrator does not have a backlog of cases and because the procedures are simpler. Second, in\ncomplex cases, the quality of the decision may be higher, because the parties can select an\narbitrator with specialized knowledge.\nUnder both federal and state law, arbitration is favored, and a decision rendered by an arbitrator\nis binding by law and may be enforced by the courts. The arbitrator\xe2\x80\x99s decision is final and\nbinding, with very few exceptions (such as fraud or manifest disregard of the law by the\narbitrator or panel of arbitrators). Saying that arbitration is favored means that if you have\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n115\n\n\x0cagreed to arbitration, you can\xe2\x80\x99t go to court if the other party wants you to arbitrate. Under the\nFederal Arbitration Act, the other party can go to court and get a stay against your litigation and\nalso get an order compelling you to go to arbitration.\n\nMediation\nUnlike adjudication, mediation gives the neutral party no power to impose a decision. The\nmediator is a go-between who attempts to help the parties negotiate a solution. The mediator\nwill communicate the parties\xe2\x80\x99 positions to each other, will facilitate the finding of common\nground, and will suggest outcomes. But the parties have complete control: they may ignore the\nrecommendations of the mediator entirely, settle in their own way, find another mediator, agree\nto binding arbitration, go to court, or forget the whole thing!\n\nKEY TAKEAWAY\n\nLitigation is not the only way to resolve disputes. Informal negotiation between the\ndisputants usually comes first, but both mediation and arbitration are available. Arbitration,\nthough, is final and binding. Once you agree to arbitrate, you will have a final, binding arbitral\naward that is enforceable through the courts, and courts will almost never allow you to\nlitigate after you have agreed to arbitrate.\n\nEXERCISES\n\n1. When Mrs. Robinson buys her Audi from Seaway, there is a paragraph in the bill of sale,\nwhich both the dealer and Mrs. Robinson sign, that says, \xe2\x80\x9cIn the event of any complaint by\ncustomer/buyer against Seaway regarding the vehicle purchased herein, such complaint shall\nnot be litigated, but may only be arbitrated under the rules of the American Arbitration\nAssociation and in accordance with New York law.\xe2\x80\x9d Mrs. Robinson did not see the provision,\ndoesn\xe2\x80\x99t like it, and wants to bring a lawsuit in Oklahoma against Seaway. What result?\n2. Hendrik Koster (Netherlands) contracts with Automark, Inc. (a US company based in Illinois)\nto supply Automark with a large quantity of valve cap gauges. He does, and Automark fails to\npay. Koster thinks he is owed $66,000. There is no agreement to arbitrate or mediate. Can\nKoster make Automark mediate or arbitrate?\n3. Suppose that there is an agreement between Koster and Automark to arbitrate. It says, \xe2\x80\x9cThe\nparties agree to arbitrate any dispute arising under this agreement in accordance with the\nlaws of the Netherlands and under the auspices of the International Chamber of Commerce\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n116\n\n\x0carbitration facility.\xe2\x80\x9d The International Chamber of Commerce has arbitration rules and will\nappoint an arbitrator or arbitral panel in the event the parties cannot agree on an arbitrator.\nThe arbitration takes place in Geneva. Koster gets an arbitral award for $66,000 plus interest.\nAutomark does not participate in any way. Will a court in Illinois enforce the arbitral award?\n\n3.9 Cases\nBurger King v. Rudzewicz\nBurger King Corp. v. Rudzewicz\n471 U.S. 462 (U.S. Supreme Court 1985)\n\nSummary\nBurger King Corp. is a Florida corporation with principal offices in Miami. It principally\nconducts restaurant business through franchisees. The franchisees are licensed to use Burger\nKing\xe2\x80\x99s trademarks and service marks in standardized restaurant facilities. Rudzewicz is a\nMichigan resident who, with a partner (MacShara) operated a Burger King franchise in Drayton\nPlains, Michigan. Negotiations for setting up the franchise occurred in 1978 largely between\nRudzewicz, his partner, and a regional office of Burger King in Birmingham, Michigan, although\nsome deals and concessions were made by Burger King in Florida. A preliminary agreement was\nsigned in February of 1979. Rudzewicz and MacShara assumed operation of an existing facility\nin Drayton Plains and MacShara attended prescribed management courses in Miami during the\nfour months following Feb. 1979.\nRudzewicz and MacShara bought $165,000 worth of restaurant equipment from Burger King\xe2\x80\x99s\nDavmor Industries division in Miami. But before the final agreements were signed, the parties\nbegan to disagree over site-development fees, building design, computation of monthly rent, and\nwhether Rudzewicz and MacShara could assign their liabilities to a corporation they had\nformed. Negotiations took place between Rudzewicz, MacShara, and the Birmingham regional\noffice; but Rudzewicz and MacShara learned that the regional office had limited decisionmaking power and turned directly to Miami headquarters for their concerns. The final\nagreement was signed by June 1979 and provided that the franchise relationship was governed\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n117\n\n\x0cby Florida law, and called for payment of all required fees and forwarding of all relevant notices\nto Miami headquarters.\nThe Drayton Plains restaurant did fairly well at first, but a recession in late 1979 caused the\nfranchisees to fall far behind in their monthly payments to Miami. Notice of default was sent\nfrom Miami to Rudzewicz, who nevertheless continued to operate the restaurant as a Burger\nKing franchise. Burger King sued in federal district court for the southern district of Florida.\nRudzewicz contested the court\xe2\x80\x99s personal jurisdiction over him, since he had never been to\nFlorida.\nThe federal court looked to Florida\xe2\x80\x99s long arm statute and held that it did have personal\njurisdiction over the non-resident franchisees, and awarded Burger King a quarter of a million\ndollars in contract damages and enjoined the franchisees from further operation of the Drayton\nPlains facility. Franchisees appealed to the 11th Circuit Court of Appeals and won a reversal\nbased on lack of personal jurisdiction. Burger King petitioned the Supreme Ct. for a writ of\ncertiorari.\nJustice Brennan delivered the opinion of the court.\nThe Due Process Clause protects an individual\xe2\x80\x99s liberty interest in not being subject to the\nbinding judgments of a forum with which he has established no meaningful \xe2\x80\x9ccontacts, ties, or\nrelations.\xe2\x80\x9d International Shoe Co. v. Washington. By requiring that individuals have \xe2\x80\x9cfair\nwarning that a particular activity may subject [them] to the jurisdiction of a foreign sovereign,\xe2\x80\x9d\nthe Due Process Clause \xe2\x80\x9cgives a degree of predictability to the legal system that allows potential\ndefendants to structure their primary conduct with some minimum assurance as to where that\nconduct will and will not render them liable to suit.\xe2\x80\x9d\xe2\x80\xa6\nWhere a forum seeks to assert specific jurisdiction over an out-of-state defendant who has not\nconsented to suit there, this \xe2\x80\x9cfair warning\xe2\x80\x9d requirement is satisfied if the defendant has\n\xe2\x80\x9cpurposefully directed\xe2\x80\x9d his activities at residents of the forum, and the litigation results from\nalleged injuries that \xe2\x80\x9carise out of or relate to\xe2\x80\x9d those activities, Thus \xe2\x80\x9c[t]he forum State does not\nexceed its powers under the Due Process Clause if it asserts personal jurisdiction over a\ncorporation that delivers its products into the stream of commerce with the expectation that\nthey will be purchased by consumers in the forum State\xe2\x80\x9d and those products subsequently injure\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n118\n\n\x0cforum consumers. Similarly, a publisher who distributes magazines in a distant State may fairly\nbe held accountable in that forum for damages resulting there from an allegedly defamatory\nstory.\xe2\x80\xa6\n\xe2\x80\xa6[T]he constitutional touchstone remains whether the defendant purposefully established\n\xe2\x80\x9cminimum contacts\xe2\x80\x9d in the forum State.\xe2\x80\xa6In defining when it is that a potential defendant\nshould \xe2\x80\x9creasonably anticipate\xe2\x80\x9d out-of-state litigation, the Court frequently has drawn from the\nreasoning of Hanson v. Denckla, 357 U.S. 235, 253 (1958):\nThe unilateral activity of those who claim some relationship with a nonresident defendant\ncannot satisfy the requirement of contact with the forum State. The application of that rule will\nvary with the quality and nature of the defendant\xe2\x80\x99s activity, but it is essential in each case that\nthere be some act by which the defendant purposefully avails itself of the privilege of conducting\nactivities within the forum State, thus invoking the benefits and protections of its laws.\nThis \xe2\x80\x9cpurposeful availment\xe2\x80\x9d requirement ensures that a defendant will not be haled into a\njurisdiction solely as a result of \xe2\x80\x9crandom,\xe2\x80\x9d \xe2\x80\x9cfortuitous,\xe2\x80\x9d or \xe2\x80\x9cattenuated\xe2\x80\x9d contacts, or of the\n\xe2\x80\x9cunilateral activity of another party or a third person,\xe2\x80\x9d [Citations] Jurisdiction is proper,\nhowever, where the contacts proximately result from actions by the defendant himself that\ncreate a \xe2\x80\x9csubstantial connection\xe2\x80\x9d with the forum State. [Citations] Thus where the defendant\n\xe2\x80\x9cdeliberately\xe2\x80\x9d has engaged in significant activities within a State, or has created \xe2\x80\x9ccontinuing\nobligations\xe2\x80\x9d between himself and residents of the forum, he manifestly has availed himself of\nthe privilege of conducting business there, and because his activities are shielded by \xe2\x80\x9cthe\nbenefits and protections\xe2\x80\x9d of the forum\xe2\x80\x99s laws it is presumptively not unreasonable to require\nhim to submit to the burdens of litigation in that forum as well.\nJurisdiction in these circumstances may not be avoided merely because the defendant did not\nphysically enter the forum State. Although territorial presence frequently will enhance a\npotential defendant\xe2\x80\x99s affiliation with a State and reinforce the reasonable foreseeability of suit\nthere, it is an inescapable fact of modern commercial life that a substantial amount of business\nis transacted solely by mail and wire communications across state lines, thus obviating the need\nfor physical presence within a State in which business is conducted. So long as a commercial\nactor\xe2\x80\x99s efforts are \xe2\x80\x9cpurposefully directed\xe2\x80\x9d toward residents of another State, we have\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n119\n\n\x0cconsistently rejected the notion that an absence of physical contacts can defeat personal\njurisdiction there.\nOnce it has been decided that a defendant purposefully established minimum contacts within\nthe forum State, these contacts may be considered in light of other factors to determine whether\nthe assertion of personal jurisdiction would comport with \xe2\x80\x9cfair play and substantial\njustice.\xe2\x80\x9d International Shoe Co. v. Washington, 326 U.S., at 320. Thus courts in \xe2\x80\x9cappropriate\ncase[s]\xe2\x80\x9d may evaluate \xe2\x80\x9cthe burden on the defendant,\xe2\x80\x9d \xe2\x80\x9cthe forum State\xe2\x80\x99s interest in adjudicating\nthe dispute,\xe2\x80\x9d \xe2\x80\x9cthe plaintiff\xe2\x80\x99s interest in obtaining convenient and effective relief,\xe2\x80\x9d \xe2\x80\x9cthe interstate\njudicial system\xe2\x80\x99s interest in obtaining the most efficient resolution of controversies,\xe2\x80\x9d and the\n\xe2\x80\x9cshared interest of the several States in furthering fundamental substantive social policies.\xe2\x80\x9d\nThese considerations sometimes serve to establish the reasonableness of jurisdiction upon a\nlesser showing of minimum contacts than would otherwise be required. [Citations] Applying\nthese principles to the case at hand, we believe there is substantial record evidence supporting\nthe District Court\xe2\x80\x99s conclusion that the assertion of personal jurisdiction over Rudzewicz in\nFlorida for the alleged breach of his franchise agreement did not offend due process.\xe2\x80\xa6\nIn this case, no physical ties to Florida can be attributed to Rudzewicz other than MacShara\xe2\x80\x99s\nbrief training course in Miami. Rudzewicz did not maintain offices in Florida and, for all that\nappears from the record, has never even visited there. Yet this franchise dispute grew directly\nout of \xe2\x80\x9ca contract which had a substantial connection with that State.\xe2\x80\x9d Eschewing the option of\noperating an independent local enterprise, Rudzewicz deliberately \xe2\x80\x9creach[ed] out beyond\xe2\x80\x9d\nMichigan and negotiated with a Florida corporation for the purchase of a long-term franchise\nand the manifold benefits that would derive from affiliation with a nationwide organization.\nUpon approval, he entered into a carefully structured 20-year relationship that envisioned\ncontinuing and wide-reaching contacts with Burger King in Florida. In light of Rudzewicz\xe2\x80\x99\nvoluntary acceptance of the long-term and exacting regulation of his business from Burger\nKing\xe2\x80\x99s Miami headquarters, the \xe2\x80\x9cquality and nature\xe2\x80\x9d of his relationship to the company in\nFlorida can in no sense be viewed as \xe2\x80\x9crandom,\xe2\x80\x9d \xe2\x80\x9cfortuitous,\xe2\x80\x9d or \xe2\x80\x9cattenuated.\xe2\x80\x9d Rudzewicz\xe2\x80\x99 refusal\nto make the contractually required payments in Miami, and his continued use of Burger King\xe2\x80\x99s\ntrademarks and confidential business information after his termination, caused foreseeable\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n120\n\n\x0cinjuries to the corporation in Florida. For these reasons it was, at the very least, presumptively\nreasonable for Rudzewicz to be called to account there for such injuries.\n\xe2\x80\xa6Because Rudzewicz established a substantial and continuing relationship with Burger King\xe2\x80\x99s\nMiami headquarters, received fair notice from the contract documents and the course of dealing\nthat he might be subject to suit in Florida, and has failed to demonstrate how jurisdiction in that\nforum would otherwise be fundamentally unfair, we conclude that the District Court\xe2\x80\x99s exercise\nof jurisdiction pursuant to Fla. Stat. 48.193(1)(g) (Supp. 1984) did not offend due process. The\njudgment of the Court of Appeals is accordingly reversed, and the case is remanded for further\nproceedings consistent with this opinion.\nIt is so ordered.\n\nCASE QUESTIONS\n\n1. Why did Burger King sue in Florida rather than in Michigan?\n2. If Florida has a long-arm statute that tells Florida courts that it may exercise personal\njurisdiction over someone like Rudzewicz, why is the court talking about the due process\nclause?\n3. Why is this case in federal court rather than in a Florida state court?\n4. If this case had been filed in state court in Florida, would Rudzewicz be required to come to\nFlorida? Explain.\n\nFerlito v. Johnson & Johnson\nFerlito v. Johnson & Johnson Products, Inc.\n771 F. Supp. 196 (U.S. District Ct., Eastern District of Michigan 1991)\nGadola, J.\nPlaintiffs Susan and Frank Ferlito, husband and wife, attended a Halloween party in 1984\ndressed as Mary (Mrs. Ferlito) and her little lamb (Mr. Ferlito). Mrs. Ferlito had constructed a\nlamb costume for her husband by gluing cotton batting manufactured by defendant Johnson &\nJohnson Products (\xe2\x80\x9cJJP\xe2\x80\x9d) to a suit of long underwear. She had also used defendant\xe2\x80\x99s product to\nfashion a headpiece, complete with ears. The costume covered Mr. Ferlito from his head to his\nankles, except for his face and hands, which were blackened with Halloween paint. At the party\nMr. Ferlito attempted to light his cigarette by using a butane lighter. The flame passed close to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n121\n\n\x0chis left arm, and the cotton batting on his left sleeve ignited. Plaintiffs sued defendant for\ninjuries they suffered from burns which covered approximately one-third of Mr. Ferlito\xe2\x80\x99s body.\nFollowing a jury verdict entered for plaintiffs November 2, 1989, the Honorable Ralph M.\nFreeman entered a judgment for plaintiff Frank Ferlito in the amount of $555,000 and for\nplaintiff Susan Ferlito in the amount of $ 70,000. Judgment was entered November 7, 1989.\nSubsequently, on November 16, 1989, defendant JJP filed a timely motion for judgment\nnotwithstanding the verdict pursuant to Fed.R.Civ.P. 50(b) or, in the alternative, for new trial.\nPlaintiffs filed their response to defendant\xe2\x80\x99s motion December 18, 1989; and defendant filed a\nreply January 4, 1990. Before reaching a decision on this motion, Judge Freeman died. The case\nwas reassigned to this court April 12, 1990.\nMOTION FOR JUDGMENT NOTWITHSTANDING THE VERDICT\nDefendant JJP filed two motions for a directed verdict, the first on October 27, 1989, at the close\nof plaintiffs\xe2\x80\x99 proofs, and the second on October 30, 1989, at the close of defendant\xe2\x80\x99s proofs.\nJudge Freeman denied both motions without prejudice. Judgment for plaintiffs was entered\nNovember 7, 1989; and defendant\xe2\x80\x99s instant motion, filed November 16, 1989, was filed in a\ntimely manner.\nThe standard for determining whether to grant a j.n.o.v. is identical to the standard for\nevaluating a motion for directed verdict:\nIn determining whether the evidence is sufficient, the trial court may neither weigh the\nevidence, pass on the credibility of witnesses nor substitute its judgment for that of the jury.\nRather, the evidence must be viewed in the light most favorable to the party against whom the\nmotion is made, drawing from that evidence all reasonable inferences in his favor. If after\nreviewing the evidence\xe2\x80\xa6the trial court is of the opinion that reasonable minds could not come to\nthe result reached by the jury, then the motion for j.n.o.v. should be granted.\nTo recover in a \xe2\x80\x9cfailure to warn\xe2\x80\x9d product liability action, a plaintiff must prove each of the\nfollowing four elements of negligence: (1) that the defendant owed a duty to the plaintiff, (2) that\nthe defendant violated that duty, (3) that the defendant\xe2\x80\x99s breach of that duty was a proximate\ncause of the damages suffered by the plaintiff, and (4) that the plaintiff suffered damages.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n122\n\n\x0cTo establish a prima facie case that a manufacturer\xe2\x80\x99s breach of its duty to warn was a proximate\ncause of an injury sustained, a plaintiff must present evidence that the product would have been\nused differently had the proffered warnings been given. [1][Citations omitted] In the absence of\nevidence that a warning would have prevented the harm complained of by altering the plaintiff\xe2\x80\x99s\nconduct, the failure to warn cannot be deemed a proximate cause of the plaintiff\xe2\x80\x99s injury as a\nmatter of law. [In accordance with procedure in a diversity of citizenship case, such as this one,\nthe court cites Michigan case law as the basis for its legal interpretation.]\n\xe2\x80\xa6\nA manufacturer has a duty \xe2\x80\x9cto warn the purchasers or users of its product about dangers\nassociated with intended use.\xe2\x80\x9d Conversely, a manufacturer has no duty to warn of a danger\narising from an unforeseeable misuse of its product. [Citation] Thus, whether a manufacturer\nhas a duty to warn depends on whether the use of the product and the injury sustained by it are\nforeseeable. Gootee v. Colt Industries Inc., 712 F.2d 1057, 1065 (6th Cir. 1983); Owens v. AllisChalmers Corp., 414 Mich. 413, 425, 326 N.W.2d 372 (1982). Whether a plaintiff\xe2\x80\x99s use of a\nproduct is foreseeable is a legal question to be resolved by the court. Trotter, supra. Whether the\nresulting injury is foreseeable is a question of fact for the jury. [2] Thomas v. International\nHarvester Co., 57 Mich. App. 79, 225 N.W.2d 175 (1974).\nIn the instant action no reasonable jury could find that JJP\xe2\x80\x99s failure to warn of the flammability\nof cotton batting was a proximate cause of plaintiffs\xe2\x80\x99 injuries because plaintiffs failed to offer any\nevidence to establish that a flammability warning on JJP\xe2\x80\x99s cotton batting would have dissuaded\nthem from using the product in the manner that they did.\nPlaintiffs repeatedly stated in their response brief that plaintiff Susan Ferlito testified that \xe2\x80\x9cshe\nwould never again use cotton batting to make a costume\xe2\x80\xa6However, a review of the trial\ntranscript reveals that plaintiff Susan Ferlito never testified that she would never again use\ncotton batting to make a costume. More importantly, the transcript contains no statement by\nplaintiff Susan Ferlito that a flammability warning on defendant JJP\xe2\x80\x99s product would have\ndissuaded her from using the cotton batting to construct the costume in the first place. At oral\nargument counsel for plaintiffs conceded that there was no testimony during the trial that either\nplaintiff Susan Ferlito or her husband, plaintiff Frank J. Ferlito, would have acted any different\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n123\n\n\x0cif there had been a flammability warning on the product\xe2\x80\x99s package. The absence of such\ntestimony is fatal to plaintiffs\xe2\x80\x99 case; for without it, plaintiffs have failed to prove proximate\ncause, one of the essential elements of their negligence claim.\nIn addition, both plaintiffs testified that they knew that cotton batting burns when it is exposed\nto flame. Susan Ferlito testified that she knew at the time she purchased the cotton batting that\nit would burn if exposed to an open flame. Frank Ferlito testified that he knew at the time he\nappeared at the Halloween party that cotton batting would burn if exposed to an open flame. His\nadditional testimony that he would not have intentionally put a flame to the cotton batting\nshows that he recognized the risk of injury of which he claims JJP should have warned. Because\nboth plaintiffs were already aware of the danger, a warning by JJP would have been superfluous.\nTherefore, a reasonable jury could not have found that JJP\xe2\x80\x99s failure to provide a warning was a\nproximate cause of plaintiffs\xe2\x80\x99 injuries.\nThe evidence in this case clearly demonstrated that neither the use to which plaintiffs put JJP\xe2\x80\x99s\nproduct nor the injuries arising from that use were foreseeable. Susan Ferlito testified that the\nidea for the costume was hers alone. As described on the product\xe2\x80\x99s package, its intended uses\nare for cleansing, applying medications, and infant care. Plaintiffs\xe2\x80\x99 showing that the product\nmay be used on occasion in classrooms for decorative purposes failed to demonstrate the\nforeseeability of an adult male encapsulating himself from head to toe in cotton batting and then\nlighting up a cigarette.\nORDER\nNOW, THEREFORE, IT IS HEREBY ORDERED that defendant JJP\xe2\x80\x99s motion for judgment\nnotwithstanding the verdict is GRANTED.\nIT IS FURTHER ORDERED that the judgment entered November 2, 1989, is SET ASIDE.\nIT IS FURTHER ORDERED that the clerk will enter a judgment in favor of the defendant JJP.\n\nCASE QUESTIONS\n\n1. The opinion focuses on proximate cause. As we will see in Chapter 7 "Introduction to Tort\nLaw", a negligence case cannot be won unless the plaintiff shows that the defendant has\nbreached a duty and that the defendant\xe2\x80\x99s breach has actually and proximately caused the\ndamage complained of. What, exactly, is the alleged breach of duty by the defendant here?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n124\n\n\x0c2. Explain why Judge Gadola reasoning that JJP had no duty to warn in this case. After this case,\nwould they then have a duty to warn, knowing that someone might use their product in this\nway?\n\n[1] By \xe2\x80\x9cprima facie case,\xe2\x80\x9d the court means a case in which the plaintiff has presented all the basic\nelements of the cause of action alleged in the complaint. If one or more elements of proof are missing,\nthen the plaintiff has fallen short of establishing a prima facie case, and the case should be dismissed\n(usually on the basis of a directed verdict).\n[2] Note the division of labor here: questions of law are for the judge, while questions of \xe2\x80\x9cfact\xe2\x80\x9d are for\nthe jury. Here, \xe2\x80\x9cforeseeability\xe2\x80\x9d is a fact question, while the judge retains authority over questions of law.\nThe division between questions of fact and questions of law is not an easy one, however.\n\nChapter 4\nConstitutional Law and US Commerce\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should be able to do the following:\n1. Explain the historical importance and basic structure of the US Constitution.\n2. Know what judicial review is and what it represents in terms of the separation of powers\nbetween the executive, legislative, and judicial branches of government.\n3. Locate the source of congressional power to regulate the economy under the Constitution,\nand explain what limitations there are to the reach of congressional power over interstate\ncommerce.\n4. Describe the different phases of congressional power over commerce, as adjudged by the US\nSupreme Court over time.\n5. Explain what power the states retain over commerce, and how the Supreme Court may\nsometimes limit that power.\n6. Describe how the Supreme Court, under the supremacy clause of the Constitution, balances\nstate and federal laws that may be wholly or partly in conflict.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n125\n\n\x0c7. Explain how the Bill of Rights relates to business activities in the United States.\nThe US Constitution is the foundation for all of US law. Business and commerce are directly\naffected by the words, meanings, and interpretations of the Constitution. Because it speaks in\ngeneral terms, its provisions raise all kinds of issues for scholars, lawyers, judges, politicians,\nand commentators. For example, arguments still rage over the nature and meaning of\n\xe2\x80\x9cfederalism,\xe2\x80\x9d the concept that there is shared governance between the states and the federal\ngovernment. The US Supreme Court is the ultimate arbiter of those disputes, and as such it has\na unique role in the legal system. It has assumed the power of judicial review, unique among\nfederal systems globally, through which it can strike down federal or state statutes that it\nbelieves violate the Constitution and can even void the president\xe2\x80\x99s executive orders if they are\ncontrary to the Constitution\xe2\x80\x99s language. No knowledgeable citizen or businessperson can afford\nto be ignorant of its basic provisions.\n\n4.1 Basic Aspects of the US Constitution\nLEARNING OBJECTIVES\n\n1. Describe the American values that are reflected in the US Constitution.\n2. Know what federalism means, along with separation of powers.\n3. Explain the process of amending the Constitution and why judicial review is particularly\nsignificant.\n\nThe Constitution as Reflecting American Values\nIn the US, the one document to which all public officials and military personnel pledge their\nunswerving allegiance is the Constitution. If you serve, you are asked to \xe2\x80\x9csupport and defend\xe2\x80\x9d\nthe Constitution \xe2\x80\x9cagainst all enemies, foreign and domestic.\xe2\x80\x9d The oath usually includes a\nstatement that you swear that this oath is taken freely, honestly, and without \xe2\x80\x9cany purpose of\nevasion.\xe2\x80\x9d This loyalty oath may be related to a time\xe2\x80\x94fifty years ago\xe2\x80\x94when \xe2\x80\x9cun-American\xe2\x80\x9d\nactivities were under investigation in Congress and the press; the fear of communism (as\nantithetical to American values and principles) was paramount. As you look at the Constitution\nand how it affects the legal environment of business, please consider what basic values it may\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n126\n\n\x0cimpart to us and what makes it uniquely American and worth defending \xe2\x80\x9cagainst all enemies,\nforeign and domestic.\xe2\x80\x9d\nIn Article I, the Constitution places the legislature first and prescribes the ways in which\nrepresentatives are elected to public office. Article I balances influence in the federal legislature\nbetween large states and small states by creating a Senate in which the smaller states (by\npopulation) as well as the larger states have two votes. In Article II, the Constitution sets forth\nthe powers and responsibilities of the branch\xe2\x80\x94the presidency\xe2\x80\x94and makes it clear that the\npresident should be the commander in chief of the armed forces. Article II also gives states\nrather than individuals (through the Electoral College) a clear role in the election process.\nArticle III creates the federal judiciary, and the Bill of Rights, adopted in 1791, makes clear that\nindividual rights must be preserved against activities of the federal government. In general, the\nidea of rights is particularly strong.\nThe Constitution itself speaks of rights in fairly general terms, and the judicial interpretation of\nvarious rights has been in flux. The \xe2\x80\x9cright\xe2\x80\x9d of a person to own another person was notably\naffirmed by the Supreme Court in the Dred Scott decision in 1857.[1] The \xe2\x80\x9cright\xe2\x80\x9d of a child to\nfreely contract for long, tedious hours of work was upheld by the court in Hammer v.\nDagenhart in 1918. Both decisions were later repudiated, just as the decision that a woman has\na \xe2\x80\x9cright\xe2\x80\x9d to an abortion in the first trimester of pregnancy could later be repudiated if Roe v.\nWade is overturned by the Supreme Court.[2]\n\nGeneral Structure of the Constitution\nLook at the Constitution. Notice that there are seven articles, starting with Article I (legislative\npowers), Article II (executive branch), and Article III (judiciary). Notice that there is no separate\narticle for administrative agencies. The Constitution also declares that it is \xe2\x80\x9cthe supreme Law of\nthe Land\xe2\x80\x9d (Article VI). Following Article VII are the ten amendments adopted in 1791 that are\nreferred to as the Bill of Rights. Notice also that in 1868, a new amendment, the Fourteenth, was\nadopted, requiring states to provide \xe2\x80\x9cdue process\xe2\x80\x9d and \xe2\x80\x9cequal protection of the laws\xe2\x80\x9d to citizens\nof the United States.\n\nFederalism\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n127\n\n\x0cThe partnership created in the Constitution between the states and the federal government is\ncalled federalism. The Constitution is a document created by the states in which certain powers\nare delegated to the national government, and other powers are reserved to the states. This is\nmade explicit in the Tenth Amendment.\n\nSeparation of Powers and Judicial Review\nBecause the Founding Fathers wanted to ensure that no single branch of the government,\nespecially the executive branch, would be ascendant over the others, they created various checks\nand balances to ensure that each of the three principal branches had ways to limit or modify the\npower of the others. This is known as theseparation of powers. Thus the president retains veto\npower, but the House of Representatives is entrusted with the power to initiate spending bills.\nPower sharing was evident in the basic design of Congress, the federal legislative branch. The\nbasic power imbalance was between the large states (with greater population) and the smaller\nones (such as Delaware). The smaller ones feared a loss of sovereignty if they could be outvoted\nby the larger ones, so the federal legislature was constructed to guarantee two Senate seats for\nevery state, no matter how small. The Senate was also given great responsibility in ratifying\ntreaties and judicial nominations. The net effect of this today is that senators from a very small\nnumber of states can block treaties and other important legislation. The power of small states is\nalso magnified by the Senate\xe2\x80\x99s cloture rule, which currently requires sixty out of one hundred\nsenators to vote to bring a bill to the floor for an up-or-down vote.\nBecause the Constitution often speaks in general terms (with broad phrases such as \xe2\x80\x9cdue\nprocess\xe2\x80\x9d and \xe2\x80\x9cequal protection\xe2\x80\x9d), reasonable people have disagreed as to how those terms apply\nin specific cases. The United States is unique among industrialized democracies in having a\nSupreme Court that reserves for itself that exclusive power to interpret what the Constitution\nmeans. The famous case of Marbury v. Madison began that tradition in 1803, when the\nSupreme Court had marginal importance in the new republic. The decision in Bush v. Gore,\ndecided in December of 2000, illustrates the power of the court to shape our destiny as a nation.\nIn that case, the court overturned a ruling by the Florida Supreme Court regarding the way to\nproceed on a recount of the Florida vote for the presidency. The court\xe2\x80\x99s ruling was purportedly\nbased on the \xe2\x80\x9cequal protection of the laws\xe2\x80\x9d provision in the Fourteenth Amendment.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n128\n\n\x0cFrom Marbury to the present day, the Supreme Court has articulated the view that the US\nConstitution sets the framework for all other US laws, whether statutory or judicially created.\nThus any statute (or portion thereof) or legal ruling (judicial or administrative) in conflict with\nthe Constitution is not enforceable. And as the Bush v. Gore decision indicates, the states are not\nentirely free to do what they might choose; their own sovereignty is limited by their union with\nthe other states in a federal sovereign.\nIf the Supreme Court makes a \xe2\x80\x9cbad decision\xe2\x80\x9d as to what the Constitution means, it is not easily\noverturned. Either the court must change its mind (which it seldom does) or two-thirds of\nCongress and three-fourths of the states must make an amendment (Article V).\nBecause the Supreme Court has this power of judicial review, there have been many arguments\nabout how it should be exercised and what kind of \xe2\x80\x9cphilosophy\xe2\x80\x9d a Supreme Court justice should\nhave. President Richard Nixon often said that a Supreme Court justice should \xe2\x80\x9cstrictly construe\xe2\x80\x9d\nthe Constitution and not add to its language. Finding law in the Constitution was \xe2\x80\x9cjudicial\nactivism\xe2\x80\x9d rather than \xe2\x80\x9cjudicial restraint.\xe2\x80\x9d The general philosophy behind the call for \xe2\x80\x9cstrict\nconstructionist\xe2\x80\x9d justices is that legislatures make laws in accord with the wishes of the majority,\nand so unelected judges should not make law according to their own views and values. Nixon\nhad in mind the 1960s Warren court, which \xe2\x80\x9cfound\xe2\x80\x9d rights in the Constitution that were not\nspecifically mentioned\xe2\x80\x94the right of privacy, for example. In later years, critics of the Rehnquist\ncourt would charge that it \xe2\x80\x9cfound\xe2\x80\x9d rights that were not specifically mentioned, such as the right\nof states to be free from federal antidiscrimination laws. See, for example, Kimel v. Florida\nBoard of Regents, or the Citizens United v. Federal Election Commission case (Section 4.6.5),\nwhich held that corporations are \xe2\x80\x9cpersons\xe2\x80\x9d with \xe2\x80\x9cfree speech rights\xe2\x80\x9d that include spending\nunlimited amounts of money in campaign donations and political advocacy. [3]\nBecause Roe v. Wade has been so controversial, this chapter includes a seminal case on \xe2\x80\x9cthe\nright of privacy,\xe2\x80\x9d Griswold v. Connecticut, Section 4.6.1. Was the court was correct in\nrecognizing a \xe2\x80\x9cright of privacy\xe2\x80\x9d in Griswold? This may not seem like a \xe2\x80\x9cbusiness case,\xe2\x80\x9d but\nconsider: the manufacture and distribution of birth control devices is a highly profitable (and\nlegal) business in every US state. Moreover, Griswold illustrates another important and muchdebated concept in US constitutional law: substantive due process (see Section 4.5.3 "Fifth\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n129\n\n\x0cAmendment"). The problem of judicial review and its proper scope is brought into sharp focus\nin the abortion controversy. Abortion became a lucrative service business after Roe v. Wade was\ndecided in 1973. That has gradually changed, with state laws that have limited rather than\noverruledRoe v. Wade and with persistent antiabortion protests, killings of abortion doctors,\nand efforts to publicize the human nature of the fetuses being aborted. The key here is to\nunderstand that there is no explicit mention in the Constitution of any right of privacy. As\nJustice Harry Blackmun argued in his majority opinion in Roe v. Wade,\nThe Constitution does not explicitly mention any right of privacy. In a line of decisions, however,\nthe Court has recognized that a right of personal privacy or a guarantee of certain areas or zones\nof privacy, does exist under the Constitution.\xe2\x80\xa6[T]hey also make it clear that the right has some\nextension to activities relating to marriage\xe2\x80\xa6procreation\xe2\x80\xa6contraception\xe2\x80\xa6family\nrelationships\xe2\x80\xa6and child rearing and education.\xe2\x80\xa6The right of privacy\xe2\x80\xa6is broad enough to\nencompass a woman\xe2\x80\x99s decision whether or not to terminate her pregnancy.\nIn short, justices interpreting the Constitution wield quiet yet enormous power through judicial\nreview. In deciding that the right of privacy applied to a woman\xe2\x80\x99s decision to abort in the first\ntrimester, the Supreme Court did not act on the basis of a popular mandate or clear and\nunequivocal language in the Constitution, and it made illegal any state or federal legislative or\nexecutive action contrary to its interpretation. Only a constitutional amendment or the court\xe2\x80\x99s\nrepudiation of Roe v. Wade as a precedent could change that interpretation.\n\nKEY TAKEAWAY\n\nThe Constitution gives voice to the idea that people have basic rights and that a civilian\npresident is also the commander in chief of the armed forces. It gives instructions as to\nhow the various branches of government must share power and also tries to balance\npower between the states and the federal government. It does not expressly allow for\njudicial review, but the Supreme Court\xe2\x80\x99s ability to declare what laws are (or are not)\nconstitutional has given the judicial branch a kind of power not seen in other industrialized\ndemocracies.\n\nEXERCISES\n\n1. Suppose the Supreme Court declares that Congress and the president cannot authorize the\nindefinite detention of terrorist suspects without a trial of some sort, whether military or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n130\n\n\x0ccivilian. Suppose also that the people of the United States favor such indefinite detention\nand that Congress wants to pass a law rebuking the court\xe2\x80\x99s decision. What kind of law\nwould have to be passed, by what institutions, and by what voting percentages?\n2. When does a prior decision of the Supreme Court deserve overturning? Name one\ndecision of the Supreme Court that you think is no longer \xe2\x80\x9cgood law.\xe2\x80\x9d Does the court have\nto wait one hundred years to overturn its prior case precedents?\n\n[1] In Scott v. Sanford (the Dred Scott decision), the court states that Scott should remain a slave, that as\na slave he is not a citizen of the United States and thus not eligible to bring suit in a federal court, and\nthat as a slave he is personal property and thus has never been free.\n[2] Roe v. Wade, 410 US 113 (1973).\n\n4.2 The Commerce\n\n[3] Kimel v. Florida Board of Regents, 528 US 62 (2000).\n\nClauseL E A R N I N G O B J E C T I V E S\n\n1. Name the specific clause through which Congress has the power to regulate commerce.\nWhat, specifically, does this clause say?\n2. Explain how early decisions of the Supreme Court interpreted the scope of the commerce\nclause and how that impacted the legislative proposals and programs of Franklin Delano\nRoosevelt during the Great Depression.\n3. Describe both the wider use of the commerce clause from World War II through the 1990s\nand the limitations the Supreme Court imposed in Lopez and other cases.\nFirst, turn to Article I, Section 8. The commerce clause gives Congress the exclusive power to\nmake laws relating to foreign trade and commerce and to commerce among the various states.\nMost of the federally created legal environment springs from this one clause: if Congress is not\nauthorized in the Constitution to make certain laws, then it acts unconstitutionally and its\nactions may be ruled unconstitutional by the Supreme Court. Lately, the Supreme Court has not\nbeen shy about ruling acts of Congress unconstitutional.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n131\n\n\x0cHere are the first five parts of Article I, Section 8, which sets forth the powers of the federal\nlegislature. The commerce clause is in boldface. It is short, but most federal legislation affecting\nbusiness depends on this very clause:\n\nSection 8\n\n[Clause 1] The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises,\nto pay the Debts and provide for the common Defence and general Welfare of the United States;\nbut all Duties, Imposts and Excises shall be uniform throughout the United States;\n[Clause 2] To borrow Money on the credit of the United States;\n[Clause 3] To regulate Commerce with foreign Nations, and among the several\nStates, and with the Indian Tribes;\n[Clause 4] To establish a uniform Rule of Naturalization, and uniform Laws on the subject of\nBankruptcies throughout the United States;\n[Clause 5] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard\nof Weights and Measures;\n\nEarly Commerce Clause Cases\nFor many years, the Supreme Court was very strict in applying the commerce clause: Congress\ncould only use it to legislate aspects of the movement of goods from one state to another.\nAnything else was deemed local rather than national. For example, InHammer v. Dagenhart,\ndecided in 1918, a 1916 federal statute had barred transportation in interstate commerce of\ngoods produced in mines or factories employing children under fourteen or employing children\nfourteen and above for more than eight hours a day. A complaint was filed in the US District\nCourt for the Western District of North Carolina by a father in his own behalf and on behalf of\nhis two minor sons, one under the age of fourteen years and the other between fourteen and\nsixteen years, who were employees in a cotton mill in Charlotte, North Carolina. The father\xe2\x80\x99s\nlawsuit asked the court to enjoin (block) the enforcement of the act of Congress intended to\nprevent interstate commerce in the products of child labor.\nThe Supreme Court saw the issue as whether Congress had the power under the commerce\nclause to control interstate shipment of goods made by children under the age of fourteen. The\ncourt found that Congress did not. The court cited several cases that had considered what\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n132\n\n\x0cinterstate commerce could be constitutionally regulated by Congress. In Hipolite Egg Co. v.\nUnited States, the Supreme Court had sustained the power of Congress to pass the Pure Food\nand Drug Act, which prohibited the introduction into the states by means of interstate\ncommerce impure foods and drugs.[1] In Hoke v. United States, the Supreme Court had\nsustained the constitutionality of the so-called White Slave Traffic Act of 1910, whereby the\ntransportation of a woman in interstate commerce for the purpose of prostitution was\nforbidden. In that case, the court said that Congress had the power to protect the channels of\ninterstate commerce: \xe2\x80\x9cIf the facility of interstate transportation can be taken away from the\ndemoralization of lotteries, the debasement of obscene literature, the contagion of diseased\ncattle or persons, the impurity of food and drugs, the like facility can be taken away from the\nsystematic enticement to, and the enslavement in prostitution and debauchery of women, and,\nmore insistently, of girls.\xe2\x80\x9d [2]\nIn each of those instances, the Supreme Court said, \xe2\x80\x9c[T]he use of interstate transportation was\nnecessary to the accomplishment of harmful results.\xe2\x80\x9d In other words, although the power over\ninterstate transportation was to regulate, that could only be accomplished by prohibiting the use\nof the facilities of interstate commerce to effect the evil intended. But in Hammer v. Dagenhart,\nthat essential element was lacking. The law passed by Congress aimed to standardize among all\nthe states the ages at which children could be employed in mining and manufacturing, while the\ngoods themselves are harmless. Once the labor is done and the articles have left the factory, the\n\xe2\x80\x9clabor of their production is over, and the mere fact that they were intended for interstate\ncommerce transportation does not make their production subject to federal control under the\ncommerce power.\xe2\x80\x9d\nIn short, the early use of the commerce clause was limited to the movement of physical goods\nbetween states. Just because something might enter the channels of interstate commerce later\non does not make it a fit subject for national regulation. The production of articles intended for\ninterstate commerce is a matter of local regulation. The court therefore upheld the result from\nthe district and circuit court of appeals; the application of the federal law was enjoined. Goods\nproduced by children under the age of fourteen could be shipped anywhere in the United States\nwithout violating the federal law.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n133\n\n\x0cFrom the New Deal to the New Frontier and the Great Society:1930s\xe2\x80\x931970\nDuring the global depression of the 1930s, the US economy saw jobless rates of a third of all\nworkers, and President Roosevelt\xe2\x80\x99s New Deal program required more active federal legislation.\nIncluded in the New Deal program was the recognition of a \xe2\x80\x9cright\xe2\x80\x9d to form labor unions without\nundue interference from employers. Congress created the National Labor Relations Board\n(NLRB) in 1935 to investigate and to enjoin employer practices that violated this right.\nIn NLRB v. Jones & Laughlin Steel Corporation, a union dispute with management at a large\nsteel-producing facility near Pittsburgh, Pennsylvania, became a court case. In this case, the\nNLRB had charged the Jones & Laughlin Steel Corporation with discriminating against\nemployees who were union members. The company\xe2\x80\x99s position was that the law authorizing the\nNLRB was unconstitutional, exceeding Congress\xe2\x80\x99s powers. The court held that the act was\nnarrowly constructed so as to regulate industrial activities that had the potential to restrict\ninterstate commerce. The earlier decisions under the commerce clause to the effect that labor\nrelations had only an indirect effect on commerce were effectively reversed. Since the ability of\nemployees to engage in collective bargaining (one activity protected by the act) is \xe2\x80\x9can essential\ncondition of industrial peace,\xe2\x80\x9d the national government was justified in penalizing corporations\nengaging in interstate commerce that \xe2\x80\x9crefuse to confer and negotiate\xe2\x80\x9d with their workers. This\nwas, however, a close decision, and the switch of one justice made this ruling possible. Without\nthis switch, the New Deal agenda would have been effectively derailed.\n\nThe Substantial Effects Doctrine: World War II to the 1990s\nSubsequent to NLRB v. Jones & Laughlin Steel Corporation, Congress and the courts generally\naccepted that even modest impacts on interstate commerce were \xe2\x80\x9creachable\xe2\x80\x9d by federal\nlegislation. For example, the case of Wickard v. Filburn, from 1942, represents a fairly long\nreach for Congress in regulating what appear to be very local economic decisions (Section 4.6.2).\nWickard established that \xe2\x80\x9csubstantial effects\xe2\x80\x9d in interstate commerce could be very local indeed!\nBut commerce clause challenges to federal legislation continued. In the 1960s, the Civil Rights\nAct of 1964 was challenged on the ground that Congress lacked the power under the commerce\nclause to regulate what was otherwise fairly local conduct. For example, Title II of the act\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n134\n\n\x0cprohibited racial discrimination in public accommodations (such as hotels, motels, and\nrestaurants), leading to the famous case of Katzenbach v. McClung (1964).\nOllie McClung\xe2\x80\x99s barbeque place in Birmingham, Alabama, allowed \xe2\x80\x9ccolored\xe2\x80\x9d people to buy\ntakeout at the back of the restaurant but not to sit down with \xe2\x80\x9cwhite\xe2\x80\x9d folks inside. The US\nattorney sought a court order to require Ollie to serve all races and colors, but Ollie resisted on\ncommerce clause grounds: the federal government had no business regulating a purely local\nestablishment. Indeed, Ollie did not advertise nationally, or even regionally, and had customers\nonly from the local area. But the court found that some 42 percent of the supplies for Ollie\xe2\x80\x99s\nrestaurant had moved in the channels of interstate commerce. This was enough to sustain\nfederal regulation based on the commerce clause. [3]\nFor nearly thirty years following, it was widely assumed that Congress could almost always find\nsome interstate commerce connection for any law it might pass. It thus came as something of a\nshock in 1995 when the Rehnquist court decided U.S. v. Lopez. Lopez had been convicted under\na federal law that prohibited possession of firearms within 1,000 feet of a school. The law was\npart of a twenty-year trend (roughly 1970 to 1990) for senators and congressmen to pass laws\nthat were tough on crime. Lopez\xe2\x80\x99s lawyer admitted that Lopez had had a gun within 1,000 feet of\na San Antonio school yard but challenged the law itself, arguing that Congress exceeded its\nauthority under the commerce clause in passing this legislation. The US government\xe2\x80\x99s Solicitor\nGeneral argued on behalf of the Department of Justice to the Supreme Court that Congress was\nwithin its constitutional rights under the commerce clause because education of the future\nworkforce was the foundation for a sound economy and because guns at or near school yards\ndetracted from students\xe2\x80\x99 education. The court rejected this analysis, noting that with the\ngovernment\xe2\x80\x99s analysis, an interstate commerce connection could be conjured from almost\nanything. Lopez went free because the law itself was unconstitutional, according to the court.\nCongress made no attempt to pass similar legislation after the case was decided. But in passing\nsubsequent legislation, Congress was often careful to make a record as to why it believed it was\naddressing a problem that related to interstate commerce. In 1994, Congress passed the\nViolence Against Women Act (VAWA), having held hearings to establish why violence against\nwomen on a local level would impair interstate commerce. In 1994, while enrolled at Virginia\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n135\n\n\x0cPolytechnic Institute (Virginia Tech), Christy Brzonkala alleged that Antonio Morrison and\nJames Crawford, both students and varsity football players at Virginia Tech, had raped her. In\n1995, Brzonkala filed a complaint against Morrison and Crawford under Virginia Tech\xe2\x80\x99s sexual\nassault policy. After a hearing, Morrison was found guilty of sexual assault and sentenced to\nimmediate suspension for two semesters. Crawford was not punished. A second hearing again\nfound Morrison guilty. After an appeal through the university\xe2\x80\x99s administrative system,\nMorrison\xe2\x80\x99s punishment was set aside, as it was found to be \xe2\x80\x9cexcessive.\xe2\x80\x9d Ultimately, Brzonkala\ndropped out of the university. Brzonkala then sued Morrison, Crawford, and Virginia Tech in\nfederal district court, alleging that Morrison\xe2\x80\x99s and Crawford\xe2\x80\x99s attack violated 42 USC Section\n13981, part of the VAWA), which provides a federal civil remedy for the victims of gendermotivated violence. Morrison and Crawford moved to dismiss Brzonkala\xe2\x80\x99s suit on the ground\nthat Section 13981\xe2\x80\x99s civil remedy was unconstitutional. In dismissing the complaint, the district\ncourt found that that Congress lacked authority to enact Section 13981 under either the\ncommerce clause or the Fourteenth Amendment, which Congress had explicitly identified as the\nsources of federal authority for the VAWA. Ultimately, the court of appeals affirmed, as did the\nSupreme Court.\nThe Supreme Court held that Congress lacked the authority to enact a statute under the\ncommerce clause or the Fourteenth Amendment because the statute did not regulate an activity\nthat substantially affected interstate commerce nor did it redress harm caused by the state. Chief\nJustice William H. Rehnquist wrote for the court that \xe2\x80\x9cunder our federal system that remedy\nmust be provided by the Commonwealth of Virginia, and not by the United States.\xe2\x80\x9d Dissenting,\nJustice Stephen G. Breyer argued that the majority opinion \xe2\x80\x9cillustrates the difficulty of finding a\nworkable judicial Commerce Clause touchstone.\xe2\x80\x9d Justice David H. Souter, dissenting, noted that\nVAWA contained a \xe2\x80\x9cmountain of data assembled by Congress\xe2\x80\xa6showing the effects of violence\nagainst women on interstate commerce.\xe2\x80\x9d\nThe absence of a workable judicial commerce clause touchstone remains. In 1996, California\nvoters passed the Compassionate Use Act, legalizing marijuana for medical use. California\xe2\x80\x99s law\nconflicted with the federal Controlled Substances Act (CSA), which banned possession of\nmarijuana. After the Drug Enforcement Administration (DEA) seized doctor-prescribed\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n136\n\n\x0cmarijuana from a patient\xe2\x80\x99s home, a group of medical marijuana users sued the DEA and US\nAttorney General John Ashcroft in federal district court.\nThe medical marijuana users argued that the CSA\xe2\x80\x94which Congress passed using its\nconstitutional power to regulate interstate commerce\xe2\x80\x94exceeded Congress\xe2\x80\x99s commerce clause\npower. The district court ruled against the group, but the Ninth Circuit Court of Appeals\nreversed and ruled the CSA unconstitutional because it applied to medical marijuana use solely\nwithin one state. In doing so, the Ninth Circuit relied on U.S. v. Lopez (1995) and U.S. v.\nMorrison (2000) to say that using medical marijuana did not \xe2\x80\x9csubstantially affect\xe2\x80\x9d interstate\ncommerce and therefore could not be regulated by Congress.\nBut by a 6\xe2\x80\x933 majority, the Supreme Court held that the commerce clause gave Congress\nauthority to prohibit the local cultivation and use of marijuana, despite state law to the contrary.\nJustice John Paul Stevens argued that the court\xe2\x80\x99s precedents established Congress\xe2\x80\x99s commerce\nclause power to regulate purely local activities that are part of a \xe2\x80\x9cclass of activities\xe2\x80\x9d with a\nsubstantial effect on interstate commerce. The majority argued that Congress could ban local\nmarijuana use because it was part of such a class of activities: the national marijuana market.\nLocal use affected supply and demand in the national marijuana market, making the regulation\nof intrastate use \xe2\x80\x9cessential\xe2\x80\x9d to regulating the drug\xe2\x80\x99s national market.\nNotice how similar this reasoning is to the court\xe2\x80\x99s earlier reasoning in Wickard v.\nFilburn (Section 4.6.2). In contrast, the court\xe2\x80\x99s conservative wing was adamant that federal\npower had been exceeded. Justice Clarence Thomas\xe2\x80\x99s dissent in Gonzalez v. Raich stated that\nRaich\xe2\x80\x99s local cultivation and consumption of marijuana was not \xe2\x80\x9cCommerce\xe2\x80\xa6among the several\nStates.\xe2\x80\x9d Representing the \xe2\x80\x9coriginalist\xe2\x80\x9d view that the Constitution should mostly mean what the\nFounders meant it to mean, he also said that in the early days of the republic, it would have been\nunthinkable that Congress could prohibit the local cultivation, possession, and consumption of\nmarijuana.\n\nKEY TAKEAWAY\n\nThe commerce clause is the basis on which the federal government regulates interstate\neconomic activity. The phrase \xe2\x80\x9cinterstate commerce\xe2\x80\x9d has been subject to differing\ninterpretations by the Supreme Court over the past one hundred years. There are certain\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n137\n\n\x0cmatters that are essentially local or intrastate, but the range of federal involvement in local\nmatters is still considerable.\n\nEXERCISES\n\n1. Why would Congress have power under the Civil Rights Act of 1964 to require restaurants\nand hotels to not discriminate against interstate travelers on the basis of race, color, sex,\nreligion, or national origin? Suppose the Holiday Restaurant near I-80 in Des Moines, Iowa,\nhas a sign that says, \xe2\x80\x9cWe reserve the right to refuse service to any Muslim or person of\nMiddle Eastern descent.\xe2\x80\x9d Suppose also that the restaurant is very popular locally and that\nonly 40 percent of its patrons are travelers on I-80. Are the owners of the Holiday Restaurant\nin violation of the Civil Rights Act of 1964? What would happen if the owners resisted\nenforcement by claiming that Title II of the act (relating to \xe2\x80\x9cpublic accommodations\xe2\x80\x9d such as\nhotels, motels, and restaurants) was unconstitutional?\n2. If the Supreme Court were to go back to the days of Hammer v. Dagenhart and rule that only\ngoods and services involving interstate movement could be subject to federal law, what kinds\nof federal programs might be lacking a sound basis in the commerce clause? \xe2\x80\x9cObamacare\xe2\x80\x9d?\nMedicare? Homeland security? Social Security? What other powers are granted to Congress\nunder the Constitution to legislate for the general good of society?\n\n[1] Hipolite Egg Co. v. United States, 220 US 45 (1911).\n[2] Hoke v. United States, 227 US 308 (1913).\n[3] Katzenbach v. McClung, 379 US 294 (1964).\n\n4.3 Dormant Commerce Clause\n\nLEARNING OBJECTIVES\n\n1. Understand that when Congress does not exercise its powers under the commerce clause,\nthe Supreme Court may still limit state legislation that discriminates against interstate\ncommerce or places an undue burden on interstate commerce.\n2. Distinguish between \xe2\x80\x9cdiscrimination\xe2\x80\x9d dormant-commerce-clause cases and \xe2\x80\x9cundue burden\xe2\x80\x9d\ndormant-commerce-clause cases.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n138\n\n\x0cCongress has the power to legislate under the commerce clause and often does legislate. For\nexample, Congress might say that trucks moving on interstate highways must not be more than\nseventy feet in length. But if Congress does not exercise its powers and regulate in certain areas\n(such as the size and length of trucks on interstate highways), states may make their own rules.\nStates may do so under the so-called historic police powers of states that were never yielded up\nto the federal government.\nThese police powers can be broadly exercised by states for purposes of health, education,\nwelfare, safety, morals, and the environment. But the Supreme Court has reserved for itself the\npower to determine when state action is excessive, even when Congress has not used the\ncommerce clause to regulate. This power is claimed to exist in the dormant commerce clause.\nThere are two ways that a state may violate the dormant commerce clause. If a state passes a law\nthat is an \xe2\x80\x9cundue burden\xe2\x80\x9d on interstate commerce or that \xe2\x80\x9cdiscriminates\xe2\x80\x9d against interstate\ncommerce, it will be struck down. Kassel v. Consolidated Freightways, in Section 4.7 "Summary\nand Exercises", is an example of a case where Iowa imposed an undue burden on interstate\ncommerce by prohibiting double trailers on its highways. [1] Iowa\xe2\x80\x99s prohibition was judicially\ndeclared void when the Supreme Court judged it to be an undue burden.\nDiscrimination cases such as Hunt v. Washington Apple Advertising Commission(Section 4.6\n"Cases") pose a different standard. The court has been fairly inflexible here: if one state\ndiscriminates in its treatment of any article of commerce based on its state of origin, the court\nwill strike down the law. For example, in Oregon Waste Systems v. Department of\nEnvironmental Quality, the state wanted to place a slightly higher charge on waste coming from\nout of state. [2] The state\xe2\x80\x99s reasoning was that in-state residents had already contributed to roads\nand other infrastructure and that tipping fees at waste facilities should reflect the prior\ncontributions of in-state companies and residents. Out-of-state waste handlers who wanted to\nuse Oregon landfills objected and won their dormant commerce clause claim that Oregon\xe2\x80\x99s law\ndiscriminated \xe2\x80\x9con its face\xe2\x80\x9d against interstate commerce. Under the Supreme Court\xe2\x80\x99s rulings,\nanything that moves in channels of interstate commerce is \xe2\x80\x9ccommerce,\xe2\x80\x9d even if someone is\npaying to get rid of something instead of buying something.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n139\n\n\x0cThus the states are bound by Supreme Court decisions under the dormant commerce clause to\ndo nothing that differentiates between articles of commerce that originate from within the state\nfrom those that originate elsewhere. If Michigan were to let counties decide for themselves\nwhether to take garbage from outside of the county or not, this could also be a discrimination\nbased on a place of origin outside the state. (Suppose, for instance, each county were to decide\nnot to take waste from outside the county; then all Michigan counties would effectively be\nexcluding waste from outside of Michigan, which is discriminatory.) [3]\nThe Supreme Court probably would uphold any solid waste requirements that did not\ndifferentiate on the basis of origin. If, for example, all waste had to be inspected for specific\nhazards, then the law would apply equally to in-state and out-of-state garbage. Because this is\nthe dormant commerce clause, Congress could still act (i.e., it could use its broad commerce\nclause powers) to say that states are free to keep out-of-state waste from coming into their own\nborders. But Congress has declined to do so. What follows is a statement from one of the US\nsenators from Michigan, Carl Levin, in 2003, regarding the significant amounts of waste that\nwere coming into Michigan from Toronto, Canada.\n\nDealing with Unwelcome Waste\nSenator Carl Levin, January 2003\n\nMichigan is facing an intolerable situation with regard to the importation of waste from other\nstates and Canada.\nCanada is the largest source of waste imports to Michigan. Approximately 65 truckloads of waste\ncome in to Michigan per day from Toronto alone, and an estimated 110\xe2\x80\x93130 trucks come in\nfrom Canada each day.\nThis problem isn\xe2\x80\x99t going to get any better. Ontario\xe2\x80\x99s waste shipments are growing as the Toronto\narea signs new contracts for waste disposal here and closes its two remaining landfills. At the\nbeginning of 1999, the Toronto area was generating about 2.8 million tons of waste annually,\nabout 700,000 tons of which were shipped to Michigan. By early this year, barring unforeseen\ndevelopments, the entire 2.8 million tons will be shipped to Michigan for disposal.\nWhy can\xe2\x80\x99t Canada dispose of its trash in Canada? They say that after 20 years of searching they\nhave not been able to find a suitable Ontario site for Toronto\xe2\x80\x99s garbage. Ontario has about\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n140\n\n\x0c345,000 square miles compared to Michigan\xe2\x80\x99s 57,000 square miles. With six times the land\nmass, that argument is laughable.\nThe Michigan Department of Environmental Quality estimates that, for every five years of\ndisposal of Canadian waste at the current usage volume, Michigan is losing a full year of landfill\ncapacity. The environmental impacts on landfills, including groundwater contamination, noise\npollution and foul odors, are exacerbated by the significant increase in the use of our landfills\nfrom sources outside of Michigan.\nI have teamed up with Senator Stabenow and Congressman Dingell to introduce legislation that\nwould strengthen our ability to stop shipments of waste from Canada.\nWe have protections contained in a 17 year-old international agreement between the U.S. and\nCanada called the Agreement Concerning the Transboundary Movement of Hazardous Waste.\nThe U.S. and Canada entered into this agreement in 1986 to allow the shipment of hazardous\nwaste across the U.S./Canadian border for treatment, storage or disposal. In 1992, the two\ncountries decided to add municipal solid waste to the agreement. To protect both countries, the\nagreement requires notification of shipments to the importing country and it also provides that\nthe importing country may withdraw consent for shipments. Both reasons are evidence that\nthese shipments were intended to be limited. However, the agreement\xe2\x80\x99s provisions have not\nbeen enforced by the United States.\nCanada could not export waste to Michigan without the 1986 agreement, but the U.S. has not\nimplemented the provisions that are designed to protect the people of Michigan. Although those\nof us that introduced this legislation believe that the Environmental Protection Agency has the\nauthority to enforce this agreement, they have not done so. Our bill would require the EPA\n[Environmental Protection Agency] to enforce the agreement.\nIn order to protect the health and welfare of the citizens of Michigan and our environment, we\nmust consider the impact of the importation of trash on state and local recycling efforts, landfill\ncapacity, air emissions, road deterioration resulting from increased vehicular traffic and public\nhealth and the environment.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n141\n\n\x0cOur bill would require the EPA to consider these factors in determining whether to accept\nimports of trash from Canada. It is my strong view that such a review should lead the EPA to say\n\xe2\x80\x9cno\xe2\x80\x9d to the status quo of trash imports.\n\nKEY TAKEAWAY\n\nWhere Congress does not act pursuant to its commerce clause powers, the states are free to\nlegislate on matters of commerce under their historic police powers. However, the Supreme\nCourt has set limits on such powers. Specifically, states may not impose undue burdens on\ninterstate commerce and may not discriminate against articles in interstate commerce.\n\nEXERCISES\n\n1. Suppose that the state of New Jersey wishes to limit the amount of hazardous waste that\nenters into its landfills. The general assembly in New Jersey passes a law that specifically\nforbids any hazardous waste from entering into the state. All landfills are subject to tight\nregulations that will allow certain kinds of hazardous wastes originating in New Jersey to be\nput in New Jersey landfills but that impose significant criminal fines on landfill operators that\naccept out-of-state hazardous waste. The Baldessari Brothers Landfill in Linden, New Jersey,\nis fined for taking hazardous waste from a New York State transporter and appeals that ruling\non the basis that New Jersey\xe2\x80\x99s law is unconstitutional. What is the result?\n2. The state of Arizona determines through its legislature that trains passing through the state\ncannot be longer than seventy cars. There is some evidence that in Eastern US states longer\ntrains pose some safety hazards. There is less evidence that long trains are a problem in\nWestern states. Several major railroads find the Arizona legislation costly and burdensome\nand challenge the legislation after applied-for permits for longer trains are denied. What kind\nof dormant commerce clause challenge is this, and what would it take for the challenge to be\nsuccessful?\n\n[1] Kassell v. Consolidated Freightways, 450 US 662 (1981).\n[2] Oregon Waste Systems v. Department of Environmental Quality, 511 US 93 (1994).\n[3] Fort Gratiot Sanitary Landfill v. Michigan Dep\xe2\x80\x99t of Natural Resources, 504 US 353 (1992).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n142\n\n\x0c4.4 Preemption: The Supremacy Clause\nLEARNING OBJECTIVES\n\n1. Understand the role of the supremacy clause in the balance between state and federal\npower.\n2. Give examples of cases where state legislation is preempted by federal law and cases where\nstate legislation is not preempted by federal law.\nWhen Congress does use its power under the commerce clause, it can expressly state that it\nwishes to have exclusive regulatory authority. For example, when Congress determined in the\n1950s to promote nuclear power (\xe2\x80\x9catoms for peace\xe2\x80\x9d), it set up the Nuclear Regulatory\nCommission and provided a limitation of liability for nuclear power plants in case of a nuclear\naccident. The states were expressly told to stay out of the business of regulating nuclear power\nor the movement of nuclear materials. Thus Rochester, Minnesota, or Berkeley, California, could\ndeclare itself a nuclear-free zone, but the federal government would have preempted such\nlegislation. If Michigan wished to set safety standards at Detroit Edison\xe2\x80\x99s Fermi II nuclear\nreactor that were more stringent than the federal Nuclear Regulatory Commission\xe2\x80\x99s standards,\nMichigan\xe2\x80\x99s standards would be preempted and thus be void.\nEven where Congress does not expressly preempt state action, such action may be impliedly preempted. States cannot constitutionally pass laws that interfere with the accomplishment of the\npurposes of the federal law. Suppose, for example, that Congress passes a comprehensive law\nthat sets standards for foreign vessels to enter the navigable waters and ports of the United\nStates. If a state creates a law that sets standards that conflict with the federal law or sets\nstandards so burdensome that they interfere with federal law, the doctrine of preemption will\n(in accordance with the supremacy clause) void the state law or whatever parts of it are\ninconsistent with federal law.\nBut Congress can allow what might appear to be inconsistencies; the existence of federal\nstatutory standards does not always mean that local and state standards cannot be more\nstringent. If California wants cleaner air or water than other states, it can set stricter standards\xe2\x80\x94\nnothing in the Clean Water Act or Clean Air Act forbids the state from setting stricter pollution\nstandards. As the auto industry well knows, California has set stricter standards for auto\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n143\n\n\x0cemissions. Since the 1980s, most automakers have made both a federal car and a California car,\nbecause federal Clean Air Act emissions restrictions do not preempt more rigorous state\nstandards.\nLarge industries and companies actually prefer regulation at the national level. It is easier for a\nlarge company or industry association to lobby in Washington, DC, than to lobby in fifty\ndifferent states. Accordingly, industry often asks Congress to put preemptive language into its\nstatutes. The tobacco industry is a case in point.\nThe cigarette warning legislation of the 1960s (where the federal government required warning\nlabels on cigarette packages) effectively preempted state negligence claims based on failure to\nwarn. When the family of a lifetime smoker who had died sued in New Jersey court, one cause of\naction was the company\xe2\x80\x99s failure to warn of the dangers of its product. The Supreme Court\nreversed the jury\xe2\x80\x99s award based on the federal preemption of failure to warn claims under state\nlaw. [1]\n\nThe Supremacy Clause\nArticle VI\nThis Constitution, and the Laws of the United States which shall be made in Pursuance thereof;\nand all Treaties made, or which shall be made, under the Authority of the United States, shall be\nthe supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing\nin the Constitution or Laws of any State to the Contrary notwithstanding.\nThe preemption doctrine derives from the supremacy clause of the Constitution, which states\nthat the \xe2\x80\x9cConstitution and the Laws of the United States\xe2\x80\xa6shall be the supreme Law of the\nLand\xe2\x80\xa6any Thing in the Constitutions or Laws of any State to the Contrary notwithstanding.\xe2\x80\x9d\nThis means of course, that any federal law\xe2\x80\x94even a regulation of a federal agency\xe2\x80\x94would control\nover any conflicting state law.\nPreemption can be either express or implied. When Congress chooses to expressly preempt state\nlaw, the only question for courts becomes determining whether the challenged state law is one\nthat the federal law is intended to preempt. Implied preemption presents more difficult issues.\nThe court has to look beyond the express language of federal statutes to determine whether\nCongress has \xe2\x80\x9coccupied the field\xe2\x80\x9d in which the state is attempting to regulate, or whether a state\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n144\n\n\x0claw directly conflicts with federal law, or whether enforcement of the state law might frustrate\nfederal purposes.\nFederal \xe2\x80\x9coccupation of the field\xe2\x80\x9d occurs, according to the court in Pennsylvania v.\nNelson (1956), when there is \xe2\x80\x9cno room\xe2\x80\x9d left for state regulation. Courts are to look to the\npervasiveness of the federal scheme of regulation, the federal interest at stake, and the danger of\nfrustration of federal goals in making the determination as to whether a challenged state law can\nstand.\nIn Silkwood v. Kerr-McGee (1984), the court, voting 5\xe2\x80\x934, found that a $10 million punitive\ndamages award (in a case litigated by famed attorney Gerry Spence) against a nuclear power\nplant was not impliedly preempted by federal law. Even though the court had recently held that\nstate regulation of the safety aspects of a federally licensed nuclear power plant was preempted,\nthe court drew a different conclusion with respect to Congress\xe2\x80\x99s desire to displace state tort\nlaw\xe2\x80\x94even though the tort actions might be premised on a violation of federal safety regulations.\nCipollone v. Liggett Group (1993) was a closely watched case concerning the extent of an\nexpress preemption provision in two cigarette labeling laws of the 1960s. The case was a\nwrongful death action brought against tobacco companies on behalf of Rose Cipollone, a lung\ncancer victim who had started smoking cigarette in the 1940s. The court considered the\npreemptive effect on state law of a provision that stated, \xe2\x80\x9cNo requirement based on smoking and\nhealth shall be imposed under state law with respect to the advertising and promotion of\ncigarettes.\xe2\x80\x9d The court concluded that several types of state tort actions were preempted by the\nprovision but allowed other types to go forward.\n\nKEY TAKEAWAY\n\nIn cases of conflicts between state and federal law, federal law will preempt (or control) state\nlaw because of the supremacy clause. Preemption can be express or implied. In cases where\npreemption is implied, the court usually finds that compliance with both state and federal\nlaw is not possible or that a federal regulatory scheme is comprehensive (i.e., \xe2\x80\x9coccupies the\nfield\xe2\x80\x9d) and should not be modified by state actions.\n\nEXERCISES\n\n1. For many years, the United States engaged in discussions with friendly nations as to the\nreciprocal use of ports and harbors. These discussions led to various multilateral agreements\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n145\n\n\x0cbetween the nations as to the configuration of oceangoing vessels and how they would be\npiloted. At the same time, concern over oil spills in Puget Sound led the state of Washington\nto impose fairly strict standards on oil tankers and requirements for the training of oil tanker\npilots. In addition, Washington\xe2\x80\x99s state law imposed many other requirements that went\nabove and beyond agreed-upon requirements in the international agreements negotiated by\nthe federal government. Are the Washington state requirements preempted by federal law?\n2. The Federal Arbitration Act of 1925 requires that all contracts for arbitration be treated as\nany other contract at common law. Suppose that the state of Alabama wishes to protect its\ncitizens from a variety of arbitration provisions that they might enter into unknowingly. Thus\nthe legislation provides that all predispute arbitration clauses be in bold print, that they be of\ntwelve-point font or larger, that they be clearly placed within the first two pages of any\ncontract, and that they have a separate signature line where the customer, client, or patient\nacknowledges having read, understood, and signed the arbitration clause in addition to any\nother signatures required on the contract. The legislation does preserve the right of\nconsumers to litigate in the event of a dispute arising with the product or service provider;\nthat is, with this legislation, consumers will not unknowingly waive their right to a trial at\ncommon law. Is the Alabama law preempted by the Federal Arbitration Act?\n\n[1] Cippolone v. Liggett Group, 505 US 504 (1993).\n\n4.5 Business and the Bill of Rights\n\nLEARNING OBJECTIVES\n\n1. Understand and describe which articles in the Bill of Rights apply to business activities and\nhow they apply.\n2. Explain the application of the Fourteenth Amendment\xe2\x80\x94including the due process clause and\nthe equal protection clause\xe2\x80\x94to various rights enumerated in the original Bill of Rights.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n146\n\n\x0cWe have already seen the Fourteenth Amendment\xe2\x80\x99s application in Burger King v.\nRudzewicz (Section 3.9 "Cases"). In that case, the court considered whether it was\nconstitutionally correct for a court to assert personal jurisdiction over a nonresident. The states\ncannot constitutionally award a judgment against a nonresident if doing so would offend\ntraditional notions of fair play and substantial justice. Even if the state\xe2\x80\x99s long-arm statute would\nseem to allow such a judgment, other states should not give it full faith and credit (see Article V\nof the Constitution). In short, a state\xe2\x80\x99s long-arm statute cannot confer personal jurisdiction that\nthe state cannot constitutionally claim.\nThe Bill of Rights (the first ten amendments to the Constitution) was originally meant to apply\nto federal actions only. During the twentieth century, the court began to apply selected rights to\nstate action as well. So, for example, federal agents were prohibited from using evidence seized\nin violation of the Fourth Amendment, but state agents were not, until Mapp v. Ohio (1960),\nwhen the court applied the guarantees (rights) of the Fourth Amendment to state action as well.\nIn this and in similar cases, the Fourteenth Amendment\xe2\x80\x99s due process clause was the basis for\nthe court\xe2\x80\x99s action. The due process clause commanded that states provide due process in cases\naffecting the life, liberty, or property of US citizens, and the court saw in this command certain\n\xe2\x80\x9cfundamental guarantees\xe2\x80\x9d that states would have to observe. Over the years, most of the\nimportant guarantees in the Bill of Rights came to apply to state as well as federal action. The\ncourt refers to this process as selective incorporation.\nHere are some very basic principles to remember:\n1. The guarantees of the Bill of Rights apply only to state and federal government action. They do\nnot limit what a company or person in the private sector may do. For example, states may not\nimpose censorship on the media or limit free speech in a way that offends the First Amendment,\nbut your boss (in the private sector) may order you not to talk to the media.\n2. In some cases, a private company may be regarded as participating in \xe2\x80\x9cstate action.\xe2\x80\x9d For\nexample, a private defense contractor that gets 90 percent of its business from the federal\ngovernment has been held to be public for purposes of enforcing the constitutional right to free\nspeech (the company had a rule barring its employees from speaking out in public against its\ncorporate position). It has even been argued that public regulation of private activity is sufficient\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n147\n\n\x0cto convert the private into public activity, thus subjecting it to the requirements of due process.\nBut the Supreme Court rejected this extreme view in 1974 when it refused to require private\npower companies, regulated by the state, to give customers a hearing before cutting off\nelectricity for failure to pay the bill. [1]\n3. States have rights, too. While \xe2\x80\x9cstates rights\xe2\x80\x9d was a battle cry of Southern states before the Civil\nWar, the question of what balance to strike between state sovereignty and federal union has\nnever been simple. In Kimel v. Florida, for example, the Supreme Court found in the words of\nthe Eleventh Amendment a basis for declaring that states may not have to obey certain federal\nstatutes.\n\nFirst Amendment\nIn part, the First Amendment states that \xe2\x80\x9cCongress shall make no law\xe2\x80\xa6abridging the freedom of\nspeech, or of the press.\xe2\x80\x9d The Founding Fathers believed that democracy would work best if\npeople (and the press) could talk or write freely, without governmental interference. But the\nFirst Amendment was also not intended to be as absolute as it sounded. Oliver Wendell\nHolmes\xe2\x80\x99s famous dictum that the law does not permit you to shout \xe2\x80\x9cFire!\xe2\x80\x9d in a crowded theater\nhas seldom been answered, \xe2\x80\x9cBut why not?\xe2\x80\x9d And no one in 1789 thought that defamation laws\n(torts for slander and libel) had been made unconstitutional. Moreover, because the apparent\npurpose of the First Amendment was to make sure that the nation had a continuing, vigorous\ndebate over matters political, political speech has been given the highest level of protection over\nsuch other forms of speech as (1) \xe2\x80\x9ccommercial speech,\xe2\x80\x9d (2) speech that can and should be\nlimited by reasonable \xe2\x80\x9ctime, place, and manner\xe2\x80\x9d restrictions, or (3) obscene speech.\nBecause of its higher level of protection, political speech can be false, malicious, mean-spirited,\nor even a pack of lies. A public official in the United States must be prepared to withstand all\nkinds of false accusations and cannot succeed in an action for defamation unless the defendant\nhas acted with \xe2\x80\x9cmalice\xe2\x80\x9d and \xe2\x80\x9creckless disregard\xe2\x80\x9d of the truth. Public figures, such as CEOs of the\nlargest US banks, must also be prepared to withstand accusations that are false. In any\ndefamation action, truth is a defense, but a defamation action brought by a public figure or\npublic official must prove that the defendant not only has his facts wrong but also lies to the\npublic in a malicious way with reckless disregard of the truth. Celebrities such as Lindsay Lohan\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n148\n\n\x0cand Jon Stewart have the same burden to go forward with a defamation action. It is for this\nreason that the National Enquirer writes exclusively about public figures, public officials, and\ncelebrities; it is possible to say many things that aren\xe2\x80\x99t completely true and still have the\nprotection of the First Amendment.\nPolitical speech is so highly protected that the court has recognized the right of people to\nsupport political candidates through campaign contributions and thus promote the particular\nviewpoints and speech of those candidates. Fearing the influence of money on politics, Congress\nhas from time to time placed limitations on corporate contributions to political campaigns. But\nthe Supreme Court has had mixed reactions over time. Initially, the court recognized the First\nAmendment right of a corporation to donate money, subject to certain limits. [2] In another\ncase, Austin v. Michigan Chamber of Commerce (1990), the Michigan Campaign Finance Act\nprohibited corporations from using treasury money for independent expenditures to support or\noppose candidates in elections for state offices. But a corporation could make such expenditures\nif it set up an independent fund designated solely for political purposes. The law was passed on\nthe assumption that \xe2\x80\x9cthe unique legal and economic characteristics of corporations necessitate\nsome regulation of their political expenditures to avoid corruption or the appearance of\ncorruption.\xe2\x80\x9d\nThe Michigan Chamber of Commerce wanted to support a candidate for Michigan\xe2\x80\x99s House of\nRepresentatives by using general funds to sponsor a newspaper advertisement and argued that\nas a nonprofit organization, it was not really like a business firm. The court disagreed and\nupheld the Michigan law. Justice Marshall found that the chamber was akin to a business group,\ngiven its activities, linkages with community business leaders, and high percentage of members\n(over 75 percent) that were business corporations. Furthermore, Justice Marshall found that the\nstatute was narrowly crafted and implemented to achieve the important goal of maintaining\nintegrity in the political process. But as you will see in Citizens United v. Federal Election\nCommission(Section 4.6 "Cases"), Austin was overruled; corporations are recognized as\n\xe2\x80\x9cpersons\xe2\x80\x9d with First Amendment political speech rights that cannot be impaired by Congress or\nthe states without some compelling governmental interest with restrictions on those rights that\nare \xe2\x80\x9cnarrowly tailored.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n149\n\n\x0cFourth Amendment\nThe Fourth Amendment says, \xe2\x80\x9call persons shall be secure in their persons, houses, papers, and\neffects from unreasonable searches and seizures, and no warrants shall issue, but upon probable\ncause, before a magistrate and upon Oath, specifically describing the persons to be searched and\nplaces to be seized.\xe2\x80\x9d\nThe court has read the Fourth Amendment to prohibit only those government searches or\nseizures that are \xe2\x80\x9cunreasonable.\xe2\x80\x9d Because of this, businesses that are in an industry that is\n\xe2\x80\x9cclosely regulated\xe2\x80\x9d can be searched more frequently and can be searched without a warrant. In\none case, an auto parts dealer at a junkyard was charged with receiving stolen auto parts. Part of\nhis defense was to claim that the search that found incriminating evidence was unconstitutional.\nBut the court found the search reasonable, because the dealer was in a \xe2\x80\x9cclosely regulated\nindustry.\xe2\x80\x9d\nIn the 1980s, Dow Chemical objected to an overflight by the US Environmental Protection\nAgency (EPA). The EPA had rented an airplane to fly over the Midland, Michigan, Dow plant,\nusing an aerial mapping camera to photograph various pipes, ponds, and machinery that were\nnot covered by a roof. Because the court\xe2\x80\x99s precedents allowed governmental intrusions into\n\xe2\x80\x9copen fields,\xe2\x80\x9d the EPA search was ruled constitutional. Because the literal language of the\nFourth Amendment protected \xe2\x80\x9cpersons, houses, papers, and effects,\xe2\x80\x9d anything searched by the\ngovernment in \xe2\x80\x9copen fields\xe2\x80\x9d was reasonable. (The court\xe2\x80\x99s opinion suggested that if Dow had\nreally wanted privacy from governmental intrusion, it could have covered the pipes and\nmachinery that were otherwise outside and in open fields.)\nNote again that constitutional guarantees like the Fourth Amendment apply to governmental\naction. Your employer or any private enterprise is not bound by constitutional limits. For\nexample, if drug testing of all employees every week is done by government agency, the\nemployees may have a cause of action to object based on the Fourth Amendment. However, if a\nprivate employer begins the same kind of routine drug testing, employees have no constitutional\narguments to make; they can simply leave that employer, or they may pursue whatever statutory\nor common-law remedies are available.\n\nFifth Amendment\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n150\n\n\x0cThe Fifth Amendment states, \xe2\x80\x9cNo person shall be\xe2\x80\xa6deprived of life, liberty, or property, without\ndue process of law; nor shall private property be taken for public use, without just\ncompensation.\xe2\x80\x9d\nThe Fifth Amendment has three principal aspects: procedural due process, thetakings clause,\nand substantive due process. In terms of procedural due process, the amendment prevents\ngovernment from arbitrarily taking the life of a criminal defendant. In civil lawsuits, it is also\nconstitutionally essential that the proceedings be fair. This is why, for example, the defendant\nin Burger King v. Rudzewicz had a serious constitutional argument, even though he lost.\nThe takings clause of the Fifth Amendment ensures that the government does not take private\nproperty without just compensation. In the international setting, governments that take private\nproperty engage in what is called expropriation. The standard under customary international\nlaw is that when governments do that, they must provide prompt, adequate, and effective\ncompensation. This does not always happen, especially where foreign owners\xe2\x80\x99 property is being\nexpropriated. The guarantees of the Fifth Amendment (incorporated against state action by the\nFourteenth Amendment) are available to property owners where state, county, or municipal\ngovernment uses the power of eminent domain to take private property for public purposes. Just\nwhat is a public purpose is a matter of some debate. For example, if a city were to condemn\neconomically viable businesses or neighborhoods to construct a baseball stadium with public\nmoney to entice a private enterprise (the baseball team) to stay, is a public purpose being\nserved?\nIn Kelo v. City of New London, Mrs. Kelo and other residents fought the city of New London, in\nits attempt to use powers of eminent domain to create an industrial park and recreation area\nthat would have Pfizer & Co. as a principal tenant. [3] The city argued that increasing its tax base\nwas a sufficient public purpose. In a very close decision, the Supreme Court determined that\nNew London\xe2\x80\x99s actions did not violate the takings clause. However, political reactions in various\nstates resulted in a great deal of new state legislation that would limit the scope of public\npurpose in eminent domain takings and provide additional compensation to property owners in\nmany cases.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n151\n\n\x0cIn addition to the takings clause and aspects of procedural due process, the Fifth Amendment is\nalso the source of what is called substantive due process. During the first third of the twentieth\ncentury, the Supreme Court often nullified state and federal laws using substantive due process.\nIn 1905, for example, in Lochner v. New York, the Supreme Court voided a New York statute\nthat limited the number of hours that bakers could work in a single week. New York had passed\nthe law to protect the health of employees, but the court found that this law interfered with the\nbasic constitutional right of private parties to freely contract with one another. Over the next\nthirty years, dozens of state and federal laws were struck down that aimed to improve working\nconditions, secure social welfare, or establish the rights of unions. However, in 1934, during the\nGreat Depression, the court reversed itself and began upholding the kinds of laws it had struck\ndown earlier.\nSince then, the court has employed a two-tiered analysis of substantive due process claims.\nUnder the first tier, legislation on economic matters, employment relations, and other business\naffairs is subject to minimal judicial scrutiny. This means that a law will be overturned only if it\nserves no rational government purpose. Under the second tier, legislation concerning\nfundamental liberties is subject to \xe2\x80\x9cheightened judicial scrutiny,\xe2\x80\x9d meaning that a law will be\ninvalidated unless it is \xe2\x80\x9cnarrowly tailored to serve a significant government purpose.\xe2\x80\x9d\nThe Supreme Court has identified two distinct categories of fundamental liberties. The first\ncategory includes most of the liberties expressly enumerated in the Bill of Rights. Through a\nprocess known as selective incorporation, the court has interpreted the due process clause of the\nFourteenth Amendment to bar states from denying their residents the most important freedoms\nguaranteed in the first ten amendments to the federal Constitution. Only the Third Amendment\nright (against involuntary quartering of soldiers) and the Fifth Amendment right to be indicted\nby a grand jury have not been made applicable to the states. Because these rights are still not\napplicable to state governments, the Supreme Court is often said to have \xe2\x80\x9cselectively\nincorporated\xe2\x80\x9d the Bill of Rights into the due process clause of the Fourteenth Amendment.\nThe second category of fundamental liberties includes those liberties that are not expressly\nstated in the Bill of Rights but that can be seen as essential to the concepts of freedom and\nequality in a democratic society. These unstated liberties come from Supreme Court precedents,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n152\n\n\x0ccommon law, moral philosophy, and deeply rooted traditions of US legal history. The Supreme\nCourt has stressed that he word libertycannot be defined by a definitive list of rights; rather, it\nmust be viewed as a rational continuum of freedom through which every aspect of human\nbehavior is protected from arbitrary impositions and random restraints. In this regard, as the\nSupreme Court has observed, the due process clause protects abstract liberty interests, including\nthe right to personal autonomy, bodily integrity, self-dignity, and self-determination.\nThese liberty interests often are grouped to form a general right to privacy, which was first\nrecognized in Griswold v. Connecticut (Section 4.6.1), where the Supreme Court struck down a\nstate statute forbidding married adults from using, possessing, or distributing contraceptives on\nthe ground that the law violated the sanctity of the marital relationship. According to Justice\nDouglas\xe2\x80\x99s plurality opinion, this penumbra of privacy, though not expressly mentioned in the\nBill of Rights, must be protected to establish a buffer zone or breathing space for those freedoms\nthat are constitutionally enumerated.\nBut substantive due process has seen fairly limited use since the 1930s. During the 1990s, the\nSupreme Court was asked to recognize a general right to die under the doctrine of substantive\ndue process. Although the court stopped short of establishing such a far-reaching right, certain\npatients may exercise a constitutional liberty to hasten their deaths under a narrow set of\ncircumstances. In Cruzan v. Missouri Department of Health, the Supreme Court ruled that the\ndue process clause guarantees the right of competent adults to make advanced directives for the\nwithdrawal of life-sustaining measures should they become incapacitated by a disability that\nleaves them in a persistent vegetative state. [4] Once it has been established by clear and\nconvincing evidence that a mentally incompetent and persistently vegetative patient made such\na prior directive, a spouse, parent, or other appropriate guardian may seek to terminate any\nform of artificial hydration or nutrition.\n\nFourteenth Amendment: Due Process and Equal Protection Guarantees\nThe Fourteenth Amendment (1868) requires that states treat citizens of other states with due\nprocess. This can be either an issue of procedural due process (as in Section 3.9 "Cases", Burger\nKing v. Rudzewicz) or an issue of substantive due process. For substantive due process, consider\nwhat happened in an Alabama court not too long ago. [5]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n153\n\n\x0cThe plaintiff, Dr. Ira Gore, bought a new BMW for $40,000 from a dealer in Alabama. He later\ndiscovered that the vehicle\xe2\x80\x99s exterior had been slightly damaged in transit from Europe and had\ntherefore been repainted by the North American distributor prior to his purchase. The vehicle\nwas, by best estimates, worth about 10 percent less than he paid for it. The distributor, BMW of\nNorth America, had routinely sold slightly damaged cars as brand new if the damage could be\nfixed for less than 3 percent of the cost of the car. In the trial, Dr. Gore sought $4,000 in\ncompensatory damages and also punitive damages. The Alabama trial jury considered that\nBMW was engaging in a fraudulent practice and wanted to punish the defendant for a number of\nfrauds it estimated at somewhere around a thousand nationwide. The jury awarded not only the\n$4,000 in compensatory damages but also $4 million in punitive damages, which was later\nreduced to $2 million by the Alabama Supreme Court. On appeal to the US Supreme Court, the\ncourt found that punitive damages may not be \xe2\x80\x9cgrossly excessive.\xe2\x80\x9d If they are, then they violate\nsubstantive due process. Whatever damages a state awards must be limited to what is\nreasonably necessary to vindicate the state\xe2\x80\x99s legitimate interest in punishment and deterrence.\n\xe2\x80\x9cEqual protection of the laws\xe2\x80\x9d is a phrase that originates in the Fourteenth Amendment,\nadopted in 1868. The amendment provides that no state shall \xe2\x80\x9cdeny to any person within its\njurisdiction the equal protection of the laws.\xe2\x80\x9d This is the equal protection clause. It means that,\ngenerally speaking, governments must treat people equally. Unfair classifications among people\nor corporations will not be permitted. A well-known example of unfair classification would be\nrace discrimination: requiring white children and black children to attend different public\nschools or requiring \xe2\x80\x9cseparate but equal\xe2\x80\x9d public services, such as water fountains or restrooms.\nYet despite the clear intent of the 1868 amendment, \xe2\x80\x9cseparate but equal\xe2\x80\x9d was the law of the land\nuntil Brown v. Board of Education (1954). [6]\nGovernments make classifications every day, so not all classifications can be illegal under the\nequal protection clause. People with more income generally pay a greater percentage of their\nincome in taxes. People with proper medical training are licensed to become doctors; people\nwithout that training cannot be licensed and commit a criminal offense if they do practice\nmedicine. To know what classifications are permissible under the Fourteenth Amendment, we\nneed to know what is being classified. The court has created three classifications, and the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n154\n\n\x0coutcome of any equal protection case can usually be predicted by knowing how the court is likely\nto classify the case:\n\xe2\x80\xa2\n\nMinimal scrutiny: economic and social relations. Government actions are usually upheld if there\nis a rational basis for them.\n\n\xe2\x80\xa2\n\nIntermediate scrutiny: gender. Government classifications are sometimes upheld.\n\n\xe2\x80\xa2\n\nStrict scrutiny: race, ethnicity, and fundamental rights. Classifications based on any of these are\nalmost never upheld.\nUnder minimal scrutiny for economic and social regulation, laws that regulate economic or\nsocial issues are presumed valid and will be upheld if they are rationally related to legitimate\ngoals of government. So, for example, if the city of New Orleans limits the number of street\nvendors to some rational number (more than one but fewer than the total number that could\npossibly fit on the sidewalks), the local ordinance would not be overturned as a violation of\nequal protection.\nUnder intermediate scrutiny, the city of New Orleans might limit the number of street vendors\nwho are men. For example, suppose that the city council decreed that all street vendors must be\nwomen, thinking that would attract even more tourism. A classification like this, based on sex,\nwill have to meet a sterner test than a classification resulting from economic or social regulation.\nA law like this would have to substantially relate to important government objectives.\nIncreasingly, courts have nullified government sex classifications as societal concern with\ngender equality has grown. (See Shannon Faulkner\xe2\x80\x99s case against The Citadel, an all-male state\nschool.)[7]\nSuppose, however, that the city of New Orleans decided that no one of Middle Eastern heritage\ncould drive a taxicab or be a street vendor. That kind of classification would be examined with\nstrict scrutiny to see if there was any compelling justification for it. As noted, classifications such\nas this one are almost never upheld. The law would be upheld only if it were necessary to\npromote a compelling state interest. Very few laws that have a racial or ethnic classification meet\nthat test.\nThe strict scrutiny test will be applied to classifications involving racial and ethnic criteria as\nwell as classifications that interfere with a fundamental right. In Palmore v. Sidoti, the state\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n155\n\n\x0crefused to award custody to the mother because her new spouse was racially different from the\nchild. [8]This practice was declared unconstitutional because the state had made a racial\nclassification; this was presumptively invalid, and the government could not show a compelling\nneed to enforce such a classification through its law. An example of government action\ninterfering with a fundamental right will also receive strict scrutiny. When New York State gave\nan employment preference to veterans who had been state residents at the time of entering the\nmilitary, the court declared that veterans who were new to the state were less likely to get jobs\nand that therefore the statute interfered with the right to travel, which was deemed a\nfundamental right. [9]\n\nKEY TAKEAWAY\n\nThe Bill of Rights, through the Fourteenth Amendment, largely applies to state actions. The\nBill of Rights has applied to federal actions from the start. Both the Bill of Rights and the\nFourteenth Amendment apply to business in various ways, but it is important to remember\nthat the rights conferred are rights against governmental action and not the actions of\nprivate enterprise.\n\nEXERCISES\n\n1. John Hanks works at ProLogis. The company decides to institute a drug-testing policy. John is\na good and longtime employee but enjoys smoking marijuana on the weekends. The drug\ntesting will involve urine samples and, semiannually, a hair sample. It is nearly certain that\nthe drug-testing protocol that ProLogis proposes will find that Hanks is a marijuana user. The\ncompany has made it clear that it will have zero tolerance for any kind of nonprescribed\ncontrolled substances. John and several fellow employees wish to go to court to challenge\nthe proposed testing as \xe2\x80\x9can unreasonable search and seizure.\xe2\x80\x9d Can he possibly succeed?\n2. Larry Reed, majority leader in the Senate, is attacked in his reelection campaign by a series of\nads sponsored by a corporation (Global Defense, Inc.) that does not like his voting record.\nThe corporation is upset that Reed would not write a special provision that would favor\nGlobal Defense in a defense appropriations bill. The ads run constantly on television and\nradio in the weeks immediately preceding election day and contain numerous falsehoods.\nFor example, in order to keep the government running financially, Reed found it necessary to\nvote for a bill that included a last-minute rider that defunded a small government program\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n156\n\n\x0cfor the handicapped, sponsored by someone in the opposing party that wanted to privatize\nall programs for the handicapped. The ad is largely paid for by Global Defense and depicts a\nhandicapped child being helped by the existing program and large letters saying \xe2\x80\x9cDoes Larry\nReed Just Not Care?\xe2\x80\x9d The ad proclaims that it is sponsored by Citizens Who Care for a Better\nTomorrow. Is this protected speech? Why or why not? Can Reed sue for defamation? Why or\nwhy not?\n\n[1] Jackson v. Metropolitan Edison Co., 419 US 345 (1974).\n[2] Buckley v. Valeo, 424 US 1 (1976).\n[3] Kelo v. City of New London, 545 US 469 (2005).\n[4] Cruzan v. Missouri Department of Health, 497 US 261 (1990).\n[5] BMW of North America, Inc. v. Gore, 517 U.S. 559 (1996)\n[6] Plessy v. Ferguson, 163 US 537 (1896).\n[7] United States v. Virginia, 518 US 515 (1996).\n[8] Palmore v. Sidoti, 466 US 429 (1984).\n[9] Atty. Gen. of New York v. Soto-Lopez, 476 US 898 (1986).\n\n4.6 Cases\nGriswold v. Connecticut\nGriswold v. Connecticut\n381 U.S. 479 (U.S. Supreme Court 1965)\nA nineteenth-century Connecticut law made the use, possession, or distribution of birth control\ndevices illegal. The law also prohibited anyone from giving information about such devices.\nThe executive director and medical director of a planned parenthood association were found\nguilty of giving out such information to a married couple that wished to delay having children\nfor a few years. The directors were fined $100 each.\nThey appealed throughout the Connecticut state court system, arguing that the state law\nviolated (infringed) a basic or fundamental right of privacy of a married couple: to live\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n157\n\n\x0ctogether and have sex together without the restraining power of the state to tell them they may\nlegally have intercourse but not if they use condoms or other birth control devices. At each\nlevel (trial court, court of appeals, and Connecticut Supreme Court), the Connecticut courts\nupheld the constitutionality of the convictions.\nPlurality Opinion by Justice William O. Douglass\nWe do not sit as a super legislature to determine the wisdom, need, and propriety of laws that\ntouch economic problems, business affairs, or social conditions. The [Connecticut] law,\nhowever, operates directly on intimate relation of husband and wife and their physician\xe2\x80\x99s role in\none aspect of that relation.\n[Previous] cases suggest that specific guarantees in the Bill of Rights have penumbras, formed\nby emanations from those guarantees that help give them life and substance.\xe2\x80\xa6Various\nguarantees create zones of privacy. The right of association contained in the penumbra of the\nFirst Amendment is one.\xe2\x80\xa6The Third Amendment in its prohibition against the quartering of\nsoldiers \xe2\x80\x9cin any house\xe2\x80\x9d in time of peace without the consent of the owner is another facet of that\nprivacy. The Fourth Amendment explicitly affirms the \xe2\x80\x9cright of the people to be secure in their\npersons, houses, papers and effects, against unreasonable searches and seizures.\xe2\x80\x9d The Fifth\nAmendment in its Self-Incrimination Clause enables the citizen to create a zone of privacy which\nthe government may not force him to surrender to his detriment. The Ninth Amendment\nprovides: \xe2\x80\x9cThe enumeration in the Constitution, of certain rights, shall not be construed to deny\nor disparage others retained by the people.\xe2\x80\x9d\nThe Fourth and Fifth Amendments were described\xe2\x80\xa6as protection against all governmental\ninvasions \xe2\x80\x9cof the sanctity of a man\xe2\x80\x99s home and the privacies of life.\xe2\x80\x9d We recently referred\nin Mapp v. Ohio\xe2\x80\xa6to the Fourth Amendment as creating a \xe2\x80\x9cright to privacy, no less important\nthan any other right carefully and particularly reserved to the people.\xe2\x80\x9d\n[The law in question here], in forbidding the use of contraceptives rather than regulating their\nmanufacture or sale, seeks to achieve its goals by having a maximum destructive impact on [the\nmarital] relationship. Such a law cannot stand.\xe2\x80\xa6Would we allow the police to search the sacred\nprecincts of marital bedrooms for telltale signs of the use of contraceptives? The very idea is\nrepulsive to the notions of privacy surrounding the marital relationship.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n158\n\n\x0cWe deal with a right of privacy older than the Bill of Rights\xe2\x80\x94older than our political parties,\nolder than our school system. Marriage is a coming together for better or for worse, hopefully\nenduring, and intimate to the degree of being sacred. It is an association that promotes a way of\nlife, not causes; a harmony in living, not political faiths; a bilateral loyalty, not commercial or\nsocial projects. Yet it is an association for as noble a purpose as any involved in our prior\ndecisions.\nMr. Justice Stewart, whom Mr. Justice Black joins, dissenting.\nSince 1879 Connecticut has had on its books a law which forbids the use of contraceptives by\nanyone. I think this is an uncommonly silly law. As a practical matter, the law is obviously\nunenforceable, except in the oblique context of the present case. As a philosophical matter, I\nbelieve the use of contraceptives in the relationship of marriage should be left to personal and\nprivate choice, based upon each individual\xe2\x80\x99s moral, ethical, and religious beliefs. As a matter of\nsocial policy, I think professional counsel about methods of birth control should be available to\nall, so that each individual\xe2\x80\x99s choice can be meaningfully made. But we are not asked in this case\nto say whether we think this law is unwise, or even asinine. We are asked to hold that it violates\nthe United States Constitution. And that I cannot do.\nIn the course of its opinion the Court refers to no less than six Amendments to the Constitution:\nthe First, the Third, the Fourth, the Fifth, the Ninth, and the Fourteenth. But the Court does not\nsay which of these Amendments, if any, it thinks is infringed by this Connecticut law.\n\xe2\x80\xa6\nAs to the First, Third, Fourth, and Fifth Amendments, I can find nothing in any of them to\ninvalidate this Connecticut law, even assuming that all those Amendments are fully applicable\nagainst the States. It has not even been argued that this is a law \xe2\x80\x9crespecting an establishment of\nreligion, or prohibiting the free exercise thereof.\xe2\x80\x9d And surely, unless the solemn process of\nconstitutional adjudication is to descend to the level of a play on words, there is not involved\nhere any abridgment of \xe2\x80\x9cthe freedom of speech, or of the press; or the right of the people\npeaceably to assemble, and to petition the Government for a redress of grievances.\xe2\x80\x9d No soldier\nhas been quartered in any house. There has been no search, and no seizure. Nobody has been\ncompelled to be a witness against himself.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n159\n\n\x0cThe Court also quotes the Ninth Amendment, and my Brother Goldberg\xe2\x80\x99s concurring opinion\nrelies heavily upon it. But to say that the Ninth Amendment has anything to do with this case is\nto turn somersaults with history. The Ninth Amendment, like its companion the Tenth, which\nthis Court held \xe2\x80\x9cstates but a truism that all is retained which has not been surrendered,\xe2\x80\x9d United\nStates v. Darby, 312 U.S. 100, 124, was framed by James Madison and adopted by the States\nsimply to make clear that the adoption of the Bill of Rights did not alter the plan that\nthe Federal Government was to be a government of express and limited powers, and that all\nrights and powers not delegated to it were retained by the people and the individual States. Until\ntoday no member of this Court has ever suggested that the Ninth Amendment meant anything\nelse, and the idea that a federal court could ever use the Ninth Amendment to annul a law\npassed by the elected representatives of the people of the State of Connecticut would have\ncaused James Madison no little wonder.\nWhat provision of the Constitution, then, does make this state law invalid? The Court says it is\nthe right of privacy \xe2\x80\x9ccreated by several fundamental constitutional guarantees.\xe2\x80\x9d With all\ndeference, I can find no such general right of privacy in the Bill of Rights, in any other part of the\nConstitution, or in any case ever before decided by this Court.\nAt the oral argument in this case we were told that the Connecticut law does not \xe2\x80\x9cconform to\ncurrent community standards.\xe2\x80\x9d But it is not the function of this Court to decide cases on the\nbasis of community standards. We are here to decide cases \xe2\x80\x9cagreeably to the Constitution and\nlaws of the United States.\xe2\x80\x9d It is the essence of judicial duty to subordinate our own personal\nviews, our own ideas of what legislation is wise and what is not. If, as I should surely hope, the\nlaw before us does not reflect the standards of the people of Connecticut, the people of\nConnecticut can freely exercise their true Ninth and Tenth Amendment rights to persuade their\nelected representatives to repeal it. That is the constitutional way to take this law off the books.\n\nCASE QUESTIONS\n\n1. Which opinion is the strict constructionist opinion here\xe2\x80\x94Justice Douglas\xe2\x80\x99s or that of Justices\nStewart and Black?\n2. What would have happened if the Supreme Court had allowed the Connecticut Supreme\nCourt decision to stand and followed Justice Black\xe2\x80\x99s reasoning? Is it likely that the citizens of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n160\n\n\x0cConnecticut would have persuaded their elected representatives to repeal the law\nchallenged here?\n\nWickard v. Filburn\nWickard v. Filburn\n317 U.S. 111 (U.S. Supreme Court 1942)\nMr. Justice Jackson delivered the opinion of the Court.\nMr. Filburn for many years past has owned and operated a small farm in Montgomery County,\nOhio, maintaining a herd of dairy cattle, selling milk, raising poultry, and selling poultry and\neggs. It has been his practice to raise a small acreage of winter wheat, sown in the Fall and\nharvested in the following July; to sell a portion of the crop; to feed part to poultry and livestock\non the farm, some of which is sold; to use some in making flour for home consumption; and to\nkeep the rest for the following seeding.\nHis 1941 wheat acreage allotment was 11.1 acres and a normal yield of 20.1 bushels of wheat an\nacre. He sowed, however, 23 acres, and harvested from his 11.9 acres of excess acreage 239\nbushels, which under the terms of the Act as amended on May 26, 1941, constituted farm\nmarketing excess, subject to a penalty of 49 cents a bushel, or $117.11 in all.\nThe general scheme of the Agricultural Adjustment Act of 1938 as related to wheat is to control\nthe volume moving in interstate and foreign commerce in order to avoid surpluses and\nshortages and the consequent abnormally low or high wheat prices and obstructions to\ncommerce. [T]he Secretary of Agriculture is directed to ascertain and proclaim each year a\nnational acreage allotment for the next crop of wheat, which is then apportioned to the states\nand their counties, and is eventually broken up into allotments for individual farms.\nIt is urged that under the Commerce Clause of the Constitution, Article I, \xc2\xa7 8, clause 3, Congress\ndoes not possess the power it has in this instance sought to exercise. The question would merit\nlittle consideration since our decision in United States v. Darby, 312 U.S. 100, sustaining the\nfederal power to regulate production of goods for commerce, except for the fact that this Act\nextends federal regulation to production not intended in any part for commerce but wholly for\nconsumption on the farm.\n\nKassel v. Consolidated Freightways Corp.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n161\n\n\x0cKassel v. Consolidated Freightways Corp.\n450 U.S. 662 (U.S. Supreme Court 1981)\nJUSTICE POWELL announced the judgment of the Court and delivered an opinion, in which\nJUSTICE WHITE, JUSTICE BLACKMUN, and JUSTICE STEVENS joined.\nThe question is whether an Iowa statute that prohibits the use of certain large trucks within the\nState unconstitutionally burdens interstate commerce.\n\nI\nAppellee Consolidated Freightways Corporation of Delaware (Consolidated) is one of the largest\ncommon carriers in the country: it offers service in 48 States under a certificate of public\nconvenience and necessity issued by the Interstate Commerce Commission. Among other routes,\nConsolidated carries commodities through Iowa on Interstate 80, the principal east-west route\nlinking New York, Chicago, and the west coast, and on Interstate 35, a major north-south route.\nConsolidated mainly uses two kinds of trucks. One consists of a three-axle tractor pulling a 40foot two-axle trailer. This unit, commonly called a single, or \xe2\x80\x9csemi,\xe2\x80\x9d is 55 feet in length overall.\nSuch trucks have long been used on the Nation\xe2\x80\x99s highways. Consolidated also uses a two-axle\ntractor pulling a single-axle trailer which, in turn, pulls a single-axle dolly and a second singleaxle trailer. This combination, known as a double, or twin, is 65 feet long overall. Many trucking\ncompanies, including Consolidated, increasingly prefer to use doubles to ship certain kinds of\ncommodities. Doubles have larger capacities, and the trailers can be detached and routed\nseparately if necessary. Consolidated would like to use 65-foot doubles on many of its trips\nthrough Iowa.\nThe State of Iowa, however, by statute, restricts the length of vehicles that may use its highways.\nUnlike all other States in the West and Midwest, Iowa generally prohibits the use of 65-foot\ndoubles within its borders.\n\xe2\x80\xa6\nBecause of Iowa\xe2\x80\x99s statutory scheme, Consolidated cannot use its 65-foot doubles to move\ncommodities through the State. Instead, the company must do one of four things: (i) use 55-foot\nsingles; (ii) use 60-foot doubles; (iii) detach the trailers of a 65-foot double and shuttle each\nthrough the State separately; or (iv) divert 65-foot doubles around Iowa. Dissatisfied with these\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n162\n\n\x0coptions, Consolidated filed this suit in the District Court averring that Iowa\xe2\x80\x99s statutory scheme\nunconstitutionally burdens interstate commerce. Iowa defended the law as a reasonable safety\nmeasure enacted pursuant to its police power. The State asserted that 65-foot doubles are more\ndangerous than 55-foot singles and, in any event, that the law promotes safety and reduces road\nwear within the State by diverting much truck traffic to other states.\nIn a 14-day trial, both sides adduced evidence on safety and on the burden on interstate\ncommerce imposed by Iowa\xe2\x80\x99s law. On the question of safety, the District Court found that the\n\xe2\x80\x9cevidence clearly establishes that the twin is as safe as the semi.\xe2\x80\x9d 475 F.Supp. 544, 549 (SD Iowa\n1979). For that reason, \xe2\x80\x9cthere is no valid safety reason for barring twins from Iowa\xe2\x80\x99s highways\nbecause of their configuration.\xe2\x80\xa6The evidence convincingly, if not overwhelmingly, establishes\nthat the 65-foot twin is as safe as, if not safer than, the 60-foot twin and the 55-foot semi.\xe2\x80\xa6\xe2\x80\x9d\n\xe2\x80\x9cTwins and semis have different characteristics. Twins are more maneuverable, are less sensitive\nto wind, and create less splash and spray. However, they are more likely than semis to jackknife\nor upset. They can be backed only for a short distance. The negative characteristics are not such\nthat they render the twin less safe than semis overall. Semis are more stable, but are more likely\nto \xe2\x80\x98rear-end\xe2\x80\x99 another vehicle.\xe2\x80\x9d\nIn light of these findings, the District Court applied the standard we enunciated inRaymond\nMotor Transportation, Inc. v. Rice, 434 U.S. 429 (1978), and concluded that the state law\nimpermissibly burdened interstate commerce: \xe2\x80\x9c[T]he balance here must be struck in favor of the\nfederal interests. The total effect of the law as a safety measure in reducing accidents and\ncasualties is so slight and problematical that it does not outweigh the national interest in\nkeeping interstate commerce free from interferences that seriously impede it.\xe2\x80\x9d\nThe Court of Appeals for the Eighth Circuit affirmed. 612 F.2d 1064 (1979). It accepted the\nDistrict Court\xe2\x80\x99s finding that 65-foot doubles were as safe as 55-foot singles. Id. at 1069. Thus,\nthe only apparent safety benefit to Iowa was that resulting from forcing large trucks to detour\naround the State, thereby reducing overall truck traffic on Iowa\xe2\x80\x99s highways. The Court of\nAppeals noted that this was not a constitutionally permissible interest. It also commented that\nthe several statutory exemptions identified above, such as those applicable to border cities and\nthe shipment of livestock, suggested that the law, in effect, benefited Iowa residents at the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n163\n\n\x0cexpense of interstate traffic. Id. at 1070-1071. The combination of these exemptions weakened\nthe presumption of validity normally accorded a state safety regulation. For these reasons, the\nCourt of Appeals agreed with the District Court that the Iowa statute unconstitutionally\nburdened interstate commerce.\nIowa appealed, and we noted probable jurisdiction. 446 U.S. 950 (1980). We now affirm.\n\nII\nIt is unnecessary to review in detail the evolution of the principles of Commerce Clause\nadjudication. The Clause is both a \xe2\x80\x9cprolific \xe2\x80\x98 of national power and an equally prolific source of\nconflict with legislation of the state[s].\xe2\x80\x9d H. P. Hood & Sons, Inc. v. Du Mond, 336 U.S. 525, 336\nU.S. 534 (1949). The Clause permits Congress to legislate when it perceives that the national\nwelfare is not furthered by the independent actions of the States. It is now well established, also,\nthat the Clause itself is \xe2\x80\x9ca limitation upon state power even without congressional\nimplementation.\xe2\x80\x9d Hunt v. Washington Apple Advertising Comm\xe2\x80\x99n, 432 U.S. 333 at 350 (1977).\nThe Clause requires that some aspects of trade generally must remain free from interference by\nthe States. When a State ventures excessively into the regulation of these aspects of commerce, it\n\xe2\x80\x9ctrespasses upon national interests,\xe2\x80\x9d Great A&P Tea Co. v. Cottrell, 424 U.S. 366, 424 U.S. 373\n(1976), and the courts will hold the state regulation invalid under the Clause alone.\nThe Commerce Clause does not, of course, invalidate all state restrictions on commerce. It has\nlong been recognized that, \xe2\x80\x9cin the absence of conflicting legislation by Congress, there is a\nresiduum of power in the state to make laws governing matters of local concern which\nnevertheless in some measure affect interstate commerce or even, to some extent, regulate\nit.\xe2\x80\x9d Southern Pacific Co. v. Arizona, 325 U.S. 761 (1945).\nThe extent of permissible state regulation is not always easy to measure. It may be said with\nconfidence, however, that a State\xe2\x80\x99s power to regulate commerce is never greater than in matters\ntraditionally of local concern. Washington Apple Advertising Comm\xe2\x80\x99n, supra at 432 U.S. 350.\nFor example, regulations that touch upon safety\xe2\x80\x94especially highway safety\xe2\x80\x94are those that \xe2\x80\x9cthe\nCourt has been most reluctant to invalidate.\xe2\x80\x9d Raymond, supra at 434 U.S. 443 (and other cases\ncited). Indeed, \xe2\x80\x9cif safety justifications are not illusory, the Court will not second-guess legislative\njudgment about their importance in comparison with related burdens on interstate\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n164\n\n\x0ccommerce.\xe2\x80\x9dRaymond, supra at 434 U.S. at 449. Those who would challenge such bona fide\nsafety regulations must overcome a \xe2\x80\x9cstrong presumption of validity.\xe2\x80\x9d Bibb v. Navajo Freight\nLines, Inc., 359 U.S. 520 at (1959).\nBut the incantation of a purpose to promote the public health or safety does not insulate a state\nlaw from Commerce Clause attack. Regulations designed for that salutary purpose nevertheless\nmay further the purpose so marginally, and interfere with commerce so substantially, as to be\ninvalid under the Commerce Clause. In the Court\xe2\x80\x99s recent unanimous decision in Raymond we\ndeclined to \xe2\x80\x9caccept the State\xe2\x80\x99s contention that the inquiry under the Commerce Clause is ended\nwithout a weighing of the asserted safety purpose against the degree of interference with\ninterstate commerce.\xe2\x80\x9d This \xe2\x80\x9cweighing\xe2\x80\x9d by a court requires\xe2\x80\x94and indeed the constitutionality of\nthe state regulation depends on\xe2\x80\x94\xe2\x80\x9ca sensitive consideration of the weight and nature of the state\nregulatory concern in light of the extent of the burden imposed on the course of interstate\ncommerce.\xe2\x80\x9d Id. at 434 U.S. at 441; accord, Pike v. Bruce Church, Inc., 397 U.S. 137 at 142\n(1970); Bibb, supra, at 359 U.S. at 525-530.\n\nIII\nApplying these general principles, we conclude that the Iowa truck length limitations\nunconstitutionally burden interstate commerce.\nIn Raymond Motor Transportation, Inc. v. Rice, the Court held that a Wisconsin statute that\nprecluded the use of 65-foot doubles violated the Commerce Clause. This case\nis Raymond revisited. Here, as in Raymond, the State failed to present any persuasive evidence\nthat 65-foot doubles are less safe than 55-foot singles. Moreover, Iowa\xe2\x80\x99s law is now out of step\nwith the laws of all other Midwestern and Western States. Iowa thus substantially burdens the\ninterstate flow of goods by truck. In the absence of congressional action to set uniform\nstandards, some burdens associated with state safety regulations must be tolerated. But where,\nas here, the State\xe2\x80\x99s safety interest has been found to be illusory, and its regulations impair\nsignificantly the federal interest in efficient and safe interstate transportation, the state law\ncannot be harmonized with the Commerce Clause.\n\nA\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n165\n\n\x0cIowa made a more serious effort to support the safety rationale of its law than did Wisconsin\nin Raymond, but its effort was no more persuasive. As noted above, the District Court found\nthat the \xe2\x80\x9cevidence clearly establishes that the twin is as safe as the semi.\xe2\x80\x9d The record supports\nthis finding. The trial focused on a comparison of the performance of the two kinds of trucks in\nvarious safety categories. The evidence showed, and the District Court found, that the 65-foot\ndouble was at least the equal of the 55-foot single in the ability to brake, turn, and maneuver.\nThe double, because of its axle placement, produces less splash and spray in wet weather. And,\nbecause of its articulation in the middle, the double is less susceptible to dangerous \xe2\x80\x9cofftracking,\xe2\x80\x9d and to wind.\nNone of these findings is seriously disputed by Iowa. Indeed, the State points to only three ways\nin which the 55-foot single is even arguably superior: singles take less time to be passed and to\nclear intersections; they may back up for longer distances; and they are somewhat less likely to\njackknife.\nThe first two of these characteristics are of limited relevance on modern interstate highways. As\nthe District Court found, the negligible difference in the time required to pass, and to cross\nintersections, is insignificant on 4-lane divided highways, because passing does not require\ncrossing into oncoming traffic lanes, Raymond, 434 U.S. at 444, and interstates have few, if any,\nintersections. The concern over backing capability also is insignificant, because it seldom is\nnecessary to back up on an interstate. In any event, no evidence suggested any difference in\nbacking capability between the 60-foot doubles that Iowa permits and the 65-foot doubles that it\nbans. Similarly, although doubles tend to jackknife somewhat more than singles, 65-foot\ndoubles actually are less likely to jackknife than 60-foot doubles.\nStatistical studies supported the view that 65-foot doubles are at least as safe overall as 55-foot\nsingles and 60-foot doubles. One such study, which the District Court credited, reviewed\nConsolidated\xe2\x80\x99s comparative accident experience in 1978 with its own singles and doubles. Each\nkind of truck was driven 56 million miles on identical routes. The singles were involved in 100\naccidents resulting in 27 injuries and one fatality. The 65-foot doubles were involved in 106\naccidents resulting in 17 injuries and one fatality. Iowa\xe2\x80\x99s expert statistician admitted that this\nstudy provided \xe2\x80\x9cmoderately strong evidence\xe2\x80\x9d that singles have a higher injury rate than doubles.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n166\n\n\x0cAnother study, prepared by the Iowa Department of Transportation at the request of the state\nlegislature, concluded that \xe2\x80\x9c[s]ixty-five foot twin trailer combinations have not been shown by\nexperiences in other states to be less safe than 60-foot twin trailer combinations orconventional\ntractor-semitrailers.\xe2\x80\x9d\nIn sum, although Iowa introduced more evidence on the question of safety than did Wisconsin\nin Raymond, the record as a whole was not more favorable to the State.\n\nB\nConsolidated, meanwhile, demonstrated that Iowa\xe2\x80\x99s law substantially burdens interstate\ncommerce. Trucking companies that wish to continue to use 65-foot doubles must route them\naround Iowa or detach the trailers of the doubles and ship them through separately.\nAlternatively, trucking companies must use the smaller 55-foot singles or 65-foot doubles\npermitted under Iowa law. Each of these options engenders inefficiency and added expense. The\nrecord shows that Iowa\xe2\x80\x99s law added about $12.6 million each year to the costs of trucking\ncompanies.\nConsolidated alone incurred about $2 million per year in increased costs.\nIn addition to increasing the costs of the trucking companies (and, indirectly, of the service to\nconsumers), Iowa\xe2\x80\x99s law may aggravate, rather than, ameliorate, the problem of highway\naccidents. Fifty-five-foot singles carry less freight than 65-foot doubles. Either more small trucks\nmust be used to carry the same quantity of goods through Iowa or the same number of larger\ntrucks must drive longer distances to bypass Iowa. In either case, as the District Court noted, the\nrestriction requires more highway miles to be driven to transport the same quantity of goods.\nOther things being equal, accidents are proportional to distance traveled. Thus, if 65-foot\ndoubles are as safe as 55-foot singles, Iowa\xe2\x80\x99s law tends to increase the number of accidents and\nto shift the incidence of them from Iowa to other States.\n\n[IV. Omitted]\nV\nIn sum, the statutory exemptions, their history, and the arguments Iowa has advanced in\nsupport of its law in this litigation all suggest that the deference traditionally accorded a State\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n167\n\n\x0csafety judgment is not warranted. See Raymond, supra at 434 U.S. at 444-447. The controlling\nfactors thus are the findings of the District Court, accepted by the Court of Appeals, with respect\nto the relative safety of the types of trucks at issue, and the substantiality of the burden on\ninterstate commerce.\nBecause Iowa has imposed this burden without any significant countervailing safety interest, its\nstatute violates the Commerce Clause. The judgment of the Court of Appeals is affirmed.\nIt is so ordered.\n\nCASE QUESTIONS\n\n1. Under the Constitution, what gives Iowa the right to make rules regarding the size or\nconfiguration of trucks upon highways within the state?\n2. Did Iowa try to exempt trucking lines based in Iowa, or was the statutory rule\nnondiscriminatory as to the origin of trucks that traveled on Iowa highways?\n3. Are there any federal size or weight standards noted in the case? Is there any kind of truck\nsize or weight that could be limited by Iowa law, or must Iowa simply accept federal\nstandards or, if none, impose no standards at all?\n\nHunt v. Washington Apple Advertising Commission\nHunt v. Washington Apple Advertising Commission\n432 U.S. 33 (U.S. Supreme Court 1977)\nMR. CHIEF JUSTICE BURGER delivered the opinion of the Court.\nIn 1973, North Carolina enacted a statute which required, inter alia, all closed containers of\napples sold, offered for sale, or shipped into the State to bear \xe2\x80\x9cno grade other than the applicable\nU.S. grade or standard.\xe2\x80\x9d\xe2\x80\xa6Washington State is the Nation\xe2\x80\x99s largest producer of apples, its crops\naccounting for approximately 30% of all apples grown domestically and nearly half of all apples\nshipped in closed containers in interstate commerce. [Because] of the importance of the apple\nindustry to the State, its legislature has undertaken to protect and enhance the reputation of\nWashington apples by establishing a stringent, mandatory inspection program [that] requires all\napples shipped in interstate commerce to be tested under strict quality standards and graded\naccordingly. In all cases, the Washington State grades [are] the equivalent of, or superior to, the\ncomparable grades and standards adopted by the [U.S. Dept. of] Agriculture (USDA).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n168\n\n\x0c[In] 1972, the North Carolina Board of Agriculture adopted an administrative regulation, unique\nin the 50 States, which in effect required all closed containers of apples shipped into or sold in\nthe State to display either the applicable USDA grade or a notice indicating no classification.\nState grades were expressly prohibited. In addition to its obvious consequence\xe2\x80\x94prohibiting the\ndisplay of Washington State apple grades on containers of apples shipped into North Carolina\xe2\x80\x94\nthe regulation presented the Washington apple industry with a marketing problem of potentially\nnationwide significance. Washington apple growers annually ship in commerce approximately\n40 million closed containers of apples, nearly 500,000 of which eventually find their way into\nNorth Carolina, stamped with the applicable Washington State variety and grade. [Compliance]\nwith North Carolina\xe2\x80\x99s unique regulation would have required Washington growers to obliterate\nthe printed labels on containers shipped to North Carolina, thus giving their product a damaged\nappearance. Alternatively, they could have changed their marketing practices to accommodate\nthe needs of the North Carolina market, i.e., repack apples to be shipped to North Carolina in\ncontainers bearing only the USDA grade, and/or store the estimated portion of the harvest\ndestined for that market in such special containers. As a last resort, they could discontinue the\nuse of the preprinted containers entirely. None of these costly and less efficient options was very\nattractive to the industry. Moreover, in the event a number of other States followed North\nCarolina\xe2\x80\x99s lead, the resultant inability to display the Washington grades could force the\nWashington growers to abandon the State\xe2\x80\x99s expensive inspection and grading system which\ntheir customers had come to know and rely on over the 60-odd years of its existence.\xe2\x80\xa6\nUnsuccessful in its attempts to secure administrative relief [with North Carolina], the\nCommission instituted this action challenging the constitutionality of the statute. [The] District\nCourt found that the North Carolina statute, while neutral on its face, actually discriminated\nagainst Washington State growers and dealers in favor of their local counterparts [and]\nconcluded that this discrimination [was] not justified by the asserted local interest\xe2\x80\x94the\nelimination of deception and confusion from the marketplace\xe2\x80\x94arguably furthered by the\n[statute].\n\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n169\n\n\x0c[North Carolina] maintains that [the] burdens on the interstate sale of Washington apples were\nfar outweighed by the local benefits flowing from what they contend was a valid exercise of\nNorth Carolina\xe2\x80\x99s [police powers]. Prior to the statute\xe2\x80\x99s enactment,\xe2\x80\xa6apples from 13 different\nStates were shipped into North Carolina for sale. Seven of those States, including [Washington],\nhad their own grading systems which, while differing in their standards, used similar descriptive\nlabels (e.g., fancy, extra fancy, etc.). This multiplicity of inconsistent state grades [posed]\ndangers of deception and confusion not only in the North Carolina market, but in the Nation as\na whole. The North Carolina statute, appellants claim, was enacted to eliminate this source of\ndeception and confusion. [Moreover], it is contended that North Carolina sought to accomplish\nthis goal of uniformity in an evenhanded manner as evidenced by the fact that its statute applies\nto all apples sold in closed containers in the State without regard to their point of origin.\n[As] the appellants properly point out, not every exercise of state authority imposing some\nburden on the free flow of commerce is invalid, [especially] when the State acts to protect its\ncitizenry in matters pertaining to the sale of foodstuffs. By the same token, however, a finding\nthat state legislation furthers matters of legitimate local concern, even in the health and\nconsumer protection areas, does not end the inquiry. Rather, when such state legislation comes\ninto conflict with the Commerce Clause\xe2\x80\x99s overriding requirement of a national \xe2\x80\x9ccommon\nmarket,\xe2\x80\x9d we are confronted with the task of effecting an accommodation of the competing\nnational and local interests. We turn to that task.\nAs the District Court correctly found, the challenged statute has the practical effect of not only\nburdening interstate sales of Washington apples, but also discriminating against them. This\ndiscrimination takes various forms. The first, and most obvious, is the statute\xe2\x80\x99s consequence of\nraising the costs of doing business in the North Carolina market for Washington apple growers\nand dealers, while leaving those of their North Carolina counterparts unaffected. [This]\ndisparate effect results from the fact that North Carolina apple producers, unlike their\nWashington competitors, were not forced to alter their marketing practices in order to comply\nwith the statute. They were still free to market their wares under the USDA grade or none at all\nas they had done prior to the statute\xe2\x80\x99s enactment. Obviously, the increased costs imposed by the\nstatute would tend to shield the local apple industry from the competition of Washington apple\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n170\n\n\x0cgrowers and dealers who are already at a competitive disadvantage because of their great\ndistance from the North Carolina market.\nSecond, the statute has the effect of stripping away from the Washington apple industry the\ncompetitive and economic advantages it has earned for itself through its expensive inspection\nand grading system. The record demonstrates that the Washington apple-grading system has\ngained nationwide acceptance in the apple trade. [The record] contains numerous affidavits\n[stating a] preference [for] apples graded under the Washington, as opposed to the USDA,\nsystem because of the former\xe2\x80\x99s greater consistency, its emphasis on color, and its supporting\nmandatory inspections. Once again, the statute had no similar impact on the North Carolina\napple industry and thus operated to its benefit.\nThird, by prohibiting Washington growers and dealers from marketing apples under their\nState\xe2\x80\x99s grades, the statute has a leveling effect which insidiously operates to the advantage of\nlocal apple producers. [With] free market forces at work, Washington sellers would normally\nenjoy a distinct market advantage vis-\xc3\xa0-vis local producers in those categories where the\nWashington grade is superior. However, because of the statute\xe2\x80\x99s operation, Washington apples\nwhich would otherwise qualify for and be sold under the superior Washington grades will now\nhave to be marketed under their inferior USDA counterparts. Such \xe2\x80\x9cdowngrading\xe2\x80\x9d offers the\nNorth Carolina apple industry the very sort of protection against competing out-of-state\nproducts that the Commerce Clause was designed to prohibit. At worst, it will have the effect of\nan embargo against those Washington apples in the superior grades as Washington dealers\nwithhold them from the North Carolina market. At best, it will deprive Washington sellers of the\nmarket premium that such apples would otherwise command.\nDespite the statute\xe2\x80\x99s facial neutrality, the Commission suggests that its discriminatory impact on\ninterstate commerce was not an unintended by-product, and there are some indications in the\nrecord to that effect. The most glaring is the response of the North Carolina Agriculture\nCommissioner to the Commission\xe2\x80\x99s request for an exemption following the statute\xe2\x80\x99s passage in\nwhich he indicated that before he could support such an exemption, he would \xe2\x80\x9cwant to have the\nsentiment from our apple producers since they were mainly responsible for this legislation\nbeing passed.\xe2\x80\x9d [Moreover], we find it somewhat suspect that North Carolina singled out only\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n171\n\n\x0cclosed containers of apples, the very means by which apples are transported in commerce, to\neffectuate the statute\xe2\x80\x99s ostensible consumer protection purpose when apples are not generally\nsold at retail in their shipping containers. However, we need not ascribe an economic protection\nmotive to the North Carolina Legislature to resolve this case; we conclude that the challenged\nstatute cannot stand insofar as it prohibits the display of Washington State grades even if\nenacted for the declared purpose of protecting consumers from deception and fraud in the\nmarketplace.\n\xe2\x80\xa6\nFinally, we note that any potential for confusion and deception created by the Washington\ngrades was not of the type that led to the statute\xe2\x80\x99s enactment. Since Washington grades are in all\ncases equal or superior to their USDA counterparts, they could only \xe2\x80\x9cdeceive\xe2\x80\x9d or \xe2\x80\x9cconfuse\xe2\x80\x9d a\nconsumer to his benefit, hardly a harmful result.\nIn addition, it appears that nondiscriminatory alternatives to the outright ban of Washington\nState grades are readily available. For example, North Carolina could effectuate its goal by\npermitting out-of-state growers to utilize state grades only if they also marked their shipments\nwith the applicable USDA label. In that case, the USDA grade would serve as a benchmark\nagainst which the consumer could evaluate the quality of the various state grades.\xe2\x80\xa6\n[The court affirmed the lower court\xe2\x80\x99s holding that the North Carolina statute was\nunconstitutional.]\n\nCASE QUESTIONS\n\n1. Was the North Carolina law discriminatory on its face? Was it, possibly, an undue burden on\ninterstate commerce? Why wouldn\xe2\x80\x99t it be?\n2. What evidence was there of discriminatory intent behind the North Carolina law? Did that\nevidence even matter? Why or why not?\n\nCitizens United v. Federal Election Commission\nCitizens United v. Federal Election Commission\n588 U.S. ____; 130 S.Ct. 876 (U.S. Supreme Court 2010)\nJustice Kennedy delivered the opinion of the Court.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n172\n\n\x0cFederal law prohibits corporations and unions from using their general treasury funds to make\nindependent expenditures for speech defined as an \xe2\x80\x9celectioneering communication\xe2\x80\x9d or for\nspeech expressly advocating the election or defeat of a candidate. 2 U.S.C. \xc2\xa7441b. Limits on\nelectioneering communications were upheld inMcConnell v. Federal Election Comm\xe2\x80\x99n, 540 U.S.\n93, 203\xe2\x80\x93209 (2003). The holding ofMcConnell rested to a large extent on an earlier case, Austin\nv. Michigan Chamber of Commerce, 494 U.S. 652 (1990). Austin had held that political speech\nmay be banned based on the speaker\xe2\x80\x99s corporate identity.\nIn this case we are asked to reconsider Austin and, in effect, McConnell. It has been noted that\n\xe2\x80\x9cAustin was a significant departure from ancient First Amendment principles,\xe2\x80\x9d Federal Election\nComm\xe2\x80\x99n v. Wisconsin Right to Life, Inc., 551 U.S. 449, 490 (2007) (WRTL) (Scalia, J.,\nconcurring in part and concurring in judgment). We agree with that conclusion and hold\nthat stare decisis does not compel the continued acceptance of Austin. The Government may\nregulate corporate political speech through disclaimer and disclosure requirements, but it may\nnot suppress that speech altogether. We turn to the case now before us.\n\nI\nA\nCitizens United is a nonprofit corporation. It has an annual budget of about $12 million. Most of\nits funds are from donations by individuals; but, in addition, it accepts a small portion of its\nfunds from for-profit corporations.\nIn January 2008, Citizens United released a film entitled Hillary: The Movie. We refer to the\nfilm as Hillary. It is a 90-minute documentary about then-Senator Hillary Clinton, who was a\ncandidate in the Democratic Party\xe2\x80\x99s 2008 Presidential primary elections. Hillary mentions\nSenator Clinton by name and depicts interviews with political commentators and other persons,\nmost of them quite critical of Senator Clinton.\xe2\x80\xa6\nIn December 2007, a cable company offered, for a payment of $1.2 million, to\nmakeHillary available on a video-on-demand channel called \xe2\x80\x9cElections \xe2\x80\x9908.\xe2\x80\x9d\xe2\x80\xa6Citizens United\nwas prepared to pay for the video-on-demand; and to promote the film, it produced two 10second ads and one 30-second ad for Hillary. Each ad includes a short (and, in our view,\npejorative) statement about Senator Clinton, followed by the name of the movie and the movie\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n173\n\n\x0cWebsite address. Citizens United desired to promote the video-on-demand offering by running\nadvertisements on broadcast and cable television.\n\nB\nBefore the Bipartisan Campaign Reform Act of 2002 (BCRA), federal law prohibited\xe2\x80\x94and still\ndoes prohibit\xe2\x80\x94corporations and unions from using general treasury funds to make direct\ncontributions to candidates or independent expenditures that expressly advocate the election or\ndefeat of a candidate, through any form of media, in connection with certain qualified federal\nelections.\xe2\x80\xa6BCRA \xc2\xa7203 amended \xc2\xa7441b to prohibit any \xe2\x80\x9celectioneering communication\xe2\x80\x9d as well.\nAn electioneering communication is defined as \xe2\x80\x9cany broadcast, cable, or satellite\ncommunication\xe2\x80\x9d that \xe2\x80\x9crefers to a clearly identified candidate for Federal office\xe2\x80\x9d and is made\nwithin 30 days of a primary or 60 days of a general election. \xc2\xa7434(f)(3)(A). The Federal Election\nCommission\xe2\x80\x99s (FEC) regulations further define an electioneering communication as a\ncommunication that is \xe2\x80\x9cpublicly distributed.\xe2\x80\x9d 11 CFR \xc2\xa7100.29(a)(2) (2009). \xe2\x80\x9cIn the case of a\ncandidate for nomination for President\xe2\x80\xa6publicly distributed means\xe2\x80\x9d that the communication\n\xe2\x80\x9c[c]an be received by 50,000 or more persons in a State where a primary election\xe2\x80\xa6is being held\nwithin 30 days.\xe2\x80\x9d 11 CFR \xc2\xa7100.29(b)(3)(ii). Corporations and unions are barred from using their\ngeneral treasury funds for express advocacy or electioneering communications. They may\nestablish, however, a \xe2\x80\x9cseparate segregated fund\xe2\x80\x9d (known as a political action committee, or PAC)\nfor these purposes. 2 U.S.C. \xc2\xa7441b(b)(2). The moneys received by the segregated fund are\nlimited to donations from stockholders and employees of the corporation or, in the case of\nunions, members of the union. Ibid.\n\nC\nCitizens United wanted to make Hillary available through video-on-demand within 30 days of\nthe 2008 primary elections. It feared, however, that both the film and the ads would be covered\nby \xc2\xa7441b\xe2\x80\x99s ban on corporate-funded independent expenditures, thus subjecting the corporation\nto civil and criminal penalties under \xc2\xa7437g. In December 2007, Citizens United sought\ndeclaratory and injunctive relief against the FEC. It argued that (1) \xc2\xa7441b is unconstitutional as\napplied to Hillary; and (2) BCRA\xe2\x80\x99s disclaimer and disclosure requirements, BCRA \xc2\xa7\xc2\xa7201 and\n311, are unconstitutional as applied to Hillary and to the three ads for the movie.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n174\n\n\x0cThe District Court denied Citizens United\xe2\x80\x99s motion for a preliminary injunction, and then\ngranted the FEC\xe2\x80\x99s motion for summary judgment.\n\xe2\x80\xa6\nThe court held that \xc2\xa7441b was facially constitutional under McConnell, and that \xc2\xa7441b was\nconstitutional as applied to Hillary because it was \xe2\x80\x9csusceptible of no other interpretation than to\ninform the electorate that Senator Clinton is unfit for office, that the United States would be a\ndangerous place in a President Hillary Clinton world, and that viewers should vote against her.\xe2\x80\x9d\n530 F. Supp. 2d, at 279. The court also rejected Citizens United\xe2\x80\x99s challenge to BCRA\xe2\x80\x99s disclaimer\nand disclosure requirements. It noted that \xe2\x80\x9cthe Supreme Court has written approvingly of\ndisclosure provisions triggered by political speech even though the speech itself was\nconstitutionally protected under the First Amendment.\xe2\x80\x9d Id. at 281.\n\nII\n[Omitted: the court considers whether it is possible to reject the BCRA without declaring certain\nprovisions unconstitutional. The court concludes it cannot find a basis to reject the BCRA that\ndoes not involve constitutional issues.]\n\nIII\nThe First Amendment provides that \xe2\x80\x9cCongress shall make no law\xe2\x80\xa6abridging the freedom of\nspeech.\xe2\x80\x9d Laws enacted to control or suppress speech may operate at different points in the\nspeech process.\xe2\x80\xa6The law before us is an outright ban, backed by criminal sanctions. Section\n441b makes it a felony for all corporations\xe2\x80\x94including nonprofit advocacy corporations\xe2\x80\x94either\nto expressly advocate the election or defeat of candidates or to broadcast electioneering\ncommunications within 30 days of a primary election and 60 days of a general election. Thus,\nthe following acts would all be felonies under \xc2\xa7441b: The Sierra Club runs an ad, within the\ncrucial phase of 60 days before the general election, that exhorts the public to disapprove of a\nCongressman who favors logging in national forests; the National Rifle Association publishes a\nbook urging the public to vote for the challenger because the incumbent U.S. Senator supports a\nhandgun ban; and the American Civil Liberties Union creates a Web site telling the public to\nvote for a Presidential candidate in light of that candidate\xe2\x80\x99s defense of free speech. These\nprohibitions are classic examples of censorship.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n175\n\n\x0cSection 441b is a ban on corporate speech notwithstanding the fact that a PAC created by a\ncorporation can still speak. PACs are burdensome alternatives; they are expensive to administer\nand subject to extensive regulations. For example, every PAC must appoint a treasurer, forward\ndonations to the treasurer promptly, keep detailed records of the identities of the persons\nmaking donations, preserve receipts for three years, and file an organization statement and\nreport changes to this information within 10 days.\nAnd that is just the beginning. PACs must file detailed monthly reports with the FEC, which are\ndue at different times depending on the type of election that is about to occur.\xe2\x80\xa6\nPACs have to comply with these regulations just to speak. This might explain why fewer than\n2,000 of the millions of corporations in this country have PACs. PACs, furthermore, must exist\nbefore they can speak. Given the onerous restrictions, a corporation may not be able to establish\na PAC in time to make its views known regarding candidates and issues in a current campaign.\nSection 441b\xe2\x80\x99s prohibition on corporate independent expenditures is thus a ban on speech. As a\n\xe2\x80\x9crestriction on the amount of money a person or group can spend on political communication\nduring a campaign,\xe2\x80\x9d that statute \xe2\x80\x9cnecessarily reduces the quantity of expression by restricting\nthe number of issues discussed, the depth of their exploration, and the size of the audience\nreached.\xe2\x80\x9d Buckley v. Valeo, 424 U.S. 1 at 19 (1976).\xe2\x80\xa6\nSpeech is an essential mechanism of democracy, for it is the means to hold officials accountable\nto the people. See Buckley, supra, at 14\xe2\x80\x9315 (\xe2\x80\x9cIn a republic where the people are sovereign, the\nability of the citizenry to make informed choices among candidates for office is essential.\xe2\x80\x9d) The\nright of citizens to inquire, to hear, to speak, and to use information to reach consensus is a\nprecondition to enlightened self-government and a necessary means to protect it. The First\nAmendment \xe2\x80\x9c\xe2\x80\x98has its fullest and most urgent application\xe2\x80\x99 to speech uttered during a campaign\nfor political office.\xe2\x80\x9d\nFor these reasons, political speech must prevail against laws that would suppress it, whether by\ndesign or inadvertence. Laws that burden political speech are \xe2\x80\x9csubject to strict scrutiny,\xe2\x80\x9d which\nrequires the Government to prove that the restriction \xe2\x80\x9cfurthers a compelling interest and is\nnarrowly tailored to achieve that interest.\xe2\x80\x9d\n\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n176\n\n\x0cThe Court has recognized that First Amendment protection extends to corporations. This\nprotection has been extended by explicit holdings to the context of political speech. Under the\nrationale of these precedents, political speech does not lose First Amendment protection \xe2\x80\x9csimply\nbecause its source is a corporation.\xe2\x80\x9d Bellotti, supra, at 784. The Court has thus rejected the\nargument that political speech of corporations or other associations should be treated differently\nunder the First Amendment simply because such associations are not \xe2\x80\x9cnatural persons.\xe2\x80\x9d\nThe purpose and effect of this law is to prevent corporations, including small and nonprofit\ncorporations, from presenting both facts and opinions to the public. This makes Austin\xe2\x80\x99s\nantidistortion rationale all the more an aberration. \xe2\x80\x9c[T]he First Amendment protects the right of\ncorporations to petition legislative and administrative bodies.\xe2\x80\x9d Bellotti, 435 U.S., at 792, n. 31.\xe2\x80\xa6\nEven if \xc2\xa7441b\xe2\x80\x99s expenditure ban were constitutional, wealthy corporations could still lobby\nelected officials, although smaller corporations may not have the resources to do so. And\nwealthy individuals and unincorporated associations can spend unlimited amounts on\nindependent expenditures. See, e.g., WRTL, 551 U.S., at 503\xe2\x80\x93504 (opinion of Scalia, J.) (\xe2\x80\x9cIn the\n2004 election cycle, a mere 24 individuals contributed an astounding total of $142 million to [26\nU.S.C. \xc2\xa7527 organizations]\xe2\x80\x9d). Yet certain disfavored associations of citizens\xe2\x80\x94those that have\ntaken on the corporate form\xe2\x80\x94are penalized for engaging in the same political speech.\nWhen Government seeks to use its full power, including the criminal law, to command where a\nperson may get his or her information or what distrusted source he or she may not hear, it uses\ncensorship to control thought. This is unlawful. The First Amendment confirms the freedom to\nthink for ourselves.\nWhat we have said also shows the invalidity of other arguments made by the Government. For\nthe most part relinquishing the anti-distortion rationale, the Government falls back on the\nargument that corporate political speech can be banned in order to prevent corruption or its\nappearance.\xe2\x80\xa6\nWhen Congress finds that a problem exists, we must give that finding due deference; but\nCongress may not choose an unconstitutional remedy. If elected officials succumb to improper\ninfluences from independent expenditures; if they surrender their best judgment; and if they put\nexpediency before principle, then surely there is cause for concern. We must give weight to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n177\n\n\x0cattempts by Congress to seek to dispel either the appearance or the reality of these influences.\nThe remedies enacted by law, however, must comply with the First Amendment; and, it is our\nlaw and our tradition that more speech, not less, is the governing rule. An outright ban on\ncorporate political speech during the critical preelection period is not a permissible remedy.\nHere Congress has created categorical bans on speech that are asymmetrical to preventing quid\npro quocorruption.\nOur precedent is to be respected unless the most convincing of reasons demonstrates that\nadherence to it puts us on a course that is sure error. \xe2\x80\x9cBeyond workability, the relevant factors in\ndeciding whether to adhere to the principle of stare decisis include the antiquity of the\nprecedent, the reliance interests at stake, and of course whether the decision was well reasoned.\xe2\x80\x9d\n[citing prior cases]\nThese considerations counsel in favor of rejecting Austin, which itself contravened this Court\xe2\x80\x99s\nearlier precedents in Buckley and Bellotti. \xe2\x80\x9cThis Court has not hesitated to overrule decisions\noffensive to the First Amendment.\xe2\x80\x9d WRTL, 551 U.S., at 500 (opinion of Scalia, J.). \xe2\x80\x9c[S]tare\ndecisis is a principle of policy and not a mechanical formula of adherence to the latest\ndecision.\xe2\x80\x9d Helvering v. Hallock, 309 U.S. 106 at 119 (1940).\nAustin is undermined by experience since its announcement. Political speech is so ingrained in\nour culture that speakers find ways to circumvent campaign finance laws. See, e.g., McConnell,\n540 U.S., at 176\xe2\x80\x93177 (\xe2\x80\x9cGiven BCRA\xe2\x80\x99s tighter restrictions on the raising and spending of soft\nmoney, the incentives\xe2\x80\xa6to exploit [26 U.S.C. \xc2\xa7527] organizations will only increase\xe2\x80\x9d). Our\nNation\xe2\x80\x99s speech dynamic is changing, and informative voices should not have to circumvent\nonerous restrictions to exercise their First Amendment rights. Speakers have become adept at\npresenting citizens with sound bites, talking points, and scripted messages that dominate the\n24-hour news cycle. Corporations, like individuals, do not have monolithic views. On certain\ntopics corporations may possess valuable expertise, leaving them the best equipped to point out\nerrors or fallacies in speech of all sorts, including the speech of candidates and elected officials.\nRapid changes in technology\xe2\x80\x94and the creative dynamic inherent in the concept of free\nexpression\xe2\x80\x94counsel against upholding a law that restricts political speech in certain media or by\ncertain speakers. Today, 30-second television ads may be the most effective way to convey a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n178\n\n\x0cpolitical message. Soon, however, it may be that Internet sources, such as blogs and social\nnetworking Web sites, will provide citizens with significant information about political\ncandidates and issues. Yet, \xc2\xa7441b would seem to ban a blog post expressly advocating the\nelection or defeat of a candidate if that blog were created with corporate funds. The First\nAmendment does not permit Congress to make these categorical distinctions based on the\ncorporate identity of the speaker and the content of the political speech.\nDue consideration leads to this conclusion: Austin should be and now is overruled. We return to\nthe principle established in Buckley and Bellotti that the Government may not suppress political\nspeech on the basis of the speaker\xe2\x80\x99s corporate identity. No sufficient governmental interest\njustifies limits on the political speech of nonprofit or for-profit corporations.\n\n[IV. Omitted]\nV\nWhen word concerning the plot of the movie Mr. Smith Goes to Washington reached the circles\nof Government, some officials sought, by persuasion, to discourage its distribution. See\nSmoodin, \xe2\x80\x9cCompulsory\xe2\x80\x9d Viewing for Every Citizen: Mr. Smith and the Rhetoric of Reception, 35\nCinema Journal 3, 19, and n. 52 (Winter 1996) (citing Mr. Smith Riles Washington, Time, Oct.\n30, 1939, p. 49); Nugent, Capra\xe2\x80\x99s Capitol Offense, N. Y. Times, Oct. 29, 1939, p. X5.\nUnder Austin, though, officials could have done more than discourage its distribution\xe2\x80\x94they\ncould have banned the film. After all, it, likeHillary, was speech funded by a corporation that\nwas critical of Members of Congress.Mr. Smith Goes to Washington may be fiction and\ncaricature; but fiction and caricature can be a powerful force.\nModern day movies, television comedies, or skits on YouTube.com might portray public officials\nor public policies in unflattering ways. Yet if a covered transmission during the blackout period\ncreates the background for candidate endorsement or opposition, a felony occurs solely because\na corporation, other than an exempt media corporation, has made the \xe2\x80\x9cpurchase, payment,\ndistribution, loan, advance, deposit, or gift of money or anything of value\xe2\x80\x9d in order to engage in\npolitical speech. 2 U.S.C. \xc2\xa7431(9)(A)(i). Speech would be suppressed in the realm where its\nnecessity is most evident: in the public dialogue preceding a real election. Governments are\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n179\n\n\x0coften hostile to speech, but under our law and our tradition it seems stranger than fiction for our\nGovernment to make this political speech a crime. Yet this is the statute\xe2\x80\x99s purpose and design.\nSome members of the public might consider Hillary to be insightful and instructive; some might\nfind it to be neither high art nor a fair discussion on how to set the Nation\xe2\x80\x99s course; still others\nsimply might suspend judgment on these points but decide to think more about issues and\ncandidates. Those choices and assessments, however, are not for the Government to make. \xe2\x80\x9cThe\nFirst Amendment underwrites the freedom to experiment and to create in the realm of thought\nand speech. Citizens must be free to use new forms, and new forums, for the expression of ideas.\nThe civic discourse belongs to the people, and the Government may not prescribe the means\nused to conduct it.\xe2\x80\x9d McConnell, supra, at 341 (opinion of Kennedy, J.).\nThe judgment of the District Court is reversed with respect to the constitutionality of 2 U.S.C.\n\xc2\xa7441b\xe2\x80\x99s restrictions on corporate independent expenditures. The case is remanded for further\nproceedings consistent with this opinion.\nIt is so ordered.\n\nCASE QUESTIONS\n\n1. What does the case say about disclosure? Corporations have a right of free speech under the\nFirst Amendment and may exercise that right through unrestricted contributions of money to\npolitical parties and candidates. Can the government condition that right by requiring that\nthe parties and candidates disclose to the public the amount and origin of the contribution?\nWhat would justify such a disclosure requirement?\n2. Are a corporation\xe2\x80\x99s contributions to political parties and candidates tax deductible as a\nbusiness expense? Should they be?\n3. How is the donation of money equivalent to speech? Is this a strict construction of the\nConstitution to hold that it is?\n4. Based on the Court\xe2\x80\x99s description of the Austin case, what purpose do you think\nthe Austin court was trying to achieve by limiting corporate campaign contributions? Was\nthat purpose consistent (or inconsistent) with anything in the Constitution, or is the\nConstitution essentially silent on this issue?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n180\n\n\x0c4.7 Summary and Exercises\nSummary\n\nThe US. Constitution sets the framework for all other laws of the United States, at both the\nfederal and the state level. It creates a shared balance of power between states and the federal\ngovernment (federalism) and shared power among the branches of government (separation of\npowers), establishes individual rights against governmental action (Bill of Rights), and provides\nfor federal oversight of matters affecting interstate commerce and commerce with foreign\nnations. Knowing the contours of the US legal system is not possible without understanding the\nrole of the US Constitution.\nThe Constitution is difficult to amend. Thus when the Supreme Court uses its power of judicial\nreview to determine that a law is unconstitutional, it actually shapes what the Constitution\nmeans. New meanings that emerge must do so by the process of amendment or by the passage\nof time and new appointments to the court. Because justices serve for life, the court changes its\nphilosophical outlook slowly.\nThe Bill of Rights is an especially important piece of the Constitutional framework. It provides\nlegal causes of action for infringements of individual rights by government, state or federal.\nThrough the due process clause of the Fifth Amendment and the Fourteenth Amendment, both\nprocedural and (to some extent) substantive due process rights are given to individuals.\n\nEXERCISES\n\n1. For many years, the Supreme Court believed that \xe2\x80\x9ccommercial speech\xe2\x80\x9d was entitled\nto less protection than other forms of speech. One defining element of\ncommercial speech is that its dominant theme is to propose a commercial\ntransaction. This kind of speech is protected by the First Amendment, but the\ngovernment is permitted to regulate it more closely than other forms of speech.\nHowever, the government must make reasonable distinctions, must narrowly\ntailor the rules restricting commercial speech, and must show that government\nhas a legitimate goal that the law furthers.\nEdward Salib owned a Winchell\xe2\x80\x99s Donut House in Mesa, Arizona. To attract\ncustomers, he displayed large signs in store windows. The city ordered him to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n181\n\n\x0cremove the signs because they violated the city\xe2\x80\x99s sign code, which prohibited\ncovering more than 30 percent of a store\xe2\x80\x99s windows with signs. Salib sued,\nclaiming that the sign code violated his First Amendment rights. What was the\nresult, and why?\n2. Jennifer is a freshman at her local public high school. Her sister, Jackie, attends a nearby\nprivate high school. Neither school allows them to join its respective wrestling team; only\nboys can wrestle at either school. Do either of them have a winning case based on the equal\nprotection clause of the Fourteenth Amendment?\n3. The employees of the US Treasury Department that work the border crossing between the\nUnited States and Mexico learned that they will be subject to routine drug testing. The\ncustoms bureau, which is a division of the treasury department, announces this policy along\nwith its reasoning: since customs agents must routinely search for drugs coming into the\nUnited States, it makes sense that border guards must themselves be completely drug-free.\nMany border guards do not use drugs, have no intention of using drugs, and object to the\ninvasion of their privacy. What is the constitutional basis for their objection?\n4. Happy Time Chevrolet employs Jim Bydalek as a salesman. Bydalek takes part in a Gay Pride\nMarch in Los Angeles, is interviewed by a local news camera crew, and reports that he is gay\nand proud of it. His employer is not, and he is fired. Does he have any constitutional causes\nof action against his employer?\n5. You begin work at the Happy-Go-Lucky Corporation on Halloween. On your second day at\nwork, you wear a political button on your coat, supporting your choice for US senator in the\nupcoming election. Your boss, who is of a different political persuasion, looks at the button\nand says, \xe2\x80\x9cTake that stupid button off or you\xe2\x80\x99re fired.\xe2\x80\x9d Has your boss violated your\nconstitutional rights?\n6. David Lucas paid $975,000 for two residential parcels on the Isle of Palms near Charleston,\nSouth Carolina. His intention was to build houses on them. Two years later, the South\nCarolina legislature passed a statute that prohibited building beachfront properties. The\npurpose was to leave the dunes system in place to mitigate the effects of hurricanes and\nstrong storms. The South Carolina Coastal Commission created the rules and regulations with\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n182\n\n\x0csubstantial input from the community and from experts and with protection of the dune\nsystem primarily in mind. People had been building on the shoreline for years, with harmful\nresults to localities and the state treasury. When Lucas applied for permits to build two\nhouses near the shoreline, his permits were rejected. He sued, arguing that the South\nCarolina legislation had effectively \xe2\x80\x9ctaken\xe2\x80\x9d his property. At trial, South Carolina conceded\nthat because of the legislation, Lucas\xe2\x80\x99s property was effectively worth zero. Has there been a\ntaking under the Fifth Amendment (as incorporated through the Fourteenth Amendment),\nand if so, what should the state owe to Lucas? Suppose that Lucas could have made an\nadditional $1 million by building a house on each of his parcels. Is he entitled to recover his\noriginal purchase price or his potential profits?\n\nSELF-TEST QUESTIONS\n\n1. Harvey filed a suit against the state of Colorado, claiming that a Colorado state law\nviolates the commerce clause. The court will agree if the statute\na.\n\nplaces an undue burden on interstate commerce\n\nb. promotes the public health, safety, morals, or general welfare of Colorado\nc. regulates economic activities within the state\xe2\x80\x99s borders\nd. a and b\ne. b and c\nThe state legislature in Maine enacts a law that directly conflicts with a\nfederal law. Mapco Industries, located in Portland, Maine, cannot comply with\nboth the state and the federal law.\na.\n\nBecause of federalism, the state law will have priority, as long as Maine is\n\nusing its police powers.\nb. Because there\xe2\x80\x99s a conflict, both laws are invalid; the state and the federal\ngovernment will have to work out a compromise of some sort.\nc. The federal law preempts the state law.\nd. Both laws govern concurrently.\nHannah, who lives in Ada, is the owner of Superior Enterprises, Inc. She\nbelieves that certain actions in the state of Ohio infringe on her federal\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n183\n\n\x0cconstitutional rights, especially those found in the Bill of Rights. Most of these\nrights apply to the states under\na.\n\nthe supremacy clause\n\nb. the protection clause\nc. the due process clause of the Fourteenth Amendment\nd. the Tenth Amendment\nMinnesota enacts a statute that bans all advertising that is in \xe2\x80\x9cbad taste,\xe2\x80\x9d\n\xe2\x80\x9cvulgar,\xe2\x80\x9d or \xe2\x80\x9cindecent.\xe2\x80\x9d In Michigan, Aaron Calloway and his brother, Clarence\n\xe2\x80\x9cCab\xe2\x80\x9d Calloway, create unique beer that they decide to call Old Fart Ale. In their\nmarketing, the brothers have a label in which an older man in a dirty T-shirt is\nsitting in easy chair, looking disheveled and having a three-day growth of stubble\non his chin. It appears that the man is in the process of belching. He is also holding\na can of Old Fart Ale. The Minnesota liquor commission orders all Minnesota\nrestaurants, bars, and grocery stores to remove Old Fart Ale from their shelves.\nThe state statute and the commission\xe2\x80\x99s order are likely to be held by a court to be\na.\n\na violation of the Tenth Amendment\n\nb. a violation of the First Amendment\nc. a violation of the Calloways\xe2\x80\x99 right to equal protection of the laws\nd. a violation of the commerce clause, since only the federal laws can prevent an\narticle of commerce from entering into Minnesota\xe2\x80\x99s market\nRaunch Unlimited, a Virginia partnership, sells smut whenever and\nwherever it can. Some of its material is \xe2\x80\x9cobscene\xe2\x80\x9d (meeting the Supreme Court\xe2\x80\x99s\ndefinition under Miller v. California) and includes child pornography. North\nCarolina has a statute that criminalizes obscenity. What are possible results if a\nstore in Raleigh, North Carolina, carries Raunch merchandise?\na.\n\nThe partners could be arrested in North Carolina and may well be\n\nconvicted.\nb. The materials in Raleigh may be the basis for a criminal conviction.\nc. The materials are protected under the First Amendment\xe2\x80\x99s right of free speech.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n184\n\n\x0cd. The materials are protected under state law.\ne. a and b\n\nSELF-TEST ANSWERS\n\n1. a\n2. c\n3. c\n4. b\n5. e\n\nChapter 5\nAdministrative Law\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should be able to do the following:\n1. Understand the purpose served by federal administrative agencies.\n2. Know the difference between executive branch agencies and independent agencies.\n3. Understand the political control of agencies by the president and Congress.\n4. Describe how agencies make rules and conduct hearings.\n5. Describe how courts can be used to challenge administrative rulings.\nFrom the 1930s on, administrative agencies, law, and procedures have virtually remade our\ngovernment and much of private life. Every day, business must deal with rules and decisions of\nstate and federal administrative agencies. Informally, such rules are often called regulations,\nand they differ (only in their source) from laws passed by Congress and signed into law by the\npresident. The rules created by agencies are voluminous: thousands of new regulations pour\nforth each year. The overarching question of whether there is too much regulation\xe2\x80\x94or the wrong\nkind of regulation\xe2\x80\x94of our economic activities is an important one but well beyond the scope of\nthis chapter, in which we offer an overview of the purpose of administrative agencies, their\nstructure, and their impact on business.\n\n5.1 Administrative Agencies: Their Structure and Powers\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n185\n\n\x0c1. Explain the reasons why we have federal administrative agencies.\n2. Explain the difference between executive branch agencies and independent agencies.\n3. Describe the constitutional issue that questions whether administrative agencies could have\nauthority to make enforceable rules that affect business.\n\nWhy Have Administrative Agencies?\nThe US Constitution mentions only three branches of government: legislative, executive, and\njudicial (Articles I, II, and III). There is no mention of agencies in the Constitution, even though\nfederal agencies are sometimes referred to as \xe2\x80\x9cthe fourth branch of government.\xe2\x80\x9d The Supreme\nCourt has recognized the legitimacy of federaladministrative agencies to make rules that have\nthe same binding effect as statutes by Congress.\nMost commentators note that having agencies with rule-making power is a practical necessity:\n(1) Congress does not have the expertise or continuity to develop specialized knowledge in\nvarious areas (e.g., communications, the environment, aviation). (2) Because of this, it makes\nsense for Congress to set forth broad statutory guidance to an agency and delegate authority to\nthe agency to propose rules that further the statutory purposes. (3) As long as Congress makes\nthis delegating guidance sufficiently clear, it is not delegating improperly. If Congress\xe2\x80\x99s\nguidelines are too vague or undefined, it is (in essence) giving away its constitutional power to\nsome other group, and this it cannot do.\n\nWhy Regulate the Economy at All?\nThe market often does not work properly, as economists often note. Monopolies, for example,\nhappen in the natural course of human events but are not always desirable. To fix this, wellconceived and objectively enforced competition law (what is called antitrust law in the United\nStates) is needed.\nNegative externalities must be \xe2\x80\x9cfixed,\xe2\x80\x9d as well. For example, as we see in tort law (Chapter 7\n"Introduction to Tort Law"), people and business organizations often do things that impose\ncosts (damages) on others, and the legal system will try\xe2\x80\x94through the award of compensatory\ndamages\xe2\x80\x94to make fair adjustments. In terms of the ideal conditions for a free market, think of\ntort law as the legal system\xe2\x80\x99s attempt to compensate for negative externalities: those costs\nimposed on people who have not voluntarily consented to bear those costs.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n186\n\n\x0cIn terms of freedoms to enter or leave the market, the US constitutional guarantees of equal\nprotection can prevent local, state, and federal governments from imposing discriminatory rules\nfor commerce that would keep minorities, women, and gay people from full participation in\nbusiness. For example, if the small town of Xenophobia, Colorado, passed a law that required all\nbusiness owners and their employees to be Christian, heterosexual, and married, the equal\nprotection clause (as well as numerous state and federal equal opportunity employment laws)\nwould empower plaintiffs to go to court and have the law struck down as unconstitutional.\nKnowing that information is power, we will see many laws administered by regulatory agencies\nthat seek to level the playing field of economic competition by requiring disclosure of the most\npertinent information for consumers (consumer protection laws), investors (securities laws),\nand citizens (e.g., the toxics release inventory laws in environmental law).\n\nIdeal Conditions for a Free Market\n\n1. There are many buyers and many sellers, and none of them has a substantial share of the\nmarket.\n2. All buyers and sellers in the market are free to enter the market or leave it.\n3. All buyers and all sellers have full and perfect knowledge of what other buyers and sellers are up\nto, including knowledge of prices, quantity, and quality of all goods being bought or sold.\n4. The goods being sold in the market are similar enough to each other that participants do not\nhave strong preferences as to which seller or buyer they deal with.\n5. The costs and benefits of making or using the goods that are exchanged in the market are borne\nonly by those who buy or sell those goods and not by third parties or people \xe2\x80\x9cexternal\xe2\x80\x9d to the\nmarket transaction. (That is, there are no \xe2\x80\x9cexternalities.\xe2\x80\x9d)\n6. All buyers and sellers are utility maximizers; each participant in the market tries to get as much\nas possible for as little as possible.\n7. There are no parties, institutions, or governmental units regulating the price, quantity, or\nquality of any of the goods being bought and sold in the market.\nIn short, some forms of legislation and regulation are needed to counter a tendency toward\nconsolidation of economic power and discriminatory attitudes toward certain individuals and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n187\n\n\x0cgroups and to insist that people and companies clean up their own messes and not hide\ninformation that would empower voluntary choices in the free market.\nBut there are additional reasons to regulate. For example, in economic systems, it is likely for\nnatural monopolies to occur. These are where one firm can most efficiently supply all of the\ngood or service. Having duplicate (or triplicate) systems for supplying electricity, for example,\nwould be inefficient, so most states have a public utilities commission to determine both price\nand quality of service. This is direct regulation.\nSometimes destructive competition can result if there is no regulation. Banking and insurance\nare good examples of this. Without government regulation of banks (setting standards and\nmethods), open and fierce competition would result in widespread bank failures. That would\nerode public confidence in banks and business generally. The current situation (circa 2011) of six\nmajor banks that are \xe2\x80\x9ctoo big to fail\xe2\x80\x9d is, however, an example of destructive noncompetition.\nOther market imperfections can yield a demand for regulation. For example, there is a need to\nregulate frequencies for public broadcast on radio, television, and other wireless transmissions\n(for police, fire, national defense, etc.). Many economists would also list an adequate supply of\npublic goods as something that must be created by government. On its own, for example, the\nmarket would not provide public goods such as education, a highway system, lighthouses, a\nmilitary for defense.\nTrue laissez-faire capitalism\xe2\x80\x94a market free from any regulation\xe2\x80\x94would not try to deal with\nmarket imperfections and would also allow people to freely choose products, services, and other\narrangements that historically have been deemed socially unacceptable. These would include\nmaking enforceable contracts for the sale and purchase of persons (slavery), sexual services,\n\xe2\x80\x9cstreet drugs\xe2\x80\x9d such as heroin or crack cocaine, votes for public office, grades for this course in\nbusiness law, and even marriage partnership.\nThus the free market in actual terms\xe2\x80\x94and not in theory\xe2\x80\x94consists of commerce legally\nconstrained by what is economically desirable and by what is socially desirable as well. Public\npolicy objectives in the social arena include ensuring equal opportunity in employment,\nprotecting employees from unhealthy or unsafe work environments, preserving environmental\nquality and resources, and protecting consumers from unsafe products. Sometimes these\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n188\n\n\x0cobjectives are met by giving individuals statutory rights that can be used in bringing a complaint\n(e.g., Title VII of the Civil Rights Act of 1964, for employment discrimination), and sometimes\nthey are met by creating agencies with the right to investigate and monitor and enforce statutory\nlaw and regulations created to enforce such law (e.g., the Environmental Protection Agency, for\nbringing a lawsuit against a polluting company).\n\nHistory of Federal Agencies\nThrough the commerce clause in the US Constitution, Congress has the power to regulate trade\nbetween the states and with foreign nations. The earliest federal agency therefore dealt with\ntrucking and railroads, to literally set the rules of the road for interstate commerce. The first\nfederal agency, the Interstate Commerce Commission (ICC), was created in 1887. Congress\ndelegated to the ICC the power to enforce federal laws against railroad rate discrimination and\nother unfair pricing practices. By the early part of this century, the ICC gained the power to fix\nrates. From the 1970s through 1995, however, Congress passed deregulatory measures, and the\nICC was formally abolished in 1995, with its powers transferred to the Surface Transportation\nBoard.\nBeginning with the Federal Trade Commission (FTC) in 1914, Congress has created numerous\nother agencies, many of them familiar actors in American government. Today more than eightyfive federal agencies have jurisdiction to regulate some form of private activity. Most were\ncreated since 1930, and more than a third since 1960. A similar growth has occurred at the state\nlevel. Most states now have dozens of regulatory agencies, many of them overlapping in function\nwith the federal bodies.\n\nClassification of Agencies\nIndependent agencies are different from federal executive departments and other executive\nagencies by their structural and functional characteristics. Most executive departments have a\nsingle director, administrator, or secretary appointed by the president of the United States.\nIndependent agencies almost always have a commission or board consisting of five to seven\nmembers who share power over the agency. The president appoints the commissioners or board\nsubject to Senate confirmation, but they often serve with staggered terms and often for longer\nterms than a usual four-year presidential term. They cannot be removed except for \xe2\x80\x9cgood cause.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n189\n\n\x0cThis means that most presidents will not get to appoint all the commissioners of a given\nindependent agency. Most independent agencies have a statutory requirement of bipartisan\nmembership on the commission, so the president cannot simply fill vacancies with members of\nhis own political party.\nIn addition to the ICC and the FTC, the major independent agencies are the Federal\nCommunications Commission (1934), Securities and Exchange Commission (1934), National\nLabor Relations Board (1935), and Environmental Protection Agency (1970). See Note 5.4 "Ideal\nConditions for a Free Market" in the sidebar.\nBy contrast, members of executive branch agencies serve at the pleasure of the president and are\ntherefore far more amenable to political control. One consequence of this distinction is that the\nrules that independent agencies promulgate may not be reviewed by the president or his staff\xe2\x80\x94\nonly Congress may directly overrule them\xe2\x80\x94whereas the White House or officials in the various\ncabinet departments may oversee the work of the agencies contained within them (unless\nspecifically denied the power by Congress).\n\nPowers of Agencies\nAgencies have a variety of powers. Many of the original statutes that created them, like the\nFederal Communications Act, gave them licensing power. No party can enter into the productive\nactivity covered by the act without prior license from the agency\xe2\x80\x94for example, no utility can\nstart up a nuclear power plant unless first approved by the Nuclear Regulatory Commission. In\nrecent years, the move toward deregulation of the economy has led to diminution of some\nlicensing power. Many agencies also have the authority to set the rates charged by companies\nsubject to the agency\xe2\x80\x99s jurisdiction. Finally, the agencies can regulate business practices. The\nFTC has general jurisdiction over all business in interstate commerce to monitor and root out\n\xe2\x80\x9cunfair acts\xe2\x80\x9d and \xe2\x80\x9cdeceptive practices.\xe2\x80\x9d The Securities and Exchange Commission (SEC)\noversees the issuance of corporate securities and other investments and monitors the practices\nof the stock exchanges.\nUnlike courts, administrative agencies are charged with the responsibility of carrying out a\nspecific assignment or reaching a goal or set of goals. They are not to remain neutral on the\nvarious issues of the day; they must act. They have been given legislative powers because in a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n190\n\n\x0csociety growing ever more complex, Congress does not know how to legislate with the kind of\ndetail that is necessary, nor would it have the time to approach all the sectors of society even if it\ntried. Precisely because they are to do what general legislative bodies cannot do, agencies are\nspecialized bodies. Through years of experience in dealing with similar problems they\naccumulate a body of knowledge that they can apply to accomplish their statutory duties.\nAll administrative agencies have two different sorts of personnel. The heads, whether a single\nadministrator or a collegial body of commissioners, are political appointees and serve for\nrelatively limited terms. Below them is a more or less permanent staff\xe2\x80\x94the bureaucracy. Much\npolicy making occurs at the staff level, because these employees are in essential control of\ngathering facts and presenting data and argument to the commissioners, who wield the ultimate\npower of the agencies.\n\nThe Constitution and Agencies\nCongress can establish an agency through legislation. When Congress gives powers to an agency,\nthe legislation is known as an enabling act. The concept that Congress can delegate power to an\nagency is known as the delegation doctrine. Usually, the agency will have all three kinds of\npower: executive, legislative, and judicial. (That is, the agency can set the rules that business\nmust comply with, can investigate and prosecute those businesses, and can hold administrative\nhearings for violations of those rules. They are, in effect, rule maker, prosecutor, and judge.)\nBecause agencies have all three types of governmental powers, important constitutional\nquestions were asked when Congress first created them. The most important question was\nwhether Congress was giving away its legislative power. Was the separation of powers violated if\nagencies had power to make rules that were equivalent to legislative statutes?\nIn 1935, in Schechter Poultry Corp. v. United States, the Supreme Court overturned the\nNational Industrial Recovery Act on the ground that the congressional delegation of power was\ntoo broad. [1] Under the law, industry trade groups were granted the authority to devise a code of\nfair competition for the entire industry, and these codes became law if approved by the\npresident. No administrative body was created to scrutinize the arguments for a particular code,\nto develop evidence, or to test one version of a code against another. Thus it was\nunconstitutional for the Congress to transfer all of its legislative powers to an agency. In later\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n191\n\n\x0cdecisions, it was made clear that Congress could delegate some of its legislative powers, but only\nif the delegation of authority was not overly broad.\nStill, some congressional enabling acts are very broad, such as the enabling legislation for the\nOccupational Safety and Health Administration (OSHA), which is given the authority to make\nrules to provide for safe and healthful working conditions in US workplaces. Such a broad\ninitiative power gives OSHA considerable discretion. But, as noted in Section 5.2 "Controlling\nAdministrative Agencies", there are both executive and judicial controls over administrative\nagency activities, as well as ongoing control by Congress through funding and the continuing\noversight of agencies, both in hearings and through subsequent statutory amendments.\n\nKEY TAKEAWAY\n\nCongress creates administrative agencies through enabling acts. In these acts, Congress must\ndelegate authority by giving the agency some direction as to what it wants the agency to do.\nAgencies are usually given broad powers to investigate, set standards (promulgating\nregulations), and enforce those standards. Most agencies are executive branch agencies, but\nsome are independent.\n\nEXERCISES\n\n1. Explain why Congress needs to delegate rule-making authority to a specialized agency.\n2. Explain why there is any need for interference in the market by means of laws or regulations.\n\n[1] Schechter Poultry Corp. v. United States, 295 US 495 (1935).\n\n5.2 Controlling Administrative Agencies\nLEARNING OBJECTIVES\n\n1. Understand how the president controls administrative agencies.\n2. Understand how Congress controls administrative agencies.\n3. Understand how the courts can control administrative agencies.\nDuring the course of the past seventy years, a substantial debate has been conducted, often in\nshrill terms, about the legitimacy of administrative lawmaking. One criticism is that agencies are\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n192\n\n\x0c\xe2\x80\x9ccaptured\xe2\x80\x9d by the industry they are directed to regulate. Another is that they overregulate,\nstifling individual initiative and the ability to compete. During the 1960s and 1970s, a massive\noutpouring of federal law created many new agencies and greatly strengthened the hands of\nexisting ones. In the late 1970s during the Carter administration, Congress began to deregulate\nAmerican society, and deregulation increased under the Reagan administration. But the\naccounting frauds of WorldCom, Enron, and others led to the Sarbanes-Oxley Act of 2002, and\nthe financial meltdown of 2008 has led to reregulation of the financial sector. It remains to be\nseen whether the Deepwater Horizon oil blowout of 2010 will lead to more environmental\nregulations or a rethinking on how to make agencies more effective regulators.\nAdministrative agencies are the focal point of controversy because they are policy-making\nbodies, incorporating facets of legislative, executive, and judicial power in a hybrid form that fits\nuneasily at best in the framework of American government (seeFigure 5.1 "Major Administrative\nAgencies of the United States"). They are necessarily at the center of tugging and hauling by the\nlegislature, the executive branch, and the judiciary, each of which has different means of\nexercising political control over them. In early 1990, for example, the Bush administration\napproved a Food and Drug Administration regulation that limited disease-prevention claims by\nfood packagers, reversing a position by the Reagan administration in 1987 permitting such\nclaims.\n\nFigure 5.1 Major Administrative Agencies of the United States\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n193\n\n\x0cLegislative Control\nCongress can always pass a law repealing a regulation that an agency promulgates. Because this\nis a time-consuming process that runs counter to the reason for creating administrative bodies,\nit happens rarely. Another approach to controlling agencies is to reduce or threaten to reduce\ntheir appropriations. By retaining ultimate control of the purse strings, Congress can exercise\nconsiderable informal control over regulatory policy.\n\nExecutive Control\nThe president (or a governor, for state agencies) can exercise considerable control over agencies\nthat are part of his cabinet departments and that are not statutorily defined as independent.\nFederal agencies, moreover, are subject to the fiscal scrutiny of the Office of Management and\nBudget (OMB), subject to the direct control of the president. Agencies are not permitted to go\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n194\n\n\x0cdirectly to Congress for increases in budget; these requests must be submitted through the\nOMB, giving the president indirect leverage over the continuation of administrators\xe2\x80\x99 programs\nand policies.\n\nJudicial Review of Agency Actions\nAdministrative agencies are creatures of law and like everyone else must obey the law. The\ncourts have jurisdiction to hear claims that the agencies have overstepped their legal authority\nor have acted in some unlawful manner.\nCourts are unlikely to overturn administrative actions, believing in general that the agencies are\nbetter situated to judge their own jurisdiction and are experts in rulemaking for those matters\ndelegated to them by Congress. Some agency activities are not reviewable, for a number of\nreasons. However, after a business (or some other interested party) has exhausted all\nadministrative remedies, it may seek judicial review of a final agency decision. The reviewing\ncourt is often asked to strike down or modify agency actions on several possible bases\n(see Section 5.5.2 "Strategies for Obtaining Judicial Review" on \xe2\x80\x9cStrategies for Obtaining\nJudicial Review\xe2\x80\x9d).\n\nKEY TAKEAWAY\n\nAdministrative agencies are given unusual powers: to legislate, investigate, and adjudicate.\nBut these powers are limited by executive and legislative controls and by judicial review.\n\nEXERCISES\n\n1. Find the website of the Consumer Product Safety Commission (CPSC). Identify from that site\na product that has been banned by the CPSC for sale in the United States. What reasons were\ngiven for its exclusion from the US market?\n2. What has Congress told the CPSC to do in its enabling act? Is this a clear enough mandate to\nguide the agency? What could Congress do if the CPSC does something that may be outside\nof the scope of its powers? What can an affected business do?\n\n5.3 The Administrative Procedure Act\nLEARNING OBJECTIVES\n\n1. Understand why the Administrative Procedure Act was needed.\n2. Understand how hearings are conducted under the act.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n195\n\n\x0c3. Understand how the act affects rulemaking by agencies.\nIn 1946, Congress enacted the Administrative Procedure Act (APA). This fundamental statute\ndetailed for all federal administrative agencies how they must function when they are deciding\ncases or issuing regulations, the two basic tasks of administration. At the state level, the Model\nState Administrative Procedure Act, issued in 1946 and revised in 1961, has been adopted in\ntwenty-eight states and the District of Columbia; three states have adopted the 1981 revision.\nThe other states have statutes that resemble the model state act to some degree.\n\nTrial-Type Hearings\nDeciding cases is a major task of many agencies. For example, the Federal Trade Commission\n(FTC) is empowered to charge a company with having violated the Federal Trade Commission\nAct. Perhaps a seller is accused of making deceptive claims in its advertising. Proceeding in a\nmanner similar to a court, staff counsel will prepare a case against the company, which can\ndefend itself through its lawyers. The case is tried before an administrative law judge (ALJ),\nformerly known as an administrative hearing examiner. The change in nomenclature was made\nin 1972 to enhance the prestige of ALJs and more accurately reflect their duties. Although not\nappointed for life as federal judges are, the ALJ must be free of assignments inconsistent with\nthe judicial function and is not subject to supervision by anyone in the agency who carries on an\ninvestigative or prosecutorial function.\nThe accused parties are entitled to receive notice of the issues to be raised, to present evidence,\nto argue, to cross-examine, and to appear with their lawyers. Ex parte (eks PAR-tay)\ncommunications\xe2\x80\x94contacts between the ALJ and outsiders or one party when both parties are\nnot present\xe2\x80\x94are prohibited. However, the usual burden-of-proof standard followed in a civil\nproceeding in court does not apply: the ALJ is not bound to decide in favor of that party\nproducing the more persuasive evidence. The rule in most administrative proceedings is\n\xe2\x80\x9csubstantial evidence,\xe2\x80\x9d evidence that is not flimsy or weak, but is not necessarily overwhelming\nevidence, either. The ALJ in most cases will write an opinion. That opinion is not the decision of\nthe agency, which can be made only by the commissioners or agency head. In effect, the ALJ\xe2\x80\x99s\nopinion is appealed to the commission itself.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n196\n\n\x0cCertain types of agency actions that have a direct impact on individuals need not be filtered\nthrough a full-scale hearing. Safety and quality inspections (grading of food, inspection of\nairplanes) can be made on the spot by skilled inspectors. Certain licenses can be administered\nthrough tests without a hearing (a test for a driver\xe2\x80\x99s license), and some decisions can be made by\nelection of those affected (labor union elections).\n\nRulemaking\nTrial-type hearings generally impose on particular parties liabilities based on past or present\nfacts. Because these cases will serve as precedents, they are a partial guide to future conduct by\nothers. But they do not directly apply to nonparties, who may argue in a subsequent case that\ntheir conduct does not fit within the holding announced in the case. Agencies can affect future\nconduct far more directly by announcing rules that apply to all who come within the agency\xe2\x80\x99s\njurisdiction.\nThe acts creating most of the major federal agencies expressly grant them authority to engage in\nrulemaking. This means, in essence, authority to legislate. The outpouring of federal regulations\nhas been immense. The APA directs agencies about to engage in rulemaking to give notice in\nthe <em class="emphasis">Federal Register</em class="emphasis"> of their intent to do so.\nThe Federal Register is published daily, Monday through Friday, in Washington, DC, and\ncontains notice of various actions, including announcements of proposed rulemaking and\nregulations as adopted. The notice must specify the time, place, and nature of the rulemaking\nand offer a description of the proposed rule or the issues involved. Any interested person or\norganization is entitled to participate by submitting written \xe2\x80\x9cdata, views or arguments.\xe2\x80\x9d\nAgencies are not legally required to air debate over proposed rules, though they often do so.\nThe procedure just described is known as \xe2\x80\x9cinformal\xe2\x80\x9d rulemaking. A different procedure is\nrequired for \xe2\x80\x9cformal\xe2\x80\x9d rulemaking, defined as those instances in which the enabling legislation\ndirects an agency to make rules \xe2\x80\x9con the record after opportunity for an agency hearing.\xe2\x80\x9d When\nengaging in formal rulemaking, agencies must hold an adversary hearing.\nAdministrative regulations are not legally binding unless they are published. Agencies must\npublish in the Federal Register the text of final regulations, which ordinarily do not become\neffective until thirty days later. Every year the annual output of regulations is collected and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n197\n\n\x0creprinted in\nthe <em class="emphasis">Code of Federal Regulations (CFR)</em class="emphasis">, a\nmultivolume paperback series containing all federal rules and regulations keyed to the fifty titles\nof the US Code (the compilation of all federal statutes enacted by Congress and grouped\naccording to subject).\n\nKEY TAKEAWAY\n\nAgencies make rules that have the same effect as laws passed by Congress and the president.\nBut such rules (regulations) must allow for full participation by interested parties. The\nAdministrative Procedure Act (APA) governs both rulemaking and the agency enforcement of\nregulations, and it provides a process for fair hearings.\n\nEXERCISES\n\n1. Go to http://www.regulations.gov/search/Regs/home.html#home. Browse the site. Find a\ntopic that interests you, and then find a proposed regulation. Notice how comments on the\nproposed rule are invited.\n2. Why would there be a trial by an administrative agency? Describe the process.\n\n5.4 Administrative Burdens on Business Operations\nLEARNING OBJECTIVES\n\n1. Describe the paperwork burden imposed by administrative agencies.\n2. Explain why agencies have the power of investigation, and what limits there are to that\npower.\n3. Explain the need for the Freedom of Information Act and how it works in the US legal system.\n\nThe Paperwork Burden\nThe administrative process is not frictionless. The interplay between government agency and\nprivate enterprise can burden business operations in a number of ways. Several of these are\nnoted in this section.\nDeciding whether and how to act are not decisions that government agencies reach out of the\nblue. They rely heavily on information garnered from business itself. Dozens of federal agencies\nrequire corporations to keep hundreds of types of records and to file numerous periodic reports.\nThe Commission on Federal Paperwork, established during the Ford administration to consider\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n198\n\n\x0cways of reducing the paperwork burden, estimated in its final report in 1977 that the total\nannual cost of federal paperwork amounted to $50 billion and that the 10,000 largest business\nenterprises spent $10 billion annually on paperwork alone. The paperwork involved in licensing\na single nuclear power plant, the commission said, costs upward of $15 million.\nNot surprisingly, therefore, businesses have sought ways of avoiding requests for data. Since the\n1940s, the Federal Trade Commission (FTC) has collected economic data on corporate\nperformance from individual companies for statistical purposes. As long as each company\nengages in a single line of business, data are comparable. When the era of conglomerates began\nin the 1970s, with widely divergent types of businesses brought together under the roof of a\nsingle corporate parent, the data became useless for purposes of examining the competitive\nbehavior of different industries. So the FTC ordered dozens of large companies to break out their\neconomic information according to each line of business that they carried on. The companies\nresisted, but the US Court of Appeals for the District of Columbia Circuit, where much of the\nlitigation over federal administrative action is decided, directed the companies to comply with\nthe commission\xe2\x80\x99s order, holding that the Federal Trade Commission Act clearly permits the\nagency to collect information for investigatory purposes. [1]\nIn 1980, responding to cries that businesses, individuals, and state and local governments were\nbeing swamped by federal demands for paperwork, Congress enacted the Paperwork Reduction\nAct. It gives power to the federal Office of Management and Budget (OMB) to develop uniform\npolicies for coordinating the gathering, storage, and transmission of all the millions of reports\nflowing in each year to the scores of federal departments and agencies requesting information.\nThese reports include tax and Medicare forms, financial loan and job applications,\nquestionnaires of all sorts, compliance reports, and tax and business records. The OMB was\ngiven the power also to determine whether new kinds of information are needed. In effect, any\nagency that wants to collect new information from outside must obtain the OMB\xe2\x80\x99s approval.\n\nInspections\nNo one likes surprise inspections. A section of the Occupational Safety and Health Act of 1970\nempowers agents of the Occupational Safety and Health Administration (OSHA) to search work\nareas for safety hazards and for violations of OSHA regulations. The act does not specify\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n199\n\n\x0cwhether inspectors are required to obtain search warrants, required under the Fourth\nAmendment in criminal cases. For many years, the government insisted that surprise\ninspections are not unreasonable and that the time required to obtain a warrant would defeat\nthe surprise element. The Supreme Court finally ruled squarely on the issue in 1978.\nIn Marshall v. Barlow\xe2\x80\x99s, Inc., the court held that no less than private individuals, businesses are\nentitled to refuse police demands to search the premises unless a court has issued a search\nwarrant. [2]\nBut where a certain type of business is closely regulated, surprise inspections are the norm, and\nno warrant is required. For example, businesses with liquor licenses that might sell to minors\nare subject to both overt and covert inspections (e.g., an undercover officer may \xe2\x80\x9csearch\xe2\x80\x9d a\nliquor store by sending an underage patron to the store). Or a junkyard that specializes in\nautomobiles and automobile parts may also be subject to surprise inspections, on the rationale\nthat junkyards are highly likely to be active in the resale of stolen autos or stolen auto parts. [3]\nIt is also possible for inspections to take place without a search warrant and without the\npermission of the business. For example, the Environmental Protection Agency (EPA) wished to\ninspect parts of the Dow Chemical facility in Midland, Michigan, without the benefit of warrant.\nWhen they were refused, agents of the EPA obtained a fairly advanced aerial mapping camera\nand rented an airplane to fly over the Dow facility. Dow went to court for a restraining order\nagainst the EPA and a request to have the EPA turn over all photographs taken. But the\nSupreme Court ruled that the areas photographed were \xe2\x80\x9copen fields\xe2\x80\x9d and not subject to the\nprotections of the Fourth Amendment. [4]\n\nAccess to Business Information in Government Files\nIn 1966, Congress enacted the Freedom of Information Act (FOIA), opening up to the citizenry\nmany of the files of the government. (The act was amended in 1974 and again in 1976 to\novercome a tendency of many agencies to stall or refuse access to their files.) Under the FOIA,\nany person has a legally enforceable right of access to all government documents, with nine\nspecific exceptions, such as classified military intelligence, medical files, and trade secrets and\ncommercial or financial information if \xe2\x80\x9cobtained from a person and privileged or confidential.\xe2\x80\x9d\nWithout the trade-secret and financial-information exemptions, business competitors could,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n200\n\n\x0cmerely by requesting it, obtain highly sensitive competitive information sitting in government\nfiles.\nA federal agency is required under the FOIA to respond to a document request within ten days.\nBut in practice, months or even years may pass before the government actually responds to an\nFOIA request. Requesters must also pay the cost of locating and copying the records. Moreover,\nnot all documents are available for public inspection. Along with the trade-secret and financialinformation exemptions, the FOIA specifically exempts the following:\n\xe2\x80\xa2\n\nrecords required by executive order of the president to be kept secret in the interest of national\ndefense or public policy\n\n\xe2\x80\xa2\n\nrecords related solely to the internal personnel rules and practice of an agency\n\n\xe2\x80\xa2\n\nrecords exempted from disclosure by another statute\n\n\xe2\x80\xa2\n\ninteragency memos or decisions reflecting the deliberative process\n\n\xe2\x80\xa2\n\npersonnel files and other files that if disclosed, would constitute an unwarranted invasion of\npersonal privacy\n\n\xe2\x80\xa2\n\ninformation compiled for law enforcement purposes\n\n\xe2\x80\xa2\n\ngeological information concerning wells\nNote that the government may provide such information but is not required to provide such\ninformation; it retains discretion to provide information or not.\nRegulated companies are often required to submit confidential information to the government.\nFor these companies, submitting such information presents a danger under the FOIA of\ndisclosure to competitors. To protect information from disclosure, the company is well advised\nto mark each document as privileged and confidential so that government officials reviewing it\nfor a FOIA request will not automatically disclose it. Most agencies notify a company whose data\nthey are about to disclose. But these practices are not legally required under the FOIA.\n\nKEY TAKEAWAY\n\nGovernment agencies, in order to do their jobs, collect a great deal of information from\nbusinesses. This can range from routine paperwork (often burdensome) to inspections, those\nwith warrants and those without. Surprise inspections are allowed for closely regulated\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n201\n\n\x0cindustries but are subject to Fourth Amendment requirements in general. Some information\ncollected by agencies can be accessed using the Freedom of Information Act.\n\nEXERCISES\n\n1. Give two examples of a closely regulated industry. Explain why some warrantless searches\nwould be allowed.\n2. Find out why FOIA requests often take months or years to accomplish.\n\n[1] In re FTC Line of Business Report Litigation, 595 F.2d 685 (D.C. Cir. 1978).\n[2] Marshall v. Barlow\xe2\x80\x99s, Inc., 436 US 307 (1978).\n[3] New York v. Burger, 482 US 691 (1987).\n[4] Dow Chemical Co. v. United States Environmental Protection Agency, 476 US 227 (1986).\n\n5.5 The Scope of Judicial Review\n\nLEARNING OBJECTIVES\n\n1. Describe the \xe2\x80\x9cexhaustion of remedies\xe2\x80\x9d requirement.\n2. Detail various strategies for obtaining judicial review of agency rules.\n3. Explain under what circumstances it is possible to sue the government.\nNeither an administrative agency\xe2\x80\x99s adjudication nor its issuance of a regulation is necessarily\nfinal. Most federal agency decisions are appealable to the federal circuit courts. To get to court,\nthe appellant must overcome numerous complex hurdles. He or she must have standing\xe2\x80\x94that is,\nbe in some sense directly affected by the decision or regulation. The case must be ripe for\nreview; administrative remedies such as further appeal within the agency must have been\nexhausted.\n\nExhaustion of Administrative Remedies\nBefore you can complain to court about an agency\xe2\x80\x99s action, you must first try to get the agency to\nreconsider its action. Generally, you must have asked for a hearing at the hearing examiner\nlevel, there must have been a decision reached that was unfavorable to you, and you must have\nappealed the decision to the full board. The full board must rule against you, and only then will\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n202\n\n\x0cyou be heard by a court. The broadest exception to\nthis exhaustion of administrative remedies requirement is if the agency had no authority to issue\nthe rule or regulation in the first place, if exhaustion of remedies would be impractical or futile,\nor if great harm would happen should the rule or regulation continue to apply. Also, if the\nagency is not acting in good faith, the courts will hear an appeal without exhaustion.\n\nStrategies for Obtaining Judicial Review\nOnce these obstacles are cleared, the court may look at one of a series of claims. The appellant\nmight assert that the agency\xe2\x80\x99s action was ultra vires (UL-truh VI-reez)\xe2\x80\x94beyond the scope of its\nauthority as set down in the statute. This attack is rarely successful. A somewhat more successful\nclaim is that the agency did not abide by its own procedures or those imposed upon it by the\nAdministrative Procedure Act.\nIn formal rulemaking, the appellant also might insist that the agency lacked substantial evidence\nfor the determination that it made. If there is virtually no evidence to support the agency\xe2\x80\x99s\nfindings, the court may reverse. But findings of fact are not often overturned by the courts.\nLikewise, there has long been a presumption that when an agency issues a regulation, it has the\nauthority to do so: those opposing the regulation must bear a heavy burden in court to upset it.\nThis is not a surprising rule, for otherwise courts, not administrators, would be the authors of\nregulations. Nevertheless, regulations cannot exceed the scope of the authority conferred by\nCongress on the agency. In an important 1981 case before the Supreme Court, the issue was\nwhether the secretary of labor, acting through the Occupational Health and Safety\nAdministration (OSHA), could lawfully issue a standard limiting exposure to cotton dust in the\nworkplace without first undertaking a cost-benefit analysis. A dozen cotton textile\nmanufacturers and the American Textile Manufacturers Institute, representing 175 companies,\nasserted that the cotton dust standard was unlawful because it did not rationally relate the\nbenefits to be derived from the standard to the costs that the standard would impose.\nSee Section 5.6 "Cases",American Textile Manufacturers Institute v. Donovan.\nIn summary, then, an individual or a company may (after exhaustion of administrative\nremedies) challenge agency action where such action is the following:\n\xe2\x80\xa2\n\nnot in accordance with the agency\xe2\x80\x99s scope of authority\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n203\n\n\x0c\xe2\x80\xa2\n\nnot in accordance with the US Constitution or the Administrative Procedure Act\n\n\xe2\x80\xa2\n\nnot in accordance with the substantial evidence test\n\n\xe2\x80\xa2\n\nunwarranted by the facts\n\n\xe2\x80\xa2\n\narbitrary, capricious, an abuse of discretion, or otherwise not in accord with the law\nSection 706 of the Administrative Procedure Act sets out those standards. While it is difficult to\nshow that an agency\xe2\x80\x99s action is arbitrary and capricious, there are cases that have so held. For\nexample, after the Reagan administration set aside a Carter administration rule from the\nNational Highway Traffic and Safety Administration on passive restraints in automobiles, State\nFarm and other insurance companies challenged the reversal as arbitrary and capricious.\nExamining the record, the Supreme Court found that the agency had failed to state enough\nreasons for its reversal and required the agency to review the record and the rule and provide\nadequate reasons for its reversal. State Farm and other insurance companies thus gained a legal\nbenefit by keeping an agency rule that placed costs on automakers for increased passenger\nsafety and potentially reducing the number of injury claims from those it had insured. [1]\n\nSuing the Government\nIn the modern administrative state, the range of government activity is immense, and\nadministrative agencies frequently get in the way of business enterprise. Often, bureaucratic\ninvolvement is wholly legitimate, compelled by law; sometimes, however, agencies or\ngovernment officials may overstep their bounds, in a fit of zeal or spite. What recourse does the\nprivate individual or company have?\nMainly for historical reasons, it has always been more difficult to sue the government than to\nsue private individuals or corporations. For one thing, the government has long had recourse to\nthe doctrine of sovereign immunity as a shield against lawsuits. Yet in 1976, Congress amended\nthe Administrative Procedure Act to waive any federal claim to sovereign immunity in cases of\ninjunctive or other nonmonetary relief. Earlier, in 1946, in the Federal Tort Claims Act,\nCongress had waived sovereign immunity of the federal government for most tort claims for\nmoney damages, although the act contains several exceptions for specific agencies (e.g., one\ncannot sue for injuries resulting from fiscal operations of the Treasury Department or for\ninjuries stemming from activities of the military in wartime). The act also contains a major\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n204\n\n\x0cexception for claims \xe2\x80\x9cbased upon [an official\xe2\x80\x99s] exercise or performance or the failure to exercise\nor perform a discretionary function or duty.\xe2\x80\x9d This exception prevents suits against parole boards\nfor paroling dangerous criminals who then kill or maim in the course of another crime and suits\nagainst officials whose decision to ship explosive materials by public carrier leads to mass deaths\nand injuries following an explosion en route. [2]\nIn recent years, the Supreme Court has been stripping away the traditional immunity enjoyed by\nmany government officials against personal suits. Some government employees\xe2\x80\x94judges,\nprosecutors, legislators, and the president, for example\xe2\x80\x94have absolute immunity against suit for\nofficial actions. But many public administrators and government employees have at best a\nqualified immunity. Under a provision of the Civil Rights Act of 1871 (so-called Section 1983\nactions), state officials can be sued in federal court for money damages whenever \xe2\x80\x9cunder color of\nany state law\xe2\x80\x9d they deprive anyone of his rights under the Constitution or federal law. In Bivens\nv. Six Unknown Federal Narcotics Agents, the Supreme Court held that federal agents may be\nsued for violating the plaintiff\xe2\x80\x99s Fourth Amendment rights against an unlawful search of his\nhome. [3] Subsequent cases have followed this logic to permit suits for violations of other\nconstitutional provisions. This area of the law is in a state of flux, and it is likely to continue to\nevolve.\nSometimes damage is done to an individual or business because the government has given out\nerroneous information. For example, suppose that Charles, a bewildered, disabled navy\nemployee, is receiving a federal disability annuity. Under the regulations, he would lose his\npension if he took a job that paid him in each of two succeeding years more than 80 percent of\nwhat he earned in his old navy job. A few years later, Congress changed the law, making him\nineligible if he earned more than 80 percent in anyone year. For many years, Charles earned\nconsiderably less than the ceiling amount. But then one year he got the opportunity to make\nsome extra money. Not wishing to lose his pension, he called an employee relations specialist in\nthe US Navy and asked how much he could earn and still keep his pension. The specialist gave\nhim erroneous information over the telephone and then sent him an out-of-date form that said\nCharles could safely take on the extra work. Unfortunately, as it turned out, Charles did exceed\nthe salary limit, and so the government cut off his pension during the time he earned too much.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n205\n\n\x0cCharles sues to recover his lost pension. He argues that he relied to his detriment on false\ninformation supplied by the navy and that in fairness the government should be estopped from\ndenying his claim.\nUnfortunately for Charles, he will lose his case. In Office of Personnel Management v.\nRichmond, the Supreme Court reasoned that it would be unconstitutional to permit\nrecovery. [4] The appropriations clause of Article I says that federal money can be paid out only\nthrough an appropriation made by law. The law prevented this particular payment to be made.\nIf the court were to make an exception, it would permit executive officials in effect to make\nbinding payments, even though unauthorized, simply by misrepresenting the facts. The harsh\nreality, therefore, is that mistakes of the government are generally held against the individual,\nnot the government, unless the law specifically provides for recompense (as, for example, in the\nFederal Tort Claims Act just discussed).\n\nKEY TAKEAWAY\n\nAfter exhausting administrative remedies, there are numerous grounds for seeking judicial\nreview of an agency\xe2\x80\x99s order or of a final rule. While courts defer to agencies to some degree,\nan agency must follow its own rules, comply with the Administrative Procedure Act, act\nwithin the scope of its delegated authority, avoid acting in an arbitrary manner, and make\nfinal rules that are supported by substantial evidence.\n\nEXERCISES\n\n1. Why would US courts require that someone seeking judicial review of an agency order first\nexhaust administrative remedies?\n2. On the Internet, find a case where someone has successfully sued the US government under\nthe Federal Tort Claims Act. What kind of case was it? Did the government argue sovereign\nimmunity? Does sovereign immunity even make sense to you?\n\n[1] Motor Vehicle Manufacturers\xe2\x80\x99 Assn. v. State Farm Mutual Ins., 463 US 29 (1983).\n[2] Dalehite v. United States, 346 US 15 (1953).\n[3] Bivens v. Six Unknown Federal Narcotics Agents, 403 US 388 (1971).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n206\n\n\x0c[4] Office of Personnel Management v. Richmond, 110 S. Ct. 2465 (1990).\n\n5.6 Cases\nMarshall v. Barlow\xe2\x80\x99s, Inc.\nMarshall v. Barlow\xe2\x80\x99s, Inc.\n436 U.S. 307 (U.S. Supreme Court 1978)\nMR. JUSTICE WHITE delivered the opinion of the Court.\nSection 8(a) of the Occupational Safety and Health Act of 1970 (OSHA or Act) empowers agents\nof the Secretary of Labor (Secretary) to search the work area of any employment facility within\nthe Act\xe2\x80\x99s jurisdiction. The purpose of the search is to inspect for safety hazards and violations of\nOSHA regulations. No search warrant or other process is expressly required under the Act.\nOn the morning of September 11, 1975, an OSHA inspector entered the customer service area of\nBarlow\xe2\x80\x99s, Inc., an electrical and plumbing installation business located in Pocatello, Idaho. The\npresident and general manager, Ferrol G. \xe2\x80\x9cBill\xe2\x80\x9d Barlow, was on hand; and the OSHA inspector,\nafter showing his credentials, informed Mr. Barlow that he wished to conduct a search of the\nworking areas of the business. Mr. Barlow inquired whether any complaint had been received\nabout his company. The inspector answered no, but that Barlow\xe2\x80\x99s, Inc., had simply turned up in\nthe agency\xe2\x80\x99s selection process. The inspector again asked to enter the nonpublic area of the\nbusiness; Mr. Barlow\xe2\x80\x99s response was to inquire whether the inspector had a search warrant.\nThe inspector had none. Thereupon, Mr. Barlow refused the inspector admission to the\nemployee area of his business. He said he was relying on his rights as guaranteed by the Fourth\nAmendment of the United States Constitution.\nThree months later, the Secretary petitioned the United States District Court for the District of\nIdaho to issue an order compelling Mr. Barlow to admit the inspector. The requested order was\nissued on December 30, 1975, and was presented to Mr. Barlow on January 5, 1976. Mr. Barlow\nagain refused admission, and he sought his own injunctive relief against the warrantless\nsearches assertedly permitted by OSHA.\xe2\x80\xa6The Warrant Clause of the Fourth Amendment\nprotects commercial buildings as well as private homes. To hold otherwise would belie the origin\nof that Amendment, and the American colonial experience.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n207\n\n\x0cAn important forerunner of the first 10 Amendments to the United States Constitution, the\nVirginia Bill of Rights, specifically opposed \xe2\x80\x9cgeneral warrants, whereby an officer or messenger\nmay be commanded to search suspected places without evidence of a fact committed.\xe2\x80\x9d The\ngeneral warrant was a recurring point of contention in the Colonies immediately preceding the\nRevolution. The particular offensiveness it engendered was acutely felt by the merchants and\nbusinessmen whose premises and products were inspected for compliance with the several\nparliamentary revenue measures that most irritated the colonists.\xe2\x80\xa6\n***\nThis Court has already held that warrantless searches are generally unreasonable, and that this\nrule applies to commercial premises as well as homes. In Camara v. Municipal Court, we held:\n[E]xcept in certain carefully defined classes of cases, a search of private property without proper\nconsent is \xe2\x80\x98unreasonable\xe2\x80\x99 unless it has been authorized by a valid search warrant.\nOn the same day, we also ruled: As we explained in Camara, a search of private houses is\npresumptively unreasonable if conducted without a warrant. The businessman, like the\noccupant of a residence, has a constitutional right to go about his business free from\nunreasonable official entries upon his private commercial property. The businessman, too, has\nthat right placed in jeopardy if the decision to enter and inspect for violation of regulatory laws\ncan be made and enforced by the inspector in the field without official authority evidenced by a\nwarrant. These same cases also held that the Fourth Amendment prohibition against\nunreasonable searches protects against warrantless intrusions during civil as well as criminal\ninvestigations. The reason is found in the \xe2\x80\x9cbasic purpose of this Amendment\xe2\x80\xa6[which] is to\nsafeguard the privacy and security of individuals against arbitrary invasions by governmental\nofficials.\xe2\x80\x9d If the government intrudes on a person\xe2\x80\x99s property, the privacy interest suffers whether\nthe government\xe2\x80\x99s motivation is to investigate violations of criminal laws or breaches of other\nstatutory or regulatory standards.\xe2\x80\xa6\n[A]n exception from the search warrant requirement has been recognized for \xe2\x80\x9cpervasively\nregulated business[es],\xe2\x80\x9d United States v. Biswell, 406 U.S. 311, 316 (1972), and for \xe2\x80\x9cclosely\nregulated\xe2\x80\x9d industries \xe2\x80\x9clong subject to close supervision and inspection,\xe2\x80\x9d Colonnade Catering\nCorp. v. United States, 397 U.S. 72, 74, 77 (1970). These cases are indeed exceptions, but they\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n208\n\n\x0crepresent responses to relatively unique circumstances. Certain industries have such a history of\ngovernment oversight that no reasonable expectation of privacy could exist for a proprietor over\nthe stock of such an enterprise. Liquor (Colonnade) and firearms (Biswell) are industries of this\ntype when an entrepreneur embarks upon such a business, he has voluntarily chosen to subject\nhimself to a full arsenal of governmental regulation.\n***\nThe clear import of our cases is that the closely regulated industry of the type involved\ninColonnade and Biswell is the exception. The Secretary would make it the rule. Invoking the\nWalsh-Healey Act of 1936, 41 U.S.C. \xc2\xa7 35 et seq., the Secretary attempts to support a conclusion\nthat all businesses involved in interstate commerce have long been subjected to close\nsupervision of employee safety and health conditions. But\xe2\x80\xa6it is quite unconvincing to argue that\nthe imposition of minimum wages and maximum hours on employers who contracted with the\nGovernment under the Walsh-Healey Act prepared the entirety of American interstate\ncommerce for regulation of working conditions to the minutest detail. Nor can any but the most\nfictional sense of voluntary consent to later searches be found in the single fact that one\nconducts a business affecting interstate commerce. Under current practice and law, few\nbusinesses can be conducted without having some effect on interstate commerce.\n***\nThe critical fact in this case is that entry over Mr. Barlow\xe2\x80\x99s objection is being sought by a\nGovernment agent. Employees are not being prohibited from reporting OSHA violations. What\nthey observe in their daily functions is undoubtedly beyond the employer\xe2\x80\x99s reasonable\nexpectation of privacy. The Government inspector, however, is not an employee. Without a\nwarrant he stands in no better position than a member of the public. What is observable by the\npublic is observable, without a warrant, by the Government inspector as well. The owner of a\nbusiness has not, by the necessary utilization of employees in his operation, thrown open the\nareas where employees alone are permitted to the warrantless scrutiny of Government agents.\nThat an employee is free to report, and the Government is free to use, any evidence of\nnoncompliance with OSHA that the employee observes furnishes no justification for federal\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n209\n\n\x0cagents to enter a place of business from which the public is restricted and to conduct their own\nwarrantless search.\n***\n[The District Court judgment is affirmed.]\n\nCASE QUESTIONS\n\n1. State, as briefly and clearly as possible, the argument that Barlow\xe2\x80\x99s is making in this case.\n2. Why would some industries or businesses be \xe2\x80\x9cclosely regulated\xe2\x80\x9d? What are some of those\nbusinesses?\n3. The Fourth Amendment speaks of \xe2\x80\x9cpeople\xe2\x80\x9d being secure in their \xe2\x80\x9cpersons, houses, papers,\nand effects.\xe2\x80\x9d Why would the Fourth Amendment apply to a business, which is not in a\n\xe2\x80\x9chouse\xe2\x80\x9d?\n4. If the Fourth Amendment does not distinguish between closely regulated industries and\nthose that are not, why does the court do so?\n\nAmerican Textile Manufacturers Institute v. Donovan\nAmerican Textile Manufacturers Institute v. Donovan\n452 U.S. 490 (1981)\nJUSTICE BRENNAN delivered the opinion of the Court.\nCongress enacted the Occupational Safety and Health Act of 1970 (Act) \xe2\x80\x9cto assure so far as\npossible every working man and woman in the Nation safe and healthful working\nconditions.\xe2\x80\xa6\xe2\x80\x9cThe Act authorizes the Secretary of Labor to establish, after notice and\nopportunity to comment, mandatory nationwide standards governing health and safety in the\nworkplace. In 1978, the Secretary, acting through the Occupational Safety and Health\nAdministration (OSHA), promulgated a standard limiting occupational exposure to cotton dust,\nan airborne particle byproduct of the preparation and manufacture of cotton products, exposure\nto which produces a \xe2\x80\x9cconstellation of respiratory effects\xe2\x80\x9d known as \xe2\x80\x9cbyssinosis.\xe2\x80\x9d This disease\nwas one of the expressly recognized health hazards that led to passage of the Act.\nPetitioners in these consolidated cases representing the interests of the cotton industry,\nchallenged the validity of the \xe2\x80\x9cCotton Dust Standard\xe2\x80\x9d in the Court of Appeals for the District of\nColumbia Circuit pursuant to \xc2\xa7 6 (f) of the Act, 29 U.S.C. \xc2\xa7 655 (f). They contend in this Court, as\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n210\n\n\x0cthey did below, that the Act requires OSHA to demonstrate that its Standard reflects a\nreasonable relationship between the costs and benefits associated with the Standard.\nRespondents, the Secretary of Labor and two labor organizations, counter that Congress\nbalanced the costs and benefits in the Act itself, and that the Act should therefore be construed\nnot to require OSHA to do so. They interpret the Act as mandating that OSHA enact the most\nprotective standard possible to eliminate a significant risk of material health impairment,\nsubject to the constraints of economic and technological feasibility.\nThe Court of Appeals held that the Act did not require OSHA to compare costs and benefits.\nWe granted certiorari, 449 U.S. 817 (1980), to resolve this important question, which was\npresented but not decided in last Term\xe2\x80\x99s Industrial Union Dept. v. American Petroleum\nInstitute, 448 U.S. 607 (1980), and to decide other issues related to the Cotton Dust Standard.\n***\nNot until the early 1960\xe2\x80\x99s was byssinosis recognized in the United States as a distinct\noccupational hazard associated with cotton mills. In 1966, the American Conference of\nGovernmental Industrial Hygienists (ACGIH), a private organization, recommended that\nexposure to total cotton dust be limited to a \xe2\x80\x9cthreshold limit value\xe2\x80\x9d of 1,000 micrograms per\ncubic meter of air (1,000 g/m3.) averaged over an 8-hour workday. See 43 Fed. Reg. 27351, col. 1\n(1978). The United States Government first regulated exposure to cotton dust in 1968, when the\nSecretary of Labor, pursuant to the Walsh-Healey Act, 41 U.S.C. 35 (e), promulgated airborne\ncontaminant threshold limit values, applicable to public contractors, that included the 1,000\ng/m3 limit for total cotton dust. 34 Fed. Reg. 7953 (1969). Following passage of the Act in 1970,\nthe 1,000 g/m3. standard was adopted as an \xe2\x80\x9cestablished Federal standard\xe2\x80\x9d under 6 (a) of the\nAct, 84 Stat. 1593, 29 U.S.C. 655 (a), a provision designed to guarantee immediate protection of\nworkers for the period between enactment of the statute and promulgation of permanent\nstandards.\nThat same year, the Director of the National Institute for Occupational Safety and Health\n(NIOSH), pursuant to the Act, 29 U.S.C. \xc2\xa7\xc2\xa7 669(a)(3), 671 (d)(2), submitted to the Secretary of\nLabor a recommendation for a cotton dust standard with a permissible exposure limit (PEL)\nthat \xe2\x80\x9cshould be set at the lowest level feasible, but in no case at an environmental concentration\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n211\n\n\x0cas high as 0.2 mg lint-free cotton dust/cu m,\xe2\x80\x9d or 200 g/m3. of lint-free respirable dust. Several\nmonths later, OSHA published an Advance Notice of Proposed Rulemaking, 39 Fed.Reg. 44769\n(1974), requesting comments from interested parties on the NIOSH recommendation and other\nrelated matters. Soon thereafter, the Textile Worker\xe2\x80\x99s Union of America, joined by the North\nCarolina Public Interest Research Group, petitioned the Secretary, urging a more stringent PEL\nof 100 g/m3.\nOn December 28, 1976, OSHA published a proposal to replace the existing federal standard on\ncotton dust with a new permanent standard, pursuant to \xc2\xa7 6(b)(5) of the Act, 29 U.S.C. \xc2\xa7\n655(b)(5). 41 Fed.Reg. 56498. The proposed standard contained a PEL of 200 g/m3 of vertical\nelutriated lint-free respirable cotton dust for all segments of the cotton industry. Ibid. It also\nsuggested an implementation strategy for achieving the PEL that relied on respirators for the\nshort term and engineering controls for the long-term. OSHA invited interested parties to\nsubmit written comments within a 90-day period.\n***\nThe starting point of our analysis is the language of the statute itself. Section 6(b)(5) of the Act,\n29 U.S.C. \xc2\xa7 655(b)(5) (emphasis added), provides:\nThe Secretary, in promulgating standards dealing with toxic materials or harmful physical\nagents under this subsection, shall set the standard which most adequately assures, to the\nextent feasible, on the basis of the best available evidence, that no employee will suffer\nmaterial impairment of health or functional capacity even if such employee has regular exposure\nto the hazard dealt with by such standard for the period of his working life. Although their\ninterpretations differ, all parties agree that the phrase \xe2\x80\x9cto the extent feasible\xe2\x80\x9d contains the\ncritical language in \xc2\xa7 6(b)(5) for purposes of these cases.\nThe plain meaning of the word \xe2\x80\x9cfeasible\xe2\x80\x9d supports respondents\xe2\x80\x99 interpretation of the statute.\nAccording to Webster\xe2\x80\x99s Third New International Dictionary of the English Language 831 (1976),\n\xe2\x80\x9cfeasible\xe2\x80\x9d means \xe2\x80\x9ccapable of being done, executed, or effected.\xe2\x80\x9d In accord, the Oxford English\nDictionary 116 (1933) (\xe2\x80\x9cCapable of being done, accomplished or carried out\xe2\x80\x9d); Funk & Wagnalls\nNew \xe2\x80\x9cStandard\xe2\x80\x9d Dictionary of the English Language 903 (1957) (\xe2\x80\x9cThat may be done, performed\nor effected\xe2\x80\x9d). Thus, \xc2\xa7 6(b)(5) directs the Secretary to issue the standard that \xe2\x80\x9cmost adequately\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n212\n\n\x0cassures\xe2\x80\xa6that no employee will suffer material impairment of health,\xe2\x80\x9d limited only by the extent\nto which this is \xe2\x80\x9ccapable of being done.\xe2\x80\x9d In effect then, as the Court of Appeals held, Congress\nitself defined the basic relationship between costs and benefits, by placing the \xe2\x80\x9cbenefit\xe2\x80\x9d of\nworker health above all other considerations save those making attainment of this \xe2\x80\x9cbenefit\xe2\x80\x9d\nunachievable. Any standard based on a balancing of costs and benefits by the Secretary that\nstrikes a different balance than that struck by Congress would be inconsistent with the\ncommand set forth in \xc2\xa7 6(b)(5). Thus, cost-benefit analysis by OSHA is not required by the\nstatute because feasibility analysis is.\nWhen Congress has intended that an agency engage in cost-benefit analysis, it has clearly\nindicated such intent on the face of the statute. One early example is the Flood Control Act of\n1936, 33 U.S.C. \xc2\xa7 701:\n[T]he Federal Government should improve or participate in the improvement of navigable\nwaters or their tributaries, including watersheds thereof, for flood control purposes if\nthe benefits to whomsoever they may accrue are in excess of the estimated costs,\nand if the lives and social security of people are otherwise adversely affected. (emphasis added)\nA more recent example is the Outer Continental Shelf Lands Act Amendments of 1978,\nproviding that offshore drilling operations shall use the best available and safest technologies\nwhich the Secretary determines to be economically feasible, wherever failure of equipment\nwould have a significant effect on safety, health, or the environment, except where the Secretary\ndetermines that the incremental benefits are clearly insufficient to justify the incremental costs\nof using such technologies.\nThese and other statutes demonstrate that Congress uses specific language when intending that\nan agency engage in cost-benefit analysis. Certainly in light of its ordinary meaning, the word\n\xe2\x80\x9cfeasible\xe2\x80\x9d cannot be construed to articulate such congressional intent. We therefore reject the\nargument that Congress required cost-benefit analysis in \xc2\xa7 6(b)(5).\n\nCASE QUESTIONS\n\n1. What is byssinosis? Why should byssinosis be anything that the textile companies are\nresponsible for, ethically or legally? If it is well-known that textile workers get cotton dust in\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n213\n\n\x0ctheir systems and develop brown lung, don\xe2\x80\x99t they nevertheless choose to work there and\nassume the risk of all injuries?\n2. By imposing costs on the textile industry, what will be the net effect on US textile\nmanufacturing jobs?\n3. How is byssinosis a \xe2\x80\x9cnegative externality\xe2\x80\x9d that is not paid for by either the manufacturer or\nthe consumer of textile products? How should the market, to be fair and efficient, adjust for\nthese negative externalities other than by setting a reasonable standard that shares the\nburden between manufacturers and their employees? Should all the burden be on the\nmanufacturer?\n\n5.7 Summary and Exercises\nSummary\n\nAdministrative rules and regulations constitute the largest body of laws that directly affect\nbusiness. These regulations are issued by dozens of federal and state agencies that regulate\nvirtually every aspect of modern business life, including the natural environment, corporate\nfinance, transportation, telecommunications, energy, labor relations, and trade practices. The\nadministrative agencies derive their power to promulgate regulations from statutes passed by\nCongress or state legislatures.\nThe agencies have a variety of powers. They can license companies to carry on certain activities\nor prohibit them from doing so, lay down codes of conduct, set rates that companies may charge\nfor their services, and supervise various aspects of business.\n\nEXERCISES\n\n1. The Equal Employment Opportunity Commission seeks data about the racial composition of\nTerrific Textiles\xe2\x80\x99 labor force. Terrific refuses on the grounds that inadvertent disclosure of the\nnumbers might cause certain \xe2\x80\x9celements\xe2\x80\x9d to picket its factories. The EEOC takes Terrific to\ncourt to get the data. What is the result?\n2. In order to police the profession, the state legislature has just passed a law permitting the\nState Plumbers\xe2\x80\x99 Association the power to hold hearings to determine whether a particular\nplumber has violated the plumbing code of ethics, written by the association. Sam, a\nplumber, objects to the convening of a hearing when he is accused by Roger, a fellow\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n214\n\n\x0cplumber, of acting unethically by soliciting business from Roger\xe2\x80\x99s customers. Sam goes to\ncourt, seeking to enjoin the association\xe2\x80\x99s disciplinary committee from holding the hearing.\nWhat is the result? How would you argue Sam\xe2\x80\x99s case? The association\xe2\x80\x99s case?\n3. Assume that the new president of the United States was elected overwhelmingly by pledging\nin his campaign to \xe2\x80\x9cdo away with bureaucrats who interfere in your lives.\xe2\x80\x9d The day he takes\nthe oath of office he determines to carry out his pledge. Discuss which of the following\ncourses he may lawfully follow: (a) Fire all incumbent commissioners of federal agencies in\norder to install new appointees. (b) Demand that all pending regulations being considered by\nfederal agencies be submitted to the White House for review and redrafting, if necessary. (c)\nInterview potential nominees for agency positions to determine whether their regulatory\nphilosophy is consistent with his.\n4. Dewey owned a mine in Wisconsin. He refused to allow Department of Labor agents into the\nmine to conduct warrantless searches to determine whether previously found safety\nviolations had been corrected. The Federal Mine Safety and Health Amendments Act of 1977\nauthorizes four warrantless inspections per year. Is the provision for warrantless inspections\nby this agency constitutional?[1]\n5. In determining the licensing requirements for nuclear reactors, the Nuclear Regulatory\nCommission (NRC) adopted a zero-release assumption: that the permanent storage of certain\nnuclear waste would have no significant environmental impact and that potential storage\nleakages should not be a factor discussed in the appropriate environmental impact\nstatement (EIS) required before permitting construction of a nuclear power plant. This\nassumption is based on the NRC\xe2\x80\x99s belief that technology would be developed to isolate the\nwastes from the environment, and it was clear from the record that the NRC had \xe2\x80\x9cdigested a\nmassive material and disclosed all substantial risks\xe2\x80\x9d and had considered that the zero-release\nassumption was uncertain. There was a remote possibility of contamination by water leakage\ninto the storage facility. An environmental NGO sued, asserting that the NRC had violated the\nregulations governing the EIS by arbitrarily and capriciously ignoring the potential\ncontamination. The court of appeals agreed, and the power plant appealed. Had the NRC\nacted arbitrarily and capriciously? [2]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n215\n\n\x0cSELF-TEST QUESTIONS\n1. Most federal administrative agencies are created by\na.\n\nan executive order by the president\n\nb. a Supreme Court decision\nc. the passage of enabling legislation by Congress, signed by the president\nd. a and c\nThe Federal Trade Commission, like most administrative agencies of the\nfederal government, is part of\na.\n\nthe executive branch of government\n\nb. the legislative branch of government\nc. the judicial branch of government\nd. the administrative branch of government\nIn the Clean Water Act, Congress sets broad guidelines, but it is the\nEnvironmental Protection Agency that proposes rules to regulate industrial\ndischarges. Where do proposed rules originally appear?\na.\n\nin the Congressional record\n\nb. in the Federal Register\nc. in the Code of Federal Regulations\nd. in the United States code service\nThe legal basis for all administrative law, including regulations of the\nFederal Trade Commission, is found in\na.\n\nthe Administrative Procedure Act\n\nb. the US Constitution\nc. the commerce clause\nd. none of the above\nThe Federal Trade Commission, like other administrative agencies, has the\npower to\na.\n\nissue proposed rules\n\nb. undertake investigations of firms that may have violated FTC regulations\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n216\n\n\x0cc. prosecute firms that have violated FTC regulations\nd. none of the above\ne. all of the above\n\nSELF-TEST ANSWERS\n\n1. c\n2. a\n3. b\n4. b\n5. e\n\n[1] Donovan v. Dewey, 452 US 594 (1981).\n[2] Baltimore Gas and Electric Co. v. Natural Resources Defense Council Inc., 462 US 87 (1983).\n\nChapter 6\nCriminal Law\n\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1. Explain how criminal law differs from civil law.\n2. Categorize the various types of crimes and define the most serious felonies.\n3. Discuss and question the criminal \xe2\x80\x9cintent\xe2\x80\x9d of a corporation.\n4. Explain basic criminal procedure and the rights of criminal defendants.\nAt times, unethical behavior by businesspeople can be extreme enough that society will respond\nby criminalizing certain kinds of activities. Ponzi schemes, arson, various kinds of fraud,\nembezzlement, racketeering, foreign corrupt practices, tax evasion, and insider trading are just a\nfew. A corporation can face large fines, and corporate managers can face both fines and jail\nsentences for violating criminal laws. This chapter aims to explain how criminal law differs from\ncivil law, to discuss various types of crimes, and to relate the basic principles of criminal\nprocedure.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n217\n\n\x0c6.1 The Nature of Criminal Law\nCriminal law is the most ancient branch of the law. Many wise observers have tried to define and\nexplain it, but the explanations often include many complex and subtle distinctions. A\ntraditional criminal law course would include a lot of discussions on criminal intent, the nature\nof criminal versus civil responsibility, and the constitutional rights accorded the accused. But in\nthis chapter, we will consider only the most basic aspects of intent, responsibility, and\nconstitutional rights.\nUnlike civil actions, where plaintiffs seek compensation or other remedies for themselves,\ncrimes involve \xe2\x80\x9cthe state\xe2\x80\x9d (the federal government, a state government, or some subunit of state\ngovernment). This is because crimes involve some \xe2\x80\x9charm to society\xe2\x80\x9d and not just harm to certain\nindividuals. But \xe2\x80\x9charm to society\xe2\x80\x9d is not always evident in the act itself. For example, two friends\nof yours at a party argue, take the argument outside, and blows are struck; one has a bloody nose\nand immediately goes home. The crimes of assault and battery have been committed, even\nthough no one else knows about the fight and the friends later make up. By contrast, suppose a\nmajor corporation publicly announces that it is closing operations in your community and\nmoving operations to Southeast Asia. There is plenty of harm to society as the plant closes down\nand no new jobs take the place of the company\xe2\x80\x99s jobs. Although the effects on society are greater\nin the second example, only the first example is a crime.\nCrimes are generally defined by legislatures, in statutes; the statutes describe in general terms\nthe nature of the conduct they wish to criminalize. For government punishment to be fair,\ncitizens must have clear notice of what is criminally prohibited. Ex post facto laws\xe2\x80\x94laws created\n\xe2\x80\x9cafter the fact\xe2\x80\x9d to punish an act that was legal at the time\xe2\x80\x94are expressly prohibited by the US\nConstitution. Overly vague statutes can also be struck down by courts under a constitutional\ndoctrine known as \xe2\x80\x9cvoid for vagueness.\xe2\x80\x9d\nWhat is considered a crime will also vary from society to society and from time to time. For\nexample, while cocaine use was legal in the United States at one time, it is now a controlled\nsubstance, and unauthorized use is now a crime. Medical marijuana was not legal fifty years ago\nwhen its use began to become widespread, and in some states its use or possession was a felony.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n218\n\n\x0cNow, some states make it legal to use or possess it under some circumstances. In the United\nStates, you can criticize and make jokes about the president of the United States without\ncommitting a crime, but in many countries it is a serious criminal act to criticize a public official.\nAttitudes about appropriate punishment for crimes will also vary considerably from nation to\nnation. Uganda has decreed long prison sentences for homosexuals and death to repeat\noffenders. In Saudi Arabia, the government has proposed to deliberately paralyze a criminal\ndefendant who criminally assaulted someone and unintentionally caused the victim\xe2\x80\x99s paralysis.\nLimits on punishment are set in the United States through the Constitution\xe2\x80\x99s prohibition on\n\xe2\x80\x9ccruel or unusual punishments.\xe2\x80\x9d\nIt is often said that ignorance of the law is no excuse. But there are far too many criminal laws\nfor anyone to know them all. Also, because most people do not actually read statutes, the\nquestion of \xe2\x80\x9ccriminal intent\xe2\x80\x9d comes up right away: if you don\xe2\x80\x99t know that the legislature has\nmade driving without a seat belt fastened a misdemeanor, you cannot have intended to harm\nsociety. You might even argue that there is no harm to anyone but yourself!\nThe usual answer to this is that the phrase \xe2\x80\x9cignorance of the law is no excuse\xe2\x80\x9d means that society\n(through its elected representatives) gets to decide what is harmful to society, not you. Still, you\nmay ask, \xe2\x80\x9cIsn\xe2\x80\x99t it my choice whether to take the risk of failing to wear a seat belt? Isn\xe2\x80\x99t this a\nvictimless crime? Where is the harm to society?\xe2\x80\x9d A policymaker or social scientist may answer\nthat your injuries, statistically, are generally going to be far greater if you don\xe2\x80\x99t wear one and\nthat your choice may actually impose costs on society. For example, you might not have enough\ninsurance, so that a public hospital will have to take care of your head injuries, injuries that\nwould likely have been avoided by your use of a seat belt.\nBut, as just noted, it is hard to know the meaning of some criminal laws. Teenagers hanging\naround the sidewalks on Main Street were sometimes arrested for \xe2\x80\x9cloitering.\xe2\x80\x9d The constitutional\nvoid-for-vagueness doctrine has led the courts to overturn statutes that are not clear. For\nexample, \xe2\x80\x9cvagrancy\xe2\x80\x9d was long held to be a crime, but US courts began some forty years ago to\noverturn vagrancy and \xe2\x80\x9csuspicious person\xe2\x80\x9d statutes on the grounds that they are too vague for\npeople to know what they are being asked not to do.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n219\n\n\x0cThis requirement that criminal statutes not be vague does not mean that the law always defines\ncrimes in ways that can be easily and clearly understood. Many statutes use terminology\ndeveloped by the common-law courts. For example, a California statute defines murder as \xe2\x80\x9cthe\nunlawful killing of a human being, with malice aforethought.\xe2\x80\x9d If no history backed up these\nwords, they would be unconstitutionally vague. But there is a rich history of judicial decisions\nthat provides meaning for much of the arcane language like \xe2\x80\x9cmalice aforethought\xe2\x80\x9d strewn about\nin the statute books.\nBecause a crime is an act that the legislature has defined as socially harmful, the parties involved\ncannot agree among themselves to forget a particular incident, such as a barroom brawl, if the\nauthorities decide to prosecute. This is one of the critical distinctions between criminal and civil\nlaw. An assault is both a crime and a tort. The person who was assaulted may choose to forgive\nhis assailant and not to sue him for damages. But he cannot stop the prosecutor from bringing\nan indictment against the assailant. (However, because of crowded dockets, a victim that\ndeclines to press charges may cause a busy prosecutor to choose to not to bring an indictment.)\nA crime consists of an act defined as criminal\xe2\x80\x94an actus reus\xe2\x80\x94and the requisite \xe2\x80\x9ccriminal\nintent.\xe2\x80\x9d Someone who has a burning desire to kill a rival in business or romance and who may\nactually intend to murder but does not act on his desire has not committed a crime. He may\nhave a \xe2\x80\x9cguilty mind\xe2\x80\x9d\xe2\x80\x94the translation of the Latin phrase mens rea\xe2\x80\x94but he is guilty of no crime.\nA person who is forced to commit a crime at gunpoint is not guilty of a crime, because although\nthere was an act defined as criminal\xe2\x80\x94an actus reus\xe2\x80\x94there was no criminal intent.\n\nKEY TAKEAWAY\n\nCrimes are usually defined by statute and constitute an offense against society. In each case,\nthere must be both an act and some mens rea (criminal intent).\n\nEXERCISES\n\n1. Other than deterring certain kinds of conduct, what purpose does the criminal law serve?\n2. Why is ignorance of the law no excuse? Why shouldn\xe2\x80\x99t it be an excuse, when criminal laws\ncan be complicated and sometimes ambiguous?\n\n6.2 Types of Crimes\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n220\n\n\x0cLEARNING OBJECTIVES\n1. Categorize various types of crimes.\n2. Name and define the major felonies in criminal law.\n3. Explain how white-collar crime differs from other crimes.\n4. Define a variety of white-collar crimes.\nMost classifications of crime turn on the seriousness of the act. In general, seriousness is defined\nby the nature or duration of the punishment set out in the statute. A felony is a crime punishable\n(usually) by imprisonment of more than one year or by death. (Crimes punishable by death are\nsometimes known as capital crimes; they are increasingly rare in the United States.) The major\nfelonies include murder, rape, kidnapping, armed robbery, embezzlement, insider trading,\nfraud, and racketeering. All other crimes are usually known as misdemeanors, petty offenses, or\ninfractions. Another way of viewing crimes is by the type of social harm the statute is intended to\nprevent or deter, such as offenses against the person, offenses against property, and white-collar\ncrime.\n\nOffenses against the Person\nHomicide\nHomicide is the killing of one person by another. Not every killing is criminal. When the law\npermits one person to kill another\xe2\x80\x94for example, a soldier killing an enemy on the battlefield\nduring war, or a killing in self-defense\xe2\x80\x94the death is considered the result of justifiable homicide.\nAn excusable homicide, by contrast, is one in which death results from an accident in which the\nkiller is not at fault.\nAll other homicides are criminal. The most severely punished form is murder, defined as\nhomicide committed with \xe2\x80\x9cmalice aforethought.\xe2\x80\x9d This is a term with a very long history. Boiled\ndown to its essentials, it means that the defendant had the intent to kill. A killing need not be\npremeditated for any long period of time; the premeditation might be quite sudden, as in a bar\nfight that escalates in that moment when one of the fighters reaches for a knife with the intent to\nkill.\nSometimes a homicide can be murder even if there is no intent to kill; an intent to inflict great\nbodily harm can be murder if the result is the death of another person. A killing that takes place\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n221\n\n\x0cwhile a felony (such as armed robbery) is being committed is also murder, whether or not the\nkiller intended any harm. This is the so-called felony murder rule. Examples are the accidental\ndischarge of a gun that kills an innocent bystander or the asphyxiation death of a fireman from\nsmoke resulting from a fire set by an arsonist. The felony murder rule is more significant than it\nsounds, because it also applies to the accomplices of one who does the killing. Thus the driver of\na getaway car stationed a block away from the scene of the robbery can be convicted of murder if\na gun accidentally fires during the robbery and someone is killed. Manslaughter is an act of\nkilling that does not amount to murder. Voluntary manslaughter is an intentional killing, but\none carried out in the \xe2\x80\x9csudden heat of passion\xe2\x80\x9d as the result of some provocation. An example is\na fight that gets out of hand. Involuntary manslaughter entails a lesser degree of willfulness; it\nusually occurs when someone has taken a reckless action that results in death (e.g., a death\nresulting from a traffic accident in which one driver recklessly runs a red light).\n\nAssault and Battery\nOrdinarily, we would say that a person who has struck another has \xe2\x80\x9cassaulted\xe2\x80\x9d him. Technically,\nthat is a battery\xe2\x80\x94the unlawful application of force to another person. The force need not be\nviolent. Indeed, a man who kisses a woman is guilty of a battery if he does it against her will. The\nother person may consent to the force. That is one reason why surgeons require patients to sign\nconsent forms, giving the doctor permission to operate. In the absence of such a consent, an\noperation is a battery. That is also why football players are not constantly being charged with\nbattery. Those who agree to play football agree to submit to the rules of the game, which of\ncourse include the right to tackle. But the consent does not apply to all acts of physical force: a\nhockey player who hits an opponent over the head with his stick can be prosecuted for the crime\nof battery.\nCriminal assault is an attempt to commit a battery or the deliberate placing of another in fear of\nreceiving an immediate battery. If you throw a rock at a friend, but he manages to dodge it, you\nhave committed an assault. Some states limit an assault to an attempt to commit a battery by\none who has a \xe2\x80\x9cpresent ability\xe2\x80\x9d to do so. Pointing an unloaded gun and threatening to shoot\nwould not be an assault, nor, of course, could it be a battery. The modem tendency, however, is\nto define an assault as an attempt to commit a battery by one with an apparent ability to do so.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n222\n\n\x0cAssault and battery may be excused. For example, a bar owner (or her agent, the bouncer) may\nuse reasonable force to remove an unruly patron. If the use of force is excessive, the bouncer can\nbe found guilty of assault and battery, and a civil action could arise against the bar owner as\nwell.\n\nOffenses against Property\nTheft: Larceny, Robbery, Embezzlement, False Pretenses\nThe concept of theft is familiar enough. Less familiar is the way the law has treated various\naspects of the act of stealing. Criminal law distinguishes among many different crimes that are\npopularly known as theft. Many technical words have entered the language\xe2\x80\x94burglary, larceny,\nrobbery\xe2\x80\x94but are often used inaccurately. Brief definitions of the more common terms are\ndiscussed here.\nThe basic crime of stealing personal property is larceny. By its old common-law definition, still\nin use today, larceny is the wrongful \xe2\x80\x9ctaking and carrying away of the personal property of\nanother with intent to steal the same.\xe2\x80\x9d\nThe separate elements of this offense have given rise to all kinds of difficult cases. Take the theft\nof fruit, for example, with regard to the essential element of \xe2\x80\x9cpersonal property.\xe2\x80\x9d If a man\nwalking through an orchard plucks a peach from a tree and eats it, he is not guilty of larceny\nbecause he has not taken away personal property (the peach is part of the land, being connected\nto the tree). But if he picks up a peach lying on the ground, he is guilty of larceny. Or consider\nthe element of \xe2\x80\x9ctaking\xe2\x80\x9d or \xe2\x80\x9ccarrying away.\xe2\x80\x9d Sneaking into a movie theater without paying is not\nan act of larceny (though in most states it is a criminal act). Taking electricity by tapping into the\npower lines of an electric utility was something that baffled judges late in the nineteenth century\nbecause it was not clear whether electricity is a \xe2\x80\x9csomething\xe2\x80\x9d that can be taken. Modern statutes\nhave tended to make clear that electricity can be the object of larceny. Or consider the element\nof an \xe2\x80\x9cintent to steal the same.\xe2\x80\x9d If you borrow your friend\xe2\x80\x99s BMW without his permission in\norder to go to the grocery store, intending to return it within a few minutes and then do return\nit, you have not committed larceny. But if you meet another friend at the store who convinces\nyou to take a long joyride with the car and you return hours later, you may have committed\nlarceny.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n223\n\n\x0cA particular form of larceny is robbery, which is defined as larceny from a person by means of\nviolence or intimidation.\nLarceny involves the taking of property from the possession of another. Suppose that a person\nlegitimately comes to possess the property of another and wrongfully appropriates it\xe2\x80\x94for\nexample, an automobile mechanic entrusted with your car refuses to return it, or a bank teller\nwho is entitled to temporary possession of cash in his drawer takes it home with him. The\ncommon law had trouble with such cases because the thief in these cases already had\npossession; his crime was in assuming ownership. Today, such wrongful conversion, known\nas embezzlement, has been made a statutory offense in all states.\nStatutes against larceny and embezzlement did not cover all the gaps in the law. A conceptual\nproblem arises in the case of one who is tricked into giving up his title to property. In larceny\nand embezzlement, the thief gains possession or ownership without any consent of the owner or\ncustodian of the property. Suppose, however, that an automobile dealer agrees to take his\ncustomer\xe2\x80\x99s present car as a trade-in. The customer says that he has full title to the car. In fact,\nthe customer is still paying off an installment loan and the finance company has an interest in\nthe old car. If the finance company repossesses the car, the customer\xe2\x80\x94who got a new car at a\ndiscount because of his false representation\xe2\x80\x94cannot be said to have taken the new car by\nlarceny or embezzlement. Nevertheless, he tricked the dealer into selling, and the dealer will\nhave lost the value of the repossessed car. Obviously, the customer is guilty of a criminal act; the\nstatutes outlawing it refer to this trickery as the crime of false pretenses, defined as obtaining\nownership of the property of another by making untrue representations of fact with intent to\ndefraud.\nA number of problems have arisen in the judicial interpretation of false-pretense statutes. One\nconcerns whether the taking is permanent or only temporary. The case ofState v. Mills (Section\n6.7 "Cases") shows the subtle questions that can be presented and the dangers inherent in\ncommitting \xe2\x80\x9ca little fraud.\xe2\x80\x9d\nIn the Mills case, the claim was that a mortgage instrument dealing with one parcel of land was\nused instead for another. This is a false representation of fact. Suppose, by contrast, that a\nperson misrepresents his state of mind: \xe2\x80\x9cI will pay you back tomorrow,\xe2\x80\x9d he says, knowing full\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n224\n\n\x0cwell that he does not intend to. Can such a misrepresentation amount to false pretenses\npunishable as a criminal offense? In most jurisdictions it cannot. A false-pretense violation\nrelates to a past event or existing fact, not to a statement of intention. If it were otherwise,\nanyone failing to pay a debt might find himself facing criminal prosecution, and business would\nbe less prone to take risks.\nThe problem of proving intent is especially difficult when a person has availed himself of the\nservices of another without paying. A common example is someone leaving a restaurant without\npaying for the meal. In most states, this is specifically defined in the statutes as theft of services.\n\nReceiving Stolen Property\nOne who engages in receiving stolen property with knowledge that it is stolen is guilty of a felony\nor misdemeanor, depending on the value of the property. The receipt need not be personal; if\nthe property is delivered to a place under the control of the receiver, then he is deemed to have\nreceived it. \xe2\x80\x9cKnowledge\xe2\x80\x9d is construed broadly: not merely actual knowledge, but (correct) belief\nand suspicion (strong enough not to investigate for fear that the property will turn out to have\nbeen stolen) are sufficient for conviction.\n\nForgery\nForgery is false writing of a document of legal significance (or apparent legal significance!) with\nintent to defraud. It includes the making up of a false document or the alteration of an existing\none. The writing need not be done by hand but can be by any means\xe2\x80\x94typing, printing, and so\nforth. Documents commonly the subject of forgery are negotiable instruments (checks, money\norders, and the like), deeds, receipts, contracts, and bills of lading. The forged instrument must\nitself be false, not merely contain a falsehood. If you fake your neighbor\xe2\x80\x99s signature on one of his\nchecks made out to cash, you have committed forgery. But if you sign a check of your own that is\nmade out to cash, knowing that there is no money in your checking account, the instrument is\nnot forged, though the act may be criminal if done with the intent to defraud.\nThe mere making of a forged instrument is unlawful. So is the \xe2\x80\x9cuttering\xe2\x80\x9d (or presentation) of\nsuch an instrument, whether or not the one uttering it actually forged it. The usual example of a\nfalse signature is by no means the only way to commit forgery. If done with intent to defraud,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n225\n\n\x0cthe backdating of a document, the modification of a corporate name, or the filling in of lines left\nblank on a form can all constitute forgery.\n\nExtortion\nUnder common law, extortion could only be committed by a government official, who corruptly\ncollected an unlawful fee under color of office. A common example is a salaried building\ninspector who refuses to issue a permit unless the permittee pays him. Under modern statutes,\nthe crime of extortion has been broadened to include the wrongful collection of money or\nsomething else of value by anyone by means of a threat (short of a threat of immediate physical\nviolence, for such a threat would make the demand an act of robbery). This kind of extortion is\nusually called blackmail. The blackmail threat commonly is to expose some fact of the victim\xe2\x80\x99s\nprivate life or to make a false accusation about him.\n\nOffenses against Habitation and Other Offenses\nBurglary\nBurglary is not a crime against property. It is defined as \xe2\x80\x9cthe breaking and entering of the\ndwelling of another in the nighttime with intent to commit a felony.\xe2\x80\x9d The intent to steal is not an\nissue: a man who sneaks into a woman\xe2\x80\x99s home intent on raping her has committed a burglary,\neven if he does not carry out the act. The student doing critical thinking will no doubt notice that\nthe definition provides plenty of room for argument. What is \xe2\x80\x9cbreaking\xe2\x80\x9d? (The courts do not\nrequire actual destruction; the mere opening of a closed door, even if unlocked, is enough.)\nWhat is entry? When does night begin? What kind of intent? Whose dwelling? Can a landlord\nburglarize the dwelling of his tenant? (Yes.) Can a person burglarize his own home? (No.)\n\nArson\nUnder common law, arson was the malicious burning of the dwelling of another. Burning one\xe2\x80\x99s\nown house for purposes of collecting insurance was not an act of arson under common law. The\nstatutes today make it a felony intentionally to set fire to any building, whether or not it is a\ndwelling and whether or not the purpose is to collect insurance.\n\nBribery\nBribery is a corrupt payment (or receipt of such a payment) for official action. The payment can\nbe in cash or in the form of any goods, intangibles, or services that the recipient would find\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n226\n\n\x0cvaluable. Under common law, only a public official could be bribed. In most states, bribery\ncharges can result from the bribe of anyone performing a public function.\nBribing a public official in government procurement (contracting) can result in serious criminal\ncharges. Bribing a public official in a foreign country to win a contract can result in charges\nunder the Foreign Corrupt Practices Act.\n\nPerjury\nPerjury is the crime of giving a false oath, either orally or in writing, in a judicial or other official\nproceeding (lies made in proceedings other than courts are sometimes termed \xe2\x80\x9cfalse swearing\xe2\x80\x9d).\nTo be perjurious, the oath must have been made corruptly\xe2\x80\x94that is, with knowledge that it was\nfalse or without sincere belief that it was true. An innocent mistake is not perjury. A statement,\nthough true, is perjury if the maker of it believes it to be false. Statements such as \xe2\x80\x9cI don\xe2\x80\x99t\nremember\xe2\x80\x9d or \xe2\x80\x9cto the best of my knowledge\xe2\x80\x9d are not sufficient to protect a person who is lying\nfrom conviction for perjury. To support a charge of perjury, however, the false statement must\nbe \xe2\x80\x9cmaterial,\xe2\x80\x9d meaning that the statement is relevant to whatever the court is trying to find out.\n\nWhite-Collar Crime\nWhite-collar crime, as distinguished from \xe2\x80\x9cstreet crime,\xe2\x80\x9d refers generally to fraud-related acts\ncarried out in a nonviolent way, usually connected with business. Armed bank robbery is not a\nwhite-collar crime, but embezzlement by a teller or bank officer is. Many white-collar crimes are\nincluded within the statutory definitions of embezzlement and false pretenses. Most are\nviolations of state law. Depending on how they are carried out, many of these same crimes are\nalso violations of federal law.\nAny act of fraud in which the United States postal system is used or which involves interstate\nphone calls or Internet connections is a violation of federal law. Likewise, many different acts\naround the buying and selling of securities can run afoul of federal securities laws. Other whitecollar crimes include tax fraud; price fixing; violations of food, drug, and environmental laws;\ncorporate bribery of foreign companies; and\xe2\x80\x94the newest form\xe2\x80\x94computer fraud. Some of these\nare discussed here; others are covered in later chapters.\n\nMail and Wire Fraud\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n227\n\n\x0cFederal law prohibits the use of the mails or any interstate electronic communications medium\nfor the purpose of furthering a \xe2\x80\x9cscheme or artifice to defraud.\xe2\x80\x9d The statute is broad, and it is\nrelatively easy for prosecutors to prove a violation. The law also bans attempts to defraud, so the\nprosecutor need not show that the scheme worked or that anyone suffered any losses. \xe2\x80\x9cFraud\xe2\x80\x9d is\nbroadly construed: anyone who uses the mails or telephone to defraud anyone else of virtually\nanything, not just of money, can be convicted under the law. In one case, a state governor was\nconvicted of mail fraud when he took bribes to influence the setting of racing dates. The court\xe2\x80\x99s\ntheory was that he defrauded the citizenry of its right to his \xe2\x80\x9chonest and faithful services\xe2\x80\x9d as\ngovernor. [1]\n\nViolations of the Food and Drug Act\nThe federal Food, Drug, and Cosmetic Act prohibits any person or corporation from sending\ninto interstate commerce any adulterated or misbranded food, drug, cosmetics, or related\ndevice. For example, in a 2010 case, Allergen had to pay a criminal fine for marketing Botox as a\nheadache or pain reliever, a use that had not been approved by the Food and Drug\nAdministration. Unlike most criminal statutes, willfulness or deliberate misconduct is not an\nelement of the act. As the United States v. Park case (Section 6.7 "Cases") shows, an executive\ncan be held criminally liable even though he may have had no personal knowledge of the\nviolation.\n\nEnvironmental Crimes\nMany federal environmental statutes have criminal provisions. These include the Federal Water\nPollution Control Act (commonly called the Clean Water Act); the Rivers and Harbors Act of\n1899 (the Refuse Act); the Clean Air Act; the Federal Insecticide, Fungicide, and Rodenticide Act\n(FIFRA); the Toxic Substances Control Act (TSCA); and the Resource Conservation and\nRecovery Act (RCRA). Under the Clean Water Act, for example, wrongful discharge of pollutants\ninto navigable waters carries a fine ranging from $2,500 to $25,000 per day and imprisonment\nfor up to one year. \xe2\x80\x9cResponsible corporate officers\xe2\x80\x9d are specifically included as potential\ndefendants in criminal prosecutions under the act. They can include officers who have\nresponsibility over a project where subcontractors and their employees actually caused the\ndischarge.[2]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n228\n\n\x0cViolations of the Foreign Corrupt Practices Act\nAs a byproduct of Watergate, federal officials at the Securities and Exchange Commission and\nthe Internal Revenue Service uncovered many instances of bribes paid by major corporations to\nofficials of foreign governments to win contracts with those governments. Congress responded\nin 1977 with the Foreign Corrupt Practices Act, which imposed a stringent requirement that the\ndisposition of assets be accurately and fairly accounted for in a company\xe2\x80\x99s books and records.\nThe act also made illegal the payment of bribes to foreign officials or to anyone who will\ntransmit the money to a foreign official to assist the payor (the one offering and delivering the\nmoney) in getting business.\n\nViolations of the Racketeering Influenced and Corrupt Organizations Act\nIn 1970 Congress enacted the Racketeering Influenced and Corrupt Organizations Act (RICO),\naimed at ending organized crime\xe2\x80\x99s infiltration into legitimate business. The act tells courts to\nconstrue its language broadly \xe2\x80\x9cto effectuate its remedial purpose,\xe2\x80\x9d and many who are not part of\norganized crime have been successfully prosecuted under the act. It bans a \xe2\x80\x9cpattern of\nracketeering,\xe2\x80\x9d defined as the commission of at least two acts within ten years of any of a variety\nof already-existing crimes, including mail, wire, and securities fraud. The act thus makes many\ntypes of fraud subject to severe penalties.\n\nComputer Crime\nComputer crime generally falls into four categories: (1) theft of money, financial instruments, or\nproperty; (2) misappropriation of computer time; (3) theft of programs; and (4) illegal\nacquisition of information. The main federal statutory framework for many computer crimes is\nthe Computer Fraud and Abuse Act (CFAA; see Table 6.1 "Summary of Provisions of the\nComputer Fraud and Abuse Act"). Congress only prohibited computer fraud and abuse where\nthere was a federal interest, as where computers of the government were involved or where the\ncrime was interstate in nature.\nTable 6.1 Summary of Provisions of the Computer Fraud and Abuse Act\nObtaining national security information\n\nSec. (a)(1)\n\n10 years maximum (20 years second\noffense)\n\nTrespassing in a government computer\n\nSec. (a)(3)\n\n1 year (5)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n229\n\n\x0cCompromising the confidentiality of a\ncomputer\n\nSec. (a)(2)\n\n1 year (10)\n\nAccessing a computer to defraud and obtain\nvalue\n\nSec. (a)4\n\n5 years (10)\n\nIntentional access and reckless damage\n\n(a)(5)(A)(ii) 5 years (20)\n\nTrafficking in passwords\n\n(a)(6)\n\n1 year (10)\n\nKEY TAKEAWAY\nOffenses can be against persons, against property, or against public policy (as when you bribe\na public official, commit perjury, use public goods such as the mails or the Internet to commit\nfraud, or commit other white-collar crimes).\n\nEXERCISES\n\n1. Which does more serious harm to society: street crimes or white-collar crimes?\n2. Why are various crimes so difficult to define precisely?\n3. Hungry Harold goes by the home of Juanita Martinez. Juanita has just finished baking a\ncherry pie and sets it in the open windowsill to cool. Harold smells the pie from the sidewalk.\nIt is twilight; while still light, the sun has officially set. Harold reaches into the window frame\nand removes the pie. Technically, has Harold committed burglary? What are the issues here\nbased on the definition of burglary?\n4. What is fraud? How is it different from dishonesty? Is being dishonest a criminal offense? If\nso, have you been a criminal already today?\n\n[1] United States v. Isaacs, 493 F.2d 1124 (7th Cir. 1974), cert. denied, 417 US 976 (1974).\n[2] U.S. v. Hanousek, 176 F.3d 1116 (9th Cir. 1999).\n\n6.3 The Nature of a Criminal Act\n\nLEARNING OBJECTIVES\n\n1. Understand how it is possible to commit a criminal act without actually doing anything that\nyou think might be criminal.\n2. Analyze and explain the importance of intention in criminal law and criminal prosecutions.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n230\n\n\x0c3. Explain how a corporation can be guilty of a crime, even though it is a corporation\xe2\x80\x99s agents\nthat commit the crime.\nTo be guilty of a crime, you must have acted. Mental desire or intent to do so is insufficient. But\nwhat constitutes an act? This question becomes important when someone begins to commit a\ncrime, or does so in association with others, or intends to do one thing but winds up doing\nsomething else.\n\nAttempt\nIt is not necessary to commit the intended crime to be found guilty of a criminal offense.\nAn attempt to commit the crime is punishable as well, though usually not as severely. For\nexample, Brett points a gun at Ashley, intending to shoot her dead. He pulls the trigger but his\naim is off, and he misses her heart by four feet. He is guilty of an attempt to murder. Suppose,\nhowever, that earlier in the day, when he was preparing to shoot Ashley, Brett had been\noverheard in his apartment muttering to himself of his intention, and that a neighbor called the\npolice. When they arrived, he was just snapping his gun into his shoulder holster.\nAt that point, courts in most states would not consider him guilty of an attempt because he had\nnot passed beyond the stage of preparation. After having buttoned his jacket he might have\nreconsidered and put the gun away. Determining when the accused has passed beyond mere\npreparation and taken an actual step toward perpetrating the crime is often difficult and is\nusually for the jury to decide.\n\nImpossibility\nWhat if a defendant is accused of attempting a crime that is factually impossible? For example,\nsuppose that men believed they were raping a drunken, unconscious woman, and were later\naccused of attempted rape, but defended on the grounds of factual impossibility because the\nwoman was actually dead at the time sexual intercourse took place? Or suppose that a husband\nintended to poison his wife with strychnine in her coffee, but put sugar in the coffee instead?\nThe \xe2\x80\x9cmens rea\xe2\x80\x9d or criminal intent was there, but the act itself was not criminal (rape requires a\nlive victim, and murder by poisoning requires the use of poison). States are divided on this, but\nthirty-seven states have ruled out factual impossibility as a defense to the crime of attempt.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n231\n\n\x0cLegal impossibility is different, and is usually acknowledged as a valid defense. If the defendant\ncompletes all of his intended acts, but those acts do not fulfill all the required elements of a\ncrime, there could be a successful \xe2\x80\x9cimpossibility\xe2\x80\x9d defense. If Barney (who has poor sight), shoots\nat a tree stump, thinking it is his neighbor, Ralph, intending to kill him, has he committed an\nattempt? Many courts would hold that he has not. But the distinction between factual\nimpossibility and legal impossibility is not always clear, and the trend seems to be to punish the\nintended attempt.\n\nConspiracy\nUnder both federal and state laws, it is a separate offense to work with others toward the\ncommission of a crime. When two or more people combine to carry out an unlawful purpose,\nthey are engaged in a conspiracy. The law of conspiracy is quite broad, especially when it is used\nby prosecutors in connection with white-collar crimes. Many people can be swept up in the net\nof conspiracy, because it is unnecessary to show that the actions they took were sufficient to\nconstitute either the crime or an attempt. Usually, the prosecution needs to show only (1) an\nagreement and (2) a single overt act in furtherance of the conspiracy. Thus if three people agree\nto rob a bank, and if one of them goes to a store to purchase a gun to be used in the holdup, the\nthree can be convicted of conspiracy to commit robbery. Even the purchase of an automobile to\nbe used as the getaway car could support a conspiracy conviction.\nThe act of any one of the conspirators is imputed to the other members of the conspiracy. It does\nnot matter, for instance, that only one of the bank robbers fired the gun that killed a guard. All\ncan be convicted of murder. That is so even if one of the conspirators was stationed as a lookout\nseveral blocks away and even if he specifically told the others that his agreement to cooperate\nwould end \xe2\x80\x9cjust as soon as there is shooting.\xe2\x80\x9d\n\nAgency and Corporations\nA person can be guilty of a crime if he acts through another. Again, the usual reason for\n\xe2\x80\x9cimputing\xe2\x80\x9d the guilt of the actor to another is that both were engaged in a conspiracy. But\nimputation of guilt is not limited to a conspiracy. The agent may be innocent even though he\nparticipates. A corporate officer directs a junior employee to take a certain bag and deliver it to\nthe officer\xe2\x80\x99s home. The employee reasonably believes that the officer is entitled to the bag.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n232\n\n\x0cUnbeknownst to the employee, the bag contains money that belongs to the company, and the\nofficer wishes to keep it. This is not a conspiracy. The employee is not guilty of larceny, but the\nofficer is, because the agent\xe2\x80\x99s act is imputed to him.\nSince intent is a necessary component of crime, an agent\xe2\x80\x99s intent cannot be imputed to his\nprincipal if the principal did not share the intent. The company president tells her sales\nmanager, \xe2\x80\x9cGo make sure our biggest customer renews his contract for next year\xe2\x80\x9d\xe2\x80\x94by which she\nmeant, \xe2\x80\x9cDon\xe2\x80\x99t ignore our biggest customer.\xe2\x80\x9d Standing before the customer\xe2\x80\x99s purchasing agent,\nthe sales manager threatens to tell the purchasing agent\xe2\x80\x99s boss that the purchasing agent has\nbeen cheating on his expense account, unless he signs a new contract. The sales manager could\nbe convicted of blackmail, but the company president could not.\nCan a corporation be guilty of a crime? For many types of crimes, the guilt of individual\nemployees may be imputed to the corporation. Thus the antitrust statutes explicitly state that\nthe corporation may be convicted and fined for violations by employees. This is so even though\nthe shareholders are the ones who ultimately must pay the price\xe2\x80\x94and who may have had\nnothing to do with the crime nor the power to stop it. The law of corporate criminal\nresponsibility has been changing in recent years. The tendency is to hold the corporation liable\nunder criminal law if the act has been directed by a responsible officer or group within the\ncorporation (the president or board of directors).\n\nKEY TAKEAWAY\n\nAlthough proving the intent to commit a crime (the mens rea) is essential, the intent can be\nestablished by inference (circumstantially). Conspirators may not actually commit a crime, for\nexample, but in preparing for a criminal act, they may be guilty of the crime of conspiracy.\nCertain corporate officers, as well, may not be directly committing criminal acts but may be\nheld criminally responsible for acts of their agents and contractors.\n\nEXERCISES\n\n1. Give an example of how someone can intend to commit a crime but fail to commit one.\n2. Describe a situation where there is a conspiracy to commit a crime without the crime actually\ntaking place.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n233\n\n\x0c3. Create a scenario based on current events where a corporation could be found guilty of\ncommitting a crime even though the CEO, the board of directors, and the shareholders have\nnot themselves done a criminal act.\n\n6.4 Responsibility\n\nLEARNING OBJECTIVES\n\n1. Explain why criminal law generally requires that the defendant charged with a crime have\ncriminal "intent."\n2. Know and explain the possible excuses relating to responsibility that are legally recognized by\ncourts, including lack of capacity.\n\nIn General\nThe mens rea requirement depends on the nature of the crime and all the circumstances\nsurrounding the act. In general, though, the requirement means that the accused must in some\nway have intended the criminal consequences of his act. Suppose, for example, that Charlie gives\nGabrielle a poison capsule to swallow. That is the act. If Gabrielle dies, is Charlie guilty of\nmurder? The answer depends on what his state of mind was. Obviously, if he gave it to her\nintending to kill her, the act was murder.\nWhat if he gave it to her knowing that the capsule was poison but believing that it would only\nmake her mildly ill? The act is still murder, because we are all liable for the consequences of any\nintentional act that may cause harm to others. But suppose that Gabrielle had asked Harry for\naspirin, and he handed her two pills that he reasonably believed to be aspirin (they came from\nthe aspirin bottle and looked like aspirin) but that turned out to be poison, the act would not be\nmurder, because he had neither intent nor a state of knowledge from which intent could be\ninferred.\nNot every criminal law requires criminal intent as an ingredient of the crime. Many regulatory\ncodes dealing with the public health and safety impose strict requirements. Failure to adhere to\nsuch requirements is a violation, whether or not the violator had mens rea. The United States v.\nPark case, Section 6.7 "Cases", a decision of the US Supreme Court, shows the different\nconsiderations involved in mens rea.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n234\n\n\x0cExcuses That Limit or Overcome Responsibility\nMistake of Fact and Mistake of Law\nOrdinarily, ignorance of the law is not an excuse. If you believe that it is permissible to turn\nright on a red light but the city ordinance prohibits it, your belief, even if reasonable, does not\nexcuse your violation of the law. Under certain circumstances, however, ignorance of law will be\nexcused. If a statute imposes criminal penalties for an action taken without a license, and if the\ngovernment official responsible for issuing the license formally tells you that you do not need\none (though in fact you do), a conviction for violating the statute cannot stand. In rare cases, a\nlawyer\xe2\x80\x99s advice, contrary to the statute, will be held to excuse the client, but usually the client is\nresponsible for his attorney\xe2\x80\x99s mistakes. Otherwise, as it is said, the lawyer would be superior to\nthe law.\nIgnorance or mistake of fact more frequently will serve as an excuse. If you take a coat from a\nrestaurant, believing it to be yours, you cannot be convicted of larceny if it is not. Your honest\nmistake of fact negates the requisite intent. In general, the rule is that a mistaken belief of fact\nwill excuse criminal responsibility if (1) the belief is honestly held, (2) it is reasonable to hold it,\nand (3) the act would not have been criminal if the facts were as the accused supposed them to\nhave been.\n\nEntrapment\nOne common technique of criminal investigation is the use of an undercover agent or decoy\xe2\x80\x94the\npoliceman who poses as a buyer of drugs from a street dealer or the elaborate \xe2\x80\x9csting\xe2\x80\x9d operations\nin which ostensibly stolen goods are \xe2\x80\x9csold\xe2\x80\x9d to underworld \xe2\x80\x9cfences.\xe2\x80\x9d Sometimes these methods\nare the only way by which certain kinds of crime can be rooted out and convictions secured.\nBut a rule against entrapment limits the legal ability of the police to play the role of criminals.\nThe police are permitted to use such techniques to detect criminal activity; they are not\npermitted to do so to instigate crime. The distinction is usually made between a person who\nintends to commit a crime and one who does not. If the police provide the former with an\nopportunity to commit a criminal act\xe2\x80\x94the sale of drugs to an undercover agent, for example\xe2\x80\x94\nthere is no defense of entrapment. But if the police knock on the door of one not known to be a\ndrug user and persist in a demand that he purchase drugs from them, finally overcoming his will\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n235\n\n\x0cto resist, a conviction for purchase and possession of drugs can be overturned on the ground of\nentrapment.\n\nOther Excuses\nA number of other circumstances can limit or excuse criminal liability. These include\ncompulsion (a gun pointed at one\xe2\x80\x99s head by a masked man who apparently is unafraid to use the\nweapon and who demands that you help him rob a store), honest consent of the \xe2\x80\x9cvictim\xe2\x80\x9d (the\nquarterback who is tackled), adherence to the requirements of legitimate public authority\nlawfully exercised (a policeman directs a towing company to remove a car parked in a tow-away\nzone), the proper exercise of domestic authority (a parent may spank a child, within limits), and\ndefense of self, others, property, and habitation. Each of these excuses is a complex subject in\nitself.\n\nLack of Capacity\nA further defense to criminal prosecution is the lack of mental capacity to commit the crime.\nInfants and children are considered incapable of committing a crime; under common law any\nchild under the age of seven could not be prosecuted for any act. That age of incapacity varies\nfrom state to state and is now usually defined by statutes. Likewise, insanity or mental disease or\ndefect can be a complete defense. Intoxication can be a defense to certain crimes, but the mere\nfact of drunkenness is not ordinarily sufficient.\n\nKEY TAKEAWAY\n\nIn the United States, some crimes can be committed by not following strict regulatory\nrequirements for health, safety, or the environment. The law does provide excuses from\ncriminal liability for mistakes of fact, entrapment, and lack of capacity.\n\nEXERCISES\n\n1. Describe several situations in which compulsion, consent, or other excuses take away\ncriminal liability.\n2. Your employee is drunk on the job and commits the crime of assault and battery on a\ncustomer. He claims lack of capacity as an excuse. Should the courts accept this excuse? Why\nor why not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n236\n\n\x0c6.5 Procedure\n\nLEARNING OBJECTIVES\n\n1. Describe the basic steps in pretrial criminal procedure that follow a government\'s\ndetermination to arrest someone for an alleged criminal act.\n2. Describe the basic elements of trial and posttrial criminal procedure.\nThe procedure for criminal prosecutions is complex. Procedures will vary from state to state. A\ncriminal case begins with an arrest if the defendant is caught in the act or fleeing from the scene;\nif the defendant is not caught, a warrant for the defendant\xe2\x80\x99s arrest will issue. The warrant is\nissued by a judge or a magistrate upon receiving a complaint detailing the charge of a specific\ncrime against the accused. It is not enough for a police officer to go before a judge and say, \xe2\x80\x9cI\xe2\x80\x99d\nlike you to arrest Bonnie because I think she\xe2\x80\x99s just murdered Clyde.\xe2\x80\x9d She must supply enough\ninformation to satisfy the magistrate that there is probable cause (reasonable grounds) to\nbelieve that the accused committed the crime. The warrant will be issued to any officer or agency\nthat has power to arrest the accused with warrant in hand.\nThe accused will be brought before the magistrate for a preliminary hearing. The purpose of the\nhearing is to determine whether there is sufficient reason to hold the accused for trial. If so, the\naccused can be sent to jail or be permitted to make bail. Bail is a sum of money paid to the court\nto secure the defendant\xe2\x80\x99s attendance at trial. If he fails to appear, he forfeits the money.\nConstitutionally, bail can be withheld only if there is reason to believe that the accused will flee\nthe jurisdiction.\nOnce the arrest is made, the case is in the hands of the prosecutor. In the fifty states,\nprosecution is a function of the district attorney\xe2\x80\x99s office. These offices are usually organized on a\ncounty-by-county basis. In the federal system, criminal prosecution is handled by the office of\nthe US attorney, one of whom is appointed for every federal district.\nFollowing the preliminary hearing, the prosecutor must either file an information (a document\nstating the crime of which the person being held is accused) or ask thegrand jury for\nan indictment. The grand jury consists of twenty-three people who sit to determine whether\nthere is sufficient evidence to warrant a prosecution. It does not sit to determine guilt or\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n237\n\n\x0cinnocence. The indictment is the grand jury\xe2\x80\x99s formal declaration of charges on which the\naccused will be tried. If indicted, the accused formally becomes a defendant.\nThe defendant will then be arraigned, that is, brought before a judge to answer the accusation in\nthe indictment. The defendant may plead guilty or not guilty. If he pleads not guilty, the case will\nbe tried before a jury (sometimes referred to as a petit jury). The jury cannot convict unless it\nfinds the defendant guilty beyond a reasonable doubt.\nThe defendant might have pleaded guilty to the offense or to a lesser charge (often referred to as\na \xe2\x80\x9clesser included offense\xe2\x80\x9d\xe2\x80\x94simple larceny, for example, is a lesser included offense of robbery\nbecause the defendant may not have used violence but nevertheless stole from the victim). Such\na plea is usually arranged throughplea bargaining with the prosecution. In return for the plea,\nthe prosecutor promises to recommend to the judge that the sentence be limited. The judge\nmost often, but not always, goes along with the prosecutor\xe2\x80\x99s recommendation.\nThe defendant is also permitted to file a plea of nolo contendere (no contest) in prosecutions for\ncertain crimes. In so doing, he neither affirms nor denies his guilt. He may be sentenced as\nthough he had pleaded guilty, although usually a nolo plea is the result of a plea bargain. Why\nplead nolo? In some offenses, such as violations of the antitrust laws, the statutes provide that\nprivate plaintiffs may use a conviction or a guilty plea as proof that the defendant violated the\nlaw. This enables a plaintiff to prove liability without putting on witnesses or evidence and\nreduces the civil trial to a hearing about the damages to plaintiff. The nolo plea permits the\ndefendant to avoid this, so that any plaintiff will have to not only prove damages but also\nestablish civil liability.\nFollowing a guilty plea or a verdict of guilt, the judge will impose a sentence after presentencing\nreports are written by various court officials (often, probation officers). Permissible sentences\nare spelled out in statutes, though these frequently give the judge a range within which to work\n(e.g., twenty years to life). The judge may sentence the defendant to imprisonment, a fine, or\nboth, or may decide to suspend sentence (i.e., the defendant will not have to serve the sentence\nas long as he stays out of trouble).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n238\n\n\x0cSentencing usually comes before appeal. As in civil cases, the defendant, now convicted, has the\nright to take at least one appeal to higher courts, where issues of procedure and constitutional\nrights may be argued.\n\nKEY TAKEAWAY\n\nCriminal procedure in US courts is designed to provide a fair process to both criminal\ndefendants and to society. The grand jury system, prosecutorial discretion, plea bargains, and\nappeals for lack of a fair trial are all part of US criminal procedure.\n\nEXERCISES\n\n1. Harold is charged with the crime of assault with a deadly weapon with intent to kill or inflict\nserious bodily injury. It is a more serious crime than simple assault. Harold\xe2\x80\x99s attorney wants\nthe prosecutor to give Harold a break, but Harold is guilty of at least simple assault and may\nalso have had the intent to kill. What is Harold\xe2\x80\x99s attorney likely to do?\n2. Kumar was driving his car, smoking marijuana, and had an accident with another vehicle. The\nother driver was slightly injured. When the officer arrived, she detected a strong odor of\nmarijuana in Kumar\xe2\x80\x99s car and a small amount of marijuana in the glove compartment. The\nother driver expects to bring a civil action against Kumar for her injuries after Kumar\xe2\x80\x99s\ncriminal case. What should Kumar plead in the criminal case\xe2\x80\x94careless driving or driving\nunder the influence?\n\n6.6 Constitutional Rights of the Accused\nLEARNING OBJECTIVES\n\n1. Describe the most significant constitutional rights of defendants in US courts, and name the\nsource of these rights.\n2. Explain the Exclusionary rule and the reason for its existence.\n\nSearch and Seizure\nThe rights of those accused of a crime are spelled out in four of the ten constitutional\namendments that make up the Bill of Rights (Amendments Four, Five, Six, and Eight). For the\nmost part, these amendments have been held to apply to both the federal and the state\ngovernments. The Fourth Amendment says in part that \xe2\x80\x9cthe right of the people to be secure in\ntheir persons, houses, papers, and effects, against unreasonable searches and seizures, shall not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n239\n\n\x0cbe violated.\xe2\x80\x9d Although there are numerous and tricky exceptions to the general rule, ordinarily\nthe police may not break into a person\xe2\x80\x99s house or confiscate his papers or arrest him unless they\nhave a warrant to do so. This means, for instance, that a policeman cannot simply stop you on a\nstreet corner and ask to see what is in your pockets (a power the police enjoy in many other\ncountries), nor can your home be raided without probable cause to believe that you have\ncommitted a crime. What if the police do search or seize unreasonably?\nThe courts have devised a remedy for the use at trial of the fruits of an unlawful search or\nseizure. Evidence that is unconstitutionally seized is excluded from the trial. This is the so-called\nexclusionary rule, first made applicable in federal cases in 1914 and brought home to the states\nin 1961. The exclusionary rule is highly controversial, and there are numerous exceptions to it.\nBut it remains generally true that the prosecutor may not use evidence willfully taken by the\npolice in violation of constitutional rights generally, and most often in the violation of Fourth\nAmendment rights. (The fruits of a coerced confession are also excluded.)\n\nDouble Jeopardy\nThe Fifth Amendment prohibits the government from prosecuting a person twice for the same\noffense. The amendment says that no person shall be \xe2\x80\x9csubject for the same offence to be twice\nput in jeopardy of life or limb.\xe2\x80\x9d If a defendant is acquitted, the government may not appeal. If a\ndefendant is convicted and his conviction is upheld on appeal, he may not thereafter be\nreprosecuted for the same crime.\n\nSelf-Incrimination\nThe Fifth Amendment is also the source of a person\xe2\x80\x99s right against self-incrimination (no person\n\xe2\x80\x9cshall be compelled in any criminal case to be a witness against himself\xe2\x80\x9d). The debate over the\nlimits of this right has given rise to an immense literature. In broadest outline, the right against\nself-incrimination means that the prosecutor may not call a defendant to the witness stand\nduring trial and may not comment to the jury on the defendant\xe2\x80\x99s failure to take the stand.\nMoreover, a defendant\xe2\x80\x99s confession must be excluded from evidence if it was not voluntarily\nmade (e.g., if the police beat the person into giving a confession). In Miranda v. Arizona, the\nSupreme Court ruled that no confession is admissible if the police have not first advised a\nsuspect of his constitutional rights, including the right to have a lawyer present to advise him\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n240\n\n\x0cduring the questioning. [1] These so-called Miranda warnings have prompted scores of follow-up\ncases that have made this branch of jurisprudence especially complex.\n\nSpeedy Trial\nThe Sixth Amendment tells the government that it must try defendants speedily. How long a\ndelay is too long depends on the circumstances in each case. In 1975, Congress enacted the\nSpeedy Trial Act to give priority to criminal cases in federal courts. It requires all criminal\nprosecutions to go to trial within seventy-five days (though the law lists many permissible\nreasons for delay).\n\nCross-Examination\nThe Sixth Amendment also says that the defendant shall have the right to confront witnesses\nagainst him. No testimony is permitted to be shown to the jury unless the person making it is\npresent and subject to cross-examination by the defendant\xe2\x80\x99s counsel.\n\nAssistance of Counsel\nThe Sixth Amendment guarantees criminal defendants the right to have the assistance of\ndefense counsel. During the eighteenth century and before, the British courts frequently refused\nto permit defendants to have lawyers in the courtroom during trial. The right to counsel is much\nbroader in this country, as the result of Supreme Court decisions that require the state to pay for\na lawyer for indigent defendants in most criminal cases.\n\nCruel and Unusual Punishment\nPunishment under the common law was frequently horrifying. Death was a common\npunishment for relatively minor crimes. In many places throughout the world, punishments still\npersist that seem cruel and unusual, such as the practice of stoning someone to death. The\nguillotine, famously in use during and after the French Revolution, is no longer used, nor are\ndefendants put in stocks for public display and humiliation. In pre-Revolutionary America, an\nunlucky defendant who found himself convicted could face brutal torture before death.\nThe Eighth Amendment banned these actions with the words that \xe2\x80\x9ccruel and unusual\npunishments [shall not be] inflicted.\xe2\x80\x9d Virtually all such punishments either never were enacted\nor have been eliminated from the statute books in the United States. Nevertheless, the Eighth\nAmendment has become a source of controversy, first with the Supreme Court\xe2\x80\x99s ruling in 1976\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n241\n\n\x0cthat the death penalty, as haphazardly applied in the various states, amounted to cruel and\nunusual punishment. Later Supreme Court opinions have made it easier for states to administer\nthe death penalty. As of 2010, there were 3,300 defendants on death row in the United States.\nOf course, no corporation is on death row, and no corporation\xe2\x80\x99s charter has ever been revoked\nby a US state, even though some corporations have repeatedly been indicted and convicted of\ncriminal offenses.\n\nPresumption of Innocence\nThe most important constitutional right in the US criminal justice system is the presumption of\ninnocence. The Supreme Court has repeatedly cautioned lower courts in the United States that\njuries must be properly instructed that the defendant is innocent until proven guilty. This is the\norigin of the \xe2\x80\x9cbeyond all reasonable doubt\xe2\x80\x9d standard of proof and is an instruction given to\njuries in each criminal case. The Fifth Amendment notes the right of \xe2\x80\x9cdue process\xe2\x80\x9d in federal\nproceedings, and the Fourteenth Amendment requires that each state provide \xe2\x80\x9cdue process\xe2\x80\x9d to\ndefendants.\n\nKEY TAKEAWAY\n\nThe US Constitution provides several important protections for criminal defendants,\nincluding a prohibition on the use of evidence that has been obtained by unconstitutional\nmeans. This would include evidence seized in violation of the Fourth Amendment and\nconfessions obtained in violation of the Fifth Amendment.\n\nEXERCISES\n\n1. Do you think it is useful to have a presumption of innocence in criminal cases? What if there\nwere not a presumption of innocence in criminal cases?\n2. Do you think public humiliation, public execution, and unusual punishments would reduce\nthe amount of crime? Why do you think so?\n3. \xe2\x80\x9cDue process\xe2\x80\x9d is another phrase for \xe2\x80\x9cfairness.\xe2\x80\x9d Why should the public show fairness toward\ncriminal defendants?\n\n[1] Miranda v. Arizona, 384 US 436 (1966).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n242\n\n\x0c6.7 Cases\nFalse Pretenses\nState v. Mills\n96 Ariz. 377, 396 P.2d 5 (Ariz. 1964)\nLOCKWOOD, VICE CHIEF JUSTICE\nDefendants appeal from a conviction on two counts of obtaining money by false pretenses in\nviolation of AR.S. \xc2\xa7\xc2\xa7 13-661.A3. and 13-663.A1. The material facts, viewed \xe2\x80\x9c\xe2\x80\xa6in the light most\nfavorable to sustaining the conviction,\xe2\x80\x9d are as follows: Defendant William Mills was a builder\nand owned approximately 150 homes in Tucson in December, 1960. Mills conducted his\nbusiness in his home. In 1960 defendant Winifred Mills, his wife, participated in the business\ngenerally by answering the telephone, typing, and receiving clients who came to the office.\nIn December 1960, Mills showed the complainant, Nathan Pivowar, a house at 1155 Knox Drive\nand another at 1210 Easy Street, and asked Pivowar if he would loan money on the Knox Drive\nhouse. Pivowar did not indicate at that time whether he would agree to such a transaction. Later\nin the same month Nathan Pivowar told the defendants that he and his brother, Joe Pivowar,\nwould loan $5,000 and $4,000 on the two houses. Three or four days later Mrs. Mills, at\nPivowar\xe2\x80\x99s request, showed him these homes again.\nMills had prepared two typed mortgages for Pivowar. Pivowar objected to the wording, so in\nMills\xe2\x80\x99 office Mrs. Mills retyped the mortgages under Pivowar\xe2\x80\x99s dictation. After the mortgages\nhad been recorded on December 31, 1960, Pivowar gave Mills a bank check for $5,791.87, some\ncash, and a second mortgage formerly obtained from Mills in the approximate sum of $3,000.\nIn exchange Mills gave Pivowar two personal notes in the sums of $5,250.00 and $4,200.00 and\nthe two mortgages as security for the loan.\nAlthough the due date for Mills\xe2\x80\x99 personal notes passed without payment being made, the\ncomplainant did not present the notes for payment, did not demand that they be paid, and did\nnot sue upon them. In 1962 the complainant learned that the mortgages which he had taken as\nsecurity in the transaction were not first mortgages on the Knox Drive and Easy Street\nproperties. These mortgages actually covered two vacant lots on which there were outstanding\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n243\n\n\x0csenior mortgages. On learning this, Pivowar signed a complaint charging the defendants with\nthe crime of theft by false pretenses.\nOn appeal defendants contend that the trial court erred in denying their motion to dismiss the\ninformation. They urge that a permanent taking of property must be proved in order to establish\nthe crime of theft. Since the complainant had the right to sue on the defendants\xe2\x80\x99 notes, the\ndefendants assert that complainant cannot be said to have been deprived of his property\npermanently. Defendants misconceive the elements of the crime of theft by false pretenses.\nStated in a different form, their argument is that although the complainant has parted with his\ncash, a bank check, and a second mortgage, the defendants intend to repay the loan.\nDefendants admit that the proposition of law which they assert is a novel one in this jurisdiction.\nRespectable authority in other states persuades us that their contention is without merit. A\ncreditor has a right to determine for himself whether he wishes to be a secured or an unsecured\ncreditor. In the former case, he has a right to know about the security. If he extends credit in\nreliance upon security which is falsely represented to be adequate, he has been defrauded even if\nthe debtor intends to repay the debt. His position is now that of an unsecured creditor. At the\nvery least, an unreasonable risk of loss has been forced upon him by reason of the deceit. This\nrisk which he did not intend to assume has been imposed upon him by the intentional act of the\ndebtor, and such action constitutes an intent to defraud.\n***\nThe cases cited by defendants in support of their contention are distinguishable from the instant\ncase in that they involved theft by larceny. Since the crime of larceny is designed to protect a\nperson\xe2\x80\x99s possessory interest in property whereas the crime of false pretenses protects one\xe2\x80\x99s title\ninterest, the requirement of a permanent deprivation is appropriate to the former. Accordingly,\nwe hold that an intent to repay a loan obtained on the basis of a false representation of the\nsecurity for the loan is no defense.\n***\nAffirmed in part, reversed in part, and remanded for resentencing.\n\nCASE QUESTIONS\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n244\n\n\x0c1. False pretenses is a crime of obtaining ownership of property of another by making untrue\nrepresentations of fact with intent to defraud. What were the untrue representations of fact\nmade by Mills?\n2. Concisely state the defendant\xe2\x80\x99s argument as to why Pivowar has not been deprived of any\nproperty.\n3. If Pivowar had presented the notes and Mills had paid, would a crime have been committed?\n\nWhite-Collar Crimes\nUnited States v. Park\n421 U.S. 658 (1975)\nMR. CHIEF JUSTICE BURGER delivered the opinion of the Court.\nWe granted certiorari to consider whether the jury instructions in the prosecution of a corporate\nofficer under \xc2\xa7 301 (k) of the Federal Food, Drug, and Cosmetic Act, 52 Stat. 1042, as amended,\n21 U.S.C. \xc2\xa7 331 (k), were appropriate under United States v. Dotterweich, 320 U.S. 277 (1943).\nAcme Markets, Inc., is a national retail food chain with approximately 36,000 employees, 874\nretail outlets, 12 general warehouses, and four special warehouses. Its headquarters, including\nthe office of the president, respondent Park, who is chief executive officer of the corporation, are\nlocated in Philadelphia, Pennsylvania. In a five-count information filed in the United States\nDistrict Court for the District of Maryland, the Government charged Acme and respondent with\nviolations of the Federal Food, Drug, and Cosmetic Act. Each count of the information alleged\nthat the defendants had received food that had been shipped in interstate commerce and that,\nwhile the food was being held for sale in Acme\xe2\x80\x99s Baltimore warehouse following shipment in\ninterstate commerce, they caused it to be held in a building accessible to rodents and to be\nexposed to contamination by rodents. These acts were alleged to have resulted in the food\xe2\x80\x99s\nbeing adulterated within the meaning of 21 U.S.C. \xc2\xa7\xc2\xa7 342 (a)(3) and (4), in violation of 21 U.S.C.\n\xc2\xa7 331 (k).\nAcme pleaded guilty to each count of the information. Respondent pleaded not guilty. The\nevidence at trial demonstrated that in April 1970 the Food and Drug Administration (FDA)\nadvised respondent by letter of insanitary conditions in Acme\xe2\x80\x99s Philadelphia warehouse. In 1971\nthe FDA found that similar conditions existed in the firm\xe2\x80\x99s Baltimore warehouse. An FDA\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n245\n\n\x0cconsumer safety officer testified concerning evidence of rodent infestation and other insanitary\nconditions discovered during a 12-day inspection of the Baltimore warehouse in November and\nDecember 1971. He also related that a second inspection of the warehouse had been conducted\nin March 1972. On that occasion the inspectors found that there had been improvement in the\nsanitary conditions, but that \xe2\x80\x9cthere was still evidence of rodent activity in the building and in the\nwarehouses and we found some rodent-contaminated lots of food items.\xe2\x80\x9d\nThe Government also presented testimony by the Chief of Compliance of the FDA\xe2\x80\x99s Baltimore\noffice, who informed respondent by letter of the conditions at the Baltimore warehouse after the\nfirst inspection. There was testimony by Acme\xe2\x80\x99s Baltimore division vice president, who had\nresponded to the letter on behalf of Acme and respondent and who described the steps taken to\nremedy the insanitary conditions discovered by both inspections. The Government\xe2\x80\x99s final\nwitness, Acme\xe2\x80\x99s vice president for legal affairs and assistant secretary, identified respondent as\nthe president and chief executive officer of the company and read a bylaw prescribing the duties\nof the chief executive officer. He testified that respondent functioned by delegating \xe2\x80\x9cnormal\noperating duties\xe2\x80\x9d including sanitation, but that he retained \xe2\x80\x9ccertain things, which are the big,\nbroad, principles of the operation of the company and had \xe2\x80\x9cthe responsibility of seeing that they\nall work together.\xe2\x80\x9d\nAt the close of the Government\xe2\x80\x99s case in chief, respondent moved for a judgment of acquittal on\nthe ground that \xe2\x80\x9cthe evidence in chief has shown that Mr. Park is not personally concerned in\nthis Food and Drug violation.\xe2\x80\x9d The trial judge denied the motion, stating that United States v.\nDotterweich, 320 U.S. 277 (1943), was controlling.\nRespondent was the only defense witness. He testified that, although all of Acme\xe2\x80\x99s employees\nwere in a sense under his general direction, the company had an \xe2\x80\x9corganizational structure for\nresponsibilities for certain functions\xe2\x80\x9d according to which different phases of its operation were\n\xe2\x80\x9cassigned to individuals who, in turn, have staff and departments under them.\xe2\x80\x9d He identified\nthose individuals responsible for sanitation, and related that upon receipt of the January 1972\nFDA letter, he had conferred with the vice president for legal affairs, who informed him that the\nBaltimore division vice president \xe2\x80\x9cwas investigating the situation immediately and would be\ntaking corrective action and would be preparing a summary of the corrective action to reply to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n246\n\n\x0cthe letter.\xe2\x80\x9d Respondent stated that he did not \xe2\x80\x9cbelieve there was anything [he] could have done\nmore constructively than what [he] found was being done.\xe2\x80\x9d\nOn cross-examination, respondent conceded that providing sanitary conditions for food offered\nfor sale to the public was something that he was \xe2\x80\x9cresponsible for in the entire operation of the\ncompany\xe2\x80\x9d and he stated that it was one of many phases of the company that he assigned to\n\xe2\x80\x9cdependable subordinates.\xe2\x80\x9d Respondent was asked about and, over the objections of his counsel,\nadmitted receiving, the April 1970 letter addressed to him from the FDA regarding insanitary\nconditions at Acme\xe2\x80\x99s Philadelphia warehouse. He acknowledged that, with the exception of the\ndivision vice president, the same individuals had responsibility for sanitation in both Baltimore\nand Philadelphia. Finally, in response to questions concerning the Philadelphia and Baltimore\nincidents, respondent admitted that the Baltimore problem indicated the system for handling\nsanitation \xe2\x80\x9cwasn\xe2\x80\x99t working perfectly\xe2\x80\x9d and that as Acme\xe2\x80\x99s chief executive officer he was\n\xe2\x80\x9cresponsible for any result which occurs in our company.\xe2\x80\x9d\nAt the close of the evidence, respondent\xe2\x80\x99s renewed motion for a judgment of acquittal was\ndenied. The relevant portion of the trial judge\xe2\x80\x99s instructions to the jury challenged by\nrespondent is set out in the margin. Respondent\xe2\x80\x99s counsel objected to the instructions on the\nground that they failed fairly to reflect our decision in United States v. Dotterweich supra, and\nto define \xe2\x80\x9c\xe2\x80\x98responsible relationship.\xe2\x80\x99\xe2\x80\x9d The trial judge overruled the objection. The jury found\nrespondent guilty on all counts of the information, and he was subsequently sentenced to pay a\nfine of $50 on each count. The Court of Appeals reversed the conviction and remanded for a new\ntrial.\n***\nThe question presented by the Government\xe2\x80\x99s petition for certiorari in United States v.\nDotterweich, and the focus of this Court\xe2\x80\x99s opinion, was whether the manager of a corporation, as\nwell as the corporation itself, may be prosecuted under the Federal Food, Drug, and Cosmetic\nAct of 1938 for the introduction of misbranded and adulterated articles into interstate\ncommerce. In Dotterweich, a jury had disagreed as to the corporation, a jobber purchasing\ndrugs from manufacturers and shipping them in interstate commerce under its own label, but\nhad convicted Dotterweich, the corporation\xe2\x80\x99s president and general manager. The Court of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n247\n\n\x0cAppeals reversed the conviction on the ground that only the drug dealer, whether corporation or\nindividual, was subject to the criminal provisions of the Act, and that where the dealer was a\ncorporation, an individual connected therewith might be held personally only if he was\noperating the corporation as his \xe2\x80\x98alter ego.\xe2\x80\x99\nIn reversing the judgment of the Court of Appeals and reinstating Dotterweich\xe2\x80\x99s conviction, this\nCourt looked to the purposes of the Act and noted that they \xe2\x80\x9ctouch phases of the lives and health\nof people which, in the circumstances of modern industrialism, are largely beyond selfprotection. It observed that the Act is of \xe2\x80\x9ca now familiar type\xe2\x80\x9d which \xe2\x80\x9cdispenses with the\nconventional requirement for criminal conduct-awareness of some wrongdoing: In the interest\nof the larger good it puts the burden of acting at hazard upon a person otherwise innocent but\nstanding in responsible relation to a public danger. Central to the Court\xe2\x80\x99s conclusion that\nindividuals other than proprietors are subject to the criminal provisions of the Act was the\nreality that the only way in which a corporation can act is through the individuals, who act on its\nbehalf.\n***\nThe Court recognized that, because the Act dispenses with the need to prove \xe2\x80\x9cconsciousness of\nwrongdoing,\xe2\x80\x9d it may result in hardship even as applied to those who share \xe2\x80\x9cresponsibility in the\nbusiness process resulting in\xe2\x80\x9d a violation.\xe2\x80\xa6The rule that corporate employees who have \xe2\x80\x9ca\nresponsible share in the furtherance of the transaction which the statute outlaws\xe2\x80\x9d are subject to\nthe criminal provisions of the Act was not formulated in a vacuum. Cf. Morissette v. United\nStates, 342 U.S. 246, 258 (1952). Cases under the Federal Food and Drugs Act of 1906 reflected\nthe view both that knowledge or intent were not required to be proved in prosecutions under its\ncriminal provisions, and that responsible corporate agents could be subjected to the liability\nthereby imposed.\n***\nThe rationale of the interpretation given the Act in Dotterweich\xe2\x80\xa6has been confirmed in our\nsubsequent cases. Thus, the Court has reaffirmed the proposition that the public interest in the\npurity of its food is so great as to warrant the imposition of the highest standard of care on\ndistributors.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n248\n\n\x0cThus Dotterweich and the cases which have followed reveal that in providing sanctions which\nreach and touch the individuals who execute the corporate mission\xe2\x80\x94and this is by no means\nnecessarily confined to a single corporate agent or employee\xe2\x80\x94the Act imposes not only a\npositive duty to seek out and remedy violations when they occur but also, and primarily, a duty\nto implement measures that will insure that violations will not occur. The requirements of\nforesight and vigilance imposed on responsible corporate agents are beyond question\ndemanding, and perhaps onerous, but they are no more stringent than the public has a right to\nexpect of those who voluntarily assume positions of authority in business enterprises whose\nservices and products affect the health and well-being of the public that supports them.\n***\nReading the entire charge satisfies us that the jury\xe2\x80\x99s attention was adequately focused on the\nissue of respondent\xe2\x80\x99s authority with respect to the conditions that formed the basis of the\nalleged violations. Viewed as a whole, the charge did not permit the jury to find guilt solely on\nthe basis of respondent\xe2\x80\x99s position in the corporation; rather, it fairly advised the jury that to find\nguilt it must find respondent \xe2\x80\x9chad a responsible relation to the situation,\xe2\x80\x9d and \xe2\x80\x9cby virtue of his\nposition\xe2\x80\xa6had\xe2\x80\xa6authority and responsibility\xe2\x80\x9d to deal with the situation.\nThe situation referred to could only be \xe2\x80\x9cfood\xe2\x80\xa6held in unsanitary conditions in a warehouse with\nthe result that it consisted, in part, of filth or\xe2\x80\xa6may have been contaminated with filth.\xe2\x80\x9d\nOur conclusion that the Court of Appeals erred in its reading of the jury charge suggests as well\nour disagreement with that court concerning the admissibility of evidence demonstrating that\nrespondent was advised by the FDA in 1970 of insanitary conditions in Acme\xe2\x80\x99s Philadelphia\nwarehouse. We are satisfied that the Act imposes the highest standard of care and permits\nconviction of responsible corporate officials who, in light of this standard of care, have the\npower to prevent or correct violations of its provisions.\n***\nReversed.\n\nCASE QUESTIONS\n\n1. Did Park have criminal intent to put adulterated food into commerce? If not, how can Park\xe2\x80\x99s\nconduct be criminalized?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n249\n\n\x0c2. To get a conviction, what does the prosecutor have to show, other than that Park was the\nCEO of Acme and therefore responsible for what his company did or didn\xe2\x80\x99t do?\n\n6.8 Summary and Exercises\nSummary\n\nCriminal law is that branch of law governing offenses against society. Most criminal law requires\na specific intent to commit the prohibited act (although a very few economic acts, made criminal\nby modern legislation, dispense with the requirement of intent). In this way, criminal law differs\nfrom much of civil law\xe2\x80\x94for example, from the tort of negligence, in which carelessness, rather\nthan intent, can result in liability.\nMajor crimes are known as felonies. Minor crimes are known as misdemeanors. Most people\nhave a general notion about familiar crimes, such as murder and theft. But conventional\nknowledge does not suffice for understanding technical distinctions among related crimes, such\nas larceny, robbery, and false pretenses. These distinctions can be important because an\nindividual can be found guilty not merely for committing one of the acts defined in the criminal\nlaw but also for attempting or conspiring to commit such an act. It is usually easier to convict\nsomeone of attempt or conspiracy than to convict for the main crime, and a person involved in a\nconspiracy to commit a felony may find that very little is required to put him into serious\ntrouble.\nOf major concern to the business executive is white-collar crime, which encompasses a host of\noffenses, including bribery, embezzlement, fraud, restraints of trade, and computer crime.\nAnyone accused of crime should know that they always have the right to consult with a lawyer\nand should always do so.\n\nEXERCISES\n\n1. Bill is the chief executive of a small computer manufacturing company that desperately\nneeds funds to continue operating. One day a stranger comes to Bill to induce him to take\npart in a cocaine smuggling deal that would net Bill millions of dollars. Unbeknownst to Bill,\nthe stranger is an undercover policeman. Bill tells the stranger to go away. The stranger\npersists, and after five months of arguing and cajoling, the stranger wears down Bill\xe2\x80\x99s will to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n250\n\n\x0cresist. Bill agrees to take delivery of the cocaine and hands over a down payment of $10,000\nto the undercover agent, who promptly arrests him for conspiracy to violate the narcotics\nlaws. What defenses does Bill have?\n2. You are the manager of a bookstore. A customer becomes irritated at having to stand in line\nand begins to shout at the salesclerk for refusing to wait on him. You come out of your office\nand ask the customer to calm down. He shouts at you. You tell him to leave. He refuses. So\nyou and the salesclerk pick him up and shove him bodily out the door. He calls the police to\nhave you arrested for assault. Should the police arrest you? Assuming that they do, how\nwould you defend yourself in court?\n3. Marilyn is arrested for arson against a nuclear utility, a crime under both state and federal\nlaw. She is convicted in state court and sentenced to five years in jail. Then the federal\ngovernment decides to prosecute her for the same offense. Does she have a double-jeopardy\ndefense against the federal prosecution?\n4. Tectonics, a US corporation, is bidding on a project in Nigeria, and its employee wins the bid\nby secretly giving $100,000 to the Nigerian public official that has the most say about which\ncompany will be awarded the contract. The contract is worth $80 million, and Tectonics\nexpects to make at least $50 million on the project. Has a crime under US law been\ncommitted?\n5. Suppose that the CEO of Tectonics, Ted Nelson, is not actually involved in bribery of the\nNigerian public official Adetutu Adeleke. Instead, suppose that the CFO, Jamie Skillset, is very\naccomplished at insulating both top management and the board of directors from some of\nthe \xe2\x80\x9coperational realities\xe2\x80\x9d within the company. Skillset knows that Whoopi Goldmine, a\nNigerian employee of Tectonics, has made the deal with Adeleke and secured the contract\nfor Tectonics. Is it possible that Nelson, as well as Skillset, can be found guilty of a crime?\n6. You have graduated from college and, after working hard for ten years, have scraped enough\nmoney together to make a down payment on a forty-acre farm within driving distance to the\nsmall city where you work in Colorado. In town at lunch one day, you run into an old friend\nfrom high school, Hayley Mills, who tells you that she is saving her money to start a high-end\nconsignment shop in town. You allow her to have a room in your house for a few months\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n251\n\n\x0cuntil she has enough money to go into business. Over the following weeks, however, you\nrealize that old acquaintances from high school are stopping by almost daily for short visits.\nWhen you bring this up to Hayley, she admits that many old friends are now relying on her\nfor marijuana. She is not a licensed caregiver in Colorado and is clearly violating the law. Out\nof loyalty, you tell her that she has three weeks to move out, but you do not prevent her\nfrom continuing sales while she is there. What crime have you committed?\n7. The Center Art Galleries\xe2\x80\x94Hawaii sells artwork, and much of it involves art by the famous\nsurrealist painter Salvador Dali. The federal government suspected the center of selling\nforged Dali artwork and obtained search warrants for six locations controlled by the center.\nThe warrants told the executing officer to seize any items that were \xe2\x80\x9cevidence of violations\nof federal criminal law.\xe2\x80\x9d The warrants did not describe the specific crime suspected, nor did\nthe warrants limit the seizure of items solely to Dali artwork or suspected Dali forgeries. Are\nthese search warrants valid? [1]\n\nSELF-TEST QUESTIONS\n\n1. Jared has made several loans to debtors who have declared bankruptcy. These are\nunsecured claims. Jared \xe2\x80\x9cdoctors\xe2\x80\x9d the documentation to show amounts owed\nthat are higher than the debtors actually owe. Later, Jared is charged with the\nfederal criminal offense of filing false claims. The standard (or \xe2\x80\x9cburden\xe2\x80\x9d) of proof\nthat the US attorney must meet in the prosecution is\na. beyond all doubt\nb. beyond a reasonable doubt\nc. clear and convincing evidence\nd. a preponderance of the evidence\nJethro, a businessman who resides in Atlanta, creates a disturbance at a\nlocal steakhouse and is arrested for being drunk and disorderly. Drunk and\ndisorderly is a misdemeanor under Georgia law. A misdemeanor is a crime\npunishable by imprisonment for up to\na.\n\none year\nb. two years\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n252\n\n\x0cc. five years\nd. none of the above\nYuan is charged with a crime. To find him guilty, the prosecutor must show\na.\n\nactus reus and mens rea\nb. mens rea only\nc. the performance of a prohibited act\nd. none of the above\nKira works for Data Systems Ltd. and may be liable for larceny if she steals\n\na.\n\na competitor\xe2\x80\x99s trade secrets\nb. company computer time\nc. the use of Data Systems\xe2\x80\x99 Internet for personal business\nd. any of the above\nCandace is constructing a new office building that is near its completion.\nShe offers Paul $500 to overlook certain things that are noncompliant with the\ncity\xe2\x80\x99s construction code. Paul accepts the money and overlooks the violations.\nLater, Candace is charged with the crime of bribery. This occurred when\n\na.\n\nCandace offered the bribe.\nb. Paul accepted the bribe.\nc. Paul overlooked the violations.\nd. none of the above\n\nSELF-TEST ANSWERS\n\n1. b\n2. a\n3. a\n4. d\n5. a\n\n[1] Center Art Galleries\xe2\x80\x94Hawaii, Inc. v. United States, 875 F.2d 747 (9th Cir. 1989).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n253\n\n\x0cChapter 7\nIntroduction to Tort Law\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should be able to do the following:\n1. Know why most legal systems have tort law.\n2. Identify the three kinds of torts.\n3. Show how tort law relates to criminal law and contract law.\n4. Understand negligent torts and defenses to claims of negligence.\n5. Understand strict liability torts and the reasons for them in the US legal system.\nIn civil litigation, contract and tort claims are by far the most numerous. The law attempts to\nadjust for harms done by awarding damages to a successful plaintiff who demonstrates that the\ndefendant was the cause of the plaintiff\xe2\x80\x99s losses. Torts can be intentional torts, negligent torts, or\nstrict liability torts. Employers must be aware that in many circumstances, their employees may\ncreate liability in tort. This chapter explains the different kind of torts, as well as available\ndefenses to tort claims.\n\n7.1 Purpose of Tort Laws\n\nLEARNING OBJECTIVES\n\n1. Explain why a sound market system requires tort law.\n2. Define a tort and give two examples.\n3. Explain the moral basis of tort liability.\n4. Understand the purposes of damage awards in tort.\n\nDefinition of Tort\nThe term tort is the French equivalent of the English word wrong. The word tort is also derived\nfrom the Latin word tortum, which means twisted or crooked or wrong, in contrast to the\nword rectum, which means straight (rectitude uses that Latin root). Thus conduct that is twisted\nor crooked and not straight is a tort. The term was introduced into the English law by the\nNorman jurists.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n254\n\n\x0cLong ago, tort was used in everyday speech; today it is left to the legal system. A judge will\ninstruct a jury that a tort is usually defined as a wrong for which the law will provide a remedy,\nmost often in the form of money damages. The law does not remedy all \xe2\x80\x9cwrongs.\xe2\x80\x9d The preceding\ndefinition of tort does not reveal the underlying principles that divide wrongs in the legal sphere\nfrom those in the moral sphere. Hurting someone\xe2\x80\x99s feelings may be more devastating than\nsaying something untrue about him behind his back; yet the law will not provide a remedy for\nsaying something cruel to someone directly, while it may provide a remedy for "defaming"\nsomeone, orally or in writing, to others.\nAlthough the word is no longer in general use, tort suits are the stuff of everyday headlines.\nMore and more people injured by exposure to a variety of risks now seek redress (some sort of\nremedy through the courts). Headlines boast of multimillion-dollar jury awards against doctors\nwho bungled operations, against newspapers that libeled subjects of stories, and against oil\ncompanies that devastate entire ecosystems. All are examples of tort suits.\nThe law of torts developed almost entirely in the common-law courts; that is, statutes passed by\nlegislatures were not the source of law that plaintiffs usually relied on. Usually, plaintiffs would\nrely on the common law (judicial decisions). Through thousands of cases, the courts have\nfashioned a series of rules that govern the conduct of individuals in their noncontractual\ndealings with each other. Through contracts, individuals can craft their own rights and\nresponsibilities toward each other. In the absence of contracts, tort law holds individuals legally\naccountable for the consequences of their actions. Those who suffer losses at the hands of others\ncan be compensated.\nMany acts (like homicide) are both criminal and tortious. But torts and crimes are different, and\nthe difference is worth noting. A crime is an act against the people as a whole. Society punishes\nthe murderer; it does not usually compensate the family of the victim. Tort law, on the other\nhand, views the death as a private wrong for which damages are owed. In a civil case, the tort\nvictim or his family, not the state, brings the action. The judgment against a defendant in a civil\ntort suit is usually expressed in monetary terms, not in terms of prison times or fines, and is the\nlegal system\xe2\x80\x99s way of trying to make up for the victim\xe2\x80\x99s loss.\n\nKinds of Torts\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n255\n\n\x0cThere are three kinds of torts: intentional torts, negligent torts, and strict liability torts.\nIntentional torts arise from intentional acts, whereas unintentional torts often result from\ncarelessness (e.g., when a surgical team fails to remove a clamp from a patient\xe2\x80\x99s abdomen when\nthe operation is finished). Both intentional torts and negligent torts imply some fault on the part\nof the defendant. In strict liability torts, by contrast, there may be no fault at all, but tort law will\nsometimes require a defendant to make up for the victim\xe2\x80\x99s losses even where the defendant was\nnot careless and did not intend to do harm.\n\nDimensions of Tort Liability\nThere is a clear moral basis for recovery through the legal system where the defendant has been\ncareless (negligent) or has intentionally caused harm. Using the concepts that we are free and\nautonomous beings with basic rights, we can see that when others interfere with either our\nfreedom or our autonomy, we will usually react negatively. As the old saying goes, \xe2\x80\x9cYour right to\nswing your arm ends at the tip of my nose.\xe2\x80\x9d The law takes this even one step further: under\nintentional tort law, if you frighten someone by swinging your arms toward the tip of her nose,\nyou may have committed the tort of assault, even if there is no actual touching (battery).\nUnder a capitalistic market system, rational economic rules also call for no negative\nexternalities. That is, actions of individuals, either alone or in concert with others, should not\nnegatively impact third parties. The law will try to compensate third parties who are harmed by\nyour actions, even as it knows that a money judgment cannot actually mend a badly injured\nvictim.\nFigure 7.1 Dimensions of Tort Liability\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n256\n\n\x0cDimensions of Tort: Fault\nTort principles can be viewed along different dimensions. One is the fault dimension. Like\ncriminal law, tort law requires a wrongful act by a defendant for the plaintiff to recover. Unlike\ncriminal law, however, there need not be a specific intent. Since tort law focuses on injury to the\nplaintiff, it is less concerned than criminal law about the reasons for the defendant\xe2\x80\x99s actions. An\ninnocent act or a relatively innocent one may still provide the basis for liability. Nevertheless,\ntort law\xe2\x80\x94except for strict liability\xe2\x80\x94relies on standards of fault, or blameworthiness.\nThe most obvious standard is willful conduct. If the defendant (often called thetortfeasor\xe2\x80\x94i.e.,\nthe one committing the tort) intentionally injures another, there is little argument about tort\nliability. Thus all crimes resulting in injury to a person or property (murder, assault, arson, etc.)\nare also torts, and the plaintiff may bring a separate lawsuit to recover damages for injuries to\nhis person, family, or property.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n257\n\n\x0cMost tort suits do not rely on intentional fault. They are based, rather, on negligent conduct that\nin the circumstances is careless or poses unreasonable risks of causing damage. Most\nautomobile accident and medical malpractice suits are examples of negligence suits.\nThe fault dimension is a continuum. At one end is the deliberate desire to do injury. The middle\nground is occupied by careless conduct. At the other end is conduct that most would consider\nentirely blameless, in the moral sense. The defendant may have observed all possible\nprecautions and yet still be held liable. This is calledstrict liability. An example is that incurred\nby the manufacturer of a defective product that is placed on the market despite all possible\nprecautions, including quality-control inspection. In many states, if the product causes injury,\nthe manufacturer will be held liable.\n\nDimensions of Tort: Nature of Injury\nTort liability varies by the type of injury caused. The most obvious type is physical harm to the\nperson (assault, battery, infliction of emotional distress, negligent exposure to toxic pollutants,\nwrongful death) or property (trespass, nuisance, arson, interference with contract). Mental\nsuffering can be redressed if it is a result of physical injury (e.g., shock and depression following\nan automobile accident). A few states now permit recovery for mental distress alone (a mother\xe2\x80\x99s\nshock at seeing her son injured by a car while both were crossing the street). Other protected\ninterests include a person\xe2\x80\x99s reputation (injured by defamatory statements or writings), privacy\n(injured by those who divulge secrets of his personal life), and economic interests\n(misrepresentation to secure an economic advantage, certain forms of unfair competition).\n\nDimensions of Tort: Excuses\nA third element in the law of torts is the excuse for committing an apparent wrong. The law does\nnot condemn every act that ultimately results in injury.\nOne common rule of exculpation is assumption of risk. A baseball fan who sits along the third\nbase line close to the infield assumes the risk that a line drive foul ball may fly toward him and\nstrike him. He will not be permitted to complain in court that the batter should have been more\ncareful or that management should have either warned him or put up a protective barrier.\nAnother excuse is negligence of the plaintiff. If two drivers are careless and hit each other on the\nhighway, some states will refuse to permit either to recover from the other. Still another excuse\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n258\n\n\x0cis consent: two boxers in the ring consent to being struck with fists (but not to being bitten on\nthe ear).\n\nDamages\nSince the purpose of tort law is to compensate the victim for harm actually done, damages are\nusually measured by the extent of the injury. Expressed in money terms, these include\nreplacement of property destroyed, compensation for lost wages, reimbursement for medical\nexpenses, and dollars that are supposed to approximate the pain that is suffered. Damages for\nthese injuries are called compensatory damages.\nIn certain instances, the courts will permit an award of punitive damages. As the\nword punitive implies, the purpose is to punish the defendant\xe2\x80\x99s actions. Because a punitive\naward (sometimes called exemplary damages) is at odds with the general purpose of tort law, it\nis allowable only in aggravated situations. The law in most states permits recovery of punitive\ndamages only when the defendant has deliberately committed a wrong with malicious intent or\nhas otherwise done something outrageous.\nPunitive damages are rarely allowed in negligence cases for that reason. But if someone sets out\nintentionally and maliciously to hurt another person, punitive damages may well be appropriate.\nPunitive damages are intended not only to punish the wrongdoer, by exacting an additional and\nsometimes heavy payment (the exact amount is left to the discretion of jury and judge), but also\nto deter others from similar conduct. The punitive damage award has been subject to heavy\ncriticism in recent years in cases in which it has been awarded against manufacturers. One fear\nis that huge damage awards on behalf of a multitude of victims could swiftly bankrupt the\ndefendant. Unlike compensatory damages, punitive damages are taxable.\n\nKEY TAKEAWAY\n\nThere are three kinds of torts, and in two of them (negligent torts and strict liability torts),\ndamages are usually limited to making the victim whole through an enforceable judgment for\nmoney damages. These compensatory damages awarded by a court accomplish only\napproximate justice for the injuries or property damage caused by a tortfeasor. Tort laws go\na step further toward deterrence, beyond compensation to the plaintiff, in occasionally\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n259\n\n\x0cawarding punitive damages against a defendant. These are almost always in cases where an\nintentional tort has been committed.\n\nEXERCISES\n\n1. Why is deterrence needed for intentional torts (where punitive damages are awarded) rather\nthan negligent torts?\n2. Why are costs imposed on others without their consent problematic for a market economy?\nWhat if the law did not try to reimpose the victim\xe2\x80\x99s costs onto the tortfeasor? What would a\ntotally nonlitigious society be like?\n\n7.2 Intentional Torts\n\nLEARNING OBJECTIVES\n\n1. Distinguish intentional torts from other kinds of torts.\n2. Give three examples of an intentional tort\xe2\x80\x94one that causes injury to a person, one that\ncauses injury to property, and one that causes injury to a reputation.\nThe analysis of most intentional torts is straightforward and parallels the substantive crimes\nalready discussed in Chapter 6 "Criminal Law". When physical injury or damage to property is\ncaused, there is rarely debate over liability if the plaintiff deliberately undertook to produce the\nharm. Certain other intentional torts are worth noting for their relevance to business.\n\nAssault and Battery\nOne of the most obvious intentional torts is assault and battery. Both criminal law and tort law\nserve to restrain individuals from using physical force on others. Assault is (1) the threat of\nimmediate harm or offense of contact or (2) any act that would arouse reasonable apprehension\nof imminent harm. Battery is unauthorized and harmful or offensive physical contact with\nanother person that causes injury.\nOften an assault results in battery, but not always. In Western Union Telegraph Co. v. Hill, for\nexample, the defendant did not touch the plaintiff\xe2\x80\x99s wife, but the case presented an issue of\npossible assault even without an actual battery; the defendant employee attempted to kiss a\ncustomer across the countertop, couldn\'t quite reach her, but nonetheless created actionable\nfear (or, as the court put it, \xe2\x80\x9capprehension\xe2\x80\x9d) on the part of the plaintiff\'s wife. It is also possible\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n260\n\n\x0cto have a battery without an assault. For example, if someone hits you on the back of the head\nwith an iron skillet and you didn\xe2\x80\x99t see it coming, there is a battery but no assault. Likewise, if\nAndrea passes out from drinking too much at the fraternity party and a stranger (Andre) kisses\nher on the lips while she is passed out, she would not be aware of any threat of offensive contact\nand would have no apprehension of any harm. Thus there has been no tort of assault, but she\ncould allege the tort of battery. (The question of what damages, if any, would be an interesting\nargument.)\nUnder the doctrine of transferred intent, if Draco aims his wand at Harry but Harry ducks just\nin time and the impact is felt by Hermione instead, English law (and American law) would\ntransfer Draco\xe2\x80\x99s intent from the target to the actual victim of the act. Thus Hermione could sue\nDraco for battery for any damages she had suffered.\n\nFalse Imprisonment\nThe tort of false imprisonment originally implied a locking up, as in a prison, but today it can\noccur if a person is restrained in a room or a car or even if his or her movements are restricted\nwhile walking down the street. People have a right to be free to go as they please, and anyone\nwho without cause deprives another of personal freedom has committed a tort. Damages are\nallowed for time lost, discomfort and resulting ill health, mental suffering, humiliation, loss of\nreputation or business, and expenses such as attorneys\xe2\x80\x99 fees incurred as a result of the restraint\n(such as a false arrest). But as the case of Lester v. Albers Super Markets, Inc. (Section 7.5\n"Cases") shows, the defendant must be shown to have restrained the plaintiff in order for\ndamages to be allowed.\n\nIntentional Infliction of Emotional Distress\nUntil recently, the common-law rule was that there could be no recovery for acts, even though\nintentionally undertaken, that caused purely mental or emotional distress. For a case to go to\nthe jury, the courts required that the mental distress result from some physical injury. In recent\nyears, many courts have overthrown the older rule and now recognize the so-called new tort. In\nan employment context, however, it is rare to find a case where a plaintiff is able to recover. The\nmost difficult hurdle is proving that the conduct was \xe2\x80\x9cextreme\xe2\x80\x9d or \xe2\x80\x9coutrageous.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n261\n\n\x0cIn an early California case, bill collectors came to the debtor\xe2\x80\x99s home repeatedly and threatened\nthe debtor\xe2\x80\x99s pregnant wife. Among other things, they claimed that the wife would have to deliver\nher child in prison. The wife miscarried and had emotional and physical complications. The\ncourt found that the behavior of the collection company\xe2\x80\x99s two agents was sufficiently outrageous\nto prove the tort of intentional infliction of emotional distress. In Roche v. Stern (New York), the\nfamous cable television talk show host Howard Stern had tastelessly discussed the remains of\nDeborah Roche, a topless dancer and cable access television host. [1] The remains had been\nbrought to Stern\xe2\x80\x99s show by a close friend of Roche, Chaunce Hayden, and a number of crude\ncomments by Stern and Hayden about the remains were videotaped and broadcast on a national\ncable television station. Roche\xe2\x80\x99s sister and brother sued Howard Stern and Infinity broadcasting\nand were able to get past the defendant\xe2\x80\x99s motion to dismiss to have a jury consider their claim.\nA plaintiff\xe2\x80\x99s burden in these cases is to show that the mental distress is severe. Many states\nrequire that this distress must result in physical symptoms such as nausea, headaches, ulcers,\nor, as in the case of the pregnant wife, a miscarriage. Other states have not required physical\nsymptoms, finding that shame, embarrassment, fear, and anger constitute severe mental\ndistress.\n\nTrespass and Nuisance\nTrespass is intentionally going on land that belongs to someone else or putting something on\nsomeone else\xe2\x80\x99s property and refusing to remove it. This part of tort law shows how strongly the\nlaw values the rights of property owners. The right to enjoy your property without interference\nfrom others is also found in common law of nuisance. There are limits to property owners\xe2\x80\x99\nrights, however. In Katko v. Briney, for example, the plaintiff was injured by a spring gun while\ntrespassing on the defendant\xe2\x80\x99s property. [2] The defendant had set up No Trespassing signs after\nten years of trespassing and housebreaking events, with the loss of some household items.\nWindows had been broken, and there was \xe2\x80\x9cmessing up of the property in general.\xe2\x80\x9d The\ndefendants had boarded up the windows and doors in order to stop the intrusions and finally\nhad set up a shotgun trap in the north bedroom of the house. One defendant had cleaned and\noiled his 20-gauge shotgun and taken it to the old house where it was secured to an iron bed\nwith the barrel pointed at the bedroom door. \xe2\x80\x9cIt was rigged with wire from the doorknob to the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n262\n\n\x0cgun\xe2\x80\x99s trigger so would fire when the door was opened.\xe2\x80\x9d The angle of the shotgun was adjusted to\nhit an intruder in the legs. The spring could not be seen from the outside, and no warning of its\npresence was posted.\nThe plaintiff, Katko, had been hunting in the area for several years and considered the property\nabandoned. He knew it had long been uninhabited. He and a friend had been to the house and\nfound several old bottles and fruit jars that they took and added to their collection of antiques.\nWhen they made a second trip to the property, they entered by removing a board from a porch\nwindow. When the plaintiff opened the north bedroom door, the shotgun went off and struck\nhim in the right leg above the ankle bone. Much of his leg was blown away. While Katko knew he\nhad no right to break and enter the house with intent to steal bottles and fruit jars, the court\nheld that a property owner could not protect an unoccupied boarded-up farmhouse by using a\nspring gun capable of inflicting death or serious injury.\nIn Katko, there is an intentional tort. But what if someone trespassing is injured by the\nnegligence of the landowner? States have differing rules about trespass and negligence. In some\nstates, a trespasser is only protected against the gross negligence of the landowner. In other\nstates, trespassers may be owed the duty of due care on the part of the landowner. The burglar\nwho falls into a drained swimming pool, for example, may have a case against the homeowner\nunless the courts or legislature of that state have made it clear that trespassers are owed the\nlimited duty to avoid gross negligence. Or a very small child may wander off his own property\nand fall into a gravel pit on a nearby property and suffer death or serious injury; if the pit should\n(in the exercise of due care) have been filled in or some barrier erected around it, then there was\nnegligence. But if the state law holds that the duty to trespassers is only to avoid gross\nnegligence, the child\xe2\x80\x99s family would lose, unless the state law makes an exception for very young\ntrespassers. In general, guests, licensees, and invitees are owed a duty of due care; a trespasser\nmay not be owed such a duty, but states have different rules on this.\n\nIntentional Interference with Contractual Relations\nTortious interference with a contract can be established by proving four elements:\n1. There was a contract between the plaintiff and a third party.\n2. The defendant knew of the contract.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n263\n\n\x0c3. The defendant improperly induced the third party to breach the contract or made performance\nof the contract impossible.\n4. There was injury to the plaintiff.\nIn a famous case of contract interference, Texaco was sued by Pennzoil for interfering with an\nagreement that Pennzoil had with Getty Oil. After complicated negotiations between Pennzoil\nand Getty, a takeover share price was struck, a memorandum of understanding was signed, and\na press release announced the agreement in principle between Pennzoil and Getty. Texaco\xe2\x80\x99s\nlawyers, however, believed that Getty oil was \xe2\x80\x9cstill in play,\xe2\x80\x9d and before the lawyers for Pennzoil\nand Getty could complete the paperwork for their agreement, Texaco announced it was offering\nGetty shareholders an additional $12.50 per share over what Pennzoil had offered.\nTexaco later increased its offer to $228 per share, and the Getty board of directors soon began\ndealing with Texaco instead of Pennzoil. Pennzoil decided to sue in Texas state court for tortious\ninterference with a contract. After a long trial, the jury returned an enormous verdict against\nTexaco: $7.53 billion in actual damages and $3 billion in punitive damages. The verdict was so\nlarge that it would have bankrupted Texaco. Appeals from the verdict centered on an obscure\nrule of the Securities and Exchange Commission (SEC), Rule 10(b)-13, and Texaco\xe2\x80\x99s argument\nwas based on that rule and the fact that the contract had not been completed. If there was no\ncontract, Texaco could not have legally interfered with one. After the SEC filed a brief that\nsupported Texaco\xe2\x80\x99s interpretation of the law, Texaco agreed to pay $3 billion to Pennzoil to\ndismiss its claim of tortious interference with a contract.\n\nMalicious Prosecution\nMalicious prosecution is the tort of causing someone to be prosecuted for a criminal act,\nknowing that there was no probable cause to believe that the plaintiff committed the crime. The\nplaintiff must show that the defendant acted with malice or with some purpose other than\nbringing the guilty to justice. A mere complaint to the authorities is insufficient to establish the\ntort, but any official proceeding will support the claim\xe2\x80\x94for example, a warrant for the plaintiff\xe2\x80\x99s\narrest. The criminal proceeding must terminate in the plaintiff\xe2\x80\x99s favor in order for his suit to be\nsustained.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n264\n\n\x0cA majority of US courts, though by no means all, permit a suit for wrongful civil proceedings.\nCivil litigation is usually costly and burdensome, and one who forces another to defend himself\nagainst baseless accusations should not be permitted to saddle the one he sues with the costs of\ndefense. However, because, as a matter of public policy, litigation is favored as the means by\nwhich legal rights can be vindicated\xe2\x80\x94indeed, the Supreme Court has even ruled that individuals\nhave a constitutional right to litigate\xe2\x80\x94the plaintiff must meet a heavy burden in proving his\ncase. The mere dismissal of the original lawsuit against the plaintiff is not sufficient proof that\nthe suit was unwarranted. The plaintiff in a suit for wrongful civil proceedings must show that\nthe defendant (who was the plaintiff in the original suit) filed the action for an improper purpose\nand had no reasonable belief that his cause was legally or factually well grounded.\n\nDefamation\nDefamation is injury to a person\xe2\x80\x99s good name or reputation. In general, if the harm is done\nthrough the spoken word\xe2\x80\x94one person to another, by telephone, by radio, or on television\xe2\x80\x94it is\ncalled slander. If the defamatory statement is published in written form, it is called libel.\nThe Restatement (Second) of Torts defines a defamatory communication as one that \xe2\x80\x9cso tends to\nharm the reputation of another as to lower him in the estimation of the community or to deter\nthird persons from associating or dealing with him.\xe2\x80\x9d [3]\nA statement is not defamatory unless it is false. Truth is an absolute defense to a charge of libel\nor slander. Moreover, the statement must be \xe2\x80\x9cpublished\xe2\x80\x9d\xe2\x80\x94that is, communicated to a third\nperson. You cannot be libeled by one who sends you a letter full of false accusations and\nscurrilous statements about you unless a third person opens it first (your roommate, perhaps).\nAny living person is capable of being defamed, but the dead are not. Corporations, partnerships,\nand other forms of associations can also be defamed, if the statements tend to injure their ability\nto do business or to garner contributions.\nThe statement must have reference to a particular person, but he or she need not be identified\nby name. A statement that \xe2\x80\x9cthe company president is a crook\xe2\x80\x9d is defamatory, as is a statement\nthat \xe2\x80\x9cthe major network weathermen are imposters.\xe2\x80\x9d The company president and the network\nweathermen could show that the words were aimed at them. But statements about large groups\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n265\n\n\x0cwill not support an action for defamation (e.g., \xe2\x80\x9call doctors are butchers\xe2\x80\x9d is not defamatory of\nany particular doctor).\nThe law of defamation is largely built on strict liability. That a person did not intend to defame is\nordinarily no excuse; a typographical error that converts a true statement into a false one in a\nnewspaper, magazine, or corporate brochure can be sufficient to make out a case of libel. Even\nthe exercise of due care is usually no excuse if the statement is in fact communicated. Repeating\na libel is itself a libel; a libel cannot be justified by showing that you were quoting someone else.\nThough a plaintiff may be able to prove that a statement was defamatory, he is not necessarily\nentitled to an award of damages. That is because the law contains a number of privileges that\nexcuse the defamation.\nPublishing false information about another business\xe2\x80\x99s product constitutes the tort of slander of\nquality, or trade libel. In some states, this is known as the tort of product disparagement. It may\nbe difficult to establish damages, however. A plaintiff must prove that actual damages\nproximately resulted from the slander of quality and must show the extent of the economic harm\nas well.\n\nAbsolute Privilege\nStatements made during the course of judicial proceedings are absolutely privileged, meaning\nthat they cannot serve as the basis for a defamation suit. Accurate accounts of judicial or other\nproceedings are absolutely privileged; a newspaper, for example, may pass on the slanderous\ncomments of a judge in court. \xe2\x80\x9cJudicial\xe2\x80\x9d is broadly construed to include most proceedings of\nadministrative bodies of the government. The Constitution exempts members of Congress from\nsuits for libel or slander for any statements made in connection with legislative business. The\ncourts have constructed a similar privilege for many executive branch officials.\n\nQualified Privilege\nAbsolute privileges pertain to those in the public sector. A narrower privilege exists for private\ncitizens. In general, a statement that would otherwise be actionable is held to be justified if made\nin a reasonable manner and for a reasonable purpose. Thus you may warn a friend to beware of\ndealing with a third person, and if you had reason to believe that what you said was true, you are\nprivileged to issue the warning, even though false. Likewise, an employee may warn an employer\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n266\n\n\x0cabout the conduct or character of a fellow or prospective employee, and a parent may complain\nto a school board about the competence or conduct of a child\xe2\x80\x99s teacher. There is a line to be\ndrawn, however, and a defendant with nothing but an idle interest in the matter (an \xe2\x80\x9cofficious\nintermeddler\xe2\x80\x9d) must take the risk that his information is wrong.\nIn 1964, the Supreme Court handed down its historic decision in New York Times v. Sullivan,\nholding that under the First Amendment a libel judgment brought by a public official against a\nnewspaper cannot stand unless the plaintiff has shown \xe2\x80\x9cactual malice,\xe2\x80\x9d which in turn was\ndefined as \xe2\x80\x9cknowledge that [the statement] was false or with a reckless disregard of whether it\nwas false or not.\xe2\x80\x9d [4] In subsequent cases, the court extended the constitutional doctrine further,\napplying it not merely to government officials but to public figures, people who voluntarily place\nthemselves in the public eye or who involuntarily find themselves the objects of public scrutiny.\nWhether a private person is or is not a public figure is a difficult question that has so far eluded\nrigorous definition and has been answered only from case to case. A CEO of a private\ncorporation ordinarily will be considered a private figure unless he puts himself in the public\neye\xe2\x80\x94for example, by starring in the company\xe2\x80\x99s television commercials.\n\nInvasion of Privacy\nThe right of privacy\xe2\x80\x94the right \xe2\x80\x9cto be let alone\xe2\x80\x9d\xe2\x80\x94did not receive judicial recognition until the\ntwentieth century, and its legal formulation is still evolving. In fact there is no single right of\nprivacy. Courts and commentators have discerned at least four different types of interests: (1)\nthe right to control the appropriation of your name and picture for commercial purposes, (2) the\nright to be free of intrusion on your \xe2\x80\x9cpersonal space\xe2\x80\x9d or seclusion, (3) freedom from public\ndisclosure of embarrassing and intimate facts of your personal life, and (4) the right not to be\npresented in a \xe2\x80\x9cfalse light.\xe2\x80\x9d\n\nAppropriation of Name or Likeness\nThe earliest privacy interest recognized by the courts was appropriation of name or likeness:\nsomeone else placing your photograph on a billboard or cereal box as a model or using your\nname as endorsing a product or in the product name. A New York statute makes it a\nmisdemeanor to use the name, portrait, or picture of any person for advertising purposes or for\nthe purposes of trade (business) without first obtaining written consent. The law also permits\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n267\n\n\x0cthe aggrieved person to sue and to recover damages for unauthorized profits and also to have\nthe court enjoin (judicially block) any further unauthorized use of the plaintiff\xe2\x80\x99s name, likeness,\nor image. This is particularly useful to celebrities.\nBecause the publishing and advertising industries are concentrated heavily in New York, the\nstatute plays an important part in advertising decisions made throughout the country. Deciding\nwhat \xe2\x80\x9ccommercial\xe2\x80\x9d or \xe2\x80\x9ctrade\xe2\x80\x9d purposes are is not always easy. Thus a newsmagazine may use a\nbaseball player\xe2\x80\x99s picture on its cover without first obtaining written permission, but a chocolate\nmanufacturer could not put the player\xe2\x80\x99s picture on a candy wrapper without consent.\n\nPersonal Space\nOne form of intrusion upon a person\xe2\x80\x99s solitude\xe2\x80\x94trespass\xe2\x80\x94has long been actionable under\ncommon law. Physical invasion of home or other property is not a new tort. But in recent years,\nthe notion of intrusion has been broadened considerably. Now, taking photos of someone else\nwith your cell phone in a locker room could constitute invasion of the right to privacy. Reading\nsomeone else\xe2\x80\x99s mail or e-mail could also constitute an invasion of the right to privacy.\nPhotographing someone on a city street is not tortious, but subsequent use of the photograph\ncould be. Whether the invasion is in a public or private space, the amount of damages will\ndepend on how the image or information is disclosed to others.\n\nPublic Disclosure of Embarassing Facts\nCirculation of false statements that do injury to a person are actionable under the laws of\ndefamation. What about true statements that might be every bit as damaging\xe2\x80\x94for example,\ndisclosure of someone\xe2\x80\x99s income tax return, revealing how much he earned? The general rule is\nthat if the facts are truly private and of no \xe2\x80\x9clegitimate\xe2\x80\x9d concern to the public, then their\ndisclosure is a violation of the right to privacy. But a person who is in the public eye cannot\nclaim the same protection.\n\nFalse Light\nA final type of privacy invasion is that which paints a false picture in a publication. Though false,\nit might not be libelous, since the publication need contain nothing injurious to reputation.\nIndeed, the publication might even glorify the plaintiff, making him seem more heroic than he\nactually is. Subject to the First Amendment requirement that the plaintiff must show intent or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n268\n\n\x0cextreme recklessness, statements that put a person in a false light, like a fictionalized biography,\nare actionable.\n\nKEY TAKEAWAY\n\nThere are many kinds of intentional torts. Some of them involve harm to the physical\nperson or to his or her property, reputation or feelings, or economic interests. In each case\nof intentional tort, the plaintiff must show that the defendant intended harm, but the\nintent to harm does not need to be directed at a particular person and need not be\nmalicious, as long as the resulting harm is a direct consequence of the defendant\xe2\x80\x99s actions.\n\nEXERCISES\n\n1. Name two kinds of intentional torts that could result in damage to a business firm\xe2\x80\x99s\nbottom line.\n2. Name two kinds of intentional torts that are based on protection of a person\xe2\x80\x99s property.\n3. Why are intentional torts more likely to result in a verdict not only for compensatory\ndamages but also for punitive damages?\n\n[1] Roche v. Stern, 675 N.Y.S.2d 133 (1998).\n[2] Katko v. Briney, 183 N.W.2d 657 (Iowa 1971).\n[3] Restatement (Second) of Torts, Section 559 (1965).\n[4] Times v. Sullivan, 376 US 254 (1964).\n\n7.3 Negligence\n\nLEARNING OBJECTIVES\n\n1. Understand how the duty of due care relates to negligence.\n2. Distinguish between actual and proximate cause.\n3. Explain the primary defenses to a claim of negligence.\n\nElements of Negligence\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n269\n\n\x0cPhysical harm need not be intentionally caused. A pedestrian knocked over by an automobile\ndoes not hurt less because the driver intended no wrong but was merely careless. The law\nimposes a duty of care on all of us in our everyday lives. Accidents caused by negligence are\nactionable.\nDetermining negligence is not always easy. If a driver runs a red light, we can say that he is\nnegligent because a driver must always be careful to ascertain whether the light is red and be\nable to stop if it is. Suppose that the driver was carrying a badly injured person to a nearby\nhospital and that after slowing down at an intersection, went through a red light, blowing his\nhorn, whereupon a driver to his right, seeing him, drove into the intersection anyway and\ncrashed into him. Must one always stop at a red light? Is proof that the light was red always\nproof of negligence? Usually, but not always: negligence is an abstract concept that must always\nbe applied to concrete and often widely varying sets of circumstances. Whether someone was or\nwas not negligent is almost always a question of fact for a jury to decide. Rarely is it a legal\nquestion that a judge can settle.\nThe tort of negligence has four elements: (1) a duty of due care that the defendant had, (2)\nthe breach of the duty of due care, (3) connection between cause and injury, and (4) actual\ndamage or loss. Even if a plaintiff can prove each of these aspects, the defendant may be able to\nshow that the law excuses the conduct that is the basis for the tort claim. We examine each of\nthese factors below.\n\nStandard of Care\nNot every unintentional act that causes injury is negligent. If you brake to a stop when you see a\nchild dart out in front of your car, and if the noise from your tires gives someone in a nearby\nhouse a heart attack, you have not acted negligently toward the person in the house. The\npurpose of the negligence standard is to protect others against the risk of injury that foreseeably\nwould ensue from unreasonably dangerous conduct.\nGiven the infinite variety of human circumstances and conduct, no general statement of a\nreasonable standard of care is possible. Nevertheless, the law has tried to encapsulate it in the\nform of the famous standard of \xe2\x80\x9cthe reasonable man.\xe2\x80\x9d This fictitious person \xe2\x80\x9cof ordinary\nprudence\xe2\x80\x9d is the model that juries are instructed to compare defendants with in assessing\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n270\n\n\x0cwhether those defendants have acted negligently. Analysis of this mythical personage has baffled\nseveral generations of commentators. How much knowledge must he have of events in the\ncommunity, of technology, of cause and effect? With what physical attributes, courage, or\nwisdom is this nonexistent person supposedly endowed? If the defendant is a person with\nspecialized knowledge, like a doctor or an automobile designer, must the jury also treat the\n\xe2\x80\x9creasonable man\xe2\x80\x9d as having this knowledge, even though the average person in the community\nwill not? (Answer: in most cases, yes.)\nDespite the many difficulties, the concept of the reasonable man is one on which most\nnegligence cases ultimately turn. If a defendant has acted \xe2\x80\x9cunreasonably under the\ncircumstances\xe2\x80\x9d and his conduct posed an unreasonable risk of injury, then he is liable for injury\ncaused by his conduct. Perhaps in most instances, it is not difficult to divine what the reasonable\nman would do. The reasonable man stops for traffic lights and always drives at reasonable\nspeeds, does not throw baseballs through windows, performs surgical operations according to\nthe average standards of the medical profession, ensures that the floors of his grocery store are\nkept free of fluids that would cause a patron to slip and fall, takes proper precautions to avoid\nspillage of oil from his supertanker, and so on. The "reasonable man" standard imposes\nhindsight on the decisions and actions of people in society; the circumstances of life are such\nthat courts may sometimes impose a standard of due care that many people might not find\nreasonable.\n\nDuty of Care and Its Breach\nThe law does not impose on us a duty to care for every person. If the rule were otherwise, we\nwould all, in this interdependent world, be our brothers\xe2\x80\x99 keepers, constantly unsure whether any\naction we took might subject us to liability for its effect on someone else. The law copes with this\ndifficulty by limiting the number of people toward whom we owe a duty to be careful.\nIn general, the law imposes no obligation to act in a situation to which we are strangers. We may\npass the drowning child without risking a lawsuit. But if we do act, then the law requires us to\nact carefully. The law of negligence requires us to behave with due regard for the foreseeable\nconsequences of our actions in order to avoid unreasonable risks of injury.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n271\n\n\x0cDuring the course of the twentieth century, the courts have constantly expanded the notion of\n\xe2\x80\x9cforeseeability,\xe2\x80\x9d so that today many more people are held to be within the zone of injury than\nwas once the case. For example, it was once believed that a manufacturer or supplier owed a\nduty of care only to immediate purchasers, not to others who might use the product or to whom\nthe product might be resold. This limitation was known as the rule of privity. And users who\nwere not immediate purchasers were said not to be in privity with a supplier or manufacturer. In\n1916, Judge Benjamin N. Cardozo, then on the New York Court of Appeals, penned an opinion in\na celebrated case that exploded the theory of privity, though it would take half a century before\nthe last state\xe2\x80\x94Mississippi in 1966\xe2\x80\x94would fall in line.\nDetermining a duty of care can be a vexing problem. Physicians, for example, are bound by\nprinciples of medical ethics to respect the confidences of their patients. Suppose a patient tells a\npsychiatrist that he intends to kill his girlfriend. Does the physician then have a higher legal duty\nto warn prospective victim? The California Supreme Court has said yes. [1]\nEstablishing a breach of the duty of due care where the defendant has violated a statute or\nmunicipal ordinance is eased considerably with the doctrine of negligence per se, a doctrine\ncommon to all US state courts. If a legislative body sets a minimum standard of care for\nparticular kinds of acts to protect a certain set of people from harm and a violation of that\nstandard causes harm to someone in that set, the defendant is negligent per se. If Harvey is\ndriving sixty-five miles per hour in a fifty-five-mile-per-hour zone when he crashes into Haley\xe2\x80\x99s\ncar and the police accident report establishes that or he otherwise admits to going ten miles per\nhour over the speed limit, Haley does not have to prove that Harvey has breached a duty of due\ncare. She will only have to prove that the speeding was an actual and proximate cause of the\ncollision and will also have to prove the extent of the resulting damages to her.\n\nCausation: Actual Cause and Proximate Cause\n\xe2\x80\x9cFor want of a nail, the kingdom was lost,\xe2\x80\x9d as the old saying has it. Virtually any cause of an\ninjury can be traced to some preceding cause. The problem for the law is to know when to draw\nthe line between causes that are immediate and causes too remote for liability reasonably to be\nassigned to them. In tort theory, there are two kinds of causes that a plaintiff must prove: actual\ncause and proximate cause.Actual cause (causation in fact) can be found if the connection\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n272\n\n\x0cbetween the defendant\xe2\x80\x99s act and the plaintiff\xe2\x80\x99s injuries passes the \xe2\x80\x9cbut for\xe2\x80\x9d test: if an injury\nwould not have occurred \xe2\x80\x9cbut for\xe2\x80\x9d the defendant\xe2\x80\x99s conduct, then the defendant is the cause of\nthe injury. Still, this is not enough causation to create liability. The injuries to the plaintiff must\nalso be foreseeable, or not \xe2\x80\x9ctoo remote,\xe2\x80\x9d for the defendant\xe2\x80\x99s act to create liability. This\nis proximate cause: a cause that is not too remote or unforseeable.\nSuppose that the person who was injured was not one whom a reasonable person could have\nexpected to be harmed. Such a situation was presented in one of the most famous US tort\ncases, Palsgraf v. Long Island Railroad (Section 7.5 "Cases"), which was decided by Judge\nBenjamin Cardozo. Although Judge Cardozo persuaded four of his seven brethren to side with\nhis position, the closeness of the case demonstrates the difficulty that unforeseeable\nconsequences and unforeseeable plaintiffs present.\n\nDamages\nFor a plaintiff to win a tort case, she must allege and prove that she was injured. The fear that\nshe might be injured in the future is not a sufficient basis for a suit. This rule has proved\ntroublesome in medical malpractice and industrial disease cases. A doctor\xe2\x80\x99s negligent act or a\ncompany\xe2\x80\x99s negligent exposure of a worker to some form of contamination might not become\nmanifest in the body for years. In the meantime, the tort statute of limitations might have run\nout, barring the victim from suing at all. An increasing number of courts have eased the\nplaintiff\xe2\x80\x99s predicament by ruling that the statute of limitations does not begin to run until the\nvictim discovers that she has been injured or contracted a disease.\nThe law allows an exception to the general rule that damages must be shown when the plaintiff\nstands in danger of immediate injury from a hazardous activity. If you discover your neighbor\nexperimenting with explosives in his basement, you could bring suit to enjoin him from further\nexperimentation, even though he has not yet blown up his house\xe2\x80\x94and yours.\n\nProblems of Proof\nThe plaintiff in a tort suit, as in any other, has the burden of proving his allegations.\nHe must show that the defendant took the actions complained of as negligent, demonstrate the\ncircumstances that make the actions negligent, and prove the occurrence and extent of injury.\nFactual issues are for the jury to resolve. Since it is frequently difficult to make out the requisite\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n273\n\n\x0cproof, the law allows certain presumptions and rules of evidence that ease the plaintiff\xe2\x80\x99s task, on\nthe ground that without them substantial injustice would be done. One important rule goes by\nthe Latin phraseres ipsa loquitur, meaning \xe2\x80\x9cthe thing speaks for itself.\xe2\x80\x9d The best evidence is\nalways the most direct evidence: an eyewitness account of the acts in question. But eyewitnesses\nare often unavailable, and in any event they frequently cannot testify directly to the\nreasonableness of someone\xe2\x80\x99s conduct, which inevitably can only be inferred from the\ncircumstances.\nIn many cases, therefore, circumstantial evidence (evidence that is indirect) will be the only\nevidence or will constitute the bulk of the evidence. Circumstantial evidence can often be quite\ntelling: though no one saw anyone leave the building, muddy footprints tracing a path along the\nsidewalk are fairly conclusive. Res ipsa loquitur is a rule of circumstantial evidence that permits\nthe jury to draw an inference of negligence. A common statement of the rule is the following:\n\xe2\x80\x9cThere must be reasonable evidence of negligence but where the thing is shown to be under the\nmanagement of the defendant or his servants, and the accident is such as in the ordinary course\nof things does not happen if those who have the management use proper care, it affords\nreasonable evidence, in the absence of explanation by the defendants, that the accident arose\nfrom want of care.\xe2\x80\x9d [2]\nIf a barrel of flour rolls out of a factory window and hits someone, or a soda bottle explodes, or\nan airplane crashes, courts in every state permit juries to conclude, in the absence of contrary\nexplanations by the defendants, that there was negligence. The plaintiff is not put to the\nimpossible task of explaining precisely how the accident occurred. A defendant can always offer\nevidence that he acted reasonably\xe2\x80\x94for example, that the flour barrel was securely fastened and\nthat a bolt of lightning, for which he was not responsible, broke its bands, causing it to roll out\nthe window. But testimony by the factory employees that they secured the barrel, in the absence\nof any further explanation, will not usually serve to rebut the inference. That the defendant was\nnegligent does not conclude the inquiry or automatically entitle the plaintiff to a judgment. Tort\nlaw provides the defendant with several excuses, some of which are discussed briefly in the next\nsection.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n274\n\n\x0cExcuses\nThere are more excuses (defenses) than are listed here, but contributory negligence or\ncomparative negligence, assumption of risk, and act of God are among the principal defenses\nthat will completely or partially excuse the negligence of the defendant.\n\nContributory and Comparative Negligence\nUnder an old common-law rule, it was a complete defense to show that the plaintiff in a\nnegligence suit was himself negligent. Even if the plaintiff was only mildly negligent, most of the\nfault being chargeable to the defendant, the court would dismiss the suit if the plaintiff\xe2\x80\x99s conduct\ncontributed to his injury. In a few states today, this rule ofcontributory negligence is still in\neffect. Although referred to as negligence, the rule encompasses a narrower form than that with\nwhich the defendant is charged, because the plaintiff\xe2\x80\x99s only error in such cases is in being less\ncareful of himself than he might have been, whereas the defendant is charged with conduct\ncareless toward others. This rule was so manifestly unjust in many cases that most states, either\nby statute or judicial decision, have changed to some version of comparative negligence. Under\nthe rule of comparative negligence, damages are apportioned according to the defendant\xe2\x80\x99s\ndegree of culpability. For example, if the plaintiff has sustained a $100,000 injury and is 20\npercent responsible, the defendant will be liable for $80,000 in damages.\n\nAssumption of Risk\nRisk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply\nbecause they took a risk and lost. The law provides, therefore, that when a person knowingly\ntakes a risk, he or she must suffer the consequences.\nThe assumption of risk doctrine comes up in three ways. The plaintiff may have formally agreed\nwith the defendant before entering a risky situation that he will relieve the defendant of liability\nshould injury occur. (\xe2\x80\x9cYou can borrow my car if you agree not to sue me if the brakes fail,\nbecause they\xe2\x80\x99re worn and I haven\xe2\x80\x99t had a chance to replace them.\xe2\x80\x9d) Or the plaintiff may have\nentered into a relationship with the defendant knowing that the defendant is not in a position to\nprotect him from known risks (the fan who is hit by a line drive in a ballpark). Or the plaintiff\nmay act in the face of a risky situation known in advance to have been created by the defendant\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n275\n\n\x0cnegligence (failure to leave, while there was an opportunity to do so, such as getting into an\nautomobile when the driver is known to be drunk).\nThe difficulty in many cases is to determine the dividing line between subjectivity and\nobjectivity. If the plaintiff had no actual knowledge of the risk, he cannot be held to have\nassumed it. On the other hand, it is easy to claim that you did not appreciate the danger, and the\ncourts will apply an objective standard of community knowledge (a \xe2\x80\x9cbut you should have\nknown\xe2\x80\x9d test) in many situations. When the plaintiff has no real alternative, however,\nassumption of risk fails as a defense (e.g., a landlord who negligently fails to light the exit to the\nstreet cannot claim that his tenants assumed the risk of using it).\nAt the turn of the century, courts applied assumption of risk in industrial cases to bar relief to\nworkers injured on the job. They were said to assume the risk of dangerous conditions or\nequipment. This rule has been abolished by workers\xe2\x80\x99 compensation statutes in most states.\n\nAct of God\nTechnically, the rule that no one is responsible for an \xe2\x80\x9cact of God,\xe2\x80\x9d or force majeure as it is\nsometimes called, is not an excuse but a defense premised on a lack of causation. If a force of\nnature caused the harm, then the defendant was not negligent in the first place. A marina,\nobligated to look after boats moored at its dock, is not liable if a sudden and fierce storm against\nwhich no precaution was possible destroys someone\xe2\x80\x99s vessel. However, if it is foreseeable that\nharm will flow from a negligent condition triggered by a natural event, then there is liability. For\nexample, a work crew failed to remove residue explosive gas from an oil barge. Lightning hit the\nbarge, exploded the gas, and injured several workmen. The plaintiff recovered damages against\nthe company because the negligence consisted in the failure to guard against any one of a\nnumber of chance occurrences that could ignite the gas. [3]\n\nVicarious Liability\nLiability for negligent acts does not always end with the one who was negligent. Under certain\ncircumstances, the liability is imputed to others. For example, an employer is responsible for the\nnegligence of his employees if they were acting in the scope of employment. This rule of\nvicarious liability is often called respondeat superior, meaning that the higher authority must\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n276\n\n\x0crespond to claims brought against one of its agents. Respondeat superior is not limited to the\nemployment relationship but extends to a number of other agency relationships as well.\nLegislatures in many states have enacted laws that make people vicariously liable for acts of\ncertain people with whom they have a relationship, though not necessarily one of agency. It is\ncommon, for example, for the owner of an automobile to be liable for the negligence of one to\nwhom the owner lends the car. So-called dram shop statutes place liability on bar and tavern\nowners and others who serve too much alcohol to one who, in an intoxicated state, later causes\ninjury to others. In these situations, although the injurious act of the drinker stemmed from\nnegligence, the one whom the law holds vicariously liable (the bartender) is not himself\nnecessarily negligent\xe2\x80\x94the law is holding him strictly liable, and to this concept we now turn.\n\nKEY TAKEAWAY\n\nThe most common tort claim is based on the negligence of the defendant. In each negligence\nclaim, the plaintiff must establish by a preponderance of the evidence that (1) the defendant\nhad a duty of due care, (2) the defendant breached that duty, (3) that the breach of duty\nboth actually and approximately has caused harm to the plaintiff, and (4) that the harm is\nmeasurable in money damages.\nIt is also possible for the negligence of one person to be imputed to another, as in the case of\nrespondeat superior, or in the case of someone who loans his automobile to another driver\nwho is negligent and causes injury. There are many excuses (defenses) to claims of\nnegligence, including assumption of risk and comparative negligence. In those few\njurisdictions where contributory negligence has not been modified to comparative\nnegligence, plaintiffs whose negligence contributes to their own injuries will be barred from\nany recovery.\n\nEXERCISES\n\n1. Explain the difference between comparative negligence and contributory negligence.\n2. How is actual cause different from probable cause?\n3. What is an example of assumption of risk?\n4. How does res ipsa loquitur help a plaintiff establish a case of negligence?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n277\n\n\x0c[1] Tarasoff v. Regents of University of California, 551 P.2d 334 (Calif. 1976).\n[2] Scott v. London & St. Katherine Docks Co., 3 H. & C. 596, 159 Eng.Rep. 665 (Q.B. 1865).\n[3] Johnson v. Kosmos Portland Cement Co., 64 F.2d 193 (6th Cir. 1933).\n\n7.4 Strict Liability\n\nLEARNING OBJECTIVES\n\n1. Understand how strict liability torts differ from negligent torts.\n2. Understand the historical origins of strict liability under common law.\n3. Be able to apply strict liability concepts to liability for defective products.\n4. Distinguish strict liability from absolute liability, and understand the major defenses to a\nlawsuit in products-liability cases.\n\nHistorical Basis of Strict Liability: Animals and Ultrahazardous Activities\nTo this point, we have considered principles of liability that in some sense depend upon the\n\xe2\x80\x9cfault\xe2\x80\x9d of the tortfeasor. This fault is not synonymous with moral blame.\nAside from acts intended to harm, the fault lies in a failure to live up to a standard of\nreasonableness or due care. But this is not the only basis for tort liability. Innocent mistakes can\nbe a sufficient basis. As we have already seen, someone who unknowingly trespasses on\nanother\xe2\x80\x99s property is liable for the damage that he does, even if he has a reasonable belief that\nthe land is his. And it has long been held that someone who engages in ultrahazardous (or\nsometimes, abnormally dangerous) activities is liable for damage that he causes, even though he\nhas taken every possible precaution to avoid harm to someone else.\nLikewise, the owner of animals that escape from their pastures or homes and damage\nneighboring property may be liable, even if the reason for their escape was beyond the power of\nthe owner to stop (e.g., a fire started by lightning that burns open a barn door). In such cases,\nthe courts invoke the principle of strict liability, or, as it is sometimes called, liability without\nfault. The reason for the rule is explained in Klein v. Pyrodyne Corporation (Section 7.5\n"Cases").\n\nStrict Liability for Products\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n278\n\n\x0cProducts liability is extremely important. Strict liability may also apply as a legal standard for\nproducts, even those that are not ultrahazardous. In some national legal systems, strict liability\nis not available as a cause of action to plaintiffs seeking to recover a judgment of products\nliability against a manufacturer, wholesaler, distributor, or retailer. (Some states limit liability to\nthe manufacturer.) But it is available in the United States and initially was created by a\nCalifornia Supreme Court decision in the 1962 case of Greenman v. Yuba Power Products, Inc.\nIn Greenman, the plaintiff had used a home power saw and bench, the Shopsmith, designed and\nmanufactured by the defendant. He was experienced in using power tools and was injured while\nusing the approved lathe attachment to the Shopsmith to fashion a wooden chalice. The case\nwas decided on the premise that Greenman had done nothing wrong in using the machine but\nthat the machine had a defect that was \xe2\x80\x9clatent\xe2\x80\x9d (not easily discoverable by the consumer).\nRather than decide the case based on warranties, or requiring that Greenman prove how the\ndefendant had been negligent, Justice Traynor found for the plaintiff based on the overall social\nutility of strict liability in cases of defective products. According to his decision, the purpose of\nsuch liability is to ensure that the \xe2\x80\x9ccost of injuries resulting from defective products is borne by\nthe manufacturers\xe2\x80\xa6rather than by the injured persons who are powerless to protect\nthemselves.\xe2\x80\x9d\nToday, the majority of US states recognize strict liability for defective products, although some\nstates limit strict liability actions to damages for personal injuries rather than property damage.\nInjured plaintiffs have to prove the product caused the harm but do not have to prove exactly\nhow the manufacturer was careless. Purchasers of the product, as well as injured guests,\nbystanders, and others with no direct relationship with the product, may sue for damages\ncaused by the product.\nThe Restatement of the Law of Torts, Section 402(a), was originally issued in 1964. It is a widely\naccepted statement of the liabilities of sellers of goods for defective products. The Restatement\nspecifies six requirements, all of which must be met for a plaintiff to recover using strict liability\nfor a product that the plaintiff claims is defective:\n1. The product must be in a defective condition when the defendant sells it.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n279\n\n\x0c2. The defendant must normally be engaged in the business of selling or otherwise distributing the\nproduct.\n3. The product must be unreasonably dangerous to the user or consumer because of its defective\ncondition.\n4. The plaintiff must incur physical harm to self or to property by using or consuming the product.\n5. The defective condition must be the proximate cause of the injury or damage.\n6. The goods must not have been substantially changed from the time the product was sold to the\ntime the injury was sustained.\nSection 402(a) also explicitly makes clear that a defendant can be held liable even though the\ndefendant has exercised \xe2\x80\x9call possible care.\xe2\x80\x9d Thus in a strict liability case, the plaintiff does not\nneed to show \xe2\x80\x9cfault\xe2\x80\x9d (or negligence).\nFor defendants, who can include manufacturers, distributors, processors, assemblers,\npackagers, bottlers, retailers, and wholesalers, there are a number of defenses that are available,\nincluding assumption of risk, product misuse and comparative negligence, commonly known\ndangers, and the knowledgeable-user defense. We have already seen assumption of risk and\ncomparative negligence in terms of negligence actions; the application of these is similar in\nproducts-liability actions.\nUnder product misuse, a plaintiff who uses a product in an unexpected and unusual way will not\nrecover for injuries caused by such misuse. For example, suppose that someone uses a rotary\nlawn mower to trim a hedge and that after twenty minutes of such use loses control because of\nits weight and suffers serious cuts to his abdomen after dropping it. Here, there would be a\ndefense of product misuse, as well as contributory negligence. Consider the urban (or Internet)\nlegend of Mervin Gratz, who supposedly put his Winnebago on autopilot to go back and make\ncoffee in the kitchen, then recovered millions after his Winnebago turned over and he suffered\nserious injuries. There are multiple defenses to this alleged action; these would include the\ndefenses of contributory negligence, comparative negligence, and product misuse. (There was\nnever any such case, and certainly no such recovery; it is not known who started this legend, or\nwhy.)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n280\n\n\x0cAnother defense against strict liability as a cause of action is the knowledgeable user defense. If\nthe parents of obese teenagers bring a lawsuit against McDonald\xe2\x80\x99s, claiming that its fast-food\nproducts are defective and that McDonald\xe2\x80\x99s should have warned customers of the adverse health\neffects of eating its products, a defense based on the knowledgeable user is available. In one\ncase, the court found that the high levels of cholesterol, fat, salt, and sugar in McDonald\xe2\x80\x99s food is\nwell known to users. The court stated, \xe2\x80\x9cIf consumers know (or reasonably should know) the\npotential ill health effects of eating at McDonald\xe2\x80\x99s, they cannot blame McDonald\xe2\x80\x99s if they,\nnonetheless, choose to satiate their appetite with a surfeit of supersized McDonald\xe2\x80\x99s\nproducts.\xe2\x80\x9d [1]\n\nKEY TAKEAWAY\n\nCommon-law courts have long held that certain activities are inherently dangerous and that\nthose who cause damage to others by engaging in those activities will be held strictly liable.\nMore recently, courts in the United States have applied strict liability to defective products.\nStrict liability, however, is not absolute liability, as there are many defenses available to\ndefendants in lawsuits based on strict liability, such as comparative negligence and product\nabuse.\n\nEXERCISES\n\n1. Someone says, \xe2\x80\x9cStrict liability means that you\xe2\x80\x99re liable for whatever you make, no matter\nwhat the consumer does with your product. It\xe2\x80\x99s a crazy system.\xe2\x80\x9d Respond to and refute this\nstatement.\n2. What is the essential difference between strict liability torts and negligent torts? Should the\nUS legal system even allow strict liability torts? What reasons seem persuasive to you?\n\n[1] Pellman v. McDonald\xe2\x80\x99s Corp., 237 F.2d 512 (S.D.N.Y. 2003).\n\n7.5 Cases\nIntentional Torts: False Imprisonment\nLester v. Albers Super Markets, Inc.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n281\n\n\x0c94 Ohio App. 313, 114 N.E.2d 529 (Ohio 1952)\nFacts: The plaintiff, carrying a bag of rolls purchased at another store, entered the defendant\xe2\x80\x99s\ngrocery store to buy some canned fruit. Seeing her bus outside, she stepped out of line and put\nthe can on the counter. The store manager intercepted her and repeatedly demanded that she\nsubmit the bag to be searched. Finally she acquiesced; he looked inside and said she could go.\nShe testified that several people witnessed the scene, which lasted about fifteen minutes, and\nthat she was humiliated. The jury awarded her $800. She also testified that no one laid a hand\non her or made a move to restrain her from leaving by any one of numerous exits.\n***\nMATTHEWS, JUDGE.\nAs we view the record, it raises the fundamental question of what is imprisonment. Before any\nneed for a determination of illegality arises there must be proof of imprisonment. In 35 Corpus\nJuris Secundum (C.J.S.), False Imprisonment, \xc2\xa7 II, pages 512\xe2\x80\x9313, it is said: \xe2\x80\x9cSubmission to the\nmere verbal direction of another, unaccompanied by force or by threats of any character, cannot\nconstitute a false imprisonment, and there is no false imprisonment where an employer\ninterviewing an employee declines to terminate the interview if no force or threat of force is used\nand false imprisonment may not be predicated on a person\xe2\x80\x99s unfounded belief that he was\nrestrained.\xe2\x80\x9d\nMany cases are cited in support of the text.\n***\nIn Fenn v. Kroger Grocery & Baking Co., Mo. Sup., 209 S.W. 885, 887, the court said:\nA case was not made out for false arrest. The plaintiff said she was intercepted as she started to\nleave the store; that Mr. Krause stood where she could not pass him in going out. She does not\nsay that he made any attempt to intercept her. She says he escorted her back to the desk, that he\nasked her to let him see the change.\n\xe2\x80\xa6She does not say that she went unwillingly\xe2\x80\xa6Evidence is wholly lacking to show that she was\ndetained by force or threats. It was probably a disagreeable experience, a humiliating one to her,\nbut she came out victorious and was allowed to go when she desired with the assurance of Mr.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n282\n\n\x0cKrause that it was all right. The demurrer to the evidence on both counts was properly\nsustained.\nThe result of the cases is epitomized in 22 Am.Jur. 368, as follows:\nA customer or patron who apparently has not paid for what he has received may be detained for\na reasonable time to investigate the circumstances, but upon payment of the demand, he has the\nunqualified right to leave the premises without restraint, so far as the proprietor is concerned,\nand it is false imprisonment for a private individual to detain one for an unreasonable time, or\nunder unreasonable circumstances, for the purpose of investigating a dispute over the payment\nof a bill alleged to be owed by the person detained for cash services.\n***\nFor these reasons, the judgment is reversed and final judgment entered for the defendantappellant.\n\nCASE QUESTIONS\n\n1. The court begins by saying what false imprisonment is not. What is the legal definition of\nfalse imprisonment?\n2. What kinds of detention are permissible for a store to use in accosting those that may have\nbeen shoplifting?\n3. Jody broke up with Jeremy and refused to talk to him. Jeremy saw Jody get into her car near\nthe business school and parked right behind her so she could not move. He then stood next\nto the driver\xe2\x80\x99s window for fifteen minutes, begging Jody to talk to him. She kept saying, \xe2\x80\x9cNo,\nlet me leave!\xe2\x80\x9d Has Jeremy committed the tort of false imprisonment?\n\nNegligence: Duty of Due Care\nWhitlock v. University of Denver\n744 P.2d 54 (Supreme Court of Colorado1987)\nOn June 19, 1978, at approximately 10:00 p.m., plaintiff Oscar Whitlock suffered a paralyzing\ninjury while attempting to complete a one-and-three-quarters front flip on a trampoline. The\ninjury rendered him a quadriplegic. The trampoline was owned by the Beta Theta Pi fraternity\n(the Beta house) and was situated on the front yard of the fraternity premises, located on the\nUniversity campus. At the time of his injury, Whitlock was twenty years old, attended the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n283\n\n\x0cUniversity of Denver, and was a member of the Beta house, where he held the office of acting\nhouse manager. The property on which the Beta house was located was leased to the local\nchapter house association of the Beta Theta Pi fraternity by the defendant University of Denver.\nWhitlock had extensive experience jumping on trampolines. He began using trampolines in\njunior high school and continued to do so during his brief tenure as a cadet at the United States\nMilitary Academy at West Point, where he learned to execute the one-and-three-quarters front\nflip. Whitlock testified that he utilized the trampoline at West Point every other day for a period\nof two months. He began jumping on the trampoline owned by the Beta house in September of\n1977. Whitlock recounted that in the fall and spring prior to the date of his injury, he jumped on\nthe trampoline almost daily. He testified further that prior to the date of his injury, he had\nsuccessfully executed the one-and-three-quarters front flip between seventy-five and one\nhundred times.\nDuring the evening of June 18 and early morning of June 19, 1978, Whitlock attended a party at\nthe Beta house, where he drank beer, vodka and scotch until 2:00 a.m. Whitlock then retired\nand did not awaken until 2:00 p.m. on June 19. He testified that he jumped on the trampoline\nbetween 2:00 p.m. and 4:00 p.m., and again at 7:00 p.m. At 10:00 p.m., the time of the injury,\nthere again was a party in progress at the Beta house, and Whitlock was using the trampoline\nwith only the illumination from the windows of the fraternity house, the outside light above the\nfront door of the house, and two street lights in the area. As Whitlock attempted to perform the\none-and-three-quarters front flip, he landed on the back of his head, causing his neck to break.\nWhitlock brought suit against the manufacturer and seller of the trampoline, the University, the\nBeta Theta Pi fraternity and its local chapter, and certain individuals in their capacities as\nrepresentatives of the Beta Theta Pi organizations. Whitlock reached settlements with all of the\nnamed defendants except the University, so only the negligence action against the University\nproceeded to trial. The jury returned a verdict in favor of Whitlock, assessing his total damages\nat $ 7,300,000. The jury attributed twenty-eight percent of causal negligence to the conduct of\nWhitlock and seventy-two percent of causal negligence to the conduct of the University. The trial\ncourt accordingly reduced the amount of the award against the University to $ 5,256,000.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n284\n\n\x0cThe University moved for judgment notwithstanding the verdict, or, in the alternative, a new\ntrial. The trial court granted the motion for judgment notwithstanding the verdict, holding that\nas a matter of law, no reasonable jury could have found that the University was more negligent\nthan Whitlock, and that the jury\xe2\x80\x99s monetary award was the result of sympathy, passion or\nprejudice.\nA panel of the court of appeals reversed\xe2\x80\xa6by a divided vote. Whitlock v. University of\nDenver, 712 P.2d 1072 (Colo. App. 1985). The court of appeals held that the University owed\nWhitlock a duty of due care to remove the trampoline from the fraternity premises or to\nsupervise its use.\xe2\x80\xa6The case was remanded to the trial court with orders to reinstate the verdict\nand damages as determined by the jury. The University then petitioned for certiorari review, and\nwe granted that petition.\n\nII.\nA negligence claim must fail if based on circumstances for which the law imposes no duty of care\nupon the defendant for the benefit of the plaintiff. [Citations] Therefore, if Whitlock\xe2\x80\x99s judgment\nagainst the University is to be upheld, it must first be determined that the University owed a\nduty of care to take reasonable measures to protect him against the injury that he sustained.\nWhether a particular defendant owes a legal duty to a particular plaintiff is a question of law.\n[Citations] \xe2\x80\x9cThe court determines, as a matter of law, the existence and scope of the duty\xe2\x80\x94that\nis, whether the plaintiff\xe2\x80\x99s interest that has been infringed by the conduct of the defendant is\nentitled to legal protection.\xe2\x80\x9d [Citations] In Smith v. City & County of Denver, 726 P.2d 1125\n(Colo. 1986), we set forth several factors to be considered in determining the existence of duty in\na particular case:\nWhether the law should impose a duty requires consideration of many factors including, for\nexample, the risk involved, the foreseeability and likelihood of injury as weighed against the\nsocial utility of the actor\xe2\x80\x99s conduct, the magnitude of the burden of guarding against injury or\nharm, and the consequences of placing the burden upon the actor.\n\xe2\x80\xa6A court\xe2\x80\x99s conclusion that a duty does or does not exist is \xe2\x80\x9can expression of the sum total of\nthose considerations of policy which lead the law to say that the plaintiff is [or is not] entitled to\nprotection.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n285\n\n\x0c\xe2\x80\xa6\nWe believe that the fact that the University is charged with negligent failure to act rather than\nnegligent affirmative action is a critical factor that strongly militates against imposition of a duty\non the University under the facts of this case. In determining whether a defendant owes a duty\nto a particular plaintiff, the law has long recognized a distinction between action and a failure to\nact\xe2\x80\x94\xe2\x80\x9cthat is to say, between active misconduct working positive injury to others [misfeasance]\nand passive inaction or a failure to take steps to protect them from harm [nonfeasance].\xe2\x80\x9d W.\nKeeton, \xc2\xa7 56, at 373. Liability for nonfeasance was slow to receive recognition in the law. \xe2\x80\x9cThe\nreason for the distinction may be said to lie in the fact that by \xe2\x80\x98misfeasance\xe2\x80\x99 the defendant has\ncreated a new risk of harm to the plaintiff, while by \xe2\x80\x98nonfeasance\xe2\x80\x99 he has at least made his\nsituation no worse, and has merely failed to benefit him by interfering in his\naffairs.\xe2\x80\x9d Id. The Restatement (Second) of Torts \xc2\xa7 314 (1965) summarizes the law on this point as\nfollows:\nThe fact that an actor realizes or should realize that action on his part is necessary for another\xe2\x80\x99s\naid or protection does not of itself impose upon him a duty to take such action.\nImposition of a duty in all such cases would simply not meet the test of fairness under\ncontemporary standards.\nIn nonfeasance cases the existence of a duty has been recognized only during the last century in\nsituations involving a limited group of special relationships between parties. Such special\nrelationships are predicated on \xe2\x80\x9csome definite relation between the parties, of such a character\nthat social policy justifies the imposition of a duty to act.\xe2\x80\x9d W. Keeton, \xc2\xa7 56, at 374. Special\nrelationships that have been recognized by various courts for the purpose of imposition of a duty\nof care include common carrier/passenger, innkeeper/guest, possessor of land/invited entrant,\nemployer/employee, parent/child, and hospital/patient. See Restatement (Second) of Torts \xc2\xa7\n314 A (1965); 3 Harper and James, \xc2\xa7 18.6, at 722\xe2\x80\x9323. The authors of theRestatement (Second)\nof Torts \xc2\xa7 314 A, comment b (1965), state that \xe2\x80\x9cthe law appears\xe2\x80\xa6to be working slowly toward a\nrecognition of the duty to aid or protect in any relation of dependence or of mutual dependence.\xe2\x80\x9d\n\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n286\n\n\x0cIII.\nThe present case involves the alleged negligent failure to act, rather than negligent action. The\nplaintiff does not complain of any affirmative action taken by the University, but asserts instead\nthat the University owed to Whitlock the duty to assure that the fraternity\xe2\x80\x99s trampoline was used\nonly under supervised conditions comparable to those in a gymnasium class, or in the\nalternative to cause the trampoline to be removed from the front lawn of the Beta house.\xe2\x80\xa6If\nsuch a duty is to be recognized, it must be grounded on a special relationship between the\nUniversity and Whitlock. According to the evidence, there are only two possible sources of a\nspecial relationship out of which such a duty could arise in this case: the status of Whitlock as a\nstudent at the University, and the lease between the University and the fraternity of which\nWhitlock was a member. We first consider the adequacy of the student-university relationship\nas a possible basis for imposing a duty on the University to control or prohibit the use of the\ntrampoline, and then examine the provisions of the lease for that same purpose.\n\nA.\nThe student-university relationship has been scrutinized in several jurisdictions, and it is\ngenerally agreed that a university is not an insurer of its students\xe2\x80\x99 safety. [Citations] The\nrelationship between a university and its students has experienced important change over the\nyears. At one time, college administrators and faculties stood in loco parentis to their students,\nwhich created a special relationship \xe2\x80\x9cthat imposed a duty on the college to exercise control over\nstudent conduct and, reciprocally, gave the students certain rights of protection by the\ncollege.\xe2\x80\x9d Bradshaw, 612 F.2d at 139. However, in modern times there has evolved a gradual\nreapportionment of responsibilities from the universities to the students, and a corresponding\ndeparture from the in loco parentis relationship. Id. at 139\xe2\x80\x9340. Today, colleges and universities\nare regarded as educational institutions rather than custodial ones. Beach, 726 P.2d at 419\n(contrasting colleges and universities with elementary and high schools).\n\xe2\x80\xa6\n\xe2\x80\xa6By imposing a duty on the University in this case, the University would be encouraged to\nexercise more control over private student recreational choices, thereby effectively taking away\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n287\n\n\x0cmuch of the responsibility recently recognized in students for making their own decisions with\nrespect to private entertainment and personal safety. Such an allocation of responsibility would\n\xe2\x80\x9cproduce a repressive and inhospitable environment, largely inconsistent with the objectives of a\nmodern college education.\xe2\x80\x9d Beach, 726 P.2d at 419.\nThe evidence demonstrates that only in limited instances has the University attempted to\nimpose regulations or restraints on the private recreational pursuits of its students, and the\nstudents have not looked to the University to assure the safety of their recreational choices.\nNothing in the University\xe2\x80\x99s student handbook, which contains certain regulations concerning\nstudent conduct, reflects an effort by the University to control the risk-taking decisions of its\nstudents in their private recreation.\xe2\x80\xa6Indeed, fraternity and sorority self-governance with\nminimal supervision appears to have been fostered by the University.\n\xe2\x80\xa6\nAside from advising the Beta house on one occasion to put the trampoline up when not in use,\nthere is no evidence that the University officials attempted to assert control over trampoline use\nby the fraternity members. We conclude from this record that the University\xe2\x80\x99s very limited\nactions concerning safety of student recreation did not give Whitlock or the other members of\ncampus fraternities or sororities any reason to depend upon the University for evaluation of the\nsafety of trampoline use.\xe2\x80\xa6Therefore, we conclude that the student-university relationship is not\na special relationship of the type giving rise to a duty of the University to take reasonable\nmeasures to protect the members of fraternities and sororities from risks of engaging in extracurricular trampoline jumping.\nThe plaintiff asserts, however, that we should recognize a duty of the University to take\naffirmative action to protect fraternity members because of the foreseeability of the injury, the\nextent of the risks involved in trampoline use, the seriousness of potential injuries, and the\nUniversity\xe2\x80\x99s superior knowledge concerning these matters. The argument in essence is that a\nduty should spring from the University\xe2\x80\x99s natural interest in the welfare and safety of its\nstudents, its superior knowledge of the nature and degree of risk involved in trampoline use, and\nits knowledge of the use of trampolines on the University campus. The evidence amply supports\na conclusion that trampoline use involves risks of serious injuries and that the potential for an\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n288\n\n\x0cinjury such as that experienced by Whitlock was foreseeable. It shows further that prior injuries\nresulting from trampoline accidents had been reported to campus security and to the student\nclinic, and that University administrators were aware of the number and severity of trampoline\ninjuries nationwide.\nThe record, however, also establishes through Whitlock\xe2\x80\x99s own testimony that he was aware of\nthe risk of an accident and injury of the very nature that he experienced.\xe2\x80\xa6\nWe conclude that the relationship between the University and Whitlock was not one of\ndependence with respect to the activities at issue here, and provides no basis for the recognition\nof a duty of the University to take measures for protection of Whitlock against the injury that he\nsuffered.\n\nB.\nWe next examine the lease between the University and the fraternity to determine whether a\nspecial relationship between the University and Whitlock can be predicated on that document.\nThe lease was executed in 1929, extends for a ninety-nine year term, and gives the fraternity the\noption to extend the term for another ninety-nine years. The premises are to be occupied and\nused by the fraternity \xe2\x80\x9cas a fraternity house, clubhouse, dormitory and boarding house, and\ngenerally for religious, educational, social and fraternal purposes.\xe2\x80\x9d Such occupation is to be\n\xe2\x80\x9cunder control of the tenant.\xe2\x80\x9d (emphasis added) The annual rental at all times relevant to this\ncase appears from the record to be one dollar. The University has the obligation to maintain the\ngrounds and make necessary repairs to the building, and the fraternity is to bear the cost of such\nmaintenance and repair.\n\xe2\x80\xa6\nWe conclude that the lease, and the University\xe2\x80\x99s actions pursuant to its rights under the lease,\nprovide no basis of dependence by the fraternity members upon which a special relationship can\nbe found to exist between the University and the fraternity members that would give rise to a\nduty upon the University to take affirmative action to assure that recreational equipment such as\na trampoline is not used under unsafe conditions.\n\nIV.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n289\n\n\x0cConsidering all of the factors presented, we are persuaded that under the facts of this case the\nUniversity of Denver had no duty to Whitlock to eliminate the private use of trampolines on its\ncampus or to supervise that use. There exists no special relationship between the parties that\njustifies placing a duty upon the University to protect Whitlock from the well-known dangers of\nusing a trampoline. Here, a conclusion that a special relationship existed between Whitlock and\nthe University sufficient to warrant the imposition of liability for nonfeasance would directly\ncontravene the competing social policy of fostering an educational environment of student\nautonomy and independence.\nWe reverse the judgment of the court of appeals and return this case to that court with\ndirections to remand it to the trial court for dismissal of Whitlock\xe2\x80\x99s complaint against the\nUniversity.\n\nCASE QUESTIONS\n\n1. How are comparative negligence numbers calculated by the trial court? How can the jury say\nthat the university is 72 percent negligent and that Whitlock is 28 percent negligent?\n2. Why is this not an assumption of risk case?\n3. Is there any evidence that Whitlock was contributorily negligent? If not, why would the court\nengage in comparative negligence calculations?\n\nNegligence: Proximate Cause\nPalsgraf v. Long Island R.R.\n248 N.Y. 339,162 N.E. 99 (N.Y. 1928)\nCARDOZO, Chief Judge\nPlaintiff was standing on a platform of defendant\xe2\x80\x99s railroad after buying a ticket to go to\nRockaway Beach. A train stopped at the station, bound for another place. Two men ran forward\nto catch it. One of the men reached the platform of the car without mishap, though the train was\nalready moving. The other man, carrying a package, jumped aboard the car, but seemed\nunsteady as if about to fall. A guard on the car, who had held the door open, reached forward to\nhelp him in, and another guard on the platform pushed him from behind. In this act, the\npackage was dislodged, and fell upon the rails. It was a package of small size, about fifteen\ninches long, and was covered by a newspaper. In fact it contained fireworks, but there was\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n290\n\n\x0cnothing in its appearance to give notice of its contents. The fireworks when they fell exploded.\nThe shock of\xc2\xb7 the explosion threw down some scales at the other end of the platform many feet\naway. The scales struck the plaintiff, causing injuries for which she sues.\nThe conduct of the defendant\xe2\x80\x99s guard, if a wrong in its relation to the holder of the package, was\nnot a wrong in its relation to the plaintiff, standing far away. Relatively to her it was not\nnegligence at all. Nothing in the situation gave notice that the falling package had in it the\npotency of peril to persons thus removed. Negligence is not actionable unless it involves the\ninvasion of a legally protected interest, the violation of a right. \xe2\x80\x9cProof of negligence in the air, so\nto speak, will not do.\xe2\x80\xa6If no hazard was apparent to the eye of ordinary vigilance, an act innocent\nand harmless, at least to outward seeming, with reference to her, did not take to itself the quality\nof a tort because it happened to be a wrong, though apparently not one involving the risk of\nbodily insecurity, with reference to someone else.\xe2\x80\xa6The plaintiff sues in her own right for a\nwrong personal to her, and not as the vicarious beneficiary of a breach of duty to another.\nA different conclusion will involve us, and swiftly too, in a maze of contradictions. A guard\nstumbles over a package which has been left upon a platform.\nIt seems to be a bundle of newspapers. It turns out to be a can of dynamite. To the eye of\nordinary vigilance, the bundle is abandoned waste, which may be kicked or trod on with\nimpunity. Is a passenger at the other end of the platform protected by the law against the\nunsuspected hazard concealed beneath the waste? If not, is the result to be any different, so far\nas the distant passenger is concerned, when the guard stumbles over a valise which a truckman\nor a porter has left upon the walk?\xe2\x80\xa6The orbit of the danger as disclosed to the eye of reasonable\nvigilance would be the orbit of the duty. One who jostles one\xe2\x80\x99s neighbor in a crowd does not\ninvade the rights of others standing at the outer fringe when the unintended contact casts a\nbomb upon the ground. The wrongdoer as to them is the man who carries the bomb, not the one\nwho explodes it without suspicion of the danger. Life will have to be made over, and human\nnature transformed, before prevision so extravagant can be accepted as the norm of conduct, the\ncustomary standard to which behavior must conform.\nThe argument for the plaintiff is built upon the shifting meanings of such words as \xe2\x80\x9cwrong\xe2\x80\x9d and\n\xe2\x80\x9cwrongful\xe2\x80\x9d and shares their instability. For what the plaintiff must show is a \xe2\x80\x9cwrong\xe2\x80\x9d to herself;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n291\n\n\x0ci.e., a violation of her own right, and not merely a \xe2\x80\x9cwrong\xe2\x80\x9d to someone else, nor conduct\n\xe2\x80\x9cwrongful\xe2\x80\x9d because unsocial, but not a \xe2\x80\x9cwrong\xe2\x80\x9d to anyone. We are told that one who drives at\nreckless speed through a crowded city street is guilty of a negligent act and therefore of a\nwrongful one, irrespective of the consequences.\nNegligent the act is, and wrongful in the sense that it is unsocial, but wrongful and unsocial in\nrelation to other travelers, only because the eye of vigilance perceives the risk of damage. If the\nsame act were to be committed on a speedway or a race course, it would lose its wrongful\nquality. The risk reasonably to be perceived defines the duty to be obeyed, and risk imports\nrelation; it is risk to another or to others within the range of apprehension. This does not mean,\nof course, that one who launches a destructive force is always relieved of liability, if the force,\nthough known to be destructive, pursues an unexpected path.\xe2\x80\xa6Some acts, such as shooting are\nso imminently dangerous to anyone who may come within reach of the missile however\nunexpectedly, as to impose a duty of prevision not far from that of an insurer. Even today, and\nmuch oftener in earlier stages of the law, one acts sometimes at one\xe2\x80\x99s peril.\xe2\x80\xa6These cases aside,\nwrong-is defined in terms of the natural or probable, at least when unintentional.\xe2\x80\xa6Negligence,\nlike risk, is thus a term of relation.\nNegligence in the abstract, apart from things related, is surely not a tort, if indeed it is\nunderstandable at all.\xe2\x80\xa6One who seeks redress at law does not make out a cause of action by\nshowing without more that there has been damage to his person. If the harm was not willful, he\nmust show that the act as to him had possibilities of danger so many and apparent as to entitle\nhim to be protected against the doing of it though the harm was unintended.\n***\nThe judgment of the Appellate Division and that of the Trial Term should be reversed, and the\ncomplaint dismissed, with costs in all courts.\n\nCASE QUESTIONS\n\n1. Is there actual cause in this case? How can you tell?\n2. Why should Mrs. Palsgraf (or her insurance company) be made to pay for injuries that were\ncaused by the negligence of the Long Island Rail Road?\n3. How is this accident not foreseeable?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n292\n\n\x0cKlein v. Pyrodyne Corporation\nKlein v. Pyrodyne Corporation\n810 P.2d 917 (Supreme Court of Washington 1991)\nPyrodyne Corporation (Pyrodyne) is a licensed fireworks display company that contracted to\ndisplay fireworks at the Western Washington State Fairgrounds in Puyallup, Washington, on\nJuly 4,1987. During the fireworks display, one of the mortar launchers discharged a rocket on a\nhorizontal trajectory parallel to the earth. The rocket exploded near a crowd of onlookers,\nincluding Danny Klein. Klein\xe2\x80\x99s clothing was set on fire, and he suffered facial burns and serious\ninjury to his eyes. Klein sued Pyrodyne for strict liability to recover for his injuries. Pyrodyne\nasserted that the Chinese manufacturer of the fireworks was negligent in producing the rocket\nand therefore Pyrodyne should not be held liable. The trial court applied the doctrine of strict\nliability and held in favor of Klein. Pyrodyne appealed.\nSection 519 of the Restatement (Second) of Torts provides that any party carrying on an\n\xe2\x80\x9cabnormally dangerous activity\xe2\x80\x9d is strictly liable for ensuing damages. The public display of\nfireworks fits this definition. The court stated: \xe2\x80\x9cAny time a person ignites rockets with the\nintention of sending them aloft to explode in the presence of large crowds of people, a high risk\nof serious personal injury or property damage is created. That risk arises because of the\npossibility that a rocket will malfunction or be misdirected.\xe2\x80\x9d Pyrodyne argued that its liability\nwas cut off by the Chinese manufacturer\xe2\x80\x99s negligence. The court rejected this argument, stating,\n\xe2\x80\x9cEven if negligence may properly be regarded as an intervening cause, it cannot function to\nrelieve Pyrodyne from strict liability.\xe2\x80\x9d\nThe Washington Supreme Court held that the public display of fireworks is an abnormally\ndangerous activity that warrants the imposition of strict liability.\nAffirmed.\n\nCASE QUESTIONS\n\n1. Why would certain activities be deemed ultrahazardous or abnormally dangerous so that\nstrict liability is imposed?\n2. If the activities are known to be abnormally dangerous, did Klein assume the risk?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n293\n\n\x0c3. Assume that the fireworks were negligently manufactured in China. Should Klein\xe2\x80\x99s only\nremedy be against the Chinese company, as Pyrodyne argues? Why or why not?\n\n7.6 Summary and Exercises\nSummary\n\nThe principles of tort law pervade modern society because they spell out the duties of care that\nwe owe each other in our private lives. Tort law has had a significant impact on business because\nmodern technology poses significant dangers and the modern market is so efficient at\ndistributing goods to a wide class of consumers.\nUnlike criminal law, tort law does not require the tortfeasor to have a specific intent to commit\nthe act for which he or she will be held liable to pay damages. Negligence\xe2\x80\x94that is, carelessness\xe2\x80\x94\nis a major factor in tort liability. In some instances, especially in cases involving injuries caused\nby products, a no-fault standard called strict liability is applied.\nWhat constitutes a legal injury depends very much on the circumstances. A person can assume a\nrisk or consent to the particular action, thus relieving the person doing the injury from tort\nliability. To be liable, the tortfeasor must be the proximate cause of the injury, not a remote\ncause. On the other hand, certain people are held to answer for the torts of another\xe2\x80\x94for\nexample, an employer is usually liable for the torts of his employees, and a bartender might be\nliable for injuries caused by someone to whom he sold too many drinks. Two types of statutes\xe2\x80\x94\nworkers\xe2\x80\x99 compensation and no-fault automobile insurance\xe2\x80\x94have eliminated tort liability for\ncertain kinds of accidents and replaced it with an immediate insurance payment plan.\nAmong the torts of particular importance to the business community are wrongful death and\npersonal injury caused by products or acts of employees, misrepresentation, defamation, and\ninterference with contractual relations.\n\nEXERCISES\n\n1. What is the difference in objectives between tort law and criminal law?\n2. A woman fell ill in a store. An employee put the woman in an infirmary but provided no\nmedical care for six hours, and she died. The woman\xe2\x80\x99s family sued the store for wrongful\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n294\n\n\x0cdeath. What arguments could the store make that it was not liable? What arguments could\nthe family make? Which seem the stronger arguments? Why?\n3. The signals on a railroad crossing are defective. Although the railroad company was notified\nof the problem a month earlier, the railroad inspector has failed to come by and repair them.\nSeeing the all-clear signal, a car drives up and stalls on the tracks as a train rounds the bend.\nFor the past two weeks the car had been stalling, and the driver kept putting off taking the\ncar to the shop for a tune-up. As the train rounds the bend, the engineer is distracted by a\nconductor and does not see the car until it is too late to stop. Who is negligent? Who must\nbear the liability for the damage to the car and to the train?\n4. Suppose in the Katko v. Briney case (Section 7.2 "Intentional Torts") that instead of setting\nsuch a device, the defendants had simply let the floor immediately inside the front door rot\nuntil it was so weak that anybody who came in and took two steps straight ahead would fall\nthrough the floor and to the cellar. Will the defendant be liable in this case? What if they\ninvited a realtor to appraise the place and did not warn her of the floor? Does it matter\nwhether the injured person is a trespasser or an invitee?\n5. Plaintiff\xe2\x80\x99s husband died in an accident, leaving her with several children and no money\nexcept a valid insurance policy by which she was entitled to $5,000. Insurance Company\nrefused to pay, delaying and refusing payment and meanwhile \xe2\x80\x9cinviting\xe2\x80\x9d Plaintiff to accept\nless than $5,000, hinting that it had a defense. Plaintiff was reduced to accepting housing and\ncharity from relatives. She sued the insurance company for bad-faith refusal to settle the\nclaim and for the intentional infliction of emotional distress. The lower court dismissed the\ncase. Should the court of appeals allow the matter to proceed to trial?\n\nSELF-TEST QUESTIONS\n\n1. Catarina falsely accuses Jeff of stealing from their employer. The statement is\ndefamatory only if\na.\n\na third party hears it\nb. Nick suffers severe emotional distress as a result\nc. the statement is the actual and proximate cause of his distress\nd. the statement is widely circulated in the local media and on Twitter\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n295\n\n\x0cGarrett files a suit against Colossal Media Corporation for defamation.\nColossal has said that Garrett is a \xe2\x80\x9csleazy, corrupt public official\xe2\x80\x9d (and provided\nsome evidence to back the claim). To win his case, Garrett will have to show that\nColossal acted with\na.\n\nmalice\nb. ill will\nc. malice aforethought\nd. actual malice\nBig Burger begins a rumor, using social media, that the meat in Burger\nWorld is partly composed of ground-up worms. The rumor is not true, as Big\nBurger well knows. Its intent is to get some customers to shift loyalty from Burger\nWorld to Big Burger. Burger World\xe2\x80\x99s best cause of action would be\n\na.\n\ntrespass on the case\nb. nuisance\nc. product disparagement\nd. intentional infliction of emotional distress\nWilfred Phelps, age 65, is driving his Nissan Altima down Main Street when\nhe suffers the first seizure of his life. He loses control of his vehicle and runs into\nthree people on the sidewalk. Which statement is true?\na.\n\nHe is liable for an intentional tort.\n\nb. He is liable for a negligent tort.\nc. He is not liable for a negligent tort.\nd. He is liable under strict liability, because driving a car is abnormally dangerous.\nJonathan carelessly bumps into Amanda, knocking her to the ground. He\nhas committed the tort of negligence\na.\n\nonly if Amanda is injured\n\nb. only if Amanda is not injured\nc. whether or not Amanda is injured\n\nSELF-TEST ANSWERS\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n296\n\n\x0c1. a\n2. d\n3. c\n4. c\n5. a\n\nChapter 8\nContracts\n\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1. What role contracts play in society today\n2. What a contract is\n3. The sources of contract law\n4. Some basic contract taxonomy\n5. The required elements of a contract: mutual assent, consideration, legality, and capacity\n6. The circumstances when a contract needs to be in writing to be enforceable\n7. The remedies for breach of contract\nThe two fundamental concepts considered the twin cornerstones of business relationships are\ncontract and tort. Although both involve the concept of duty, creation of the duty differs in a\nmanner that is important to business. The parties create contractduties through a bargaining\nprocess. The key element in the process is control; individuals are in control of a situation\nbecause they have the freedom to decide whether to enter into a contractual\nrelationship. Tort duties, in contrast, are obligations the law imposes. Despite the obvious\ndifficulty in controlling tort liability, an understanding of tort theory is important because it is a\ncritical factor in strategic planning and risk management.\n\n8.1 General Perspectives on Contracts\nLEARNING OBJECTIVES\n\n1. Understand the role of contract in society: it moves society from status to contract.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n297\n\n\x0c2. Know the definition of a contract.\n3. Recognize the sources of contract law: the common law, the UCC, and the Convention on the\nInternational Sale of Goods\xe2\x80\x94a treaty (the CISG).\n4. Understand some fundamental contract taxonomy and terminology.\n\nThe Role of Contract in Society\nContract is probably the most familiar legal concept in our society because it is so central to a\ndeeply held conviction about the essence of our political, economic, and social life. In common\nparlance, the term is used interchangeably with agreement, bargain, undertaking, or deal; but\nwhatever the word, it embodies our notion of freedom to pursue our own lives together with\nothers. Contract is central because it is the means by which a free society orders what would\notherwise be a jostling, frenetic anarchy. So commonplace is the concept of contract\xe2\x80\x94and our\nfreedom to make contracts with each other\xe2\x80\x94that it is difficult to imagine a time when contracts\nwere rare, an age when people\xe2\x80\x99s everyday associations with one another were not freely\ndetermined. Yet in historical terms, it was not so long ago that contracts were rare, entered into\nif at all by very few. In \xe2\x80\x9cprimitive\xe2\x80\x9d societies and in the medieval Europe from which our\ninstitutions sprang, the relationships among people were largely fixed; traditions spelled out\nduties that each person owed to family, tribe, or manor. Though he may have oversimplified, Sir\nHenry Maine, a nineteenth-century historian, sketched the development of society in his classic\nbook Ancient Law. As he put it:\n(F)rom a condition of society in which all the relations of Persons are summed up in the\nrelations of Family, we seem to have steadily moved towards a phase of social order in which all\nthese relations arise from the free agreement of Individuals. . . . Thus the status of the Slave has\ndisappeared\xe2\x80\x94it has been superseded by the contractual relation of the servant to his master. . . .\nThe status of the Female under Tutelage . . . has also ceased to exist. . . . So too the status of the\nSon under Power has no true place in the law of modern European societies. If any civil\nobligation binds together the Parent and the child of full age, it is one to which only contract\ngives its legal validity.... If then we employ Status, agreeably with the usage of the best writers, to\nsignify these personal conditions [arising from ancient legal privileges of the Family] only, we\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n298\n\n\x0cmay say that the movement of the progressive societies has hitherto been a movement from\nStatus to Contract. [1]\nThis movement was not accidental. It went hand-in-glove with the emerging industrial order;\nfrom the fifteenth to the nineteenth centuries, as England, especially, evolved into a booming\nmercantile economy with all that that implies\xe2\x80\x94flourishing trade, growing cities, an expanding\nmonetary system, commercialization of agriculture, mushrooming manufacturing\xe2\x80\x94contract law\nwas created of necessity.\nContract law did not develop, however, according to a conscious, far-seeing plan. It was a\nresponse to changing conditions, and the judges who created it frequently resisted, preferring\nthe quieter, imagined pastoral life of their forefathers. Not until the nineteenth century, in both\nthe United States and England, did a full-fledged law of contracts arise together with modem\ncapitalism.\n\nContract Defined\nAs usual in the law, the legal definition of \xe2\x80\x9ccontract\xe2\x80\x9d is formalistic. The Restatement says: \xe2\x80\x9cA\ncontract is a promise or a set of promises for the breach of which the law gives a remedy, or the\nperformance of which the law in some way recognizes as a duty.\xe2\x80\x9d(Restatement (Second) of\nContracts, Section 1) Similarly, the Uniform Commercial Code says: \xe2\x80\x9c\xe2\x80\x98Contract\xe2\x80\x99 means the total\nlegal obligation which results from the parties\xe2\x80\x99 agreement as affected by this Act and any other\napplicable rules of law.\xe2\x80\x9d (Section 1-201(11)) A short-hand definition is: \xe2\x80\x9cA contract is a legally\nenforceable promise.\xe2\x80\x9d\n\nEconomic View of Contract Law\nIn An Economic Analysis of Law (1973), Judge Richard A. Posner (a former University of\nChicago law professor) suggests that contract law performs three significant economic functions.\nFirst, it helps maintain incentives to individuals to exchange goods and services efficiently.\nSecond, it reduces the costs of economic transactions because its very existence means that the\nparties need not go to the trouble of negotiating a variety of rules and terms already spelled out.\nThird, the law of contracts alerts the parties to trouble spots that have arisen in the past, thus\nmaking it easier to plan the transactions more intelligently and avoid potential pitfalls.\n\nSources of Contract Law\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n299\n\n\x0cThere are four basic sources of contract law: the Constitution, federal and state statutes, federal\nand state case law, and administrative law. For our purposes, the most important of these, and\nthe ones that we will examine at some length, are case lawand statutes.\n\nCase (Common) Law and the Restatement of Contracts\nBecause contract law was forged in the common-law courtroom, hammered out case by case on\nthe anvil of individual judges, it grew in the course of time to formidable proportions. By the\nearly twentieth century, tens of thousands of contract disputes had been submitted to the courts\nfor resolution, and the published opinions, if collected in one place, would have filled dozens of\nbookshelves. Clearly this mass of case law was too unwieldy for efficient use. A similar problem\nhad developed in the other leading branches of the common law. Disturbed by the profusion of\ncases and the resulting uncertainty of the law, a group of prominent American judges, lawyers,\nand teachers founded the American law Institute in 1923 to attempt to clarify, simplify, and\nimprove the law. One of its first projects, and ultimately one of its most successful, was the\ndrafting of the Restatement of the Law of Contracts, completed in 1932. A revision\xe2\x80\x94\nthe Restatement (Second) of Contracts\xe2\x80\x94was undertaken in 1946 and finally completed in 1979.\nThe Restatements (others exist in the fields of torts, agency, conflicts of laws, judgments,\nproperty, restitution, security, and trusts) are detailed analyses of the decided cases in the field.\nThese analyses are made with an eye to discerning the various principles that have emerged\nfrom the courts, and to the maximum extent possible, the Restatements declare the law as the\ncourts have determined it to be. The Restatements, guided by a Reporter (the director of the\nproject) and a staff of legal scholars, go through several so-called \xe2\x80\x9ctentative\xe2\x80\x9d drafts\xe2\x80\x94sometimes\nas many as fifteen or twenty\xe2\x80\x94and are screened by various committees within the American Law\nInstitute before they are eventually published as final documents.\nThe Restatement of Contracts won prompt respect in the courts and has been cited in\ninnumerable cases. The Restatements are not authoritative, in the sense that they are not actual\njudicial precedents, but they are nevertheless weighty interpretive texts, and judges frequently\nlook to them for guidance. They are as close to \xe2\x80\x9cblack letter\xe2\x80\x9d rules of law as exist anywhere in the\nAmerican legal system for judge-made (common) law.\n\nStatutory Law: The Uniform Commercial Code\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n300\n\n\x0cCommon law contract principles govern contracts for real estate and for services, obviously very\nimportant areas of law. But in one area the common law has been superseded by an important\nstatute: the Uniform Commercial Code (UCC), especially Article 2, which deals with the sale of\ngoods.\n\nA Brief History\nThe UCC is a model law developed by the American law Institute and the National Conference of\nCommissioners on Uniform State Laws; it has been adopted in one form or another in all fifty\nstates, the District of Columbia, and the American territories. It is the only \xe2\x80\x9cnational\xe2\x80\x9d law not\nenacted by Congress.\nBefore the UCC was written, commercial law varied, sometimes greatly, from state to state. This\nfirst proved a nuisance and then a serious impediment to business as the American economy\nbecame nationwide during the twentieth century. Although there had been some uniform laws\nconcerned with commercial deals\xe2\x80\x94including the Uniform Sales Act, first published in 1906\xe2\x80\x94few\nwere widely adopted and none nationally. As a result, the law governing sales of goods,\nnegotiable instruments, warehouse receipts, securities, and other matters crucial to doing\nbusiness in an industrial, market economy was a crazy quilt of untidy provisions that did not\nmesh well from state to state.\nInitial drafting of the UCC began in 1942 and was ten years in the making, involving the efforts\nof hundreds of practicing lawyers, law teachers, and judges. A final draft, promulgated by the\nInstitute and the Conference, was endorsed by the American Bar Association and published in\n1951.\nPennsylvania enacted the code in its entirety in 1953. It was the only state to enact the original\nversion, because the Law Revision Commission of the New York State legislature began to\nexamine it line by line and had serious objections. Three years later, in 1956, a revised code was\nissued. This version, known as the 1957 Official Text, was enacted in Massachusetts and\nKentucky. In 1958, the Conference and the Institute amended the Code further and again\nreissued it, this time as the 1958 Official Text. Sixteen states, including Pennsylvania, adopted\nthis version.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n301\n\n\x0cBut in so doing, many of these states changed particular provisions. As a consequence, the\nUniform Commercial Code was no longer so uniform. Responding to this development the\nAmerican Law Institute established a permanent editorial board to oversee future revisions of\nthe code. Various subcommittees went to work redrafting, and a 1962 Official Text was\neventually published. Twelve more states adopted the code, eleven of them the 1962 text. By\n1966, only three states and two territories had failed to enact any version: Arizona, Idaho,\nLouisiana, Guam, and Puerto Rico.\nMeanwhile, non-uniform provisions continued to be enacted in various states, particularly in\nArticle 9, to which 337 such amendments had been made. In 1971, a redraft of that article was\nreadied and the 1972 Official Text was published. By that time, Louisiana was the only holdout.\nTwo years later, in 1974, Louisiana made the UCC a truly national law when it enacted some but\nnot all of the 1972 text (significantly, Louisiana has not adopted Article 2). One more major\nchange was made, a revision of Article 8, necessitated by the electronics revolution that led to\nnew ways of transferring investment securities from seller to purchaser. This change was\nincorporated in the 1978 Official Text, the version that remains current.\nFrom this brief history, it is clear that the UCC is now a basic law of relevance to every business\nand business lawyer in the United States, even though it is not entirely uniform because\ndifferent states have adopted it at various stages of its evolution\xe2\x80\x94an evolution that continues\nstill.\n\nThe Basic Framework of the UCC\nThe UCC embraces the Jaw of \xe2\x80\x9ccommercial transactions,\xe2\x80\x9d a term of some ambiguity. A\ncommercial transaction may seem to be a series of separate transactions; it may include, for\nexample, the making of a contract for the sale of goods, the signing of a check, the endorsement\nof the check, the shipment of goods under a bill of Lading, and so on. However, the UCC\npresupposes that each of these transactions is a facet of one single transaction: the sale of and\npayment for goods. The Code deals with phases of this transaction from start to finish. These\nphases are organized according to the following \xe2\x80\x9carticles\xe2\x80\x9d:\n\xe2\x80\xa2\n\nSales (Article 2)\n\n\xe2\x80\xa2\n\nCommercial Paper (Article 3)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n302\n\n\x0c\xe2\x80\xa2\n\nBank Deposits and Collections (Article 4)\n\n\xe2\x80\xa2\n\nLetters of Credit (Article 5)\n\n\xe2\x80\xa2\n\nBulk Transfers (Article 6)\n\n\xe2\x80\xa2\n\nWarehouse Receipts, Bills of Lading, and Other Documents of Title (Article 7)\n\n\xe2\x80\xa2\n\nInvestment Securities (Article 8)\n\n\xe2\x80\xa2\n\nSecured Transactions; Sales of Accounts and Chattel Paper (Article 9)\nWe now turn our attention to the sale\xe2\x80\x94the first facet, and the cornerstone, of the commercial\ntransaction. Sales law is a special type of contract law in that Article 2 applies only to the sale of\ngoods, defined (Section 2-105) in part as \xe2\x80\x9call things . . . which are movable at the time of\nidentification to the contract for sale other than the money in which the price is to be paid. . . .\xe2\x80\x9d\nThe only contracts and agreements covered by Article 2 are those relating to the present or\nfuture sale of goods.\nIn certain cases, the courts have difficulty in determining the nature of the object of a sales\ncontract. The problem: How can goods and services be separated in contracts calling for the\nseller to deliver a combination of goods and services? This difficulty frequently arises in product\nliability cases in which the buyer sues the seller for breach of one of the UCC warranties. For\nexample, you go to the hairdresser for a permanent and the shampoo gives you a severe scalp\nrash. May you recover damages on the grounds that either the hairdresser or the manufacturer\nbreached an implied warranty in the sale of goods?\nWhen the goods used are incidental to the service, the courts are split on whether the plaintiff\nshould win. Compare Epstein v. Giannattasio, 197 A.2d 342 (Conn. 1963), in which the court\nheld that no sale of goods had been made because the plaintiff received a treatment in which the\ncosmetics were only incidentally used, with Newmark v.Gimbel\xe2\x80\x99s Inc., 258 A.2d 697 (N.J. 1969),\nin which the court said \xe2\x80\x9c[i]f the permanent wave lotion were sold \xe2\x80\xa6 for home consumption . . .\nunquestionably an implied warranty of fitness for that purpose would have been an integral\nincident of the sale.\xe2\x80\x9d The New Jersey court rejected the defendant\xe2\x80\x99s argument that by actually\napplying the lotion to the patron\xe2\x80\x99s head the salon lessened the liability it otherwise would have\nhad if it had simply sold her the lotion.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n303\n\n\x0cIn two areas, state legislatures have taken the goods vs. services issue out of the courts\xe2\x80\x99 hands\nand resolved the issue through legislation. One area involves restaurant cases, in which typically\nthe plaintiff charges that he became ill because of tainted food. UCC Section 2\xc2\xb7314(1) states that\nany seller who is regularly a merchant of the goods sold impliedly warrants their\nmerchantability in a contract for their sale. This section explicitly declares that serving food or\ndrink is a sale, whether they are to be consumed on or off the premises.\nThe second type of case involves blood transfusions, which can give a patient hepatitis, a serious\nand sometimes fatal disease. Hospitals and blood banks obviously face large potential liability\nunder the UCC provision just referred to on implied warranty of merchantability. Because\nmedical techniques cannot detect the hepatitis virus in any form of blood used, hospitals and\nblood banks would be in constant jeopardy, without being able to take effective action to\nminimize the danger. Most states have enacted legislation specifically providing that blood\nsupplies to be used in transfusions are a service, not goods, thus relieving the suppliers and\nhospitals of an onerous burden.\n\nThree Basic Contract Types: Sources of Law\nWith this brief description of the UCC, it should now be clear that the primary sources of law for\nthe three basic types of contracts are:\n\xe2\x80\xa2\n\nReal estate: common law;\n\n\xe2\x80\xa2\n\nServices: common law;\n\n\xe2\x80\xa2\n\nSale of goods: UCC (as interpreted by the courts).\nCommon law and UCC rules are often similar. For example, both require good faith in the\nperformance of a contract. However, there are two general differences worth noting between the\ncommon law of contracts and the UCC\xe2\x80\x99s rules governing the sales of goods. First, the UCC is\nmore liberal than the common law in upholding the existence of a contract. For example, in a\nsales contract (covered by the UCC), \xe2\x80\x9copen\xe2\x80\x9d terms\xe2\x80\x94that is, those the parties have not agreed\nupon\xe2\x80\x94do not require a court to rule that no contract was made. However, open terms in\na nonsales contract will frequently result in a ruling that there is no contract. Second, although\nthe common law of contracts applies to every person equally, under the UCC \xe2\x80\x9cmerchants\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n304\n\n\x0coccasionally receive special treatment. By \xe2\x80\x9cmerchants\xe2\x80\x9d the UCC means persons who have special\nknowledge or skill who deal in the goods involved in the transaction.\n\nThe Convention on Contracts for the International Sale of Goods\nA Convention on Contracts for the International Sale of Goods (CISG) was approved in 1980 at a\ndiplomatic conference in Vienna. (A convention is a preliminary agreement that serves as the\nbasis for a formal treaty.) The Convention has been adopted by several countries, including the\nUnited States.\nThe Convention is significant for three reasons. First, the Convention is a uniform law governing\nthe sale of goods\xe2\x80\x94in effect, an international Uniform Commercial Code. The major goal of the\ndrafters was to produce a uniform law acceptable to countries with different legal, social and\neconomic systems. Second, although provisions in the Convention are generally consistent with\nthe UCC, there are significant differences. For instance, under the Convention, consideration\n(discussed below) is not required to form a contract and there is no Statute of Frauds (a\nrequirement that some contracts be evidenced by a writing to be enforceable\xe2\x80\x94also discussed\nbelow). Finally, the Convention represents the first attempt by the US Senate to reform the\nprivate law of business through its treaty powers, for the Convention preempts the UCC if the\nparties to a contract elect to use the CISG.\n\nBasic Contract Taxonomy\nContracts are not all cut from the same die. Some are written, some oral; some are explicit, some\nnot. Because contracts can be formed, expressed, and enforced in a variety of ways, a taxonomy\nof contracts has developed that is useful in lumping together like legal consequences. In general,\ncontracts are classified along these dimensions: explicitness, mutuality, enforceability, and\ndegree of completion.Explicitness is concerned with the degree to which the agreement is\nmanifest to those not party to it. Mutuality takes into account whether promises are exchanged\nby two parties or only one. Enforceability is the degree to which a given contract is\nbinding.Completion considers whether the contract is yet to be performed or the obligations\nhave been fully discharged by one or both parties. We will examine each of these concepts in\nturn.\n\nExplicitness\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n305\n\n\x0cExpress Contract\nAn express contract is one in which the terms are spelled out directly; the parties to an express\ncontract, whether written or oral, are conscious that they are making an enforceable agreement.\nFor example, an agreement to purchase your neighbor\xe2\x80\x99s car for $500 and to take title next\nMonday is an express contract.\n\nImplied Contract\nAn implied contract is one that is inferred from the actions of the parties. Although no\ndiscussion of terms took place, an implied contract exists if it is clear from the conduct of both\nparties that they intended there be one. A delicatessen patron who asks for a \xe2\x80\x9cturkey sandwich\nto go\xe2\x80\x9d has made a contract and is obligated to pay when the sandwich is made. By ordering the\nfood, the patron is implicitly agreeing to the price, whether posted or not.\n\nContract Implied in Law: Quasi-contract\nBoth express and implied contracts embody an actual agreement of the parties. Aquasi-contract,\nby contrast, is an obligation said to be \xe2\x80\x98\xe2\x80\x98imposed by law\xe2\x80\x9d in order to avoid unjust enrichment of\none person at the expense of another. In fact, a quasi-contract is not a contract at all; it is a\nfiction that the courts created to prevent injustice. Suppose, for example, that a carpenter\nmistakenly believes you have hired him to repair your porch; in fact, it is your neighbor who has\nhired him. One Saturday morning he arrives at your doorstep and begins to work. Rather than\nstop him, you let him proceed, pleased at the prospect of having your porch fixed for free (since\nyou have never talked to the carpenter, you figure you need not pay his bill). Although it is true\nthere is no contract, the law implies a contract for the value of the work.\n\nMutuality\nThe garden-variety contract is one in which the parties make mutual promises. Each is both\npromisor and promisee; that is, each pledges to do something and each is the recipient of such a\npledge. This type of contract is called a bilateral contract. But mutual promises are not necessary\nto constitute a contract. Unilateral contracts, in which only one party makes a promise, are\nequally valid but depend upon performance of the promise to be binding. If Charles says to\nFran, \xe2\x80\x9cI will pay you five dollars if you wash my car,\xe2\x80\x9d Charles is contractually bound to pay once\nFran washes the car. Fran never makes a promise, but by actually performing she makes Charles\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n306\n\n\x0cliable to pay. A common example of a unilateral contract is the offer \xe2\x80\x9c$50 for the return of my\nlost dog.\xe2\x80\x9d Frances never makes a promise to the offeror, but if she looks for the dog and finds it,\nshe is entitled to the $50.\n\nEnforceability\nNot every agreement between two people is a binding contract. An agreement that is lacking one\nof the legal elements of a contract is said to be void\xe2\x80\x94that is, not a contract at all. An agreement\nthat is illegal\xe2\x80\x94for example, a promise to commit a crime in return for a money payment\xe2\x80\x94is\nvoid. Neither party to a void \xe2\x80\x9ccontract\xe2\x80\x9d may enforce it.\nBy contrast, a voidable contract is one that is unenforceable by one party but enforceable by the\nother. For example, a minor (any person under eighteen, in most states) may \xe2\x80\x9cavoid\xe2\x80\x9d a contract\nwith an adult; the adult may not enforce the contract against the minor, if the minor refuses to\ncarry out the bargain. But the adult has no choice if the minor wishes the contract to be\nperformed. (A contract may be voidable by both parties if both are minors.) Ordinarily, the\nparties to a voidable contract are entitled to be restored to their original condition. Suppose you\nagree to buy your seventeen-year-old neighbor\xe2\x80\x99s car. He delivers it to you in exchange for your\nagreement to pay him next week. He has the legal right to terminate the deal and recover the\ncar, in which case you will of course have no obligation to pay him. If you have already paid him,\nhe still may legally demand a return to the status quo ante (previous state of affairs). You must\nreturn the car to him; he must return the cash to you.\nA voidable contract remains a valid contract until it is voided. Thus, a contract with a minor\nremains in force unless the minor decides he does not wish to be bound by it. When the minor\nreaches his majority, he may \xe2\x80\x9cratify\xe2\x80\x9d the contract\xe2\x80\x94that is, agree to be bound by it-in which case\nthe contract will no longer be voidable and will thereafter be fully enforceable.\nAn unenforceable contract is one that some rule of law bars a court from enforcing. For example,\nTom owes Pete money, but Pete has waited too long to collect it and the statute of limitations\nhas run out. The contract for repayment is unenforceable and Pete is out of luck, unless Tom\nmakes a new promise to pay or actually pays part of the debt. (However, if Pete is holding\ncollateral as security for the debt, he is entitled to keep it; not all rights are extinguished because\na contract is unenforceable.)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n307\n\n\x0cDegree of Completion\nIn medieval England, contract\xe2\x80\x94defined as set of promises\xe2\x80\x94was not an intuitive concept. The\ncourts gave relief to one who wanted to collect a debt, for in such a case the creditor presumably\nhad already given the debtor something of value, and the failure of the debtor to pay up was seen\nas manifestly unjust. But the issue was less clear when neither promise had yet been fulfilled.\nSuppose John agrees to sell Humphrey a quantity of wheat in one month. On the appointed day,\nHumphrey refuses to take the wheat or to pay. The modem law of contracts holds that a valid\ncontract exists and that Humphrey is required to pay John.\nAn agreement consisting of a set of promises is called an executory contract before either\npromise is carried out. Most executory contracts are enforceable. If one promise or set of terms\nhas been fulfilled\xe2\x80\x94if, for example, John had delivered the wheat to Humphrey\xe2\x80\x94the contract is\ncalled partially executed. A contract that has been carried out fully by both parties is called\nan executed contract.\n\nKEY TAKEAWAYS\n\nContract is the mechanism by which people in modern society make choices for themselves,\nas opposed to being born or placed into a status as is common in feudal societies. A contract\nis a legally enforceable promise. The law of contract is the common law (for contracts\ninvolving real estate and services), statutory law (the Uniform Commercial Code for contract\ninvolving the sale or leasing of goods), and treaty law (the Convention on the International\nSale of Goods). Contracts may be described based on the degree of their explicitness,\nmutuality, enforceability, and degree of completion.\n\nEXERCISES\n\n1. What did Sir Henry Maine mean when he wrote of society\xe2\x80\x99s movement \xe2\x80\x9cfrom status to\ncontract?\n2. Are all promises \xe2\x80\x9ccontracts\xe2\x80\x9d?\n3. What is the source of law for contracts involving real estate? For contracts involving the sale\nof goods?\n4. In contract taxonomy, what are the degrees of explicitness, mutuality, enforceability, and of\ncompletion?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n308\n\n\x0c[1] Sir Henry Maine, Ancient Law (1869), 180\xe2\x80\x9382.\n\n8.2 Contract Formation\n\nLEARNING OBJECTIVES\n\n1. Understand the elements of common-law contracts: mutuality of agreement (offer and\nacceptance), consideration, legality, and capacity.\n2. Learn when a contract must be in writing\xe2\x80\x94or evidenced by some writing\xe2\x80\x94to be enforceable.\nAlthough it has countless wrinkles and nuances, contract law asks two principal questions: did\nthe parties create a valid, enforceable contract? What remedies are available when one party\nbreaks the contract? The answer to the first question is not always obvious; the range of factors\nthat must be taken into account can be large and their relationship subtle. Since people in\nbusiness frequently conduct contract negotiations without the assistance of a lawyer, it is\nimportant to attend to the nuances to avoid legal trouble at the outset. Whether a valid\nenforceable contract has been formed depends in turn on whether:\n1. The parties reached an agreement (offer and acceptance);\n2. Consideration was present (some \xe2\x80\x9cprice was paid for what was received in return);\n3. The agreement was legal;\n4. The parties entered into the contract with capacity to make a contract; and\n5. The agreement is in the proper form (something in writing, if required).\n\nThe Agreement: Offer and Acceptance\nThe core of a legal contract is the agreement between the parties. That is not merely a matter of\nconvenience; it is at the heart of our received philosophical and psychological beliefs. As the\ngreat student of contract law, Samuel Williston, put it:\nIt was a consequence of the emphasis laid on the ego and the individual will that the formation\nof a contract should seem impossible unless the wills of the parties concurred. Accordingly we\nfind at the end of the eighteenth century, and the beginning of the nineteenth century, the\nprevalent idea that there must be a \xe2\x80\x9cmeeting of the minds\xe2\x80\x9d (a new phrase) in order to form a\ncontract. (1921, p. 365)\nAlthough agreements may take any form, including unspoken conduct between the parties (UCC\nSection 2-204(1)), they are usually structured in terms of an offer and anacceptance. Note,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n309\n\n\x0chowever, that not every agreement, in the broadest sense of the word, need consist of an offer\nand acceptance, and it is entirely possible, therefore, for two persons to reach agreement\nwithout forming a contract. For example, people may agree that the weather is pleasant or that it\nwould be preferable to go out for Chinese food rather than seeing a foreign film; in neither case\nhas a contract been formed. One of the major functions of the law of contracts is to sort out\nthose agreements that are legally binding\xe2\x80\x94those that are contracts\xe2\x80\x94from those that are not.\nIn interpreting agreements, courts generally apply an objective standard. TheRestatement\n(Second) of Contracts defines agreement as a \xe2\x80\x9cmanifestation of mutual assent by two or more\npersons to one another.\xe2\x80\x9d (Section 3) The UCC defines agreement as \xe2\x80\x9cthe bargain of the parties in\nfact as found in their language or by implication from other circumstances including course of\ndealing or usage of trade or course of performance.\xe2\x80\x9d (Section 1-201(3)) The critical question is\nwhat the parties said or did, not what they thought they said or did.\nThe distinction between objective and subjective standards crops up occasionally when one\nperson claims he spoke in jest. The vice president of a manufacturer of punchboards, used in\ngambling, testified to the Washington State Game Commission that he would pay $100,000 to\nanyone who found a \xe2\x80\x9ccrooked board.\xe2\x80\x9d Barnes, a bartender, who had purchased two that were\ncrooked some time before, brought one to the company office, and demanded payment. The\ncompany refused, claiming that the statement was made in jest (the audience before the\ncommission had laughed when the offer was made). The court disagreed, holding that it was\nreasonable to interpret the pledge of $100,000 as a means of promoting punchboards:\n(I)f the jest is not apparent and a reasonable hearer would believe that an offer was being made,\nthen the speaker risks the formation of a contract which was not intended. It is the objective\nmanifestations of the offeror that count and not secret, unexpressed intentions. If a party\xe2\x80\x99s\nwords or acts, judged by a reasonable standard, manifest an intention to agree in regard to the\nmatter in question, that agreement is established, and it is immaterial what may be the real but\nunexpressed state of the party\xe2\x80\x99s mind on the subject. [1]\nAn offer is a manifestation of willingness to enter into a bargain such that it would be reasonable\nfor another individual to conclude that assent to the offer would complete the bargain. Offers\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n310\n\n\x0cmust be communicated and must be definite; that is, they must spell out terms to which the\nofferee can assent.\nTo constitute an agreement, there must be an acceptance of the offer. The offeree must manifest\nhis assent to the terms of the offer in a manner invited or required by the offer. Complications\narise when an offer is accepted indirectly through correspondence. Although offers and\nrevocations of offers are not effective until received, an acceptance is deemed accepted when\nsent if the offeree accepts in the manner specified by the offeror.\nIf the offeror specifies no particular mode, then acceptance is effective when transmitted as long\nas the offeree uses a reasonable method of acceptance. It is implied that the offeree can use the\nsame means used by the offeror or a means of communication customary to the industry. For\nexample, the use of the postal service was so customary that acceptances are considered effective\nwhen mailed, regardless of the method used to transmit the offer. Indeed, the so-called \xe2\x80\x9cmailbox\nrule\xe2\x80\x9d (the acceptance is effective upon dispatch) has an ancient lineage, tracing back nearly two\nhundred years to the English courts. [2]\n\nConsideration\nConsideration, is the quid pro quo (something given or received for something else) between the\ncontracting parties in the absence of which the law will not enforce the promise or promises\nmade. Consider the following three \xe2\x80\x9ccontracts\xe2\x80\x9d:\n1. Betty offers to give a book to Lou. Lou accepts.\n2. Betty offers Lou the book in exchange for Lou\xe2\x80\x99s promise to pay $15. Lou accepts.\n3. Betty offers to give Lou the book if Lou promises to pick it up at Betty\xe2\x80\x99s house. Lou accepts.\nThe question is which, if any, is a binding contract? In American law, only situation 2 is a\nbinding contract, because only that contract contains a set of mutual promises in which each\nparty pledges to give up something to the benefit of the other.\nThe question of what constitutes a binding contract has been answered differently throughout\nhistory and in other cultures. For example, under Roman law, any contract that was reduced to\nwriting was binding, whether or not there was consideration in our sense. Moreover, in later\nRoman times, certain promises of gifts were made binding, whether written or oral; these would\nnot be binding in the United States. And in the Anglo-American tradition, the presence of a seal\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n311\n\n\x0cwas once sufficient to make a contract binding without any other consideration. In most states,\nthe seal is no longer a substitute for consideration, although in some states it creates a\npresumption of consideration. The Uniform Commercial Code has abolished the seal on\ncontracts for the sale of goods.\nThe existence of consideration is determined by examining whether the person against whom a\npromise is to be enforced (the promisor) received something in return from the person to whom\nhe made the promise (the promisee). That may seem a simple enough question. But as with\nmuch in the law, the complicating situations are never very far away. The \xe2\x80\x9csomething\xe2\x80\x9d that is\npromised or delivered cannot just be anything: a feeling of pride, warmth, amusement,\nfriendship; it must be something known as alegal detriment\xe2\x80\x94an act, a forbearance, or a promise\nof such from the promisee. The detriment need not be an actual detriment; it may in fact be a\nbenefit to the promisee, or at least not a loss. At the same time, the \xe2\x80\x9cdetriment\xe2\x80\x9d to the promisee\nneed not confer a tangible benefit on the promisor; the promisee can agree to forego something\nwithout that something being given to the promisor. Whether consideration is legally sufficient\nhas nothing to do with whether it is morally or economically adequate to make the bargain a fair\none. Moreover, legal consideration need not even be certain; it can be a promise contingent on\nan event that may never happen. Consideration is a legalconcept, and it centers on the giving up\nof a legal right or benefit.\nConsideration has two elements. The first, as just outlined, is whether the promisee has incurred\na legal detriment. (Some courts\xe2\x80\x94although a minority\xe2\x80\x94take the view that a bargained-for legal\nbenefit to the promisor is sufficient consideration.) The second is whether the legal detriment\nwas bargained for: did the promisor specifically intend the act, forbearance, or promise in\nreturn for his promise? Applying this two-pronged test to the three examples given at the outset\nof the chapter, we can easily see why only in the second is there legally sufficient consideration.\nIn the first, Lou incurred no legal detriment; he made no pledge to act or to forbear from acting,\nnor did he in fact act or forbear from acting. In the third example, what might appear to be such\na promise is not really so. Betty made a promise on a condition that Lou come to her house; the\nintent clearly is to make a gift. Betty was not seeking to induce Lou to come to her house by\npromising the book.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n312\n\n\x0cThere is a widely recognized exception to the requirement of consideration. In cases of\npromissory estoppel, the courts will enforce promises without consideration. Simply\nstated, promissory estoppel means that the courts will stop the promisor from claiming that\nthere was no consideration. The doctrine of promissory estoppel is invoked in the interests of\njustice when three conditions are met: (1) the promise is one that the promisor should\nreasonably expect to induce the promisee to take action or forbear from taking action of a\ndefinite and substantial character; (2) the action or forbearance is taken; and (3) injustice can be\navoided only by enforcing the promise.\nTimko served on the board of trustees of a school. He recommended that the school purchase a\nbuilding for a substantial sum of money, and to induce the trustees to vote for the purchase, he\npromised to help with the purchase and to pay at the end of five years the purchase price less the\ndown payment. At the end of four years, Timko died. The school sued his estate, which defended\non the ground that there was no consideration for the promise. Timko was promised or given\nnothing in return, and the purchase of the building was of no direct benefit to him (which would\nhave made the promise enforceable as a unilateral contract). The court ruled that under the\nthree-pronged promissory estoppel test, Timko\xe2\x80\x99s estate was liable. [3]\n\nIllegality\nIn general, illegal contracts are unenforceable. The courts must grapple with two types of\nillegalities: (1) statutory violations (e.g., the practice of law by a non-lawyer is forbidden by\nstatute), and (2) violations of public policy not expressly declared unlawful by statute, but so\ndeclared by the courts.\n\nCapacity\nA contract is a meeting of minds. If someone lacks mental capacity to understand what he is\nassenting to\xe2\x80\x94or that he is assenting to anything\xe2\x80\x94it is unreasonable to hold him to the\nconsequences of his act.\nThe general rule is that persons younger than eighteen can avoid their contracts. Although the\nage of majority was lowered in most states during the 1970s to correspond to the Twenty-sixth\nAmendment (ratified in 1971, guaranteeing the right to vote at eighteen), some states still put\nthe age of majority at twenty-one. Legal rights for those under twenty-one remain ambiguous,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n313\n\n\x0chowever. Although eighteen-year-olds may assent to binding contracts, not all creditors and\nlandlords believe it, and they may require parents to cosign. For those under twenty-one, there\nare also legal impediments to holding certain kinds of jobs, signing certain kinds of contracts,\nmarrying, leaving home, and drinking alcohol. There is as yet no uniform set of rules.\nThe exact day on which the disability of minority vanishes also varies. The old common law rule\nput it on the day before the twenty-first birthday. Many states have changed this rule so that\nmajority commences on the day of the eighteenth (or twenty-first) birthday.\nA minor\xe2\x80\x99s contract is voidable, not void. A child wishing to avoid the contract need do nothing\npositive to disaffirm; the defense of minority to a lawsuit is sufficient. Although the adult cannot\nenforce the contract, the child can (which is why it is said to be voidable, not void).\nWhen the minor becomes an adult, he has two choices: he may ratify the contract ordisaffirm it.\nShe may ratify explicitly; no further consideration is necessary. She may also do so by\nimplication\xe2\x80\x94for instance, by continuing to make payments or retaining goods for an\nunreasonable period of time. (In some states, a court may ratify the contract before the child\nbecomes an adult. In California, for example, a state statute permits a movie producer to seek\ncourt approval of a contract with a child actor in order to prevent the child from disaffirming it\nupon reaching majority and suing for additional wages. As quid pro quo, the court can order the\nproducer to pay a percentage of the wages into a trust fund that the child\xe2\x80\x99s parents or guardians\ncannot invade.) If the child has not disaffirmed the contract while still a minor, she may do so\nwithin a reasonable time after reaching majority.\nIn most cases of disavowal, the only obligation is to return the goods (if he still has them) or\nrepay the consideration (unless it has been dissipated). However, in two situations, a minor\nmight incur greater liability: contracts for necessities and misrepresentation of age.\n\nContract for Necessities\nAt common law, a \xe2\x80\x9cnecessity\xe2\x80\x9d was defined as an essential need of a human being: food,\nmedicine, clothing, and shelter. In recent years, however, the courts have expanded the concept,\nso that in many states today necessities include property and services that will enable the minor\nto earn a living and to provide for those dependent on him. If the contract is executory, the\nminor can simply disaffirm. If the contract has been executed, however, the minor must face\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n314\n\n\x0cmore onerous consequences. Although he will not be required to perform under the contract, he\nwill be liable under a theory of \xe2\x80\x9cquasi-contract\xe2\x80\x9d for the reasonable value of the necessity.\n\nMisrepresentation of Age\nIn most states, a minor may misrepresent his age and disaffirm in accordance with the general\nrule, because that\xe2\x80\x99s what kids do, misrepresent their age. That the adult reasonably believed the\nminor was also an adult is of no consequence in a contract suit. But some states have enacted\nstatutes that make the minor liable in certain situations. A Michigan statute, for instance,\nprohibits a minor from disaffirming if he has signed a \xe2\x80\x9cseparate instrument containing only the\nstatement of age, date of signing and the signature:\xe2\x80\x9d And some states \xe2\x80\x9cestop\xe2\x80\x9d him from claiming\nto be a minor if he falsely represented himself as an adult in making the \xc2\xb7contract. \xe2\x80\x9cEstoppel\xe2\x80\x9d is\na refusal by the courts on equitable grounds to listen to an otherwise valid defense; unless the\nminor can return the consideration, the contract will be enforced.\nContracts made by an insane or intoxicated person are also said to have been made by a person\nlacking capacity. In general, such contracts are voidable by the person when capacity is regained\n(or by the person\xe2\x80\x99s legal representative if capacity is not regained).\n\nForm\nAs a general rule, a contract need not be in writing to be enforceable. An oral agreement to pay a\nhigh-fashion model $1 million to pose for a photograph is as binding as if the language of the\ndeal were printed on vellum and signed in the presence of twenty bishops. For centuries,\nhowever, a large exception has grown up around theStatute of Frauds, first enacted in England\nin 1677 under the formal name \xe2\x80\x9cAn Act for the Prevention of Frauds and Perjuries.\xe2\x80\x9d The purpose\nof the Statute of Frauds is to prevent the fraud that occurs when one party attempts to impose\nupon another a contract that did not in fact exist. The two sections dealing with contracts read\nas follows:\n[Sect. 4] ...no action shall be brought whereby to charge any executor or administrator upon any\nspecial promise, to answer damages out of his own estate; (2) or whereby to charge the\ndefendant upon any special promise to answer for the debt, default or miscarriages of another\nperson; (3) or to charge any person upon any agreement made upon consideration of marriage;\n(4) or upon any contract or sale of lands, tenements or hereditaments, or any interest in or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n315\n\n\x0cconcerning them; (5) or upon any agreement that is not to be performed within the space of one\nyear from the making thereof; (6) unless the agreement upon which such action shall be\nbrought, or some memorandum or note thereof, shall be in writing, and signed by the party to\nbe charged therewith, or some other person thereunto by him lawfully authorized.\n[Sect. 17] ...no contract for the sale of any goods, wares and merchandizes, for the price of ten\npounds sterling or upwards, shall be allowed to be good, except the buyer shall accept part of the\ngoods so sold, and actually receive the same, or give something in earnest to bind the bargain, or\nin part of payment, or that some note or memorandum in writing of the said bargain be made\nand signed by the parties to be charged by such contract, or their agents thereunto lawfully\nauthorized.\nAgain, as may be evident from the title of the act and its language, the general purpose of the law\nis to provide evidence, in areas of some complexity and importance, that a contract was actually\nmade. To a lesser degree, the law serves to caution those about to enter a contract and \xe2\x80\x9cto create\na climate in which parties often regard their agreements as tentative until there is a signed\nwriting.\xe2\x80\x9d (Restatement (Second) of ContractsChapter 5, statutory note)\nThe Statute of Frauds has been enacted in form similar to the seventeenth century act in most\nstates. However, in the twentieth century Section 7 was been replaced by a section Uniform\nCommercial Code. The UCC requires contracts for the sale of goods for $500 or more and for the\nsale of securities to be in writing.\n\nKEY TAKEAWAYS\n\nA contract requires mutuality\xe2\x80\x94an offer and an acceptance of the offer; it requires\nconsideration\xe2\x80\x94a \xe2\x80\x9cprice\xe2\x80\x9d paid for what is obtained; it requires that the parties to the contract\nhave legal capacity to know what they are doing; it requires legality. Certain contracts\xe2\x80\x94\ngoverned by the statute of frauds\xe2\x80\x94are required to be evidenced by some writing, signed by\nthe party to be bound. The purpose here is to avoid the fraud that occurs when one person\nattempts to impose upon another a contract that did not really exist.\n\nEXERCISES\n\n1. What are the required elements of a contract?\n2. When was the Statute of Frauds first enacted, by whom, and why?\n3. Basically, what does the Statute of Frauds require?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n316\n\n\x0c[1] Barnes v. Treece, 549 P.2d 1152 (Wash. App. 1976).\n[2] Adams v. Lindsell, 1 Bamewall & Alderson 681 (K.B. 1818).\n[3] Estate of Timko v. Oral Roberts Evangelistic Assn., 215 N.W.2d 750 (Mich. App. 1974).\n\n8.3 Remedies\n\nLEARNING OBJECTIVES\n\n1. Know the types of damages: compensatory and punitive.\n2. Understand specific performance as a remedy.\n3. Understand restitution as a remedy.\n4. Recognize the interplay between contract and tort as a cause of action.\nMonetary awards (called \xe2\x80\x9cdamages\xe2\x80\x9d), specific performance, and restitution are the three\nprinciple remedies.\nIn view of the importance given to the intention of the parties in forming and interpreting\ncontracts, it may seem surprising that the remedy for every breach is not a judicial order that the\nobligor carry out his undertakings. But it is not. Of course, some duties cannot be performed\nafter a breach: time and circumstances will have altered their purpose and rendered many\nworthless. Still, although there are numerous occasions on which it would be theoretically\npossible for courts to order the parties to carry out their contracts, the courts will not do it. In\n1897, Justice Oliver Wendell Holmes, Jr., declared in a famous line that \xe2\x80\x9cthe duty to keep a\ncontract at common law means a prediction that you must pay damages if you do not keep it.\xe2\x80\x9d\nBy that he meant simply that the common law looks more toward compensating the promisee\nfor his loss than toward compelling the promisor to perform\xe2\x80\x94a person always has the power,\nthough not the right, to breach a contract. Indeed, the law of remedies often provides the parties\nwith an incentive to break the contract. In short, the promisor has a choice: to perform or pay.\nThe purpose of contract remedies is, for the most part, to compensate the non-breaching party\nfor the losses suffered\xe2\x80\x94to put the non-breaching party in the position he, she, or it would have\nbeen in had there been no breach.\n\nCompensatory Damages\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n317\n\n\x0cOne party has the right to damages (money ) when the other party has breached the contract\nunless, of course, the contract itself or other circumstances suspend or discharge that\nright. Compensatory damages is the general category of damages awarded to make the nonbreaching party whole.\n\nConsequential Damages\nA basic principle of contract law is that a person injured by breach of contract is not entitled to\ncompensation unless the breaching party, at the time the contract was made, had reason to\nforesee the loss as a probable result of the breach. The leading case, perhaps the most studied\ncase in all the common law, is Hadley v. Baxendale, decided in England in 1854. Joseph and\nJonah Hadley were proprietors of a flour mill in Gloucester. In May 1853, the shaft of the milling\nengine broke, stopping all milling. An employee went to Pickford and Company, a common\ncarrier, and asked that the shaft be sent as quickly as possible to a Greenwich foundry that\nwould use the shaft as a model to construct a new one. The carrier\xe2\x80\x99s agent promised delivery\nwithin two days. But through an error the shaft was shipped by canal rather than by rail and did\nnot arrive in Greenwich for seven days. The Hadleys sued Joseph Baxendale, managing director\nof Pickford, for the profits they lost because of the delay. In ordering a new trial, the Court of\nExchequer ruled that Baxendale was not liable because he had had no notice that the mill was\nstopped:\nWhere two parties have made a contract which one of them has broken, the damages which the\nother party ought to receive in respect of such breach of contract should be such as may fairly\nand reasonably be considered either arising naturally, i.e., according to the usual course of\nthings, from such breach of contract itself, or such as may reasonably be supposed to have been\nin the contemplation of both parties, at the time they made the contract, as the probable result\nof the breach of it. [1]\nThis rule, it has been argued, was a subtle change from the earlier rule that permitted damages\nfor any consequences as long as the breach caused the injury and the plaintiff did not exacerbate\nit. But the change was evidently rationalized, at least in part, by the observation that in the\n\xe2\x80\x9cusual course of things,\xe2\x80\x9d a mill would have on hand a spare shaft, so that its operations would\nnot cease. [2]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n318\n\n\x0cThis sub-set of compensatory damages is called consequential damages\xe2\x80\x94damages that flow as a\nforeseeable consequence of the breach. For example, if you hire a roofer to fix a leak in your\nroof, and he does a bad job so that the interior of your house suffers water damage, the roofer is\nliable not only for the poor roofing job, but also for the ruined drapes, damaged flooring and\nwalls, and so on.\n\nNominal Damages\nIf the breach caused no loss, the plaintiff is nevertheless entitled to a minor sum, perhaps one\ndollar, called nominal damages. When, for example, a buyer could purchase the same\ncommodity at the same price as that contracted for, without spending any extra time or money,\nthere can be no real damages in the event of breach.\n\nIncidental Damages\nSuppose City College hires Prof. Blake on a two-year contract, after an extensive search. After\none year the professor quits to take a job elsewhere, in breach of her contract. If City College has\nto pay $5000 more to find a replacement for year, Blake is liable for that amount\xe2\x80\x94that\xe2\x80\x99s\ncompensatory damages. But what if it costs City College $1200 to search for, bring to campus\nand interview a replacement? City College can claim that, too, as incidental damages which\ninclude additional costs incurred by the non-breaching party after the breach in a reasonable\nattempt to avoid further loss, even if the attempt is unsuccessful.\n\nPunitive Damages\nPunitive damages are those awarded for the purpose of punishing a defendant in a civil action,\nin which criminal sanctions may be unavailable. They are not part of the compensation for the\nloss suffered; they are proper in cases in which the defendant has acted willfully and maliciously\nand are thought to deter others from acting similarly. Since the purpose of contract law is\ncompensation, not punishment, punitive damages have not traditionally been awarded, with one\nexception: when the breach of contract is also a tort for which punitive damages may be\nrecovered. Punitive damages are permitted in the law of torts (in most states) when the behavior\nis malicious or willful (reckless conduct causing physical harm, deliberate defamation of one\xe2\x80\x99s\ncharacter, a knowingly unlawful taking of someone\xe2\x80\x99s property), and some kinds of contract\nbreach are also tortuous\xe2\x80\x94for example, when a creditor holding collateral as security under a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n319\n\n\x0ccontract for a loan sells the collateral to a good-faith purchaser for value even though the debtor\nwas not in default, he has breached the contract and committed the tort ofconversion. Punitive\ndamages may be awarded, assuming the behavior was willful and not merely mistaken.\nPunitive damages are not fixed by law. The judge or jury may award at its discretion whatever\nsum is believed necessary to redress the wrong or deter like conduct in the future. This means\nthat a richer person may be slapped with much heavier punitive damages than a poorer one in\nthe appropriate case. But the judge in all cases mayremit (lower) some or all of a punitive\ndamage award if he or she considers it excessive.\nPunitive damage claims have been made in cases dealing with the refusal by insurance\ncompanies to honor their contracts. Many of these cases involve disability payments, and among\nthe elements are charges of tortious conduct by the company\xe2\x80\x99s agents or employees. California\nhas been the leader among the state courts in their growing willingness to uphold punitive\ndamage awards despite insurer complaints that the concept of punitive damages is but a device\nto permit plaintiffs to extort settlements from hapless companies. Courts have also awarded\npunitive damages against other types of companies for breach of contract.\n\nSpecific Performance\nSpecific performance is a judicial order to the promisor that he undertake the performance to\nwhich he obligated himself in a contract. Specific performance is an alternative remedy to\ndamages and may be issued at the discretion of the court, subject to a number of exceptions.\n(When the promisee is seeking enforcement of a contractual provision for forbearance\xe2\x80\x94a\npromise that the promisor will refrain from doing something\xe2\x80\x94an injunction, a judicial order not\nto act in a specified manner, may be the appropriate remedy.) Emily signs a contract to sell\nCharlotte a gold samovar, a Russian antique of great sentimental value because it once belonged\nto Charlotte\xe2\x80\x99s mother. Emily then repudiates the contract while still executory. A court may\nproperly grant Charlotte an order of specific performance against Emily. Specific performance is\nan attractive but limited remedy: it is only available for breach of contract to sell a unique item\n(real estate is always unique).\n\nRestitution\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n320\n\n\x0cAs the word implies, restitution is a restoring to one party of what he gave to the other.\nTherefore, only to the extent that the injured party conferred a benefit on the other party may\nthe injured party be awarded restitution.\nIf the claimant has given the other party a sum of money, there can be no dispute over the\namount of the restitution interest. Tom gives Tim $100 to chop his tree into firewood. Tim\nrepudiates. Tom\xe2\x80\x99s restitution interest is $100. But serious difficulties can arise when the benefit\nconferred was performance. The courts have considerable discretion to award either the cost of\nhiring someone else to do the work that the injured party performed (generally, the market price\nof the service) or the value that was added to the property of the party in breach by virtue of the\nclaimant\xe2\x80\x99s performance. Mellors, a gardener, agrees to construct ten fences around Lady\nChatterley\xe2\x80\x99s flower gardens at the market price of $2,500. After erecting three, Mellors has\nperformed services that would cost $750, market value. Assume that he has increased the value\nof the Lady\xe2\x80\x99s grounds by $800. If the contract is repudiated, there are two measures of Mellors\xe2\x80\x99s\nrestitution interest: $800, the value by which the property was enhanced; or $750, the amount\nit would have cost Lady Chatterley to hire someone else to do the work. Which measure to use\ndepends on who repudiated the contract and for what reason.\n\nTort vs. Contract Remedies\nFrequently a contract breach may also amount to tortious conduct. A physician warrants her\ntreatment as perfectly safe but performs the operation negligently, scarring the patient for life.\nThe patient could sue for malpractice (tort) or for breach of warranty (contract). The choice\ninvolves at least four considerations:\n1. Statute of limitations. Most statutes of limitations prescribe longer periods for contract than for\ntort actions.\n2. Allowable damages. Punitive damages are more often permitted in tort actions, and certain\nkinds of injuries are compensable in tort but not in contract suits\xe2\x80\x94for example, pain and\nsuffering.\n3. Expert testimony. In most cases, the use of experts would be the same in either tort or contract\nsuits, but in certain contract cases, the expert witness could be dispensed with, as, for example,\nin a contract case charging that the physician abandoned the patient.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n321\n\n\x0c4. Insurance coverage. Most policies do not cover intentional torts, so a contract theory that\navoids the element of willfulness would provide the plaintiff with a surer chance of recovering\nmoney damages.\n\nKEY TAKEAWAYS\n\nThe purpose of remedies in contract is, usually, to put the non-breaching party in the\nposition he or she would have been in had there been no breach. The remedies are:\ncompensatory damages (money paid to compensate the non-breaching party for the losses\ncaused by the breach), which also include sub-categories of incidental and nominal damages;\npunitive damages (to punish the breaching party) are sometimes allowed where the breach is\negregious and intentional.\n\nEXERCISES\n\n1. What are compensatory damages?\n2. When is specific performance an appropriate remedy? Will it be used to require a person to\nperform a service (such as properly repair a leaky roof)?\n3. When is restitution used?\n4. How could a breach of contract also be a tort, and when is one cause of action chosen over\nthe other?\n5. What is the purpose of punitive damages?\n\n[1] Hadley v. Baxendale (1854), 9 Ex. 341, 354, 156 Eng.Rep. 145, 151.\n[2] R. J. Danzig, \xe2\x80\x9cHadley v. Baxendale: A Study in the Industrialization of the Law,\xe2\x80\x9d Journal of Legal\nStudies 4, no. 249 (1975): 249.\n\n8.4 Cases\nObjective Intention\nLucy v. Zehmer\n84 S.E.2d 516 (Va. 1954)\nBuchanan, J.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n322\n\n\x0cThis suit was instituted by W. O. Lucy and J. C. Lucy, complainants, against A. H. Zehmer and\nIda S. Zehmer, his wife, defendants, to have specific performance of a contract by which it was\nalleged the Zehmers had sold to W. O. Lucy a tract of land owned by A. H. Zehmer in Dinwiddie\ncounty containing 471.6 acres, more or less, known as the Ferguson farm, for $50,000. J. C.\nLucy, the other complainant, is a brother of W. O. Lucy, to whom W. O. Lucy transferred a half\ninterest in his alleged purchase.\nThe instrument sought to be enforced was written by A. H. Zehmer on December 20, 1952, in\nthese words: \xe2\x80\x9cWe hereby agree to sell to W. O. Lucy the Ferguson farm complete for\n$50,000.00, title satisfactory to buyer,\xe2\x80\x9d and signed by the defendants, A. H. Zehmer and Ida S.\nZehmer.\nThe answer of A. H. Zehmer admitted that at the time mentioned W. O. Lucy offered him\n$50,000 cash for the farm, but that he, Zehmer, considered that the offer was made in jest; that\nso thinking, and both he and Lucy having had several drinks, he wrote out \xe2\x80\x9cthe memorandum\xe2\x80\x9d\nquoted above and induced his wife to sign it; that he did not deliver the memorandum to Lucy,\nbut that Lucy picked it up, read it, put it in his pocket, attempted to offer Zehmer $5 to bind the\nbargain, which Zehmer refused to accept, and realizing for the first time that Lucy was serious,\nZehmer assured him that he had no intention of selling the farm and that the whole matter was\na joke. Lucy left the premises insisting that he had purchased the farm.\xe2\x80\xa6\nIn his testimony Zehmer claimed that he \xe2\x80\x9cwas high as a Georgia pine,\xe2\x80\x9d and that the transaction\n\xe2\x80\x9cwas just a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the\nmost.\xe2\x80\x9d That claim is inconsistent with his attempt to testify in great detail as to what was said\nand what was done.\xe2\x80\xa6\nIf it be assumed, contrary to what we think the evidence shows, that Zehmer was jesting about\nselling his farm to Lucy and that the transaction was intended by him to be a joke, nevertheless\nthe evidence shows that Lucy did not so understand it but considered it to be a serious business\ntransaction and the contract to be binding on the Zehmers as well as on himself. The very next\nday he arranged with his brother to put up half the money and take a half interest in the land.\nThe day after that he employed an attorney to examine the title. The next night, Tuesday, he was\nback at Zehmer\xe2\x80\x99s place and there Zehmer told him for the first time, Lucy said, that he wasn\xe2\x80\x99t\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n323\n\n\x0cgoing to sell and he told Zehmer, \xe2\x80\x9cYou know you sold that place fair and square.\xe2\x80\x9d After receiving\nthe report from his attorney that the title was good he wrote to Zehmer that he was ready to\nclose the deal.\nNot only did Lucy actually believe, but the evidence shows he was warranted in believing, that\nthe contract represented a serious business transaction and a good faith sale and purchase of the\nfarm.\nIn the field of contracts, as generally elsewhere, \xe2\x80\x9cWe must look to the outward expression of a\nperson as manifesting his intention rather than to his secret and unexpressed intention. The law\nimputes to a person an intention corresponding to the reasonable meaning of his words and\nacts.\xe2\x80\x9d\nAt no time prior to the execution of the contract had Zehmer indicated to Lucy by word or act\nthat he was not in earnest about selling the farm. They had argued about it and discussed its\nterms, as Zehmer admitted, for a long time. Lucy testified that if there was any jesting it was\nabout paying $50,000 that night. The contract and the evidence show that he was not expected\nto pay the money that night. Zehmer said that after the writing was signed he laid it down on the\ncounter in front of Lucy. Lucy said Zehmer handed it to him. In any event there had been what\nappeared to be a good faith offer and a good faith acceptance, followed by the execution and\napparent delivery of a written contract. Both said that Lucy put the writing in his pocket and\nthen offered Zehmer $5 to seal the bargain. Not until then, even under the defendants\xe2\x80\x99 evidence,\nwas anything said or done to indicate that the matter was a joke. Both of the Zehmers testified\nthat when Zehmer asked his wife to sign he whispered that it was a joke so Lucy wouldn\xe2\x80\x99t hear\nand that it was not intended that he should hear.\nThe mental assent of the parties is not requisite for the formation of a contract. If the words or\nother acts of one of the parties have but one reasonable meaning, his undisclosed intention is\nimmaterial except when an unreasonable meaning which he attaches to his manifestations is\nknown to the other party.\n\xe2\x80\x9c* * * The law, therefore, judges of an agreement between two persons exclusively from those\nexpressions of their intentions which are communicated between them. * * *.\xe2\x80\x9d [Citation]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n324\n\n\x0cAn agreement or mutual assent is of course essential to a valid contract but the law imputes to a\nperson an intention corresponding to the reasonable meaning of his words and acts. If his words\nand acts, judged by a reasonable standard, manifest an intention to agree, it is immaterial what\nmay be the real but unexpressed state of his mind.\nSo a person cannot set up that he was merely jesting when his conduct and words would warrant\na reasonable person in believing that he intended a real agreement.\nWhether the writing signed by the defendants and now sought to be enforced by the\ncomplainants was the result of a serious offer by Lucy and a serious acceptance by the\ndefendants, or was a serious offer by Lucy and an acceptance in secret jest by the defendants, in\neither event it constituted a binding contract of sale between the parties.\xe2\x80\xa6\nReversed and remanded.\n\nCASE QUESTIONS\n\n1. What objective evidence was there to support the defendants\xe2\x80\x99 contention that they were\njust kidding when they agreed to sell the farm?\n2. Suppose the defendants really did think the whole thing was a kind of joke. Would that make\nany difference?\n3. As a matter of public policy, why does the law use an objective standard to determine the\nseriousness of intention, instead of a subjective standard?\n4. It\xe2\x80\x99s 85 degrees in July and 5:00 p.m., quitting time. The battery in Mary\xe2\x80\x99s car is out of juice,\nagain. Mary says, \xe2\x80\x9cArrgh! I will sell this stupid car for $50!\xe2\x80\x9d Jason, walking to his car nearby,\nwhips out his checkbook and says, \xe2\x80\x9cIt\xe2\x80\x99s a deal. Leave your car here. I\xe2\x80\x99ll give you a ride home\nand pick up your car after you give me the title.\xe2\x80\x9d Do the parties have a contract?\n\nConsideration: Preexisting Obligation\nDenney v. Reppert\n432 S.W.2d 647 (Ky. 1968)\nR. L. Myre, Sr., Special Commissioner.\nThe sole question presented in this case is which of several claimants is entitled to an award for\ninformation leading to the apprehension and conviction of certain bank robbers.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n325\n\n\x0cOn June 12th or 13th, 1963, three armed men entered the First State Bank, Eubank, Kentucky,\nand with a display of arms and threats robbed the bank of over $30,000 [about $208,000 in\n2010 dollars]. Later in the day they were apprehended by State Policemen Garret Godby,\nJohnny Simms and Tilford Reppert, placed under arrest, and the entire loot was recovered.\nLater all of the prisoners were convicted and Garret Godby, Johnny Simms and Tilford Reppert\nappeared as witnesses at the trial.\nThe First State Bank of Eubank was a member of the Kentucky Bankers Association which\nprovided and advertised a reward of $500.00 for the arrest and conviction of each bank robber.\nHence the outstanding reward for the three bank robbers was $1,500.00 [about $11,000 in 2010\ndollars]. Many became claimants for the reward and the Kentucky State Bankers Association\nbeing unable to determine the merits of the claims for the reward asked the circuit court to\ndetermine the merits of the various claims and to adjudge who was entitled to receive the\nreward or share in it. All of the claimants were made defendants in the action.\nAt the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum and\nJewell Snyder were employees of the First State Bank of Eubank and came out of the grueling\nsituation with great credit and glory. Each one of them deserves approbation and an accolade.\nThey were vigilant in disclosing to the public and the peace officers the details of the crime, and\nin describing the culprits, and giving all the information that they possessed that would be\nuseful in capturing the robbers. Undoubtedly, they performed a great service. It is in the\nevidence that the claimant Murrell Denney was conspicuous and energetic in his efforts to make\nknown the robbery, to acquaint the officers as to the personal appearance of the criminals, and\nto give other pertinent facts.\nThe first question for determination is whether the employees of the robbed bank are eligible to\nreceive or share in the reward. The great weight of authority answers in the negative. [Citation]\nstates the rule thusly:\n\xe2\x80\x98To the general rule that, when a reward is offered to the general public for the performance of\nsome specified act, such reward may be claimed by any person who performs such act, is the\nexception of agents, employees and public officials who are acting within the scope of their\nemployment or official duties. * * *.\xe2\x80\x99\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n326\n\n\x0cAt the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum, and\nJewell Snyder were employees of the First State Bank of Eubank. They were under duty to\nprotect and conserve the resources and moneys of the bank, and safeguard every interest of the\ninstitution furnishing them employment. Each of these employees exhibited great courage, and\ncool bravery, in a time of stress and danger. The community and the county have recompensed\nthem in commendation, admiration and high praise, and the world looks on them as heroes. But\nin making known the robbery and assisting in acquainting the public and the officers with\ndetails of the crime and with identification of the robbers, they performed a duty to the bank and\nthe public, for which they cannot claim a reward.\nThe claims of Corbin Reynolds, Julia Reynolds, Alvie Reynolds and Gene Reynolds also must\nfail. According to their statements they gave valuable information to the arresting officers.\nHowever, they did not follow the procedure as set forth in the offer of reward in that they never\nfiled a claim with the Kentucky Bankers Association. It is well established that a claimant of a\nreward must comply with the terms and conditions of the offer of reward. [Citation]\nState Policemen Garret Godby, Johnny Simms and Tilford Reppert made the arrest of the bank\nrobbers and captured the stolen money. All participated in the prosecution. At the time of the\narrest, it was the duty of the state policemen to apprehend the criminals. Under the law they\ncannot claim or share in the reward and they are interposing no claim to it.\nThis leaves the defendant, Tilford Reppert the sole eligible claimant. The record shows that at\nthe time of the arrest he was a deputy sheriff in Rockcastle County, but the arrest and recovery\nof the stolen money took place in Pulaski County. He was out of his jurisdiction, and was thus\nunder no legal duty to make the arrest, and is thus eligible to claim and receive the reward. In\n[Citation] it was said:\n\xe2\x80\x98It is * * * well established that a public officer with the authority of the law to make an arrest\nmay accept an offer of reward or compensation for acts or services performed outside of his\nbailiwick or not within the scope of his official duties. * * *.\xe2\x80\x99\xe2\x80\xa6\nIt is manifest from the record that Tilford Reppert is the only claimant qualified and eligible to\nreceive the reward. Therefore, it is the judgment of the circuit court that he is entitled to receive\npayment of the $1,500.00 reward now deposited with the Clerk of this Court.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n327\n\n\x0cThe judgment is affirmed.\n\nCASE QUESTIONS\n\n1. Why did the Bankers Association put the resolution of this matter into the court\xe2\x80\x99s hands?\n2. Several claimants came forward for the reward; only one person got it. What was the\ndifference between the person who got the reward and those who did not?\n\nConsequential Damages\nEBWS, LLC v. Britly Corp.\n928 A.2d 497 (Vt. 2007)\nReiber, C.J.\nThe Ransom family owns Rock Bottom Farm in Strafford, Vermont, where Earl Ransom owns a\ndairy herd and operates an organic dairy farm. In 2000, the Ransoms decided to build a\ncreamery on-site to process their milk and formed EBWS, LLC to operate the dairy-processing\nplant and to market the plant\xe2\x80\x99s products. In July 2000, Earl Ransom, on behalf of EBWS, met\nwith Britly\xe2\x80\x99s president to discuss building the creamery.\xe2\x80\xa6In January 2001, EBWS and Britly\nentered into a contract requiring Britly to construct a creamery building for EBWS in exchange\nfor $160,318.\xe2\x80\xa6The creamery was substantially completed by April 15, 2001, and EBWS moved\nin soon afterward. On June 5, 2001, EBWS notified Britly of alleged defects in construction.\n[EBWS continued to use the creamery pending the necessity to vacate it for three weeks when\nrepairs were commenced].\nOn September 12, 2001, EBWS filed suit against Britly for damages resulting from defective\ndesign and construction.\xe2\x80\xa6\nFollowing a three-day trial, the jury found Britly had breached the contract and its express\nwarranty, and awarded EBWS: (1) $38,020 in direct damages, and (2) $35,711 in consequential\ndamages.\xe2\x80\xa6\n\xe2\x80\xa6The jury\xe2\x80\x99s award to EBWS included compensation for both direct and consequential damages\nthat EBWS claimed it would incur while the facility closed for repairs. Direct damages [i.e.,\ncompensatory damages] are for \xe2\x80\x9closses that naturally and usually flow from the breach itself,\xe2\x80\x9d\nand it is not necessary that the parties actually considered these damages. [Citation]. In\ncomparison, special or consequential damages \xe2\x80\x9cmust pass the tests of causation, certainty and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n328\n\n\x0cforeseeability, and, in addition, be reasonably supposed to have been in the contemplation of\nboth parties at the time they made the contract.\xe2\x80\x9d\n\xe2\x80\xa6The court ruled that EBWS could not recover for lost profits because it was not a going\nconcern at the time the contract was entered into, and profits were too speculative. The court\nconcluded, however, that EBWS could submit evidence of other business losses, including future\npayment for unused milk and staff wages.\xe2\x80\xa6\nAt trial, Huyffer, the CEO of EBWS, testified that during a repairs closure the creamery would be\nrequired to purchase milk from adjacent Rock Bottom Farm, even though it could not process\nthis milk. She admitted that such a requirement was self-imposed as there was no written\noutput contract between EBWS and the farm to buy milk. In addition, Huyffer testified that\nEBWS would pay its employees during the closure even though EBWS has no written contract to\npay its employees when they are not working. The trial court allowed these elements of damages\nto be submitted to the jury, and the jury awarded EBWS consequential damages for unused milk\nand staff wages.\nOn appeal, Britly contends that because there is no contractual or legal obligation for EBWS to\npurchase milk or pay its employees, these are not foreseeable damages. EBWS counters that it is\ncommon knowledge that cows continue to produce milk, even if the processing plant is not\nworking, and thus it is foreseeable that this loss would occur. We conclude that these damages\nare not the foreseeable result of Britly\xe2\x80\x99s breach of the construction contract and reverse the\naward.\xe2\x80\xa6\n[W]e conclude that\xe2\x80\xa6it is not reasonable to expect Britly to foresee that its failure to perform\nunder the contract would result in this type of damages. While we are sympathetic to EBWS\xe2\x80\x99s\ncontention that the cows continue to produce milk, even when the plant is closed down, this fact\nalone is not enough to demonstrate that buying and dumping milk is a foreseeable result of\nBritly\xe2\x80\x99s breach of the construction contract. Here, the milk was produced by a separate and\ndistinct entity, Rock Bottom Farm, which sold the milk to EBWS.\xe2\x80\xa6\nSimilarly, EBWS maintained no employment agreements with its employees obligating it to pay\nwages during periods of closure for repairs, dips in market demand, or for any other reason. Any\nlosses EBWS might suffer in the future because it chooses to pay its employees during a plant\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n329\n\n\x0cclosure for repairs would be a voluntary expense and not in Britly\xe2\x80\x99s contemplation at the time it\nentered the construction contract. It is not reasonable to expect Britly to foresee losses incurred\nas a result of agreements that are informal in nature and carry no legal obligation on EBWS to\nperform. \xe2\x80\x9c[P]arties are not presumed to know the condition of each other\xe2\x80\x99s affairs nor to take\ninto account contracts with a third party that is not communicated.\xe2\x80\x9d [Citation] While it is true\nthat EBWS may have business reasons to pay its employees even without a contractual\nobligation, for example, to ensure employee loyalty, no evidence was introduced at trial by\nEBWS to support a sound rationale for such considerations. Under these circumstances, this\nbusiness decision is beyond the scope of what Britly could have reasonably foreseen as damages\nfor its breach of contract.\xe2\x80\xa6\nIn addition, the actual costs of the wages and milk are uncertain.\xe2\x80\xa6[T]he the milk and wages\nhere are future expenses, for which no legal obligation was assumed by EBWS, and which are\nseparate from the terms of the parties\xe2\x80\x99 contract. We note that at the time of the construction\ncontract EBWS had not yet begun to operate as a creamery and had no history of buying milk or\npaying employees. See [Citation] (explaining that profits for a new business are uncertain and\nspeculative and not recoverable). Thus, both the cost of the milk and the number and amount of\nwages of future employees that EBWS might pay in the event of a plant closure for repairs are\nuncertain.\nAward for consequential damages is reversed.\xe2\x80\xa6\n\nCASE QUESTIONS\n\n1. Why, according to EBWS\xe2\x80\x99s CEO, would EBWS be required to purchase milk from adjacent\nRock Bottom Farm, even though it could not process this milk?\n2. Surely it is well known in Vermont dairy country that dairy farmers can\xe2\x80\x99t simply stop milking\ncows when no processing plant is available to take the milk\xe2\x80\x94the cows will soon stop\nproducing. Why was EBWS then not entitled to those damages which it will certainly suffer\nwhen the creamery is down for repairs?\n3. Britly (the contractor) must have known EBWS had employees that would be idled when the\ncreamery shut down for repairs. Why was it not liable for their lost wages?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n330\n\n\x0c4. What could EBWS have done at the time of contracting to protect itself against the damages\nit would incur in the event the creamery suffered downtime due to faulty construction?\n\n8.5 Summary and Exercises\nSummary\n\nIn this chapter we have seen that two fundamental sources of contract law are the common law\nas developed in the state courts and as summarized in theRestatement (Second) of\nContracts, and the Uniform Commercial Code for the sale of goods.\nSales law is a special type of contract law, governed by Article 2 of the UCC. Article 2 governs the\nsale of goods only, defined as things movable at the time of identification to the contract for sale.\nWhen the goods are \xe2\x80\x9csold\xe2\x80\x9d incidental to a service, the courts do not agree on whether Article 2\napplies. For two categories of goods, legislation specifically answers the question: foodstuffs\nserved by a restaurant are goods; blood supplied for transfusions is not.\nTypes of contracts can be distinguished along these axes: (1) express and implied, including\nquasi-contracts implied by law; (2) bilateral and unilateral; (3) enforceable and unenforceable;\nand (4) completed (executed) and uncompleted (executory). To understand contract law, it is\nnecessary to master these distinctions and their nuances.\nIn order to determine whether a valid, enforceable contract exists, the following questions must\nbe answered: (1) Did the parties reach an agreement? (2) Was consideration present? (3) Was\nthe agreement legal? (4) Did the parties have capacity to make a contract? (5) Was the\nagreement in the proper form?\nRemedies available against someone who breaches a contract include damages, specific\nperformance, and restitution. Frequently the party who is not in breach must choose between\ntort and contract remedies.\n\nEXERCISES\n\n1. On November 26, Joe wrote to Kate offering to purchase a farm that she owned. Upon\nreceiving the letter on November 28, Kate immediately sent Joe a letter of acceptance.\nHowever, shortly after mailing the letter, Kate had second thoughts and called Joe to advise\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n331\n\n\x0chim that she was rejecting his offer. The call was made before Joe received the letter of\nacceptance. Has a contract been formed? Why?\n2. On a busy day just before April 15, Albert Accountant received a call from a local car dealer.\nThe dealer said, \xe2\x80\x9cHi, Mr. Accountant. Now, while you have income from doing clients\xe2\x80\x99 taxes, I\nhave an excellent offer for you. You can buy a new Buick Century automobile completely\nloaded for $36,000. Al, I know you\xe2\x80\x99re busy. If I don\xe2\x80\x99t hear from you by the end of the day, I\xe2\x80\x99ll\nassume you want the car.\xe2\x80\x9d Albert, distracted, did not respond immediately, and the dealer\nhung up. Then followed an exhausting day of working with anxiety-ridden tax clients. Albert\nforgot about the conversation. Two days later a statement arrived from the dealer, with\ninstructions on how Albert should pick up the car at the dealership. Is there a contract?\nExplain.\n3. Bert purchased Ernie\xe2\x80\x99s car. Before selling the car, Ernie had stated to Bert, \xe2\x80\x9cThis car runs well\nand is reliable. Last week I drove the car all the way from Seattle to San Francisco to visit my\nmother and back again to Seattle.\xe2\x80\x9d In fact, Ernie was not telling the truth: he had driven the\ncar to San Francisco to visit his paramour, not his mother. Upon discovery of the truth, may\nBert avoid the contract? Why?\n4. Langstraat was seventeen when he purchased a motorcycle. When applying for insurance, he\nsigned a \xe2\x80\x9cNotice of Rejection,\xe2\x80\x9d declining to purchase uninsured motorist coverage. He was\ninvolved in an accident with an uninsured motorist and sought to disaffirm his rejection of\nthe uninsured motorist coverage on the basis of infancy. May he do so?\n5. Richard promised to have Darlene\xe2\x80\x99s deck awning constructed by July 10. On June 20, Darlene\ncalled him and asked if he could get the job done by July 3, in time for Independence Day.\nRichard said he could, but he failed to do so, and Darlene had to rent two canopies at some\nexpense. Darlene claims that because Richard breached his promise, he is liable for the cost\nof awning rental. Is she correct\xe2\x80\x94was his promise binding? Why?\n6. After taking a business law class at State U, Elke entered into a contract to sell her business\nlaw book to a classmate, Matthew, for $45. As part of the same contract, she agreed to\nprepare a will for Matthew\xe2\x80\x99s mother for an additional $110. Elke prepared the will and sent\nthe book to Matthew, but he refused to pay her. Is she entitled to any payment? Explain.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n332\n\n\x0c7. Sara Hohe, a fifteen-year-old junior at Mission Bay High School in San Diego, was injured\nduring a campus hypnotism show sponsored by the PTSA as a fund-raiser for the senior class.\nHypnotism shows had been held annually since 1980, and Sara had seen the previous year\xe2\x80\x99s\nshow. She was selected at random from a group of many volunteers. Her participation in the\n\xe2\x80\x9cMagic of the Mind Show\xe2\x80\x9d was conditioned on signing two release forms. Hohe\xe2\x80\x99s father\nsigned a form entitled \xe2\x80\x9cMission Bay High School PTSA Presents Dr. Karl Santo.\xe2\x80\x9d Hohe and her\nfather both signed a form titled \xe2\x80\x9cKarl Santo Hypnotist,\xe2\x80\x9d releasing Santo and the school\ndistrict from all liability. During the course of the show, while apparently hypnotized, Hohe\nslid from her chair and also fell to the floor about six times and was injured. She, through her\nfather, then sued the school district. The Hohes claimed the release was contrary to public\npolicy; the trial court dismissed the suit on summary judgment. Was the release contrary to\npublic policy? Decide.\n8. Plaintiff Irma Kozlowski cohabited with Defendant Thaddeus Kozlowski for fifteen years\nwithout marriage. She repeatedly asked him specifically about her financial situation should\nhe predecease her, and he assured her\xe2\x80\x94she said\xe2\x80\x94that he would arrange to provide for her\nfor the rest of her life. She had provided the necessary household services and emotional\nsupport to permit him to successfully pursue his business career; she had performed\nhousekeeping, cleaning, and shopping services and had run the household and raised the\nchildren, her own as well as his. When they separated and she was \xe2\x80\x9cliterally forced out of the\nhouse,\xe2\x80\x9d she was sixty-three years old and had no means or wherewithal for survival. When\nshe sued, he raised the Statute of Frauds\xe2\x80\x99 one-year rule as a defense. Is the defense good?\n9. Owner of an auto repair shop hires Contractor to remodel his shop but does not mention\nthat two days after the scheduled completion date, Owner is to receive five small US Army\npersonnel carrier trucks for service, with a three-week deadline to finish the job and turn the\ntrucks over to the army. The contract between Owner and the army has a liquidated\ndamages clause calling for $300 a day for every day trucks are not operable after the\ndeadline. Contractor is five days late in finishing the remodel. Can Owner claim the $1,500 as\ndamages against Contractor as a consequence of the latter\xe2\x80\x99s tardy completion of the\ncontract? Explain.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n333\n\n\x0c10. Calvin, a promising young basketball and baseball player, signed a multiyear contract with a\nprofessional basketball team after graduating from college. After playing basketball for one\nyear, he decided he would rather play baseball and breached his contract with the basketball\nteam. What remedy could the team seek?\n\nSELF-TEST QUESTIONS\n\n1. An implied contract\na.\n\nmust be in writing\nb. is one in which the terms are spelled out\nc. is one inferred from the actions of the parties\nd. is imposed by law to avoid an unjust result\ne. may be avoided by one party.\nThe Convention on Contracts for the International Sale of Goods is\n\na.\n\nan annual meeting of international commercial purchasing agents.\nb. contract law used in overseas US federal territories\nc. a customary format or template for drafting contracts\nd. a kind of treaty setting out international contract law, to which the United States\nis a party\ne. the organization that develops uniform international law.\nConsideration\n\na.\n\ncan consist of a written acknowledgment of some benefit received, even if in fact\n\nthe benefit is not delivered\nb. cannot be nominal in amount\nc. is a bargained-for act, forbearance, or promise from the promisee\nd. is all of the above\nAn example of valid consideration is a promise\na.\n\nby a seventeen-year-old to refrain from drinking alcohol\n\nb. to refrain from going to court\nc. to cook dinner if the promisor can get around to it\nd. to repay a friend for the four years of free legal advice he had provided.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n334\n\n\x0cA contract to pay a lobbyist to influence a public official is generally illegal.\na.\n\ntrue\n\nb. false\n\nSELF-TEST ANSWERS\n\n1. c\n2. d\n3. c\n4. b\n5. false\n\nChapter 9\nIntroduction to Property: Personal Property and\nFixtures\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. The difference between personal property and other types of property\n2. How rights in personal property are acquired and maintained\n3. How some kinds of personal property can become real property, and how to determine who\nhas rights in fixtures that are part of real property\nIn this chapter, we examine the general nature of property rights and the law relating to\npersonal property\xe2\x80\x94with special emphasis on acquisition and fixtures. In Chapter 10\n"Intellectual Property", we discuss intellectual property, a kind of personal property that is\nincreasingly profitable. In Chapter 11 "The Nature and Regulation of Real Estate and the\nEnvironment" through Chapter 13 "Landlord and Tenant Law", we focus on real property,\nincluding its nature and regulation, its acquisition by purchase (and some other methods), and\nits acquisition by lease (landlord and tenant law).\nIn Chapter 14 "Estate Planning: Wills, Estates, and Trusts" and Chapter 15 "Insurance", we\ndiscuss estate planning and insurance\xe2\x80\x94two areas of the law that relate to both personal and real\nproperty.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n335\n\n\x0c9.1 The General Nature of Property Rights\nLEARNING OBJECTIVES\n\n1. Understand the elastic and evolving boundaries of what the law recognizes as property that\ncan be bought or sold on the market.\n2. Distinguish real property from personal property.\n\nDefinition of Property\nProperty, which seems like a commonsense concept, is difficult to define in an intelligible way;\nphilosophers have been striving to define it for the past 2,500 years. To say that \xe2\x80\x9cproperty is\nwhat we own\xe2\x80\x9d is to beg the question\xe2\x80\x94that is, to substitute a synonym for the word we are trying\nto define. Blackstone\xe2\x80\x99s famous definition is somewhat wordy: \xe2\x80\x9cThe right of property is that sole\nand despotic dominion which one man claims and exercises over the external things of the\nworld, in total exclusion of the right of any other individual in the universe. It consists in the free\nuse, enjoyment, and disposal of all a person\xe2\x80\x99s acquisitions, without any control or diminution\nsave only by the laws of the land.\xe2\x80\x9d A more concise definition, but perhaps too broad, comes from\nthe Restatement of the Law of Property, which defines property as the \xe2\x80\x9clegal relationship\nbetween persons with respect to a thing.\xe2\x80\x9d\nThe Restatement\xe2\x80\x99s definition makes an important point: property is a legal relationship, the\npower of one person to use objects in ways that affect others, to exclude others from the\nproperty, and to acquire and transfer property. Still, this definition does not contain a specific\nlist of those nonhuman \xe2\x80\x9cobjects\xe2\x80\x9d that could be in such a relationship. We all know that we can\nown personal objects like iPods and DVDs, and even more complex objects like homes and\nminerals under the ground. Property also embraces objects whose worth is representative or\nsymbolic: ownership of stock in a corporation is valued not for the piece of paper called a stock\ncertificate but for dividends, the power to vote for directors, and the right to sell the stock on the\nopen market. Wholly intangible things or objects like copyrights and patents and bank accounts\nare capable of being owned as property. But the list of things that can be property is not fixed,\nfor our concept of property continues to evolve. Collateralized debt obligations (CDOs) and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n336\n\n\x0cstructured investment vehicles (SIVs), prime players in the subprime mortgage crisis, were not\non anyone\xe2\x80\x99s list of possible property even fifteen years ago.\n\nThe Economist\xe2\x80\x99s View\nProperty is not just a legal concept, of course, and different disciplines express different\nphilosophies about the purpose of property and the nature of property rights. To the jurist,\nproperty rights should be protected because it is just to do so. To an economist, the legal\nprotection of property rights functions to create incentives to use resources efficiently. For a\ntruly efficient system of property rights, some economists would require universality (everything\nis owned), exclusivity (the owners of each thing may exclude all others from using it), and\ntransferability (owners may exchange their property). Together, these aspects of property would\nlead, under an appropriate economic model, to efficient production and distribution of goods.\nBut the law of property does not entirely conform to the economic conception of the ownership\nof productive property by private parties; there remain many kinds of property that are not\nprivately owned and some parts of the earth that are considered part of \xe2\x80\x9cthe commons.\xe2\x80\x9d For\nexample, large areas of the earth\xe2\x80\x99s oceans are not \xe2\x80\x9cowned\xe2\x80\x9d by any one person or nation-state,\nand certain land areas (e.g., Yellowstone National Park) are not in private hands.\n\nClassification of Property\nProperty can be classified in various ways, including tangible versus intangible, private versus\npublic, and personal versus real. Tangible property is that which physically exists, like a\nbuilding, a popsicle stand, a hair dryer, or a steamroller.Intangible property is something\nwithout physical reality that entitles the owner to certain benefits; stocks, bonds, and\nintellectual property would be common examples.Public property is that which is owned by any\nbranch of government;private property is that which is owned by anyone else, including a\ncorporation.\nPerhaps the most important distinction is between real and personal property.\nEssentially, real property is immovable; personal property is movable. At common law, personal\nproperty has been referred to as \xe2\x80\x9cchattels.\xe2\x80\x9d When chattels become affixed to real property in a\ncertain manner, they are called fixtures and are treated as real property. (For example, a\nbathroom cabinet purchased at Home Depot and screwed into the bathroom wall may be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n337\n\n\x0cconverted to part of the real property when it is affixed.) Fixtures are discussed in Section 9.3\n"Fixtures" of this chapter.\n\nImportance of the Distinction between Real and Personal Property\nIn our legal system, the distinction between real and personal property is significant in several\nways. For example, the sale of personal property, but not real property, is governed by Article 2\nof the Uniform Commercial Code (UCC). Real estate transactions, by contrast, are governed by\nthe general law of contracts. Suppose goods are exchanged for realty. Section 2-304 of the UCC\nsays that the transfer of the goods and the seller\xe2\x80\x99s obligations with reference to them are subject\nto Article 2, but not the transfer of the interests in realty nor the transferor\xe2\x80\x99s obligations in\nconnection with them.\nThe form of transfer depends on whether the property is real or personal. Real property is\nnormally transferred by a deed, which must meet formal requirements dictated by state law. By\ncontrast, transfer of personal property often can take place without any documents at all.\nAnother difference can be found in the law that governs the transfer of property on death. A\nperson\xe2\x80\x99s heirs depend on the law of the state for distribution of his property if he dies intestate\xe2\x80\x94\nthat is, without a will. Who the heirs are and what their share of the property will be may depend\non whether the property is real or personal. For example, widows may be entitled to a different\npercentage of real property than personal property when their husbands die intestate.\nTax laws also differ in their approach to real and personal property. In particular, the rules of\nvaluation, depreciation, and enforcement depend on the character of the property. Thus real\nproperty depreciates more slowly than personal property, and real property owners generally\nhave a longer time than personal property owners to make good unpaid taxes before the state\nseizes the property.\n\nKEY TAKEAWAY\n\nProperty is difficult to define conclusively, and there are many different classifications of\nproperty. There can be public property as well as private property, tangible property as well\nas intangible property, and, most importantly, real property as well as personal property.\nThese are important distinctions, with many legal consequences.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n338\n\n\x0c1. Kristen buys a parcel of land on Marion Street, a new and publicly maintained roadway. Her\ntown\xe2\x80\x99s ordinances say that each property owner on a public street must also provide a\nsidewalk within ten feet of the curb. A year after buying the parcel, Kristen commissions a\nhouse to be built on the land, and the contractor begins by building a sidewalk in accordance\nwith the town\xe2\x80\x99s ordinance. Is the sidewalk public property or private property? If it snows,\nand if Kristen fails to remove the snow and it melts and ices over and a pedestrian slips and\nfalls, who is responsible for the pedestrian\xe2\x80\x99s injuries?\n2. When can private property become public property? Does public property ever become\nprivate property?\n\n9.2 Personal Property\n\nLEARNING OBJECTIVE\n\n1. Explain the various ways that personal property can be acquired by means other than\npurchase.\nMost legal issues about personal property center on its acquisition. Acquisition by purchase is\nthe most common way we acquire personal property, but there are at least five other ways to\nlegally acquire personal property: (1) possession, (2) finding lost or misplaced property, (3) gift,\n(4) accession, and (5) confusion.\n\nPossession\nIt is often said that \xe2\x80\x9cpossession is nine-tenths of the law.\xe2\x80\x9d There is an element of truth to this,\nbut it\xe2\x80\x99s not the whole truth. For our purposes, the more important question is, what is meant by\n\xe2\x80\x9cpossession\xe2\x80\x9d? Its meaning is not intuitively obvious, as a moment\xe2\x80\x99s reflection will reveal. For\nexample, you might suppose than you possess something when it is physically within your\ncontrol, but what do you say when a hurricane deposits a boat onto your land? What if you are\nnot even home when this happens? Do you possess the boat? Ordinarily, we would say that you\ndon\xe2\x80\x99t, because you don\xe2\x80\x99t have physical control when you are absent. You may not even have the\nintention to control the boat; perhaps instead of a fancy speedboat in relatively good shape, the\nboat is a rust bucket badly in need of repair, and you want it removed from your front yard.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n339\n\n\x0cEven the element of physical domination of the object may not be necessary. Suppose you give\nyour new class ring to a friend to examine. Is it in the friend\xe2\x80\x99s possession? No: the friend has\ncustody, not possession, and you retain the right to permit a second friend to take it from her\nhands. This is different from the case of a bailment, in which the bailor gives possession of an\nobject to the bailee. For example, a garage (a bailee) entrusted with a car for the evening, and\nnot the owner, has the right to exclude others from the car; the owner could not demand that the\ngarage attendants refrain from moving the car around as necessary.\nFrom these examples, we can see that possession or physical control must usually be understood\nas the power to exclude others from using the object. Otherwise, anomalies arise from the\ndifficulty of physically controlling certain objects. It is more difficult to exercise control over a\none-hundred-foot television antenna than a diamond ring. Moreover, in what sense do you\npossess your household furniture when you are out of the house? Only, we suggest, in the power\nto exclude others. But this power is not purely a physical one: being absent from the house, you\ncould not physically restrain anyone. Thus the concept of possession must inevitably be mixed\nwith legal rules that do or could control others.\nPossession confers ownership in a restricted class of cases only: when no person was the owner\nat the time the current owner took the object into his possession. The most obvious categories of\nobjects to which this rule of possession applies are wild animals and abandoned goods. The rule\nrequires that the would-be owner actually take possession of the animal or goods; the hunter\nwho is pursuing a particular wild animal has no legal claim until he has actually captured it. Two\nhunters are perfectly free to pursue the same animal, and whoever actually grabs it will be the\nowner.\nBut even this simple rule is fraught with difficulties in the case of both wild animals and\nabandoned goods. We examine abandoned goods in Section 9.2.2 "Lost or Misplaced Property".\nIn the case of wild game, fish in a stream, and the like, the general rule is subject to the rights of\nthe owner of the land on which the animals are caught. Thus even if the animals caught by a\nhunter are wild, as long as they are on another\xe2\x80\x99s land, the landowner\xe2\x80\x99s rights are superior to the\nhunter\xe2\x80\x99s. Suppose a hunter captures a wild animal, which subsequently escapes, and a second\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n340\n\n\x0chunter thereafter captures it. Does the first hunter have a claim to the animal? The usual rule is\nthat he does not, for once an animal returns to the wild, ownership ceases.\n\nLost or Misplaced Property\nAt common law, a technical distinction arose between lost and misplaced property. An object is\nlost if the owner inadvertently and unknowingly lets it out of his possession. It is merely\nmisplaced if the owner intentionally puts it down, intending to recover it, even if he\nsubsequently forgets to retrieve it. These definitions are important in considering the old saying\n\xe2\x80\x9cFinders keepers, losers weepers.\xe2\x80\x9d This is a misconception that is, at best, only partially true,\nand more often false. The following hierarchy of ownership claims determines the rights of\nfinders and losers.\nFirst, the owner is entitled to the return of the property unless he has intentionally abandoned\nit. The finder is said to be a quasi-bailee for the true owner, and as bailee she owes the owner\ncertain duties of care. The finder who knows the owner or has reasonable means of discovering\nthe owner\xe2\x80\x99s identity commits larceny if she holds on to the object with the intent that it be hers.\nThis rule applies only if the finder actually takes the object into her possession. For example, if\nyou spot someone\xe2\x80\x99s wallet on the street you have no obligation to pick it up; but if you do pick it\nup and see the owner\xe2\x80\x99s name in it, your legal obligation is to return it to the rightful owner. The\nfinder who returns the object is not automatically entitled to a reward, but if the loser has\noffered a reward, the act of returning it constitutes performance of a unilateral contract.\nMoreover, if the finder has had expenses in connection with finding the owner and returning the\nproperty, she is entitled to reasonable reimbursement as a quasi-bailee. But the rights of the\nowner are frequently subject to specific statutes, such as the one discussed in Bishop v.\nEllsworth in Section 9.4.1 "Lost or Misplaced Property".\nSecond, if the owner fails to claim the property within the time allowed by statute or has\nabandoned it, then the property goes to the owner of the real estate on which it was found if (1)\nthe finder was a trespasser, (2) the goods are found in a private place (though what exactly\nconstitutes a private place is open to question: is the aisle of a grocery store a private place? the\nback of the food rack? the stockroom?), (3) the goods are buried, or (4) the goods are misplaced\nrather than lost.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n341\n\n\x0cIf none of these conditions apply, then the finder is the owner. These rules are considered in\nthe Bishop case, (see Section 9.4.1 "Lost or Misplaced Property").\n\nGift\nA gift is a voluntary transfer of property without consideration or compensation. It is\ndistinguished from a sale, which requires consideration. It is distinguished from a promise to\ngive, which is a declaration of an intention to give in the future rather than a present transfer. It\nis distinguished from a testamentary disposition (will), which takes effect only upon death, not\nupon the preparation of the documents. Two other distinctions are worth noting.\nAn inter vivos (enter VYE vos) gift is one made between living persons without conditions\nattached. A causa mortis (KAW zuh mor duz) gift is made by someone contemplating death in\nthe near future.\n\nRequirements\nFigure 9.1 Gift Requirements\n\nTo make an effective gift inter vivos or causa mortis, the law imposes three requirements: (1) the\ndonor must deliver a deed or object to the donee; (2) the donor must actually intend to make a\ngift, and (3) the donee must accept (see Figure 9.1 "Gift Requirements").\n\nDelivery\nAlthough it is firmly established that the object be delivered, it is not so clear what constitutes\ndelivery. On the face of it, the requirement seems to be that the object must be transferred to the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n342\n\n\x0cdonee\xe2\x80\x99s possession. Suppose your friend tells you he is making a gift to you of certain books that\nare lying in a locked trunk. If he actually gives you the trunk so that you can carry it away, a gift\nhas been made. Suppose, however, that he had merely given you the key, so that you could come\nback the next day with your car. If this were the sole key, the courts would probably construe the\ntransfer of the key as possession of the trunk. Suppose, instead, that the books were in a bank\nvault and the friend made out a legal document giving both you and him the power to take from\nthe bank vault. This would not be a valid gift, since he retained power over the goods.\n\nIntent\nThe intent to make a gift must be an intent to give the property at the present time, not later. For\nexample, suppose a person has her savings account passbook put in her name and a friend\xe2\x80\x99s\nname, intending that on her death the friend will be able to draw out whatever money is left. She\nhas not made a gift, because she did not intend to give the money when she changed the\npassbook. The intent requirement can sometimes be sidestepped if legal title to the object is\nactually transferred, postponing to the donee only the use or enjoyment of the property until\nlater. Had the passbook been made out in the name of the donee only and delivered to a third\nparty to hold until the death of the donor, then a valid gift may have been made. Although it is\nsometimes difficult to discern this distinction in practice, a more accurate statement of the rule\nof intent is this: Intention to give in the future does not constitute the requisite intent, whereas\npresent gifts of future interests will be upheld.\n\nAcceptance\nIn the usual case, the rule requiring acceptance poses no difficulties. A friend hands you a new\nbook and says, \xe2\x80\x9cI would like you to have this.\xe2\x80\x9d Your taking the book and saying \xe2\x80\x9cthank-you\xe2\x80\x9d is\nenough to constitute your acceptance. But suppose that the friend had given you property\nwithout your knowing it. For example, a secret admirer puts her stock certificates jointly in your\nname and hers without telling you. Later, you marry someone else, and she asks you to transfer\nthe certificates back to her name. This is the first you have heard of the transaction. Has a gift\nbeen made? The usual answer is that even though you had not accepted the stock when the\nname change was made, the transaction was a gift that took effect immediately, subject to your\nright to repudiate when you find out about it. If you do not reject the gift, you have joint rights in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n343\n\n\x0cthe stock. But if you expressly refuse to accept a gift or indicate in some manner that you might\nnot have accepted it, then the gift is not effective. For example, suppose you are running for\noffice. A lobbyist whom you despise gives you a donation. If you refuse the money, no gift has\nbeen made.\n\nGifts Causa Mortis\nEven though the requirements of delivery, intent, and acceptance apply to gifts causa mortis as\nwell as inter vivos, a gift causa mortis (one made in contemplation of death) may be\ndistinguished from a gift inter vivos on other grounds. The difference between the two lies in the\npower of the donor to revoke the gift before he dies; in other words, the gift is conditional on his\ndeath. Since the law does not permit gifts that take place in the future contingent on some\nhappening, how can it be that a gift causa mortis is effective? The answer lies in the nature of the\ntransfer: the donee takes actual title when the gift is made; should the donor not in fact die or\nshould he revoke the gift before he dies, then and only then will the donee lose title. The\ndifference is subtle and amounts to the difference between saying \xe2\x80\x9cIf I die, the watch is yours\xe2\x80\x9d\nand \xe2\x80\x9cThe watch is yours, unless I survive.\xe2\x80\x9d In the former case, known as a condition precedent,\nthere is no valid gift; in the latter case, known as a condition subsequent, the gift is valid.\n\nGifts to Minors\nEvery state has adopted either the Uniform Gifts to Minors Act (UGMA) or the Uniform\nTransfers to Minors Act (UTMA), both of which establish the manner by which irrevocable gifts\nare made to minors. Under these acts, a custodian holds the gifts until the minor reaches the age\nof eighteen, twenty-one, or twenty-five, depending on state law. Gifts under UGMA are limited\nfor the most part to money or securities, while UTMA allows other types of gifts as well, such as\nreal estate or tangible personal property.\n\nGift Tax\nThe federal government and many states impose gift taxes on gifts above a certain dollar\namount. We discuss gift taxes in connection with estate taxes in Chapter 14 "Estate Planning:\nWills, Estates, and Trusts".\n\nAccession\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n344\n\n\x0cAn accession is something that is added to what one already possesses. In general, the rule is\nthat the owner of the thing owns the additional thing that comes to be attached to it. For\nexample, the owner of a cow owns her calves when she gives birth. But when one person adds\nvalue to another person\xe2\x80\x99s property, either through labor alone or by adding new materials, the\nrule must be stated somewhat differently. The general rule is this: when goods are added to\ngoods, the owner of the principal goods becomes the owner of the enhanced product. For\nexample, a garage uses its paint to repaint its customer\xe2\x80\x99s automobile. The car owner, not the\npainter, is the owner of the finished product.\nWhen someone has wrongfully converted\xe2\x80\x94that is, taken as her own\xe2\x80\x94the property of another,\nthe owner may sue for damages, either to recover his property or its value. But a problem arises\nwhen the converter has added to the value of that property. In general, the courts hold that\nwhen the conversion is willful, the owner is entitled to the full value of the goods as enhanced by\nthe converter. Suppose that a carpenter enters a ten-acre forest that he knows belongs to his\nneighbor, cuts down one hundred trees, transports them to his shop, and cuts them up into\nstandard lumber, thus increasing their market value. The owner is entitled to this full value, and\nthe carpenter will get nothing for his trouble. Thus the willful converter loses the value of his\nlabor or materials. If, on the other hand, the conversion was innocent, or at most negligent, the\nrule is somewhat more uncertain. Generally the courts will award the forest owner the value of\nthe standing timber, giving the carpenter the excess attributable to his labor and transportation.\nA more favorable treatment of the owner is to give her the full value of the lumber as cut,\nremitting to the carpenter the value of his expenses.\n\nConfusion\nIn accession, the goods of one owner are transformed into a more valuable commodity or are\ninextricably united with the goods of another to form a constituent part. Still another type of\njoining is known as confusion, and it occurs when goods of different owners, while maintaining\ntheir original form, are commingled. A common example is the intermingling of grain in a silo.\nBut goods that are identifiable as belonging to a particular person\xe2\x80\x94branded cattle, for\ninstance\xe2\x80\x94are not confused, no matter how difficult it may be to separate herds that have been\nput together.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n345\n\n\x0cWhen the goods are identical, no particular problem of division arises. Assuming that each\nowner can show how much he has contributed to the confused mass, he is entitled to that\nquantity, and it does not matter which particular grains or kernels he extracts. So if a person,\nseeing a container of grain sitting on the side of the road, mistakes it for his own and empties it\ninto a larger container in his truck, the remedy is simply to restore a like quantity to the original\nowner. When owners of like substances consent to have those substances combined (such as in a\ngrain silo), they are said to be tenants in common, holding a proportional share in the whole.\nIn the case of willful confusion of goods, many courts hold that the wrongdoer forfeits all his\nproperty unless he can identify his particular property. Other courts have modified this harsh\nrule by shifting the burden of proof to the wrongdoer, leaving it up to him to claim whatever he\ncan establish was his. If he cannot establish what was his, then he will forfeit all. Likewise, when\nthe defendant has confused the goods negligently, without intending to do so, most courts will\ntend to shift to the defendant the burden of proving how much of the mass belongs to him.\n\nKEY TAKEAWAY\n\nOther than outright purchase of personal property, there are various ways in which to\nacquire legal title. Among these are possession, gift, accession, confusion, and finding\nproperty that is abandoned, lost, or mislaid, especially if the abandoned, lost, or mislaid\nproperty is found on real property that you own.\n\nEXERCISES\n\n1. Dan captures a wild boar on US Forest Service land. He takes it home and puts it in a cage,\nbut the boar escapes and runs wild for a few days before being caught by Romero, some four\nmiles distant from Dan\xe2\x80\x99s house. Romero wants to keep the boar. Does he \xe2\x80\x9cown\xe2\x80\x9d it? Or does it\nbelong to Dan, or to someone else?\n2. Harriet finds a wallet in the college library, among the stacks. The wallet has $140 in it, but\nno credit cards or identification. The library has a lost and found at the circulation desk, and\nthe people at the circulation desk are honest and reliable. The wallet itself is unique enough\nto be identified by its owner. (a) Who owns the wallet and its contents? (b) As a matter of\nethics, should Harriet keep the money if the wallet is \xe2\x80\x9clegally\xe2\x80\x9d hers?\n\n9.3 Fixtures\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n346\n\n\x0cLEARNING OBJECTIVE\n1. Know the three tests for when personal property becomes a fixture and thus becomes real\nproperty.\n\nDefinition\nA fixture is an object that was once personal property but that has become so affixed to land or\nstructures that it is considered legally a part of the real property. For example, a stove bolted to\nthe floor of a kitchen and connected to the gas lines is usually considered a fixture, either in a\ncontract for sale, or for testamentary transfer (by will). For tax purposes, fixtures are treated as\nreal property.\n\nTests\nFigure 9.2 Fixture Tests\n\nObviously, no clear line can be drawn between what is and what is not a fixture. In general, the\ncourts look to three tests to determine whether a particular object has become a fixture:\nannexation, adaptation, and intention (see Figure 9.2 "Fixture Tests").\n\nAnnexation\nThe object must be annexed or affixed to the real property. A door on a house is affixed. Suppose\nthe door is broken and the owner has purchased a new door made to fit, but the house is sold\nbefore the new door is installed. Most courts would consider that new door a fixture under a rule\nof constructive annexation. Sometimes courts have said that an item is a fixture if its removal\nwould damage the real property, but this test is not always followed. Must the object be attached\nwith nails, screws, glue, bolts, or some other physical device? In one case, the court held that a\nfour-ton statue was sufficiently affixed merely by its weight. [1]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n347\n\n\x0cAdaptation\nAnother test is whether the object is adapted to the use or enjoyment of the real property.\nExamples are home furnaces, power equipment in a mill, and computer systems in bank\nbuildings.\n\nIntention\nRecent decisions suggest that the controlling test is whether the person who actually annexes the\nobject intends by so doing to make it a permanent part of the real estate. The intention is usually\ndeduced from the circumstances, not from what a person might later say her intention was. If an\nowner installs a heating system in her house, the law will presume she intended it as a fixture\nbecause the installation was intended to benefit the house; she would not be allowed to remove\nthe heating system when she sold the house by claiming that she had not intended to make it a\nfixture.\n\nFixture Disputes\nBecause fixtures have a hybrid nature (once personal property, subsequently real property), they\ngenerate a large number of disputes. We have already examined disputes between mortgagees\nand secured parties (Chapter 16 "Secured Transactions and Suretyship"). Two other types of\ndisputes are discussed here.\n\nTransfer of Real Estate\nWhen a homeowner sells her house, the problem frequently crops up as to whether certain items\nin the home have been sold or may be removed by the seller. Is a refrigerator, which simply\nplugs into the wall, a fixture or an item of personal property? If a dispute arises, the courts will\napply the three tests\xe2\x80\x94annexation, adaptation, and intention. Of course, the simplest way of\navoiding the dispute is to incorporate specific reference to questionable items in the contract for\nsale, indicating whether the buyer or the seller is to keep them.\n\nTenant\xe2\x80\x99s Fixtures\nTenants frequently install fixtures in the buildings they rent or the property they occupy. A\ncompany may install tens of thousands of dollars worth of equipment; a tenant in an apartment\nmay bolt a bookshelf into the wall or install shades over a window. Who owns the fixtures when\nthe tenant\xe2\x80\x99s lease expires? The older rule was that any fixture, determined by the usual tests,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n348\n\n\x0cmust remain with the landlord. Today, however, certain types of fixtures\xe2\x80\x94known\nas tenant\xe2\x80\x99s fixtures\xe2\x80\x94stay with the tenant. These fall into three categories: (1) trade fixtures\xe2\x80\x94\narticles placed on the premises to enable the tenant to carry on his or her trade or business in\nthe rented premises; (2) agricultural fixtures\xe2\x80\x94devices installed to carry on farming activities\n(e.g., milling plants and silos); (3) domestic fixtures\xe2\x80\x94items that make a tenant\xe2\x80\x99s personal life\nmore comfortable (carpeting, screens, doors, washing machines, bookshelves, and the like).\nThe three types of tenant\xe2\x80\x99s fixtures remain personal property and may be removed by the tenant\nif the following three conditions are met: (1) They must be installed for the requisite purposes of\ncarrying on the trade or business or the farming or agricultural pursuits or for making the home\nmore comfortable, (2) they must be removable without causing substantial damage to the\nlandlord\xe2\x80\x99s property, and (3) they must be removed before the tenant turns over possession of the\npremises to the landlord. Again, any debatable points can be resolved in advance by specifying\nthem in the written lease.\n\nKEY TAKEAWAY\n\nPersonal property is often converted to real property when it is affixed to real property.\nThere are three tests that courts use to determine whether a particular object has become a\nfixture and thus has become real property: annexation, adaptation, and intention. Disputes\nover fixtures often arise in the transfer of real property and in landlord-tenant relations.\n\nEXERCISES\n\n1. Jim and Donna Stoner contract to sell their house in Rochester, Michigan, to Clem and Clara\nHovenkamp. Clara thinks that the decorative chandelier in the entryway is lovely and gives\nthe house an immediate appeal. The chandelier was a gift from Donna\xe2\x80\x99s mother, \xe2\x80\x9cto enhance\nthe entryway\xe2\x80\x9d and provide \xe2\x80\x9ca touch of beauty\xe2\x80\x9d for Jim and Donna\xe2\x80\x99s house. Clem and Clara\nassume that the chandelier will stay, and nothing specific is mentioned about the chandelier\nin the contract for sale. Clem and Clara are shocked when they move in and find the\nchandelier is gone. Have Jim and Donna breached their contract of sale?\n2. Blaine Goodfellow rents a house from Associated Properties in Abilene, Texas. He is there for\ntwo years, and during that time he installs a ceiling fan, custom-builds a bookcase for an\nalcove on the main floor, and replaces the screening on the front and back doors, saving the\nold screening in the furnace room. When his lease expires, he leaves, and the bookcase\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n349\n\n\x0cremains behind. Blaine does, however, take the new screening after replacing it with the old\nscreening, and he removes the ceiling fan and puts back the light. He causes no damage to\nAssociated Properties\xe2\x80\x99 house in doing any of this. Discuss who is the rightful owner of the\nscreening, the bookcase, and the ceiling fan after the lease expires.\n\n[1] Snedeker v. Warring, 12 N.Y. 170 (1854).\n\n9.4 Case\nLost or Misplaced Property\nBishop v. Ellsworth\n91 Ill. App.2d 386, 234 N.E. 2d 50 (1968)\nOPINION BY: STOUDER, Presiding Justice\nDwayne Bishop, plaintiff, filed a complaint alleging that on July 21, 1965, defendants, Mark and\nJeff Ellsworth and David Gibson, three small boys, entered his salvage yard premises at 427\nMulberry Street in Canton, without his permission, and while there happened upon a bottle\npartially embedded in the loose earth on top of a landfill, wherein they discovered the sum of\n$12,590 in US currency. It is further alleged that said boys delivered the money to the municipal\nchief of police who deposited it with defendant, Canton State Bank. The complaint also alleges\ndefendants caused preliminary notices to be given as required by Ill. Rev. Stats., chapter 50,\nsubsections 27 and 28 (1965), but that such statute or compliance therewith does not affect the\nrights of the plaintiff. [The trial court dismissed the plaintiff\xe2\x80\x99s complaint.]\n\xe2\x80\xa6It is defendant\xe2\x80\x99s contention that the provisions of Ill Rev Stats, chapter 50, subsections 27 and\n28 govern this case. The relevant portions of this statute are as follows:\n\xe2\x80\x9c27. Lost goods\xe2\x80\xa6If any person or persons shall hereafter find any lost goods, money, bank notes,\nor other choses in action, of any description whatever, such person or persons shall inform the\nowner thereof, if known, and shall make restitution of the same, without any compensation\nwhatever, except the same shall be voluntarily given on the part of the owner. If the owner be\nunknown, and if such property found is of the value of $ 15 or upwards, the finder\xe2\x80\xa6shall, within\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n350\n\n\x0cfive days after such finding\xe2\x80\xa6appear before some judge or magistrate\xe2\x80\xa6and make affidavit of the\ndescription thereof, the time and place when and where the same was found, that no alteration\nhas been made in the appearance thereof since the finding of the same, that the owner thereof is\nunknown to him and that he has not secreted, withheld or disposed of any part thereof. The\njudge or magistrate shall enter the value of the property found as near as he can ascertain in his\nestray book together with the affidavit of the finder, and shall also, within ten days after the\nproceedings have been entered on his estray book, transmit to the county clerk a certified copy\nthereof, to be by him recorded in his estray book and to file the same in his office\xe2\x80\xa628.\nAdvertisement\xe2\x80\xa6If the value thereof exceeds the sum of $ 15, the county clerk, within 20 days\nafter receiving the certified copy of the judge or magistrate\xe2\x80\x99s estray record shall cause an\nadvertisement to be set up on the court house door, and in 3 other of the most public places in\nthe county, and also a notice thereof to be published for 3 weeks successively in some public\nnewspaper printed in this state and if the owner of such goods, money, bank notes, or other\nchoses in action does not appear and claim the same and pay the finder\xe2\x80\x99s charges and expenses\nwithin one year after the advertisement thereof as aforesaid, the ownership of such property\nshall vest in the finder.\xe2\x80\x9d\n***\nWe think it apparent that the statute to which defendants make reference provides a means of\nvesting title to lost property in the finder where the prescribed search for the owner proves\nfruitless. This statute does not purport to provide for the disposition of property deemed mislaid\nor abandoned nor does it purport to describe or determine the right to possession against any\nparty other than the true owner. The plain meaning of this statute does not support plaintiff\xe2\x80\x99s\nposition that common law is wholly abrogated thereby. The provisions of the statute are\ndesigned to provide a procedure whereby the discoverer of \xe2\x80\x9clost\xe2\x80\x9d property may be vested with\nthe ownership of said property even as against the true owner thereof, a right which theretofore\ndid not exist at common law. In the absence of any language in the statute from which the\ncontrary can be inferred it must be assumed that the term \xe2\x80\x9clost\xe2\x80\x9d was used in its generally\naccepted legal sense and no extension of the term was intended. Thus the right to possession of\ndiscovered property still depends upon the relative rights of the discoverer and the owner of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n351\n\n\x0clocus in quo and the distinctions which exist between property which is abandoned, mislaid, lost\nor is treasure trove. The statute assumes that the discoverer is in the rightful possession of lost\nproperty and proceedings under such statute is (sic) not a bar where the issue is a claim to the\ncontrary. There is a presumption that the owner or occupant of land or premises has custody of\nproperty found on it or actually imbedded in the land. The ownership or possession of the locus\nin quo is related to the right to possession of property discovered thereon or imbedded therein\nin two respects. First, if the premises on which the property is discovered are private it is\ndeemed that the property discovered thereon is and always has been in the constructive\npossession of the owner of said premises and in a legal sense the property can be neither mislaid\nnor lost. Pyle v. Springfield Marine Bank, 330 Ill App 1, 70 NE2d 257. Second, the question of\nwhether the property is mislaid or lost in a legal sense depends upon the intent of the true\nowner. The ownership or possession of the premises is an important factor in determining such\nintent. If the property be determined to be mislaid, the owner of the premises is entitled to the\npossession thereof against the discoverer. It would also appear that if the discoverer is a\ntrespasser such trespasser can have no claim to possession of such property even if it might\notherwise be considered lost.\n\xe2\x80\xa6The facts as alleged in substance are that the Plaintiff was the owner and in possession of real\nestate, that the money was discovered in a private area of said premises in a bottle partially\nimbedded in the soil and that such property was removed from the premises by the finders\nwithout any right or authority and in effect as trespassers. We believe the averment of facts in\nthe complaint substantially informs the defendants of the nature of and basis for the claim and\nis sufficient to state a cause of action. [The trial court\xe2\x80\x99s dismissal of the Plaintiff\xe2\x80\x99s complaint is\nreversed and the case is remanded.]\n\nCASE QUESTIONS\n\n1. What is the actual result in this case? Do the young boys get any of the money that they\nfound? Why or why not?\n2. Who is Dwayne Bishop, and why is he a plaintiff here? Was it Bishop that put the $12,590 in\nUS currency in a bottle in the landfill at the salvage yard? If not, then who did?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n352\n\n\x0c3. If Bishop is not the original owner of the currency, what are the rights of the original owner in\nthis case? Did the original owner \xe2\x80\x9close\xe2\x80\x9d the currency? Did the original owner \xe2\x80\x9cmisplace\xe2\x80\x9d the\ncurrency? What difference does it make whether the original owner \xe2\x80\x9clost\xe2\x80\x9d or \xe2\x80\x9cmisplaced\xe2\x80\x9d the\ncurrency? Can the original owner, after viewing the legal advertisement, have a claim\nsuperior to Dwayne Bishop\xe2\x80\x99s claim?\n\n9.5 Summary and Exercises\nSummary\n\nProperty is the legal relationship between persons with respect to things. The law spells out\nwhat can be owned and the degree to which one person can assert an interest in someone else\xe2\x80\x99s\nthings. Property is classified in several ways: personal versus real, tangible versus intangible,\nprivate versus public. The first distinction, between real and personal, is the most important, for\ndifferent legal principles often apply to each. Personal property is movable, whereas real\nproperty is immovable.\nAmong the ways personal property can be acquired are: by (1) possession, (2) finding, (3) gift,\n(4) accession, and (5) confusion.\nPossession means the power to exclude others from using an object. Possession confers\nownership only when there is no owner at the time the current owner takes possession. \xe2\x80\x9cFinders\nkeepers, losers weepers\xe2\x80\x9d is not a universal rule; the previous owner is entitled to return of his\ngoods if it is reasonably possible to locate him. If not, or if the owner does not claim his\nproperty, then it goes to the owner of the real estate on which it was found, if the finder was a\ntrespasser, or the goods were buried, were in a private place, or were misplaced rather than lost.\nIf none of these conditions applies, the property goes to the finder.\nA gift is a voluntary transfer of property without consideration. Two kinds of gifts are possible:\ninter vivos and causa mortis. To make an effective gift, (1) the donor must make out a deed or\nphysically deliver the object to the donee, (2) the donor must intend to make a gift, and (3) the\ndonee must accept the gift. Delivery does not always require physical transfer; sometimes,\nsurrender of control is sufficient. The donor must intend to give the gift now, not later.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n353\n\n\x0cAccession is an addition to that which is already owned\xe2\x80\x94for example, the birth of calves to a\ncow owned by a farmer. But when someone else, through labor or by supplying material, adds\nvalue, the accession goes to the owner of the principal goods.\nConfusion is the intermingling of like goods so that each, while maintaining its form, becomes a\npart of a larger whole, like grain mixed in a silo. As long as the goods are identical, they can\neasily enough be divided among their owners.\nA fixture is a type of property that ceases to be personal property and becomes real property\nwhen it is annexed or affixed to land or buildings on the land and adapted to the use and\nenjoyment of the real property. The common-law rules governing fixtures do not employ clearcut tests, and sellers and buyers can avoid many disputes by specifying in their contracts what\ngoes with the land. Tenant\xe2\x80\x99s fixtures remain the property of the tenant if they are for the\nconvenience of the tenant, do not cause substantial damage to the property when removed, and\nare removed before possession is returned to the landlord.\n\nEXERCISES\n\n1. Kate owns a guitar, stock in a corporation, and an antique bookcase that is built into the wall\nof her apartment. How would you classify each kind of property?\n2. After her last business law class, Ingrid casually throws her textbook into a trash can and\nmutters to herself, \xe2\x80\x9cI\xe2\x80\x99m glad I don\xe2\x80\x99t have to read that stuff anymore.\xe2\x80\x9d Tom immediately\nretrieves the book from the can. Days later, Ingrid realizes that the book will come in handy,\nsees Tom with it, and demands that he return the book. Tom refuses. Who is entitled to the\nbook? Why?\n3. In Exercise 2, suppose that Ingrid had accidentally left the book on a table in a restaurant.\nTom finds it, and chanting \xe2\x80\x9cFinders keepers, losers weepers,\xe2\x80\x9d he refuses to return the book.\nIs Ingrid entitled to the book? Why?\n4. In Exercise 3, if the owner of the book (Ingrid) is never found, who is entitled to the book\xe2\x80\x94\nthe owner of the restaurant or Tom? Why?\n5. Matilda owned an expensive necklace. On her deathbed, Matilda handed the necklace to her\nbest friend, Sadie, saying, \xe2\x80\x9cIf I die, I want you to have this.\xe2\x80\x9d Sadie accepted the gift and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n354\n\n\x0cplaced it in her safe-deposit box. Matilda died without a will, and now her only heir, Ralph,\nclaims the necklace. Is he entitled to it? Why or why not?\n\nSELF-TEST QUESTIONS\n\n1. Personal property is defined as property that is\na.\n\nnot a chattel\nb. owned by an individual\nc. movable\nd. immovable\nPersonal property can be acquired by\n\na.\n\naccession\nb. finding\nc. gift\nd. all of the above\nA gift causa mortis is\n\na.\n\nan irrevocable gift\nb. a gift made after death\nc. a gift made in contemplation of death\nd. none of the above\nTo make a gift effective,\na.\n\nthe donor must intend to make a gift\n\nb. the donor must either make out a deed or deliver the gift to the donee\nc. the donee must accept the gift\nd. all of the above are required\nTenant\xe2\x80\x99s fixtures\na.\n\nremain with the landlord in all cases\n\nb. remain the property of the tenant in all cases\nc. remain the property of the tenant if they are removable without substantial\ndamage to the landlord\xe2\x80\x99s property\nd. refer to any fixture installed by a tenant\n\nSELF-TEST ANSWERS\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n355\n\n\x0c1. c\n2. d\n3. c\n4. d\n5. c\n\nChapter 10\nIntellectual Property\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. The principal kinds of intellectual property\n2. The difference between patents and trade secrets, and why a company might choose to rely\non trade secrets rather than obtain a patent\n3. What copyrights are, how to obtain them, and how they differ from trademarks\n4. Why some \xe2\x80\x9cmarks\xe2\x80\x9d may not be eligible for trademark protection, and how to obtain\ntrademark protection for those that are\nFew businesses of any size could operate without being able to protect their rights to a particular\ntype of intangible personal property: intellectual property. The major forms of intellectual\nproperty are patents, copyrights, and trademarks. Unlike tangible personal property (machines,\ninventory) or real property (land, office buildings), intellectual property is formless. It is the\nproduct of the human intellect that is embodied in the goods and services a company offers and\nby which the company is known.\nA patent is a grant from government that gives an inventor the exclusive right to make, use, and\nsell an invention for a period of twenty years from the date of filing the application for a patent.\nA copyright is the right to exclude others from using or marketing forms of expression.\nA trademark is the right to prevent others from using a company\xe2\x80\x99s product name, slogan, or\nidentifying design. Other forms of intellectual property are trade secrets (particular kinds of\ninformation of commercial use to a company that created it) and right of publicity (the right to\nexploit a person\xe2\x80\x99s name or image). Note that the property interest protected in each case is not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n356\n\n\x0cthe tangible copy of the invention or writing\xe2\x80\x94not the machine with a particular serial number or\nthe book lying on someone\xe2\x80\x99s shelf\xe2\x80\x94but the invention or words themselves. That is why\nintellectual property is said to be intangible: it is a right to exclude any others from gaining\neconomic benefit from your own intellectual creation. In this chapter, we examine how\nCongress, the courts, and the Patent and Trademark Office have worked to protect the major\ntypes of intellectual property.\n\n10.1 Patents\n\nLEARNING OBJECTIVES\n\n1. Explain why Congress would grant exclusive monopolies (patents) for certain periods of time.\n2. Describe what kinds of things may be patentable and what kinds of things may not be\npatentable.\n3. Explain the procedures for obtaining a patent, and how patent rights may be an issue where\nthe invention is created by an employee.\n4. Understand who can sue for patent infringement, on what basis, and with what potential\nremedies.\n\nSource of Authority and Duration\nPatent and copyright law are federal, enacted by Congress under the power given by Article I of\nthe Constitution \xe2\x80\x9cto promote the Progress of Science and useful Arts, by securing for limited\nTimes to Authors and Inventors the exclusive Right to their respective Writings and\nDiscoveries.\xe2\x80\x9d Under current law, a patent gives an inventor exclusive rights to make, use, or sell\nan invention for twenty years. (If the patent is a design patent\xe2\x80\x94protecting the appearance rather\nthan the function of an item\xe2\x80\x94the period is fourteen years.) In return for this limited monopoly,\nthe inventor must fully disclose, in papers filed in the US Patent and Trademark Office (PTO), a\ncomplete description of the invention.\n\nPatentability\nWhat May Be Patented\nThe patent law says that \xe2\x80\x9cany new and useful process, machine, manufacture, or composition of\nmatter, or any new and useful improvement thereof\xe2\x80\x9d may be patented.[1] A process is a \xe2\x80\x9cprocess,\nart or method, and includes a new use of a known process, machine, manufacture, composition\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n357\n\n\x0cof matter, or material.\xe2\x80\x9d [2] A process for making rolled steel, for example, qualifies as a\npatentable process under the statute. Amachine is a particular apparatus for achieving a certain\nresult or carrying out a distinct process\xe2\x80\x94lathes, printing presses, motors, and the cotton gin are\nall examples of the hundreds of thousands of machines that have received US patents since the\nfirst Patent Act in 1790. A manufacture is an article or a product, such as a television, an\nautomobile, a telephone, or a lightbulb. A composition of matter is a new arrangement of\nelements so that the resulting compound, such as a metal alloy, is not found in nature.\nIn Commissioner of Patents v. Chakrabarty, [3] the Supreme Court said that even living\norganisms\xe2\x80\x94in particular, a new \xe2\x80\x9cgenetically engineered\xe2\x80\x9d bacterium that could \xe2\x80\x9ceat\xe2\x80\x9d oil spills\xe2\x80\x94\ncould be patented. The Chakrabarty decision has spawned innovation: a variety of small\nbiotechnology firms have attracted venture capitalists and other investors.\nAccording to the PTO, gene sequences are patentable subject matter, provided they are isolated\nfrom their natural state and processed in a way that separates them from other molecules\nnaturally occurring with them. Gene patenting, always controversial, generated new controversy\nwhen the PTO issued a patent to Human Genome Sciences, Inc. for a gene found to serve as a\nplatform from which the AIDS virus can infect cells of the body. Critics faulted the PTO for\nallowing \xe2\x80\x9cownership\xe2\x80\x9d of a naturally occurring human gene and for issuing patents without\nrequiring a showing of the gene\xe2\x80\x99s utility. New guidelines from the PTO followed in 2000; these\nfocused on requiring the applicant to make a strong showing on the utility aspect of patentability\nand somewhat diminished the rush of biotech patent requests.\nThere are still other categories of patentable subjects. An improvement is an alteration of a\nprocess, machine, manufacture, or composition of matter that satisfies one of the tests for\npatentability given later in this section. New, original ornamental designs for articles of\nmanufacture are patentable (e.g., the shape of a lamp); works of art are not patentable but are\nprotected under the copyright law. New varieties of cultivated or hybridized plants are also\npatentable, as are genetically modified strains of soybean, corn, or other crops.\n\nWhat May Not Be Patented\nMany things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3)\nabstract ideas, including algorithms (step-by-step formulas for accomplishing a specific task).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n358\n\n\x0cOne frequently asked question is whether patents can be issued for computer software. The PTO\nwas reluctant to do so at first, based on the notion that computer programs were not \xe2\x80\x9cnovel\xe2\x80\x9d\xe2\x80\x94\nthe software program either incorporated automation of manual processes or used\nmathematical equations (which were not patentable). But in 1998, the Supreme Court held\nin Diamond v. Diehr [4] that patents could be obtained for a process that incorporated a\ncomputer program if the process itself was patentable.\nA business process can also be patentable, as the US Court of Appeals for the Federal Circuit\nruled in 1998 in State Street Bank and Trust v. Signature Financial Group, Inc.[5] Signature\nFinancial had a patent for a computerized accounting system that determined share prices\nthrough a series of mathematical calculations that would help manage mutual funds. State\nStreet sued to challenge that patent. Signature argued that its model and process was protected,\nand the court of appeals upheld it as a \xe2\x80\x9cpractical application of a mathematical, algorithm,\nformula, or calculation,\xe2\x80\x9d because it produces a \xe2\x80\x9cuseful, concrete and tangible result.\xe2\x80\x9d Since State\nStreet, many other firms have applied for business process patents. For example, Amazon.com\nobtained a business process patent for its \xe2\x80\x9cone-click\xe2\x80\x9d ordering system, a method of processing\ncredit-card orders securely. (But see Amazon.com v. Barnesandnoble.com, [6] in which the court\nof appeals rejected Amazon\xe2\x80\x99s challenge to Barnesandnoble.com using its Express Land one-click\nordering system.)\n\nTests for Patentability\nJust because an invention falls within one of the categories of patentable subjects, it is not\nnecessarily patentable. The Patent Act and judicial interpretations have established certain tests\nthat must first be met. To approve a patent application, the PTO (as part of the Department of\nCommerce) will require that the invention, discovery, or process be novel, useful, and\nnonobvious in light of current technology.\nPerhaps the most significant test of patentability is that of obviousness. The act says that no\ninvention may be patented \xe2\x80\x9cif the differences between the subject matter sought to be patented\nand the prior art are such that the subject matter as a whole would have been obvious at the time\nthe invention was made to a person having ordinary skill in the art to which said subject matter\npertains.\xe2\x80\x9d This provision of the law has produced innumerable court cases, especially over\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n359\n\n\x0cimprovement patents, when those who wish to use an invention on which a patent has been\nissued have refused to pay royalties on the grounds that the invention was obvious to anyone\nwho looked.\n\nProcedures for Obtaining a Patent\nIn general, the United States (unlike many other countries) grants a patent right to the first\nperson to invent a product or process rather than to the first person to file for a patent on that\nproduct or process. As a practical matter, however, someone who invents a product or process\nbut does not file immediately should keep detailed research notes or other evidence that would\ndocument the date of invention. An inventor who fails to apply for a patent within a year of that\ndate would forfeit the rights granted to an inventor who had published details of the invention\nor offered it for sale. But until the year has passed, the PTO may not issue a patent to X if Y has\ndescribed the invention in a printed publication here or abroad or the invention has been in\npublic use or on sale in this country.\nAn inventor cannot obtain a patent automatically; obtaining a patent is an expensive and timeconsuming process, and the inventor will need the services of a patent attorney, a highly\nspecialized practitioner. The attorney will help develop the requiredspecification, a description\nof the invention that gives enough detail so that one skilled in the art will be able to make and\nuse the invention. After receiving an application, a PTO examiner will search the records and\naccept or reject the claim. Usually, the attorney will negotiate with the examiner and will rewrite\nand refine the application until it is accepted. A rejection may be appealed, first to the PTO\xe2\x80\x99s\nBoard of Appeals and then, if that fails, to the federal district court in the District of Columbia or\nto the US Court of Appeals for the Federal Circuit, the successor court to the old US Court of\nCustoms and Patent Appeals.\nOnce a patent application has been filed, the inventor or a company to which she has assigned\nthe invention may put the words \xe2\x80\x9cpatent pending\xe2\x80\x9d on the invention. These words have no legal\neffect. Anyone is free to make the invention as long as the patent has not yet been issued. But\nthey do put others on notice that a patent has been applied for. Once the patent has been\ngranted, infringers may be sued even if the infringed has made the product and offered it for sale\nbefore the patent was granted.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n360\n\n\x0cIn today\xe2\x80\x99s global market, obtaining a US patent is important but is not usually sufficient\nprotection. The inventor will often need to secure patent protection in other countries as well.\nUnder the Paris Convention for the Protection of Industrial Property (1883), parties in one\ncountry can file for patent or trademark protection in any of the other member countries (172\ncountries as of 2011). The World Trade Organization\xe2\x80\x99s Agreement on Trade-Related Aspects of\nIntellectual Property Rights (TRIPS) established standards for protecting intellectual property\nrights (patents, trademarks, and copyrights) and provides that each member nation must have\nlaws that protect intellectual property rights with effective access to judicial systems for\npursuing civil and criminal penalties for violations of such rights.\n\nPatent Ownership\nThe patent holder is entitled to make and market the invention and to exclude others from doing\nso. Because the patent is a species of property, it may be transferred. The inventor may assign\npart or all of his interest in the patent or keep the property interest and license others to\nmanufacture or use the invention in return for payments known as royalties. The license may be\nexclusive with one licensee, or the inventor may license many to exploit the invention. One\nimportant limitation on the inventor\xe2\x80\x99s right to the patent interest is the so-called shop right.\nThis is a right created by state courts on equitable grounds giving employers a nonexclusive\nroyalty-free license to use any invention made by an employee on company time and with\ncompany materials. The shop right comes into play only when a company has no express or\nimplied understanding with its employees. Most corporate laboratories have contractual\nagreements with employees about who owns the invention and what royalties will be paid.\n\nInfringement and Invalidity Suits\nSuits for patent infringement can arise in three ways: (1) the patent holder may seek damages\nand an injunction against the infringer in federal court, requesting damages for royalties and\nlost profits as well; (2) even before being sued, the accused party may take the patent holder to\ncourt under the federal Declaratory Judgment Act, seeking a court declaration that the patent is\ninvalid; (3) the patent holder may sue a licensee for royalties claimed to be due, and the licensee\nmay counterclaim that the patent is invalid. Such a suit, if begun in state court, may be removed\nto federal court.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n361\n\n\x0cIn a federal patent infringement lawsuit, the court may grant the winning party reimbursement\nfor attorneys\xe2\x80\x99 fees and costs. If the infringement is adjudged to be intentional, the court can\ntriple the amount of damages awarded. Prior to 2006, courts were typically granting permanent\ninjunctions to prevent future infringement. CitingeBay, Inc. v. Merc Exchange, LLC, [7] the\nSupreme Court ruled that patent holders are not automatically entitled to a permanent\ninjunction against infringement during the life of the patent. Courts have the discretion to\ndetermine whether justice requires a permanent injunction, and they may conclude that the\npublic interest and equitable principles may be better satisfied with compensatory damages\nonly.\nProving infringement can be a difficult task. Many companies employ engineers to \xe2\x80\x9cdesign\naround\xe2\x80\x9d a patent product\xe2\x80\x94that is, to seek ways to alter the product to such an extent that the\nsubstitute product no longer consists of enough of the elements of the invention safeguarded by\nthe patent. However, infringing products, processes, or machines need not be identical; as the\nSupreme Court said in Sanitary Refrigerator Co. v. Winers, [8] \xe2\x80\x9cone device is an infringement of\nanother\xe2\x80\xa6if two devices do the same work in substantially the same way, and accomplish\nsubstantially the same result\xe2\x80\xa6even though they differ in name, form, or shape.\xe2\x80\x9d This is known\nas thedoctrine of equivalents. In an infringement suit, the court must choose between these two\nextremes: legitimate \xe2\x80\x9cdesign around\xe2\x80\x9d and infringement through some equivalent product.\nAn infringement suit can often be dangerous because the defendant will almost always assert in\nits answer that the patent is invalid. The plaintiff patent holder thus runs the risk that his entire\npatent will be taken away from him if the court agrees. In ruling on validity, the court may\nconsider all the tests, such as prior art and obviousness, discussed in Section 10.1.2\n"Patentability" and rule on these independently of the conclusions drawn by the PTO.\n\nPatent Misuse\nAlthough a patent is a monopoly granted to the inventor or his assignee or licensee, the\nmonopoly power is legally limited. An owner who misuses the patent may find that he will lose\nan infringement suit. One common form of misuse is to tie the patented good to some\nunpatented one\xe2\x80\x94for example, a patented movie projector that will not be sold unless the buyer\nagrees to rent films supplied only by the manufacturer of the movie projector, or a copier\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n362\n\n\x0cmanufacturer that requires buyers to purchase plain paper from it. Various provisions of the\nfederal antitrust laws, including, specifically, Section 3 of the Clayton Act, outlaw certain kinds\nof tying arrangements. Another form of patent misuse is a provision in the licensing agreement\nprohibiting the manufacturer from also making competing products. Although the courts have\nheld against several other types of misuse, the general principle is that the owner may not use\nhis patent to restrain trade in unpatented goods.\n\nKEY TAKEAWAY\n\nMany different \xe2\x80\x9cthings\xe2\x80\x9d are patentable, include gene sequences, business processes, and any\nother \xe2\x80\x9cuseful invention.\xe2\x80\x9d The US Patent and Trademark Office acts on initial applications and\nmay grant a patent to an applicant. The patent, which allows a limited-time monopoly, is for\ntwenty years. The categories of patentable things include processes, machines,\nmanufactures, compositions of matter, and improvements. Ideas, mental processes,\nnaturally occurring substances, methods of doing business, printed matter, and scientific\nprinciples cannot be patented. Patent holders may sue for infringement and royalties from\nan infringer user.\n\nEXERCISES\n\n1. Calera, Inc. discovers a way to capture carbon dioxide emissions at a California power plant\nand use them to make cement. This is a win for the power company, which needs to reduce\nits carbon dioxide emissions, and a win for Calera. Calera decides to patent this invention.\nWhat kind of patent would this be? A machine? A composition of matter? A manufacture?\n2. In your opinion, what is the benefit of allowing companies to isolate genetic material and\nclaim a patent? What kind of patent would this be? A machine? A composition of matter? A\nmanufacture?\n3. How could a \xe2\x80\x9cgarage inventor,\xe2\x80\x9d working on her own, protect a patentable invention while yet\ndemonstrating it to a large company that could bring the invention to market?\n\n[1] 35 United States Code, Section 101.\n[2] 35 United States Code, Section 101.\n[3] Commissioner of Patents v. Chakrabarty, 444 U.S. 1028 (1980).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n363\n\n\x0c[4] Diamond v. Diehr, 450 U.S. 175 (1981).\n[5] State Street Bank and Trust v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998).\n[6] Amazon.com v. Barnesandnoble.com, Inc., 239 F.3d 1343 (Fed. Cir. 2001).\n[7] eBay, Inc. v. Merc Exchange, LLC, 546 U.S. 388 (2006).\n[8] Sanitary Refrigerator Co. v. Winers, 280 U.S. 30 (1929).\n\n10.2 Trade Secrets\n\nLEARNING OBJECTIVES\n\n1. Describe the difference between trade secrets and patents, and explain why a firm might\nprefer keeping a trade secret rather than obtaining a patent.\n2. Understand the dimensions of corporate espionage and the impact of the federal Economic\nEspionage Act.\n\nDefinition of Trade Secrets\nA patent is an invention publicly disclosed in return for a monopoly. A trade secret is a means to\na monopoly that a company hopes to maintain by preventing public disclosure. Why not always\ntake out a patent? There are several reasons. The trade secret might be one that is not\npatentable, such as a customer list or an improvement that does not meet the tests of novelty or\nnonobviousness. A patent can be designed around; but if the trade secret is kept, its owner will\nbe the exclusive user of it. Patents are expensive to obtain, and the process is extremely time\nconsuming. Patent protection expires in twenty years, after which anyone is free to use the\ninvention, but a trade secret can be maintained for as long as the secret is kept.\nHowever, a trade secret is valuable only so long as it is kept secret. Once it is publicly revealed,\nby whatever means, anyone is free to use it. The critical distinction between a patent and a trade\nsecret is this: a patent gives its owner the right to enjoin anyone who infringes it from making\nuse of it, whereas a trade secret gives its \xe2\x80\x9cowner\xe2\x80\x9d the right to sue only the person who\nimproperly took it or revealed it.\nAccording to the Restatement of Torts, Section 757, Comment b, a trade secret may consist of\nany formula, pattern, device or compilation of information which is used in one\xe2\x80\x99s business, and\nwhich gives him an opportunity to obtain an advantage over competitors who do not know or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n364\n\n\x0cuse it. It may be a formula for a chemical compound, a process of manufacturing, treating or\npreserving materials, a pattern for a machine or other device, or a list of customers.\xe2\x80\xa6A trade\nsecret is a process or device for continuous use in the operation of a business. Generally it relates\nto the production of goods, as, for example, a machine or formula for the production of an\narticle.\nOther types of trade secrets are customer information, pricing data, marketing methods, sources\nof supply, and secret technical know-how.\n\nElements of Trade Secrets\nTo be entitled to protection, a trade secret must be (1) original and (2) secret.\n\nOriginality\nThe trade secret must have a certain degree of originality, although not as much as would be\nnecessary to secure a patent. For example, a principle or technique that is common knowledge\ndoes not become a protectable trade secret merely because a particular company taught it to one\nof its employees who now wants to leave to work for a competitor.\n\nSecrecy\nSome types of information are obviously secret, like the chemical formula that is jealously\nguarded through an elaborate security system within the company. But other kinds of\ninformation might not be secret, even though essential to a company\xe2\x80\x99s business. For instance, a\nlist of suppliers that can be devised easily by reading through the telephone directory is not\nsecret. Nor is a method secret simply because someone develops and uses it, if no steps are\ntaken to guard it. A company that circulates a product description in its catalog may not claim a\ntrade secret in the design of the product if the description permits someone to do \xe2\x80\x9creverse\nengineering.\xe2\x80\x9d A company that hopes to keep its processes and designs secret should\naffirmatively attempt to do so\xe2\x80\x94for example, by requiring employees to sign a nondisclosure\nagreement covering the corporate trade secrets with which they work. However, a company need\nnot go to every extreme to guard a trade secret.\nTrade-secrets espionage has become a big business. To protect industrial secrets, US\ncorporations spend billions on security arrangements. The line between competitive intelligence\ngathering and espionage can sometimes be difficult to draw. The problem is by no means\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n365\n\n\x0cconfined to the United States; companies and nations all over the world have become concerned\nabout theft of trade secrets to gain competitive advantage, and foreign governments are widely\nbelieved to be involved in espionage and cyberattacks.\n\nEconomic Espionage Act\nThe Economic Espionage Act (EEA) of 1996 makes the theft or misappropriation of a trade\nsecret a federal crime. The act is aimed at protecting commercial information rather than\nclassified national defense information. Two sorts of activities are criminalized. The first section\nof the act [1] criminalizes the misappropriation of trade secrets (including conspiracy to\nmisappropriate trade secrets and the subsequent acquisition of such misappropriated trade\nsecrets) with the knowledge or intent that the theft will benefit a foreign power. Penalties for\nviolation are fines of up to US$500,000 per offense and imprisonment of up to fifteen years for\nindividuals, and fines of up to US$10 million for organizations.\nThe second section [2] criminalizes the misappropriation of trade secrets related to or included in\na product that is produced for or placed in interstate (including international) commerce, with\nthe knowledge or intent that the misappropriation will injure the owner of the trade secret.\nPenalties for violation are imprisonment for up to ten years for individuals (no fines) and fines\nof up to US$5 million for organizations.\nIn addition to these specific penalties, the fourth section of the EEA [3] also requires criminal\nforfeiture of (1) any proceeds of the crime and property derived from proceeds of the crime and\n(2) any property used, or intended to be used, in commission of the crime.\nThe EEA authorizes civil proceedings by the Department of Justice to enjoin violations of the act\nbut does not create a private cause of action. This means that anyone believing they have been\nvictimized must go through the US attorney general in order to obtain an injunction.\nThe EEA is limited to the United States and has no extraterritorial application unless (1) the\noffender is a US company or a citizen operating from abroad against a US company or (2) an act\nin furtherance of the espionage takes place in the United States. Other nations lack such\nlegislation, and some may actively support industrial espionage using both their national\nintelligence services. The US Office of the National Counterintelligence Executive publishes an\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n366\n\n\x0cannual report, mandated by the US Congress, on foreign economic collection and industrial\nespionage, which outlines these espionage activities of many foreign nations.\n\nRight of Employees to Use Trade Secrets\nA perennial source of lawsuits in the trade secrets arena is the employee who is hired away by a\ncompetitor, allegedly taking trade secrets along with him. Companies frequently seek to prevent\npiracy by requiring employees to sign confidentiality agreements. An agreement not to disclose\nparticular trade secrets learned or developed on the job is generally enforceable. Even without\nan agreement, an employer can often prevent disclosure under principles of agency law. Sections\n395 and 396 of the Restatement (Second) of Agency suggest that it is an actionable breach of\nduty to disclose to third persons information given confidentially during the course of the\nagency. However, every person is held to have a right to earn a living. If the rule were strictly\napplied, a highly skilled person who went to another company might be barred from using his\nknowledge and skills. The courts do not prohibit people from using elsewhere the general\nknowledge and skills they developed on the job. Only specific trade secrets are protected.\nTo get around this difficulty, some companies require their employees to sign agreements not to\ncompete. But unless the agreements are limited in scope and duration to protect a company\nagainst only specific misuse of trade secrets, they are unenforceable.\n\nKEY TAKEAWAY\n\nTrade secrets, if they can be kept, have indefinite duration and thus greater potential value\nthan patents. Trade secrets can be any formula, pattern, device, process, or compilation of\ninformation to be used in a business. Customer information, pricing data, marketing\nmethods, sources of supply, and technical know-how could all be trade secrets. State law has\nprotected trade secrets, and federal law has provided criminal sanctions for theft of trade\nsecrets. With the importance of digitized information, methods of theft now include\ncomputer hacking; theft of corporate secrets is a burgeoning global business that often\ninvolves cyberattacks.\n\nEXERCISES\n\n1. Wu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and \xe2\x80\x9csteals\xe2\x80\x9d plans\nand specifications for HP\xe2\x80\x99s latest products. The HP server is located in the United States. He\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n367\n\n\x0csells this information to a Chinese company in Shanghai. Has he violated the US Economic\nEspionage Act?\n2. What are the advantages of keeping a formula as a trade secret rather than getting patent\nprotection?\n\n[1] Economic Espionage Act, 18 United States Code, Section 1831(a) (1996)\n[2] Economic Espionage Act, 18 United States Code, Section 1832 (1996).\n[3] Economic Espionage Act, 18 United States Code, Section 1834 (1996).\n\n10.3 Copyright\n\nLEARNING OBJECTIVES\n\n1. Describe and explain copyrights, how to obtain one, and how they differ from trademarks.\n2. Explain the concept of fair use and describe its limits.\n\nDefinition and Duration\nCopyright is the legal protection given to \xe2\x80\x9cauthors\xe2\x80\x9d for their \xe2\x80\x9cwritings.\xe2\x80\x9d Copyright law is federal;\nlike patent law, its source lies in the Constitution. Copyright protects the expression of ideas in\nsome tangible form, but it does not protect the ideas themselves. Under the 1976 Copyright Act\nas amended, a copyright in any work created after January 1, 1978, begins when the work is\nfixed in tangible form\xe2\x80\x94for example, when a book is written down or a picture is painted\xe2\x80\x94and\ngenerally lasts for the life of the author plus 70 years after his or her death. This is similar to\ncopyright protection in many countries, but in some countries, the length of copyright\nprotection is the life of the author plus 50 years. For copyrights owned by publishing houses,\ndone as works for hire, common copyright expires 95 years from the date of publication or 120\nyears from the date of creation, whichever is first. For works created before 1978, such as many\nof Walt Disney\xe2\x80\x99s movies and cartoons, the US Sonny Bono Copyright Term Extension Act of\n1998 provided additional protection of up to 95 years from publication date. Thus works created\nin 1923 by Disney would not enter the public domain until 2019 or after, unless the copyright\nhad expired prior to 1998 or unless the Disney company released the work into the public\ndomain. In general, after expiration of the copyright, the work enters the public domain.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n368\n\n\x0cIn 1989, the United States signed the Berne Convention, an international copyright treaty. This\nlaw eliminated the need to place the symbol \xc2\xa9 or the word Copyright or the\nabbreviation Copr. on the work itself. Copyrights can be registered with the US Copyright Office\nin Washington, DC.\n\nProtected Expression\nThe Copyright Act protects a variety of \xe2\x80\x9cwritings,\xe2\x80\x9d some of which may not seem written at all.\nThese include literary works (books, newspapers, and magazines), music, drama, choreography,\nfilms, art, sculpture, and sound recordings. Since copyright covers the expression and not the\nmaterial or physical object, a book may be copyrighted whether it is on paper, microfilm, tape,\nor computer disk.\n\nRights Protected by the Copyright Act\nPreventing Copying\nA copyright gives its holder the right to prevent others from copying his or her work. The\ncopyright holder has the exclusive right to reproduce the work in any medium (paper, film,\nsound recording), to perform it (e.g., in the case of a play), or to display it (a painting or film). A\ncopyright also gives its holder the exclusive right to prepare derivative works based on the\ncopyrighted work. Thus a playwright could not adapt to the stage a novelist\xe2\x80\x99s book without the\nlatter\xe2\x80\x99s permission.\n\nFair Use\nOne major exception to the exclusivity of copyrights is the fair use doctrine. Section 107 of the\nCopyright Act provides as follows:\nFair use of a copyrighted work, including such use by reproduction in copies or phonorecords or\nby any other means specified by section 106 of the copyright, for purposes such as criticism,\ncomment, news reporting, teaching (including multiple copies for classroom use), scholarship,\nor research, is not an infringement of copyright. In determining whether the use made of a work\nin any particular case is a fair use, the factors to be considered shall include\xe2\x80\x93\n(1) the purpose and character of the use, including whether such use is of a commercial nature\nor is for nonprofit educational purposes;\n(2) the nature of the copyrighted work;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n369\n\n\x0c(3) the amount and substantiality of the portion used in relation to the copyrighted work as a\nwhole; and\n(4) the effect of the use upon the potential market for or value of the copyrighted work.[1]\nThese are broad guidelines. Accordingly, any copying could be infringement, and fair use could\nbecome a question of fact on a case-by-case basis. In determining fair use, however, courts have\noften considered the fourth factor (effect of the use upon the potential market for the\ncopyrighted work) to be the most important.\nClear examples of fair use would be when book reviewers or writers quote passages from\ncopyrighted books. Without fair use, most writing would be useless because it could not readily\nbe discussed. But the doctrine of fair use grew more troublesome with the advent of plain-paper\ncopiers and is now even more troublesome with electronic versions of copyrighted materials that\nare easily copied and distributed. The 1976 act took note of the new copier technology, listing\n\xe2\x80\x9cteaching (including multiple copies for classroom use)\xe2\x80\x9d as one application of fair use. The\nCopyright Office follows guidelines specifying just how far the copying may go\xe2\x80\x94for example,\nmultiple copies of certain works may be made for classroom use, but copies may not be used to\nsubstitute for copyrighted anthologies.\n\nInfringement\nVerbatim use of a copyrighted work is easily provable. The more difficult question arises when\nthe copyrighted work is altered in some way. As in patent law, the standard is one of substantial\nsimilarity.\n\nCopyrightability Standards\nTo be subject to copyright, the writing must be \xe2\x80\x9cfixed\xe2\x80\x9d in some \xe2\x80\x9ctangible medium of expression.\xe2\x80\x9d\nA novelist who composes a chapter of her next book in her mind and tells it to a friend before\nputting it on paper could not stop the friend from rushing home, writing it down, and selling it\n(at least the federal copyright law would offer no protection; some states might independently\noffer a legal remedy, however).\nThe work also must be creative, at least to a minimal degree. Words and phrases, such as names,\ntitles, and slogans, are not copyrightable; nor are symbols or designs familiar to the public. But\nan author who contributes her own creativity\xe2\x80\x94like taking a photograph of nature\xe2\x80\x94may\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n370\n\n\x0ccopyright the resulting work, even if the basic elements of the composition were not of her\nmaking.\nFinally, the work must be \xe2\x80\x9coriginal,\xe2\x80\x9d which means simply that it must have originated with the\nauthor. The law does not require that it be novel or unique. This requirement was summarized\npithily by Judge Learned Hand: \xe2\x80\x9cIf by some magic a man who had never known it were to\ncompose anew Keats\xe2\x80\x99s Ode on a Grecian Urn, he would be an author, and, if he copyrighted it,\nothers might not copy that poem, though they might of course copy Keats\xe2\x80\x99s.\xe2\x80\x9d [2] Sometimes the\nclaim is made that a composer, for example, just happened to compose a tune identical or\nstrikingly similar to a copyrighted song; rather than assume the unlikely coincidence that Judge\nHand hypothesized, the courts will look for evidence that the alleged copier had access to the\ncopyrighted song. If he did\xe2\x80\x94for example, the song was frequently played on the air\xe2\x80\x94he cannot\ndefend the copying with the claim that it was unconscious, because the work would not then\nhave been original.\nSection 102 of the Copyright Act excludes copyright protection for any \xe2\x80\x9cidea, procedure, process,\nsystem, method of operation, concept, principle, or discovery, regardless of the form in which it\nis described, explained, illustrated, or embodied.\xe2\x80\x9d [3]\nEinstein copyrighted books and monographs he wrote on the theory of relativity, but he could\nnot copyright the famous formula E = mc2, nor could he prevent others from writing about the\ntheory. But he could protect the particular way in which his ideas were expressed. In general,\nfacts widely known by the public are not copyrightable, and mathematical calculations are not\ncopyrightable. Compilations of facts may be copyrightable, if the way that they are coordinated\nor arranged results in a work that shows some originality. For example, compiled information\nabout yachts listed for sale may qualify for copyright protection. [4]\nOne of the most troublesome recent questions concerning expression versus ideas is whether a\ncomputer program may be copyrighted. After some years of uncertainty, the courts have\naccepted the copyrightability of computer programs. [5] Now the courts are wrestling with the\nmore difficult question of the scope of protection: what constitutes an \xe2\x80\x9cidea\xe2\x80\x9d and what\nconstitutes its mere \xe2\x80\x9cexpression\xe2\x80\x9d in a program.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n371\n\n\x0cHow far the copyright law will protect particular software products is a hotly debated topic,\nsparked by a federal district court\xe2\x80\x99s ruling in 1990 that the \xe2\x80\x9clook and feel\xe2\x80\x9d of Lotus 1-2-3\xe2\x80\x99s menu\nsystem is copyrightable and was in fact infringed by Paperback Software\xe2\x80\x99s VP-Planner, a\ncompeting spreadsheet. [6] The case has led some analysts to \xe2\x80\x9cfear that legal code, rather than\nsoftware code, is emerging as the factor that will determine which companies and products will\ndominate the 1990s.\xe2\x80\x9d [7]\n\nWho May Obtain a Copyright?\nWith one important exception, only the author may hold the initial copyright, although the\nauthor may assign it or license any one or more of the rights conveyed by the copyright. This is a\nsimple principle when the author has written a book or painted a picture. But the law is unclear\nin the case of a motion picture or a sound recording. Is the author the script writer, the\nproducer, the performer, the director, the engineer, or someone else? As a practical matter, all\nparties involved spell out their rights by contract.\nThe exception, which frequently covers the difficulties just enumerated, is for works for hire.\nAny person employed to write\xe2\x80\x94a journalist or an advertising jingle writer, for example\xe2\x80\x94is not\nthe \xe2\x80\x9cauthor.\xe2\x80\x9d For purposes of the statute, the employer is the author and may take out the\ncopyright. When the employee is in fact an \xe2\x80\x9cindependent contractor\xe2\x80\x9d and the work in question\ninvolves any one of nine types (book, movies, etc.) spelled out in the Copyright Act, the employer\nand the creator must spell out their entitlement to the copyright in a written agreement. [8]\n\nObtaining a Copyright\nUntil 1978, a work could not be copyrighted unless it was registered in the Copyright Office or\nwas published and unless each copy of the work carried a copyright notice, consisting of the\nword Copyright, the abbreviation Copr., or the common symbol \xc2\xa9, together with the date of\nfirst publication and the name of the copyright owner. Under the 1976 act, copyright became\nautomatic whenever the work was fixed in a tangible medium of expression (e.g., words on\npaper, images on film or videotape, sound on tape or compact disc), even if the work remained\nunpublished or undistributed. However, to retain copyright protection, the notice had to be\naffixed once the work was \xe2\x80\x9cpublished\xe2\x80\x9d and copies circulated to the public. After the United\nStates entered the Berne Convention, an international treaty governing copyrights, Congress\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n372\n\n\x0cenacted the Berne Implementation Act, declaring that, effective in 1989, notice, even after\npublication, was no longer required.\nNotice does, however, confer certain benefits. In the absence of notice, a copyright holder loses\nthe right to receive statutory damages (an amount stated in the Copyright Act and not required\nto be proved) if someone infringes the work. Also, although it is no longer required, an\napplication and two copies of the work (for deposit in the Library of Congress) filed with the\nCopyright Office, in Washington, DC, will enable the copyright holder to file suit should the\ncopyright be infringed. Unlike patent registration, which requires elaborate searching of Patent\nand Trademark Office (PTO) records, copyright registration does not require a reading of the\nwork to determine whether it is an original creation or an infringement of someone else\xe2\x80\x99s prior\nwork. But copyright registration does not immunize the holder from an infringement suit. If a\nsecond work has been unlawfully copied from an earlier work, the second author\xe2\x80\x99s copyright will\nnot bar the infringed author from collecting damages and obtaining an injunction.\n\nComputer Downloads and the Digital Millennium Copyright Act\nThe ubiquity of the Internet and the availability of personal computers with large capacities have\ngreatly impacted the music business. Sharing of music files took off in the late 1990s with\nNapster, which lost a legal battle on copyright and had to cease doing business. By providing the\nmeans by which individuals could copy music that had been purchased, major record labels\nwere losing substantial profits. Grokster, a privately owned software company based in the West\nIndies, provided peer-to-peer file sharing from 2001 to 2005 until the US Supreme Court\xe2\x80\x99s\ndecision in MGM Studios, Inc. v. Grokster, Ltd. [9]\nFor computers with the Microsoft operating system, the Court disallowed the peer-to-peer file\nsharing, even though Grokster claimed it did not violate any copyright laws because no files\npassed through its computers. (Grokster had assigned certain user computers as \xe2\x80\x9croot\nsupernodes\xe2\x80\x9d that acted as music hubs for the company and was not directly involved in\ncontrolling any specific music-file downloads.)\nGrokster had argued, based on Sony v. Universal Studios, [10] that the sale of its copying\nequipment (like the Betamax videocassette recorders at issue in that case) did not constitute\ncontributory infringement \xe2\x80\x9cif the product is widely used for legitimate, unobjectionable\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n373\n\n\x0cpurposes.\xe2\x80\x9d Plaintiffs successfully argued that the Sony safe-harbor concept requires proof that\nthe noninfringing use is the primary use in terms of the product\xe2\x80\x99s utility.\nThe Digital Millennium Copyright Act (DMCA), passed into law in 1998, implements two 1996\ntreaties of the World Intellectual Property Organization. It criminalizes production and sale of\ndevices or services intended to get around protective measures that control access to\ncopyrighted works. In addition, the DMCA heightens the penalties for copyright infringement on\nthe Internet. The DMCA amended Title 17 of the United States Code to extend the reach of\ncopyright, while limiting the liability of the providers of online services for copyright\ninfringement by their users.\n\nKEY TAKEAWAY\n\nCopyright is the legal protection given to \xe2\x80\x9cauthors\xe2\x80\x9d for their \xe2\x80\x9cwritings.\xe2\x80\x9d It protects ideas in\nfixed, tangible form, not ideas themselves. Copyright protection can extend as long as 120\nyears from the date of creation or publication. Expression found in literary works, music,\ndrama, film, art, sculpture, sound recordings, and the like may be copyrighted. The fair use\ndoctrine limits the exclusivity of copyright in cases where scholars, critics, or teachers use\nonly selected portions of the copyrighted material in a way that is unlikely to affect the\npotential market for or value of the copyrighted work.\n\nEXERCISES\n\n1. Explain how a list could be copyrightable.\n2. An author wrote a novel, Brunch at Bruno\xe2\x80\x99s, in 1961. She died in 1989, and her heirs now\nown the copyright. When do the rights of the heirs come to an end? That is, when\ndoes Brunch at Bruno\xe2\x80\x99s enter the public domain?\n3. Keith Bradsher writes a series of articles on China for the New York Times and is paid for\ndoing so. Suppose he wants to leave the employ of the Times and be a freelance writer. Can\nhe compile his best articles into a book, Changing Times in China, and publish it without\nthe New York Times\xe2\x80\x99s permission? Does it matter that he uses the word Times in his\nproposed title?\n4. What kind of file sharing of music is now entirely legal? Shaunese Collins buys a Yonder\nMountain String Band CD at a concert at Red Rocks in Morrison, Colorado. With her iMac, she\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n374\n\n\x0cmakes a series of CDs for her friends. She does this six times. Has she committed six\ncopyright violations?\n\n[1] 17 United States Code, Section 107.\n[2] Sheldon v. Metro-Goldwyn Pictures Corp., 81 F.2d 49 (2d Cir. 1936).\n[3] 17 United States Code, Section 102.\n[4] BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d 1129 (11th Cir. 2007).\n[5] Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1240 (3d Cir. 1983).\n[6] Lotus Development Corp. v. Paperback Software International, 740 F.Supp. 37 (D. Mass. 1990).\n[7] Peter H. Lewis, \xe2\x80\x9cWhen Computing Power Is Generated by the Lawyers,\xe2\x80\x9d New York Times, July 22\n1990.\n[8] Community for Creative Non-Violence v. Reid, 109 S.Ct. 2166 (1989).\n[9] MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005).\n[10] Sony v. Universal Studios, 464 U.S. 417 (1984).\n\n10.4 Trademarks\n\nLEARNING OBJECTIVES\n\n1. Understand what a trademark is and why it deserves protection.\n2. Know why some \xe2\x80\x9cmarks\xe2\x80\x9d may not be eligible for trademark protection, and how to obtain\ntrademark protection for those that are.\n3. Explain what \xe2\x80\x9cblurring\xe2\x80\x9d and \xe2\x80\x9ctarnishment\xe2\x80\x9d are and what remedies are available to the holder\nof the mark.\n\nDefinitions of Trademarks\nA trademark is defined in the federal Lanham Act of 1946 as \xe2\x80\x9cany word, name, symbol, or device\nor any combination thereof adopted and used by a manufacturer or merchant to identify his\ngoods and distinguish them from goods manufactured or sold by others.\xe2\x80\x9d[1]\nExamples of well-known trademarks are Coca-Cola, Xerox, and Apple. Aservice mark is used in\nthe sale or advertising of services to identify the services of one person and distinguish them\nfrom the services of others. Examples of service marks are McDonald\xe2\x80\x99s, BP, and Hilton.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n375\n\n\x0cA certification mark is used in connection with many products \xe2\x80\x9cto certify regional or other\norigin, material, mode of manufacture, quality, accuracy or other characteristics of such goods\nor services or that the work or labor on the goods or services was performed by members of a\nunion or other organization.\xe2\x80\x9d Examples are the Good Housekeeping Seal of Approval and UL\n(Underwriters Laboratories, Inc., approval mark). Unlike other forms of trademark, the owner\nof the certification mark (e.g., Good Housekeeping, or the Forest Stewardship Council\xe2\x80\x99s FSC\nmark) is not the owner of the underlying product.\n\nExtent of Trademark Protection\nKinds of Marks\nTrademarks and other kinds of marks may consist of words and phrases, pictures, symbols,\nshapes, numerals, letters, slogans, and sounds. Trademarks are a part of our everyday world: the\nsounds of a radio or television network announcing itself (NBC, BBC), the shape of a whiskey\nbottle (Haig & Haig\xe2\x80\x99s Pinch Bottle), a series of initials (GE, KPMG, IBM), or an animal\xe2\x80\x99s warning\ngrowl (MGM\xe2\x80\x99s lion).\n\nLimitations on Marks\nAlthough trademarks abound, the law limits the subjects that may fall into one of the defined\ncategories. Not every word or shape or symbol will be protected in an infringement action. To\nqualify for protection, a trademark must be used to identify and distinguish. The courts employ\na four-part test: (1) Is the mark so arbitrary and fanciful that it merits the widest protection? (2)\nIs it \xe2\x80\x9csuggestive\xe2\x80\x9d enough to warrant protection without proof of secondary meaning? (3) Is it\n\xe2\x80\x9cdescriptive,\xe2\x80\x9d warranting protection if secondary meaning is proved? (4) Is the mark generic and\nthus unprotectable?\nThese tests do not have mechanical answers; they call for judgment. Some marks are wholly\nfanciful, clearly identify origin of goods, and distinguish them from others\xe2\x80\x94Kodak, for example.\nOther marks may not be so arbitrary but may nevertheless be distinctive, either when adopted\nor as a result of advertising\xe2\x80\x94for example, Crest, as the name of a toothpaste.\nMarks that are merely descriptive of the product are entitled to protection only if it can be\nshown that the mark has acquired secondary meaning. This term reflects a process of\nidentification on the mark in the public mind with the originator of the product. Holiday Inn\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n376\n\n\x0cwas initially deemed too descriptive: an inn where people might go on holiday. But over time,\ntravelers came to identify the source of the Great Sign and the name Holiday Inn as the Holiday\nInn Corporation in Memphis, and secondary meaning was granted. Holiday Inn could thus\nprotect its mark against other innkeepers, hoteliers, and such; however, the trademark\nprotection for the words Holiday Inn was limited to the corporation\xe2\x80\x99s hotel and motel business,\nand no other.\nCertain words and phrases may not qualify at all for trademark protection. These include\ngeneric terms like \xe2\x80\x9cstraw broom\xe2\x80\x9d (for a broom made of straw) and ordinary words like \xe2\x80\x9cfast\nfood.\xe2\x80\x9d In one case, a federal appeals court held that the word \xe2\x80\x9cLite\xe2\x80\x9d is generic and cannot be\nprotected by a beer manufacturer to describe a low-calorie brew.[2] Donald Trump\xe2\x80\x99s effort to\ntrademark \xe2\x80\x9cYou\xe2\x80\x99re fired!\xe2\x80\x9d and Paris Hilton\xe2\x80\x99s desire to trademark \xe2\x80\x9cThat\xe2\x80\x99s hot!\xe2\x80\x9d were also\ndismissed as being generic.\nDeceptive words will not be accepted for registration. Thus the US Patent and Trademark Office\n(PTO) denied registration to the word Vynahyde because it suggested that the plastic material to\nwhich it was applied came from animal skin. Geographic terms are descriptive words and may\nnot be used as protected trademarks unless they have acquired a secondary meaning, such as\nHershey when used for chocolates. (Hershey\xe2\x80\x99s chocolates are made in Hershey, Pennsylvania.) A\ndesign that reflects a common style cannot be protected in a trademark to exclude other similar\ndesigns in the same tradition. Thus the courts have ruled that a silverware pattern that is a\n\xe2\x80\x9cfunctional feature\xe2\x80\x9d of the \xe2\x80\x9cbaroque style\xe2\x80\x9d does not qualify for trademark protection. Finally, the\nLanham Act denies federal registration to certain marks that fall within categories of words and\nshapes, including the following: the flag; the name, portrait, or signature of any living person\nwithout consent, or of a deceased US president during the lifetime of his widow; and immoral,\ndeceptive, or scandalous matter (in an earlier era, the phrase \xe2\x80\x9cBubby Trap\xe2\x80\x9d for brassieres was\ndenied registration).\n\nDilution, Tarnishment, and Blurring\nUnder the federal Trademark Dilution Act of 1995, companies with marks that dilute the value\nof a senior mark may be liable for damages. The act provides that owners of marks of significant\nvalue have property rights that should not be eroded, blurred, tarnished, or diluted in any way\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n377\n\n\x0cby another. But as a plaintiff, the holder of the mark must show (1) that it is a famous mark, (2)\nthat the use of a similar mark is commercial, and (3) that such use causes dilution of the\ndistinctive quality of the mark. Thus a T-shirt maker who promotes a red-and-white shirt\nbearing the mark Buttweiser may be liable to Anheuser-Busch, or a pornographic site called\nCandyland could be liable to Parker Brothers, the board game company. Interesting cases have\nalready been brought under this act, including a case brought by Victoria\xe2\x80\x99s Secret against a small\nadult store in Kentucky called Victor\xe2\x80\x99s Little Secret. Notice that unlike most prior trademark law,\nthe purpose is not to protect the consumer from confusion as to the source or origin of the goods\nor services being sold; for example, no one going to the Candyland site would think that Parker\nBrothers was the source.\n\nAcquiring Trademark Rights\nFor the first time in more than forty years, Congress, in 1988, changed the way in which\ntrademarks can be secured. Under the Lanham Act, the fundamental means of obtaining a\ntrademark was through use. The manufacturer or distributor actually must have placed the\nmark on its product\xe2\x80\x94or on related displays, labels, shipping containers, advertisements, and the\nlike\xe2\x80\x94and then have begun selling the product. If the product was sold in interstate commerce,\nthe trademark was entitled to protection under the Lanham Act (or if not, to protection under\nthe common law of the state in which the product was sold).\nUnder the Trademark Law Revision Act of 1988, which went into effect in 1989, trademarks can\nbe obtained in advance by registering with the PTO an intention to use the mark within six\nmonths (the applicant can gain extensions of up to thirty more months to put the mark into\nuse). Once obtained, the trademark will be protected for ten years (before the 1988 revision, a\nfederal trademark remained valid for twenty years); if after that time the mark is still being\nused, the registration can be renewed. Obtaining a trademark registration lies between\nobtaining patents and obtaining copyrights in difficulty. The PTO will not routinely register a\ntrademark; it searches its records to ensure that the mark meets several statutory tests and does\nnot infringe another mark. Those who feel that their own marks would be hurt by registration of\na proposed mark may file an opposition proceeding with the PTO. Until 1990, the office received\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n378\n\n\x0cabout 77,000 applications each year. With the change in procedure, some experts predicted that\napplications would rise by 30 percent.\nIn many foreign countries, use need not be shown to obtain trademark registration. It is\ncommon for some people in these countries to register marks that they expect to be valuable so\nthat they can sell the right to use the mark to the company that established the mark\xe2\x80\x99s value.\nCompanies that expect to market abroad should register their marks early.\n\nLoss of Rights\nTrademark owners may lose their rights if they abandon the mark, if a patent or copyright\nexpires on which the mark is based, or if the mark becomes generic. A mark is abandoned if a\ncompany goes out of business and ceases selling the product. Some marks are based on design\npatents; when the patent expires, the patent holder will not be allowed to extend the patent\xe2\x80\x99s\nduration by arguing that the design or name linked with the design is a registrable trademark.\nThe most widespread difficulty that a trademark holder faces is the prospect of too much\nsuccess: if a trademark comes to stand generically for the product itself, it may lose exclusivity in\nthe mark. Famous examples are aspirin, escalator, and cellophane. The threat is a continual one.\nTrademark holders can protect themselves from their marks\xe2\x80\x99 becoming generic in several ways.\n1. Use a descriptive term along with the trademark. Look on a jar of Vaseline and you will see that\nthe label refers to the contents as Vaseline petroleum jelly.\n2. Protest generic use of the mark in all publications by writing letters and taking out\nadvertisements.\n3. Always put the words Trademark, Registered Trademark, or the symbol \xc2\xae (meaning\n\xe2\x80\x9cregistered\xe2\x80\x9d) next to the mark itself, which should be capitalized.\n\nKEY TAKEAWAY\n\nTrademark protection is federal, under the Lanham Act. Branding of corporate logos, names,\nand products is essential to business success, and understanding trademarks is pivotal to\nbranding. A \xe2\x80\x9cmark\xe2\x80\x9d must be distinctive, arbitrary, or fanciful to merit protection: this means\nthat it must not be generic or descriptive. Marks can be words, symbols, pictures, slogans,\nsounds, phrases, and even shapes. In the United States, rights to marks are obtained by\nregistration and intent to use in commerce and must be renewed every ten years.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n379\n\n\x0c1. How will Google protect its trademark, assuming that people begin using \xe2\x80\x9cgoogle\xe2\x80\x9d as a verb\nsubstitute for \xe2\x80\x9cInternet search,\xe2\x80\x9d just like people began using the word \xe2\x80\x9ccellophane\xe2\x80\x9d for all\nbrands of plastic wrap?\n2. Do a small amount of web searching and find out what \xe2\x80\x9ctrade dress\xe2\x80\x9d protection is, and how it\ndiffers from trademark protection.\n3. LexisNexis is a brand for a database collection offered by Mead Data Central. Lexus is a highend automobile. Can Lexus succeed in getting Mead Data Central to stop using \xe2\x80\x9cLexis\xe2\x80\x9d as a\nmark?\n\n[1] 15 United States Code, Section 1127.\n[2] Miller Brewing Co. v. Falstaff Brewing Corp., 655 F.2d 5 (1st Cir. 1981).\n\n10.5 Cases\nFair Use in Copyright\nElvis Presley Enterprises et al. v. Passport Video et al.\n349 F.3d 622 (9th Circuit Court of Appeals, 2003)\nTALLMAN, CIRCUIT JUDGE:\nPlaintiffs are a group of companies and individuals holding copyrights in various materials\nrelating to Elvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered\nowner of several Elvis appearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns\nthe copyright to two television specials featuring Elvis: The Elvis 1968 Comeback\nSpecial and Elvis Aloha from Hawaii.\xe2\x80\xa6Many Plaintiffs are in the business of licensing their\ncopyrights. For example, SOFA Entertainment charges $10,000 per minute for use of Elvis\xe2\x80\x99\nappearances on The Ed Sullivan Show.\nPassport Entertainment and its related entities (collectively \xe2\x80\x9cPassport\xe2\x80\x9d) produced and sold The\nDefinitive Elvis, a 16-hour video documentary about the life of Elvis Presley.The Definitive Elvis\nsold for $99 at retail. Plaintiffs allege that thousands of copies were sent to retail outlets and\nother distributors. On its box, The Definitive Elvisdescribes itself as an all-encompassing, inSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n380\n\n\x0cdepth look at the life and career of a man whose popularity is unrivaled in the history of show\nbusiness and who continues to attract millions of new fans each year.\xe2\x80\xa6\nThe Definitive Elvis uses Plaintiffs\xe2\x80\x99 copyrighted materials in a variety of ways. With the video\nfootage, the documentary often uses shots of Elvis appearing on television while a narrator or\ninterviewee talks over the film. These clips range from only a few seconds in length to portions\nrunning as long as 30 seconds. In some instances, the clips are the subject of audio commentary,\nwhile in other instances they would more properly be characterized as video \xe2\x80\x9cfiller\xe2\x80\x9d because the\ncommentator is discussing a subject different from or more general than Elvis\xe2\x80\x99 performance on a\nparticular television show. But also significant is the frequency with which the copyrighted video\nfootage is used. The Definitive Elvis employs these clips, in many instances, repeatedly. In total,\nat least 5% to 10% of The Definitive Elvis uses Plaintiffs\xe2\x80\x99 copyrighted materials.\nUse of the video footage, however, is not limited to brief clips.\xe2\x80\xa6Thirty-five percent of his\nappearances on The Ed Sullivan Show is replayed, as well as three minutes from The 1968\nComeback Special.\n***\nPlaintiffs sued Passport for copyright infringement.\xe2\x80\xa6Passport, however, asserts that its use of\nthe copyrighted materials was \xe2\x80\x9cfair use\xe2\x80\x9d under 17 U.S.C. \xc2\xa7 107. Plaintiffs moved for a\npreliminary injunction, which was granted by the district court after a hearing. The district court\nfound that Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrighted materials was likely not fair use. The court\nenjoined Passport from selling or distributing The Definitive Elvis. Passport timely appeals.\n***\nWe first address the purpose and character of Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrighted materials.\nAlthough not controlling, the fact that a new use is commercial as opposed to non-profit weighs\nagainst a finding of fair use. Harper & Row Publishers, Inc. v. Nation Enters., 471 U.S. 539, 562,\n85 L. Ed. 2d 588, 105 S.Ct. 2218 (1985). And the degree to which the new user exploits the\ncopyright for commercial gain\xe2\x80\x94as opposed to incidental use as part of a commercial\nenterprise\xe2\x80\x94affects the weight we afford commercial nature as a factor. More importantly for the\nfirst fair-use factor, however, is the \xe2\x80\x9ctransformative\xe2\x80\x9d nature of the new work. Specifically, we ask\n\xe2\x80\x9cwhether the new work\xe2\x80\xa6merely supersedes the objects of the original creation, or instead adds\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n381\n\n\x0csomething new, with a further purpose or different character, altering the first with new\nexpression, meaning, or message.\xe2\x80\xa6\xe2\x80\x9d The more transformative a new work, the less significant\nother inquiries, such as commercialism, become.\n***\nThe district court below found that the purpose and character of The Definitive Elviswill likely\nweigh against a finding of fair use. We cannot say, based on this record, that the district court\nabused its discretion.\nFirst, Passport\xe2\x80\x99s use, while a biography, is clearly commercial in nature. But more significantly,\nPassport seeks to profit directly from the copyrights it uses without a license. One of the most\nsalient selling points on the box of The Definitive Elvis is that \xe2\x80\x9cEvery Film and Television\nAppearance is represented.\xe2\x80\x9d Passport is not advertising a scholarly critique or historical\nanalysis, but instead seeks to profit at least in part from the inherent entertainment value of\nElvis\xe2\x80\x99 appearances on such shows as The Steve Allen Show, The Ed Sullivan Show, and The 1968\nComeback Special. Passport\xe2\x80\x99s claim that this is scholarly research containing biographical\ncomments on the life of Elvis is not dispositive of the fair use inquiry.\nSecond, Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrights is not consistently transformative. True,\nPassport\xe2\x80\x99s use of many of the television clips is transformative because the clips play for only a\nfew seconds and are used for reference purposes while a narrator talks over them or\ninterviewees explain their context in Elvis\xe2\x80\x99 career. But voice-overs do not necessarily transform a\nwork.\xe2\x80\xa6\nIt would be impossible to produce a biography of Elvis without showing some of his most\nfamous television appearances for reference purposes. But some of the clips are played without\nmuch interruption, if any. The purpose of showing these clips likely goes beyond merely making\na reference for a biography, but instead serves the same intrinsic entertainment value that is\nprotected by Plaintiffs\xe2\x80\x99 copyrights.\n***\nThe third factor is the amount and substantiality of the portion used in relation to the\ncopyrighted work as a whole. This factor evaluates both the quantity of the work taken and the\nquality and importance of the portion taken. Regarding the quantity, copying \xe2\x80\x9cmay not be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n382\n\n\x0cexcused merely because it is insubstantial with respect to the infringingwork.\xe2\x80\x9d Harper & Row,\n471 U.S. at 565 (emphasis in original). But if the amount used is substantial with respect to the\ninfringing work, it is evidence of the value of the copy-righted work.\nPassport\xe2\x80\x99s use of clips from television appearances, although in most cases of short duration,\nwere repeated numerous times throughout the tapes. While using a small number of clips to\nreference an event for biographical purposes seems fair, using a clip over and over will likely no\nlonger serve a biographical purpose. Additionally, some of the clips were not short in length.\nPassport\xe2\x80\x99s use of Elvis\xe2\x80\x99 appearance on The Steve Allen Show plays for over a minute and many\nmore clips play for more than just a few seconds.\nAdditionally, although the clips are relatively short when compared to the entire shows that are\ncopyrighted, they are in many instances the heart of the work. What makes these copyrighted\nworks valuable is Elvis\xe2\x80\x99 appearance on the shows, in many cases singing the most familiar\npassages of his most popular songs. Plaintiffs are in the business of licensing these copyrights.\nTaking key portions extracts the most valuable part of Plaintiffs\xe2\x80\x99 copyrighted works. With\nrespect to the photographs, the entire picture is often used. The music, admittedly, is usually\nplayed only for a few seconds.\n***\nThe last, and \xe2\x80\x9cundoubtedly the single most important\xe2\x80\x9d of all the factors, is the effect the use will\nhave on the potential market for and value of the copyrighted works. Harper & Row, 471 U.S. at\n566. We must \xe2\x80\x9cconsider not only the extent of market harm caused by the particular actions of\nthe alleged infringer, but also whether unrestricted and widespread conduct of the sort engaged\nin by the defendant\xe2\x80\xa6would result in a substantially adverse impact on the potential market for\nthe original.\xe2\x80\x9d Campbell, 510 U.S. at 590. The more transformative the new work, the less likely\nthe new work\xe2\x80\x99s use of copyrighted materials will affect the market for the materials. Finally, if\nthe purpose of the new work is commercial in nature, \xe2\x80\x9cthe likelihood [of market harm] may be\npresumed.\xe2\x80\x9d A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S. at 451).\nThe district court found that Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrighted materials likely does affect\nthe market for those materials. This conclusion was not clearly erroneous.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n383\n\n\x0cFirst, Passport\xe2\x80\x99s use is commercial in nature, and thus we can assume market harm. Second,\nPassport has expressly advertised that The Definitive Elvis contains the television appearances\nfor which Plaintiffs normally charge a licensing fee. If this type of use became wide-spread, it\nwould likely undermine the market for selling Plaintiffs\xe2\x80\x99 copyrighted material. This conclusion,\nhowever, does not apply to the music and still photographs. It seems unlikely that someone in\nthe market for these materials would purchase The Definitive Elvis instead of a properly\nlicensed product. Third, Passport\xe2\x80\x99s use of the television appearances was, in some instances, not\ntransformative, and therefore these uses are likely to affect the market because they serve the\nsame purpose as Plaintiffs\xe2\x80\x99 original works.\n***\nWe emphasize that our holding today is not intended to express how we would rule were we\nexamining the case ab initio as district judges. Instead, we confine our review to whether the\ndistrict court abused its discretion when it weighed the four statutory fair-use factors together\nand determined that Plaintiffs would likely succeed on the merits. Although we might view this\ncase as closer than the district court saw it, we hold there was no abuse of discretion in the\ncourt\xe2\x80\x99s decision to grant Plaintiffs\xe2\x80\x99 requested relief.\nAFFIRMED.\n\nCASE QUESTIONS\n\n1. How would you weigh the four factors in this case? If the trial court had found fair use, would\nthe appeals court have overturned its ruling?\n2. Why do you think that the fourth factor is especially important?\n3. What is the significance of the discussion on \xe2\x80\x9ctransformative\xe2\x80\x9d aspects of the defendant\xe2\x80\x99s\nproduct?\n\nTrademark Infringement and Dilution\nPlayboy Enterprises v. Welles\n279 F.3d 796 (9th Circuit Court of Appeals, 2001)\nT. G. NELSON, Circuit Judge:\nTerri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of\nthe Year for 1981. Her use of the title \xe2\x80\x9cPlayboy Playmate of the Year 1981,\xe2\x80\x9d and her use of other\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n384\n\n\x0ctrademarked terms on her website are at issue in this suit. During the relevant time period,\nWelles\xe2\x80\x99 website offered information about and free photos of Welles, advertised photos for sale,\nadvertised memberships in her photo club, and promoted her services as a spokesperson. A\nbiographical section described Welles\xe2\x80\x99 selection as Playmate of the Year in 1981 and her years\nmodeling for PEI. The site included a disclaimer that read as follows: \xe2\x80\x9cThis site is neither\nendorsed, nor sponsored, nor affiliated with Playboy Enterprises, Inc. PLAYBOY tm PLAYMATE\nOF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered trademarks of Playboy\nEnterprises, Inc.\xe2\x80\x9d\nWells used (1) the terms \xe2\x80\x9cPlayboy \xe2\x80\x9dand \xe2\x80\x9cPlaymate\xe2\x80\x9d in the metatags of the website; (2) the phrase\n\xe2\x80\x9cPlaymate of the Year 1981\xe2\x80\x9d on the masthead of the website; (3) the phrases \xe2\x80\x9cPlayboy Playmate\nof the Year 1981\xe2\x80\x9d and \xe2\x80\x9cPlaymate of the Year 1981\xe2\x80\x9d on various banner ads, which may be\ntransferred to other websites; and (4) the repeated use of the abbreviation \xe2\x80\x9cPMOY \xe2\x80\x9981\xe2\x80\x9d as the\nwatermark on the pages of the website. PEI claimed that these uses of its marks constituted\ntrademark infringement, dilution, false designation of origin, and unfair competition. The\ndistrict court granted defendants\xe2\x80\x99 motion for summary judgment. PEI appeals the grant of\nsummary judgment on its infringement and dilution claims. We affirm in part and reverse in\npart.\nA. Trademark Infringement\nExcept for the use of PEI\xe2\x80\x99s protected terms in the wallpaper of Welles\xe2\x80\x99 website, we conclude that\nWelles\xe2\x80\x99 uses of PEI\xe2\x80\x99s trademarks are permissible, nominative uses. They imply no current\nsponsorship or endorsement by PEI. Instead, they serve to identify Welles as a past PEI\n\xe2\x80\x9cPlaymate of the Year.\xe2\x80\x9d\nWe articulated the test for a permissible, nominative use in New Kids On The Block v. New\nAmerica Publishing, Inc. The band, New Kids On The Block, claimed trademark infringement\narising from the use of their trademarked name by several newspapers. The newspapers had\nconducted polls asking which member of the band New Kids On The Block was the best and\nmost popular. The papers\xe2\x80\x99 use of the trademarked term did not fall within the traditional fair use\ndoctrine. Unlike a traditional fair use scenario, the defendant newspaper was using the\ntrademarked term to describe not its own product, but the plaintiff\xe2\x80\x99s. Thus, the factors used to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n385\n\n\x0cevaluate fair use were inapplicable. The use was nonetheless permissible, we concluded, based\non its nominative nature.\nWe adopted the following test for nominative use:\nFirst, the product or service in question must be one not readily identifiable without use of the\ntrademark; second, only so much of the mark or marks may be used as is reasonably necessary\nto identify the product or service; and third, the user must do nothing that would, in conjunction\nwith the mark, suggest sponsorship or endorsement by the trademark holder.\nWe group the uses of PEI\xe2\x80\x99s trademarked terms into three for the purpose of applying the test for\nnominative use.\n1. Headlines and banner advertisements.\n...\nThe district court properly identified Welles\xe2\x80\x99 situation as one which must\xe2\x80\xa6 be excepted. No\ndescriptive substitute exists for PEI\xe2\x80\x99s trademarks in this context.\xe2\x80\xa6Just as the newspapers\nin New Kids could only identify the band clearly by using its trademarked name, so can Welles\nonly identify herself clearly by using PEI\xe2\x80\x99s trademarked title.\nThe second part of the nominative use test requires that \xe2\x80\x9conly so much of the mark or marks\nmay be used as is reasonably necessary to identify the product or service[.]\xe2\x80\x9d New Kids provided\nthe following examples to explain this element: \xe2\x80\x9c[A] soft drink competitor would be entitled to\ncompare its product to Coca-Cola or Coke, but would not be entitled to use Coca-Cola\xe2\x80\x99s\ndistinctive lettering.\xe2\x80\x9d Similarly, in a past case, an auto shop was allowed to use the trademarked\nterm \xe2\x80\x9cVolkswagen\xe2\x80\x9d on a sign describing the cars it repaired, in part because the shop \xe2\x80\x9cdid not\nuse Volkswagen\xe2\x80\x99s distinctive lettering style or color scheme, nor did he display the encircled\n\xe2\x80\x98VW\xe2\x80\x99 emblem.\xe2\x80\x9d Welles\xe2\x80\x99 banner advertisements and headlines satisfy this element because they\nuse only the trademarked words, not the font or symbols associated with the trademarks.\nThe third element requires that the user do \xe2\x80\x9cnothing that would, in conjunction with the mark,\nsuggest sponsorship or endorsement by the trademark holder.\xe2\x80\x9d As to this element, we conclude\nthat aside from the wallpaper, which we address separately, Welles does nothing in conjunction\nwith her use of the marks to suggest sponsorship or endorsement by PEI. The marks are clearly\nused to describe the title she received from PEI in 1981, a title that helps describe who she is. It\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n386\n\n\x0cwould be unreasonable to assume that the Chicago Bulls sponsored a website of Michael\nJordan\xe2\x80\x99s simply because his name appeared with the appellation \xe2\x80\x9cformer Chicago Bull.\xe2\x80\x9d\nSimilarly, in this case, it would be unreasonable to assume that PEI currently sponsors or\nendorses someone who describes herself as a \xe2\x80\x9cPlayboy Playmate of the Year in 1981.\xe2\x80\x9d The\ndesignation of the year, in our case, serves the same function as the \xe2\x80\x9cformer\xe2\x80\x9d in our example. It\nshows that any sponsorship or endorsement occurred in the past.\nFor the foregoing reasons, we conclude that Welles\xe2\x80\x99 use of PEI\xe2\x80\x99s marks in her headlines and\nbanner advertisements is a nominative use excepted from the law of trademark infringement.\n2. Metatags\nWelles includes the terms \xe2\x80\x9cplayboy\xe2\x80\x9d and \xe2\x80\x9cplaymate\xe2\x80\x9d in her metatags. Metatags describe the\ncontents of a website using keywords. Some search engines search metatags to identify websites\nrelevant to a search. Thus, when an internet searcher enters \xe2\x80\x9cplayboy\xe2\x80\x9d or \xe2\x80\x9cplaymate\xe2\x80\x9d into a\nsearch engine that uses metatags, the results will include Welles\xe2\x80\x99 site. Because Welles\xe2\x80\x99 metatags\ndo not repeat the terms extensively, her site will not be at the top of the list of search results.\nApplying the three-factor test for nominative use, we conclude that the use of the trademarked\nterms in Welles\xe2\x80\x99 metatags is nominative.\nAs we discussed above with regard to the headlines and banner advertisements, Welles has no\npractical way of describing herself without using trademarked terms. In the context of metatags,\nwe conclude that she has no practical way of identifying the content of her website without\nreferring to PEI\xe2\x80\x99s trademarks.\n...\nPrecluding their use would have the unwanted effect of hindering the free flow of information on\nthe internet, something which is certainly not a goal of trademark law. Accordingly, the use of\ntrademarked terms in the metatags meets the first part of the test for nominative use.\xe2\x80\xa6We\nconclude that the metatags satisfy the second and third elements of the test as well. The\nmetatags use only so much of the marks as reasonably necessary and nothing is done in\nconjunction with them to suggest sponsorship or endorsement by the trademark holder. We\nnote that our decision might differ if the metatags listed the trademarked term so repeatedly\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n387\n\n\x0cthat Welles\xe2\x80\x99 site would regularly appear above PEI\xe2\x80\x99s in searches for one of the trademarked\nterms.\n3. Wallpaper/watermark.\nThe background, or wallpaper, of Welles\xe2\x80\x99 site consists of the repeated abbreviation \xe2\x80\x9cPMOY \xe2\x80\x9981,\xe2\x80\x9d\nwhich stands for \xe2\x80\x9cPlaymate of the Year 1981.\xe2\x80\x9d Welles\xe2\x80\x99 name or likeness does not appear before\nor after \xe2\x80\x9cPMOY \xe2\x80\x9981.\xe2\x80\x9d The pattern created by the repeated abbreviation appears as the\nbackground of the various pages of the website. Accepting, for the purposes of this appeal, that\nthe abbreviation \xe2\x80\x9cPMOY\xe2\x80\x9d is indeed entitled to protection, we conclude that the repeated, stylized\nuse of this abbreviation fails the nominative use test.\nThe repeated depiction of \xe2\x80\x9cPMOY \xe2\x80\x9881\xe2\x80\x9d is not necessary to describe Welles. \xe2\x80\x9cPlayboy Playmate of\nthe Year 1981\xe2\x80\x9d is quite adequate. Moreover, the term does not even appear to describe Welles\xe2\x80\x94\nher name or likeness do not appear before or after each \xe2\x80\x9cPMOY \xe2\x80\x9981.\xe2\x80\x9d Because the use of the\nabbreviation fails the first prong of the nominative use test, we need not apply the next two\nprongs of the test.\nBecause the defense of nominative use fails here, and we have already determined that the\ndoctrine of fair use does not apply, we remand to the district court. The court must determine\nwhether trademark law protects the abbreviation \xe2\x80\x9cPMOY,\xe2\x80\x9d as used in the wallpaper.\nB. Trademark Dilution [At this point, the court considers and rejects PEI\xe2\x80\x99s claim for trademark\ndilution.]\nConclusion\nFor the foregoing reasons, we affirm the district court\xe2\x80\x99s grant of summary judgment as to PEI\xe2\x80\x99s\nclaims for trademark infringement and trademark dilution, with the sole exception of the use of\nthe abbreviation \xe2\x80\x9cPMOY.\xe2\x80\x9d We reverse as to the abbreviation and remand for consideration of\nwhether it merits protection under either an infringement or a dilution theory.\n\nCASE QUESTIONS\n\n1. Do you agree with the court\xe2\x80\x99s decision that there is no dilution here?\n2. If PMOY is not a registered trademark, why does the court discuss it?\n3. What does \xe2\x80\x9cnominative use\xe2\x80\x9d mean in the context of this case?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n388\n\n\x0c4. In business terms, why would PEI even think that it was losing money, or could lose money,\nbased on Welles\xe2\x80\x99s use of its identifying marks?\n\n10.6 Summary and Exercises\nSummary\n\nThe products of the human mind are at the root of all business, but they are legally protectable\nonly to a certain degree. Inventions that are truly novel may qualify for a twenty-year patent; the\ninventor may then prohibit anyone from using the art (machine, process, manufacture, and the\nlike) or license it on his own terms. A business may sue a person who improperly gives away its\nlegitimate trade secrets, but it may not prevent others from using the unpatented trade secret\nonce publicly disclosed. Writers or painters, sculptors, composers, and other creative artists may\ngenerally protect the expression of their ideas for the duration of their lives plus seventy years,\nas long as the ideas are fixed in some tangible medium. That means that they may prevent\nothers from copying their words (or painting, etc.), but they may not prevent anyone from\ntalking about or using their ideas. Finally, one who markets a product or service may protect its\ntrademark or service or other mark that is distinctive or has taken on a secondary meaning, but\nmay lose it if the mark becomes the generic term for the goods or services.\n\nEXERCISES\n\n1. Samuel Morse filed claims in the US Patent Office for his invention of the telegraph and also\nfor the \xe2\x80\x9cuse of the motive power of the electric or galvanic current\xe2\x80\xa6however developed, for\nmarking or printing intelligible characters, signs or letters at any distances.\xe2\x80\x9d For which claim,\nif any, was he entitled to a patent? Why?\n2. In 1957, an inventor dreamed up and constructed a certain new kind of computer. He kept\nhis invention a secret. Two years later, another inventor who conceived the same machine\nfiled a patent application. The first inventor, learning of the patent application, filed for his\nown patent in 1963. Who is entitled to the patent, assuming that the invention was truly\nnovel and not obvious? Why?\n3. A large company discovered that a small company was infringing one of its patents. It wrote\nthe small company and asked it to stop. The small company denied that it was infringing.\nBecause of personnel changes in the large company, the correspondence file was lost and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n389\n\n\x0conly rediscovered eight years later. The large company sued. What would be the result?\nWhy?\n4. Clifford Witter was a dance instructor at the Arthur Murray Dance Studios in Cleveland. As a\ncondition of employment, he signed a contract not to work for a competitor. Subsequently,\nhe was hired by the Fred Astaire Dancing Studios, where he taught the method that he had\nlearned at Arthur Murray. Arthur Murray sued to enforce the noncompete contract. What\nwould be result? What additional information, if any, would you need to know to decide the\ncase?\n5. Greenberg worked for Buckingham Wax as its chief chemist, developing chemical formulas\nfor products by testing other companies\xe2\x80\x99 formulas and modifying them. Brite Products\nbought Buckingham\xe2\x80\x99s goods and resold them under its own name. Greenberg went to work\nfor Brite, where he helped Brite make chemicals substantially similar to the ones it had been\nbuying from Buckingham. Greenberg had never made any written or oral commitment to\nBuckingham restricting his use of the chemical formulas he developed. May Buckingham stop\nGreenberg from working for Brite? May it stop him from working on formulas learned while\nworking at Buckingham? Why?\n\nSELF-TEST QUESTIONS\n\n1. Which of the following cannot be protected under patent, copyright, or trademark\nlaw?\na.\n\na synthesized molecule\nb. a one-line book title\nc. a one-line advertising jingle\nd. a one-word company name\nWhich of the following does not expire by law?\n\na.\n\na closely guarded trade secret not released to the public\nb. a patent granted by the US Patent and Trademark Office\nc. a copyright registered in the US Copyright Office\nd. a federal trademark registered under the Lanham Act\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n390\n\n\x0cA sculptor casts a marble statue of a three-winged bird. To protect against\ncopying, the sculptor can obtain which of the following?\na.\n\na patent\nb. a trademark\nc. a copyright\nd. none of the above\nA stock analyst discovers a new system for increasing the value of a stock\nportfolio. He may protect against use of his system by other people by securing\na.\n\na patent\n\nb. a copyright\nc. a trademark\nd. none of the above\nA company prints up its customer list for use by its sales staff. The cover\npage carries a notice that says \xe2\x80\x9cconfidential.\xe2\x80\x9d A rival salesman gets a copy of the\nlist. The company can sue to recover the list because the list is\na.\n\npatented\n\nb. copyrighted\nc. a trade secret\nd. none of the above\n\nSELF-TEST ANSWERS\n\n1. b\n2. a\n3. c\n4. d\n5. c\n\nChapter 11\nThe Nature and Regulation of Real Estate and the\nEnvironment\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n391\n\n\x0cAfter reading this chapter, you should understand the following:\n1. The various kinds of interests (or \xe2\x80\x9cestates\xe2\x80\x9d) in real property\n2. The various rights that come with ownership of real property\n3. What easements are, how they are created, and how they function\n4. How ownership of real property is regulated by tort law, by agreement, and by the public\ninterest (through eminent domain)\n5. The various ways in which environmental laws affect the ownership and use of real property\nReal property is an important part of corporate as well as individual wealth. As a consequence,\nthe role of the corporate real estate manager has become critically important within the\ncorporation. The real estate manager must be aware not only of the value of land for purchase\nand sale but also of proper lease negotiation, tax policies and assessments, zoning and land\ndevelopment, and environmental laws.\nIn this chapter and in Chapter 12 "The Transfer of Real Estate by Sale" and Chapter 13\n"Landlord and Tenant Law", we focus on regulation of land use and the environment (see Figure\n11.1 "Chapter Overview"). We divide our discussion of the nature of real estate into three major\ncategories: (1) estates; (2) rights that are incidental to the possession and ownership of land\xe2\x80\x94for\nexample, the right to air, water, and minerals; and (3) easements\xe2\x80\x94the rights in lands of others.\n\n11.1 Estates\n\nLEARNING OBJECTIVE\n\n1. Distinguish between the various kinds of estates, or interests, in real property that the law\nrecognizes.\nIn property law, an estate is an interest in real property, ranging from absolute dominion and\ncontrol to bare possession. Ordinarily when we think of property, we think of only one kind:\nabsolute ownership. The owner of a car has the right to drive it where and when she wants,\nrebuild it, repaint it, and sell it or scrap it. The notion that the owner might lose her property\nwhen a particular event happens is foreign to our concept of personal property. Not so with real\nproperty. You would doubtless think it odd if you were sold a used car subject to the condition\nthat you not paint it a different color\xe2\x80\x94and that if you did, you would automatically be stripped\nof ownership. But land can be sold that way. Land and other real property can be divided into\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n392\n\n\x0cmany categories of interests, as we will see. (Be careful not to confuse the various types of\ninterests in real property with the forms of ownership, such as joint tenancy. An interest in real\nproperty that amounts to an estate is a measure of the degree to which a thing is owned; the\nform of ownership deals with the particular person or persons who own it.)\n\nFigure 11.1 Chapter Overview\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n393\n\n\x0cThe common law distinguishes estates along two main axes: (1) freeholds versus leaseholds and\n(2) present versus future interests. A freehold estate is an interest in land that has an uncertain\nduration. The freehold can be outright ownership\xe2\x80\x94called the fee simple absolute\xe2\x80\x94or it can be\nan interest in the land for the life of the possessor; in either case, it is impossible to say exactly\nhow long the estate will last. In the case of one who owns property outright, her estate will last\nuntil she sells or transfers it; in the case of a life estate, it will last until the death of the owner or\nanother specified individual. A leasehold estate is one whose termination date is usually known.\nA one-year lease, for example, will expire precisely at the time stated in the lease agreement.\nA present estate is one that is currently owned and enjoyed; a future estate is one that will come\ninto the owner\xe2\x80\x99s possession upon the occurrence of a particular event. In this chapter, we\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n394\n\n\x0cconsider both present and future freehold interests; leasehold interests we save for Chapter 13\n"Landlord and Tenant Law".\n\nPresent Estates (Freeholds)\nFee Simple Absolute\nThe strongest form of ownership is known as the fee simple absolute (or fee simple, or merely\nfee). This is what we think of when we say that someone \xe2\x80\x9cowns\xe2\x80\x9d the land. As one court put it,\n\xe2\x80\x9cThe grant of a fee in land conveys to the grantee complete ownership, immediately and forever,\nwith the right of possession from boundary to boundary and from the center of the earth to the\nsky, together with all the lawful uses thereof.\xe2\x80\x9d [1]Although the fee simple may be encumbered by\na mortgage (you may borrow money against the equity in your home) or an easement (you may\ngrant someone the right to walk across your backyard), the underlying control is in the hands of\nthe owner. Though it was once a complex matter in determining whether a person had been\ngiven a fee simple interest, today the law presumes that the estate being transferred is a fee\nsimple, unless the conveyance expressly states to the contrary. (In her will, Lady Gaga grants her\nfive-thousand-acre ranch \xe2\x80\x9cto my screen idol, Tilda Swinton.\xe2\x80\x9d On the death of Lady Gaga,\nSwinton takes ownership of the ranch outright in fee simple absolute.)\n\nFee Simple Defeasible\nNot every transfer of real property creates a fee simple absolute. Some transfers may limit the\nestate. Any transfer specifying that the ownership will terminate upon a particular happening is\nknown as a fee simple defeasible. Suppose, for example, that Mr. Warbucks conveys a tract of\nland \xe2\x80\x9cto Miss Florence Nightingale, for the purpose of operating her hospital and for no other\npurpose. Conveyance to be good as long as hospital remains on the property.\xe2\x80\x9d This grant of land\nwill remain the property of Miss Nightingale and her heirs as long as she and they maintain a\nhospital. When they stop doing so, the land will automatically revert to Mr. Warbucks or his\nheirs, without their having to do anything to regain title. Note that the conveyance of land could\nbe perpetual but is not absolute, because it will remain the property of Miss Nightingale only so\nlong as she observes the conditions in the grant.\n\nLife Estates\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n395\n\n\x0cAn estate measured by the life of a particular person is called a life estate. A conventional life\nestate is created privately by the parties themselves. The simplest form is that conveyed by the\nfollowing words: \xe2\x80\x9cto Scarlett for life.\xe2\x80\x9d Scarlett becomes a life tenant; as such, she is the owner of\nthe property and may occupy it for life or lease it or even sell it, but the new tenant or buyer can\nacquire only as much as Scarlett has to give, which is ownership for her life (i.e., all she can sell\nis a life estate in the land, not a fee simple absolute). If Scarlett sells the house and dies a month\nlater, the buyer\xe2\x80\x99s interest would terminate. A life estate may be based on the life of someone\nother than the life tenant: \xe2\x80\x9cto Scarlett for the life of Rhett.\xe2\x80\x9d\nThe life tenant may use the property as though he were the owner in fee simple absolute with\nthis exception: he may not act so as to diminish the value of the property that will ultimately go\nto the remainderman\xe2\x80\x94the person who will become owner when the life estate terminates. The\nlife tenant must pay the life estate for ordinary upkeep of the property, but the remainderman is\nresponsible for extraordinary repairs.\nSome life estates are created by operation of law and are known as legal life estates. The most\ncommon form is a widow\xe2\x80\x99s interest in the real property of her husband. In about one-third of the\nstates, a woman is entitled to dower, a right to a percentage (often one-third) of the property of\nher husband when he dies. Most of these states give a widower a similar interest in the property\nof his deceased wife. Dower is an alternative to whatever is bequeathed in the will; the widow\nhas the right to elect the share stated in the will or the share available under dower. To prevent\nthe dower right from upsetting the interests of remote purchasers, the right may be waived on\nsale by having the spouse sign the deed.\n\nFuture Estates\nTo this point, we have been considering present estates. But people also can have future\ninterests in real property. Despite the implications of its name, the future interest is owned now\nbut is not available to be used or enjoyed now. For the most part, future interests may be bought\nand sold, just as land held in fee simple absolute may be bought and sold. There are several\nclasses of future interests, but in general there are two major types: reversion and remainder.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n396\n\n\x0cReversion\nA reversion arises whenever the estate transferred has a duration less than that originally owned\nby the transferor. A typical example of a simple reversion is that which arises when a life estate\nis conveyed. The ownership conveyed is only for the life; when the life tenant dies, the\nownership interest reverts to the grantor. Suppose the grantor has died in the meantime. Who\ngets the reversion interest? Since the reversion is a class of property that is owned now, it can be\ninherited, and the grantor\xe2\x80\x99s heirs would take the reversion at the subsequent death of the life\ntenant.\n\nRemainder\nThe transferor need not keep the reversion interest for himself. He can give that interest to\nsomeone else, in which case it is known as a remainder interest, because the remainder of the\nproperty is being transferred. Suppose the transferor conveys land with these words: \xe2\x80\x9cto Scarlett\nfor life and then to Rhett.\xe2\x80\x9d Scarlett has a life estate; the remainder goes to Rhett in fee simple\nabsolute. Rhett is said to have a vested remainder interest, because on Scarlett\xe2\x80\x99s death, he or his\nheirs will automatically become owners of the property. Some remainder interests are\ncontingent\xe2\x80\x94and are therefore known as contingent remainder interests\xe2\x80\x94on the happening of a\ncertain event: \xe2\x80\x9cto my mother for her life, then to my sister if she marries Harold before my\nmother dies.\xe2\x80\x9d The transferor\xe2\x80\x99s sister will become the owner of the property in fee simple only if\nshe marries Harold while her mother is alive; otherwise, the property will revert to the\ntransferor or his heirs. The number of permutations of reversions and remainders can become\nquite complex, far more than we have space to discuss in this text.\n\nKEY TAKEAWAY\n\nAn estate is an interest in real property. Estates are of many kinds, but one generic difference\nis between ownership estates and possessory estates. Fee simple estates and life estates are\nownership estates, while leasehold interests are possessory. Among ownership estates, the\nprincipal division is between present estates and future estates. An owner of a future estate\nhas an interest that can be bought and sold and that will ripen into present possession at the\nend of a period of time, at the end of the life of another, or with the happening of some\ncontingent event.\n\nSaylor URL: http://www.saylor.org/books\n\nEXERCISES\nSaylor.org\n397\n\n\x0c1. Jessa owns a house and lot on 9th Avenue. She sells the house to the Hartley family, who\nwish to have a conveyance from her that says, \xe2\x80\x9cto Harriet Hartley for life, remainder to her\nson, Alexander Sandridge.\xe2\x80\x9d Alexander is married to Chloe, and they have three children,\nCarmen, Sarah, and Michael. Who has a future interest, and who has a present interest?\nWhat is the correct legal term for Harriet\xe2\x80\x99s estate? Does Alexander, Carmen, Sarah, or\nMichael have any part of the estate at the time Jessa conveys to Harriet using the stated\nlanguage?\n2. After Harriet dies, Alexander wants to sell the property. Alexander and Chloe\xe2\x80\x99s children are\nall eighteen years of age or older. Can he convey the property by his signature alone? Who\nelse needs to sign?\n\n[1] Magnolia Petroleum Co. v. Thompson, 106 F.2d 217 (8th Cir. 1939).\n\n11.2 Rights Incident to Possession and Ownership of\nReal Estate\nLEARNING OBJECTIVE\n\n1. Understand that property owners have certain rights in the airspace above their land, in the\nminerals beneath their land, and even in water that adjoins their land.\n\nRights to Airspace\nThe traditional rule was stated by Lord Coke: \xe2\x80\x9cWhoever owns the soil owns up to the sky.\xe2\x80\x9d This\ntraditional rule remains valid today, but its application can cause problems. A simple example\nwould be a person who builds an extension to the upper story of his house so that it hangs out\nover the edge of his property line and thrusts into the airspace of his neighbor. That would\nclearly be an encroachment on the neighbor\xe2\x80\x99s property. But is it trespass when an airplane\xe2\x80\x94or\nan earth satellite\xe2\x80\x94flies over your backyard? Obviously, the courts must balance the right to\ntravel against landowners\xe2\x80\x99 rights. In U.S. v. Causby, [1] the Court determined that flights over\nprivate land may constitute a diminution in the property value if they are so low and so frequent\nas to be a direct and immediate interference with the enjoyment and use of land.\n\nRights to the Depths\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n398\n\n\x0cLord Coke\xe2\x80\x99s dictum applies to the depths as well as the sky. The owner of the surface has the\nright to the oil, gas, and minerals below it, although this right can be severed and sold\nseparately. Perplexing questions may arise in the case of oil and gas, which can flow under the\nsurface. Some states say that oil and gas can be owned by the owner of the surface land; others\nsay that they are not owned until actually extracted\xe2\x80\x94although the property owner may sell the\nexclusive right to extract them from his land. But states with either rule recognize that oil and\ngas are capable of being \xe2\x80\x9ccaptured\xe2\x80\x9d by drilling that causes oil or gas from under another plot of\nland to run toward the drilled hole. Since the possibility of capture can lead to wasteful drilling\npractices as everyone nearby rushes to capture the precious commodities, many states have\nenacted statutes requiring landowners to share the resources.\n\nRights to Water\nThe right to determine how bodies of water will be used depends on basic property rules. Two\ndifferent approaches to water use in the United States\xe2\x80\x94eastern and western\xe2\x80\x94have developed\nover time (see Figure 11.2 "Water Rights"). Eastern states, where water has historically been\nmore plentiful, have adopted the so-called riparian rights theory, which itself can take two\nforms. Riparian refers to land that includes a part of the bed of a waterway or that borders on a\npublic watercourse. A riparian owner is one who owns such land. What are the rights of\nupstream and downstream owners of riparian land regarding use of the waters? One approach is\nthe \xe2\x80\x9cnatural flow\xe2\x80\x9d doctrine: Each riparian owner is entitled to have the river or other waterway\nmaintained in its natural state. The upstream owner may use the river for drinking water or for\nwashing but may not divert it to irrigate his crops or to operate his mill if doing so would\nmaterially change the amount of the flow or the quality of the water. Virtually all eastern states\ntoday are not so restrictive and rely instead on a \xe2\x80\x9creasonable use\xe2\x80\x9d doctrine, which permits the\nbenefit to be derived from use of the waterway to be weighed against the gravity of the harm.\nThis approach is illustrated in Hoover v. Crane, (seeSection 11.6.1 "Reasonable Use Doctrine". [2]\nFigure 11.2 Water Rights\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n399\n\n\x0cIn contrast to riparian rights doctrines, western states have adopted the prior appropriation\ndoctrine. This rule looks not to equality of interests but to priority in time: first in time is first in\nright. The first person to use the water for a beneficial purpose has a right superior to\nlatecomers. This rule applies even if the first user takes all the water for his own needs and even\nif other users are riparian owners. This rule developed in water-scarce states in which\ndevelopment depended on incentives to use rather than hoard water. Today, the prior\nappropriation doctrine has come under criticism because it gives incentives to those who already\nhave the right to the water to continue to use it profligately, rather than to those who might\ndevelop more efficient means of using it.\n\nKEY TAKEAWAY\n\nProperty owners have certain rights in the airspace above their land. They also have rights in\nsubsurface minerals, which include oil and gas. Those property owners who have bodies of\nwater adjacent to their land will also have certain rights to withdraw or impound water for\ntheir own use. Regarding US water law, the reasonable use doctrine in the eastern states is\ndistinctly different from the prior appropriation doctrine in western states.\n\nEXERCISES\n\n1. Steve Hannaford farms in western Nebraska. The farm has passed to succeeding generations\nof Hannafords, who use water from the North Platte River for irrigation purposes. The\nheadlands of the North Platte are in Colorado, but use of the water from the North Platte by\nNebraskans preceded use of the water by settlers in Colorado. What theory of water rights\ngoverns Nebraska and Colorado residents? Can the state of Colorado divert and use water in\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n400\n\n\x0csuch a way that less of it reaches western Nebraska and the Hannaford farm? Why or why\nnot?\n2. Jamie Stoner decides to put solar panels on the south face of his roof. Jamie lives on a block\nof one- and two-bedroom bungalows in South Miami, Florida. In 2009, someone purchases\nthe house next door and within two years decides to add a second and third story. This\nproposed addition will significantly decrease the utility of Jamie\xe2\x80\x99s solar array. Does Jamie\nhave any rights that would limit what his new neighbors can do on their own land?\n\n[1] U.S. v. Causby, 328 U.S. 256 (1946).\n[2] Hoover v. Crane, 362 Mich. 36, 106 N.W.2d 563 (1960).\n\n11.3 Easements: Rights in the Lands of Others\nLEARNING OBJECTIVES\n\n1. Explain the difference between an easement and a license.\n2. Describe the ways in which easements can be created.\n\nDefinition\nAn easement is an interest in land created by agreement that permits one person to make use of\nanother\xe2\x80\x99s estate. This interest can extend to a profit, the taking of something from the other\xe2\x80\x99s\nland. Though the common law once distinguished between an easement and profit, today the\ndistinction has faded, and profits are treated as a type of easement. An easement must be\ndistinguished from a mere license, which is permission, revocable at the will of the owner, to\nmake use of the owner\xe2\x80\x99s land. An easement is an estate; a license is personal to the grantee and\nis not assignable.\nThe two main types of easements are affirmative and negative. An affirmative easement gives a\nlandowner the right to use the land of another (e.g., crossing it or using water from it), while\na negative easement, by contrast, prohibits the landowner from using his land in ways that\nwould affect the holder of the easement. For example, the builder of a solar home would want to\nobtain negative easements from neighbors barring them from building structures on their land\nthat would block sunlight from falling on the solar home. With the growth of solar energy, some\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n401\n\n\x0cstates have begun to provide stronger protection by enacting laws that regulate one\xe2\x80\x99s ability to\ninterfere with the enjoyment of sunlight. These laws range from a relatively weak statute in\nColorado, which sets forth rules for obtaining easements, to the much stronger statute in\nCalifornia, which says in effect that the owner of a solar device has a vested right to continue to\nreceive the sunlight.\nAnother important distinction is made between easements appurtenant and easements in gross.\nAn easement appurtenant benefits the owner of adjacent land. The easement is thus\nappurtenant to the holder\xe2\x80\x99s land. The benefited land is called thedominant tenement, and the\nburdened land\xe2\x80\x94that is, the land subject to the easement\xe2\x80\x94is called\nthe servient tenement (see Figure 11.3 "Easement Appurtenant"). An easement in gross is\ngranted independent of the easement holder\xe2\x80\x99s ownership or possession of land. It is simply an\nindependent right\xe2\x80\x94for example, the right granted to a local delivery service to drive its trucks\nacross a private roadway to gain access to homes at the other end.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n402\n\n\x0cFigure 11.3 Easement Appurtenant\n\nUnless it is explicitly limited to the grantee, an easement appurtenant \xe2\x80\x9cruns with the land.\xe2\x80\x9d That\nis, when the dominant tenement is sold or otherwise conveyed, the new owner automatically\nowns the easement. A commercial easement in gross may be transferred\xe2\x80\x94for instance,\neasements to construct pipelines, telegraph and telephone lines, and railroad rights of way.\nHowever, most noncommercial easements in gross are not transferable, being deemed personal\nto the original owner of the easement. Rochelle sells her friend Mrs. Nanette\xe2\x80\x94who does not own\nland adjacent to Rochelle\xe2\x80\x94an easement across her country farm to operate skimobiles during\nthe winter. The easement is personal to Mrs. Nanette; she could not sell the easement to anyone\nelse.\n\nCreation\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n403\n\n\x0cEasements may be created by express agreement, either in deeds or in wills. The owner of the\ndominant tenement may buy the easement from the owner of the servient tenement or may\nreserve the easement for himself when selling part of his land. But courts will sometimes allow\nimplied easements under certain circumstances. For instance, if the deed refers to an easement\nthat bounds the premises\xe2\x80\x94without describing it in any detail\xe2\x80\x94a court could conclude that an\neasement was intended to pass with the sale of the property.\nAn easement can also be implied from prior use. Suppose a seller of land has two lots, with a\ndriveway connecting both lots to the street. The only way to gain access to the street from the\nback lot is to use the driveway, and the seller has always done so. If the seller now sells the back\nlot, the buyer can establish an easement in the driveway through the front lot if the prior use was\n(1) apparent at the time of sale, (2) continuous, and (3) reasonably necessary for the enjoyment\nof the back lot. The rule of implied easements through prior use operates only when the\nownership of the dominant and servient tenements was originally in the same person.\n\nUse of the Easement\nThe servient owner may use the easement\xe2\x80\x94remember, it is on or under or above his land\xe2\x80\x94as\nlong as his use does not interfere with the rights of the easement owner. Suppose you have an\neasement to walk along a path in the woods owned by your neighbor and to swim in a private\nlake that adjoins the woods. At the time you purchased the easement, your neighbor did not use\nthe lake. Now he proposes to swim in it himself, and you protest. You would not have a sound\ncase, because his swimming in the lake would not interfere with your right to do so. But if he\nproposed to clear the woods and build a mill on it, obliterating the path you took to the lake and\npolluting the lake with chemical discharges, then you could obtain an injunction to bar him from\ninterfering with your easement.\nThe owner of the dominant tenement is not restricted to using his land as he was at the time he\nbecame the owner of the easement. The courts will permit him to develop the land in some\n\xe2\x80\x9cnormal\xe2\x80\x9d manner. For example, an easement on a private roadway for the benefit of a large\nestate up in the hills would not be lost if the large estate were ultimately subdivided and many\nnew owners wished to use the roadway; the easement applies to the entire portion of the original\ndominant tenement, not merely to the part that abuts the easement itself. However, the owner\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n404\n\n\x0cof an easement appurtenant to one tract of land cannot use the easement on another tract of\nland, even if the two tracts are adjacent.\n\nKEY TAKEAWAY\n\nAn easement appurtenant runs with the land and benefits the dominant tenement,\nburdening the servient tenement. An easement, generally, has a specific location or\ndescription within or over the servient tenement. Easements can be created by deed, by will,\nor by implication.\n\nEXERCISE\n\n1. Beth Delaney owns property next to Kerry Plemmons. The deed to Delaney\xe2\x80\x99s property notes\nthat she has access to a well on the Plemmons property \xe2\x80\x9cto obtain water for household use.\xe2\x80\x9d\nThe well has been dry for many generations and has not been used by anyone on the\nPlemmons property or the Delaney property for as many generations. The well predated\nPlemmons\xe2\x80\x99s ownership of the property; as the servient tenement, the Plemmons property\nwas burdened by this easement dating back to 1898. Plemmons hires a company to dig a\nvery deep well near one of his outbuildings to provide water for his horses. The location is\none hundred yards from the old well. Does the Delaney property have any easement to use\nwater from the new well?\n\n11.4 Regulation of Land Use\n\nLEARNING OBJECTIVES\n\n1. Compare the various ways in which law limits or restricts the right to use your land in any\nway that you decide is best for you.\n2. Distinguish between regulation by common law and regulation by public acts such as zoning\nor eminent domain.\n3. Understand that property owners may restrict the uses of land by voluntary agreement,\nsubject to important public policy considerations.\nLand use regulation falls into three broad categories: (1) restriction on the use of land through\ntort law, (2) private regulation by agreement, and (3) public ownership or regulation through\nthe powers of eminent domain and zoning.\n\nRegulation of Land Use by Tort Law\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n405\n\n\x0cTort law is used to regulate land use in two ways: (1) The owner may become liable for certain\nactivities carried out on the real estate that affect others beyond the real estate. (2) The owner\nmay be liable to persons who, upon entering the real estate, are injured.\n\nLandowner\xe2\x80\x99s Activities\nThe two most common torts in this area are nuisance and trespass. A common-lawnuisance is\nan interference with the use and enjoyment of one\xe2\x80\x99s land. Examples of nuisances are excessive\nnoise (especially late at night), polluting activities, and emissions of noxious odors. But the\nactivity must produce substantial harm, not fleeting, minor injury, and it must produce those\neffects on the reasonable person, not on someone who is peculiarly allergic to the complained-of\nactivity. A person who suffered migraine headaches at the sight of croquet being played on a\nneighbor\xe2\x80\x99s lawn would not likely win a nuisance lawsuit. While the meaning of nuisance is\ndifficult to define with any precision, this common-law cause of action is a primary means for\nlandowners to obtain damages for invasive environmental harms.\nA trespass is the wrongful physical invasion of or entry upon land possessed by another. Loud\nnoise blaring out of speakers in the house next door might be a nuisance but could not be a\ntrespass, because noise is not a physical invasion. But spraying pesticides on your gladiolas\ncould constitute a trespass on your neighbor\xe2\x80\x99s property if the pesticide drifts across the\nboundary.\nNuisance and trespass are complex theories, a full explanation of which would consume far\nmore space than we have. What is important to remember is that these torts are two-edged\nswords. In some situations, the landowner himself will want to use these theories to sue\ntrespassers or persons creating a nuisance, but in other situations, the landowner will be liable\nunder these theories for his own activities.\n\nInjury to Persons Entering the Real Estate\nTraditionally, liability for injury has depended on the status of the person who enters the real\nestate.\n\nTrespassers\nIf the person is an intruder without permission\xe2\x80\x94a trespasser\xe2\x80\x94the landowner owes him no duty\nof care unless he knows of the intruder\xe2\x80\x99s presence, in which case the owner must exercise\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n406\n\n\x0creasonable care in his activities and warn of hidden dangers on his land of which he is aware. A\nknown trespasser is someone whom the landowner actually sees on the property or whom he\nknows frequently intrudes on the property, as in the case of someone who habitually walks\nacross the land. If a landowner knows that people frequently walk across his property and one\nday he puts a poisonous chemical on the ground to eliminate certain insects, he is obligated to\nwarn those who continue to walk on the grounds. Intentional injury to known trespassers is not\nallowed, even if the trespasser is a criminal intent on robbery, for the law values human life\nabove property rights.\n\nChildren\nIf the trespasser is a child, a different rule applies in most states. This is the doctrine\nofattractive nuisance. Originally this rule was enunciated to deal with cases in which something\non the land attracted the child to it, like a swimming pool. In recent years, most courts have\ndropped the requirement that the child must have been attracted to the danger. Instead, the\nfollowing elements of proof are necessary to make out a case of attractive nuisance (Restatement\nof Torts, Section 339):\n1. The child must have been injured by a structure or other artificial condition.\n2. The possessor of the land (not necessarily the owner) must have known or should have known\nthat young children would be likely to trespass.\n3. The possessor must have known or should have known that the artificial condition exists and\nthat it posed an unreasonable risk of serious injury.\n4. The child must have been too young to appreciate the danger that the artificial condition posed.\n5. The risk to the child must have far outweighed the utility of the artificial condition to the\npossessor.\n6. The possessor did not exercise reasonable care in protecting the child or eliminating the danger.\nOld refrigerators, open gravel pits, or mechanisms that a curious child would find inviting are all\nexamples of attractive nuisance. Suppose Farmer Brown keeps an old buggy on his front lawn,\naccessible from the street. A five-year-old boy clambers up the buggy one day, falls through a\nrotted floorboard, and breaks his leg. Is Farmer Brown liable? Probably so. The child was too\nyoung to appreciate the danger posed by the buggy, a structure. The farmer should have\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n407\n\n\x0cappreciated that young children would be likely to come onto the land when they saw the buggy\nand that they would be likely to climb up onto the buggy. Moreover, he should have known, if he\ndid not know in fact, that the buggy, left outside for years without being tended, would pose an\nunreasonable risk. The buggy\xe2\x80\x99s utility as a decoration was far overbalanced by the risk that it\nposed to children, and the farmer failed to exercise reasonable care.\n\nLicensees\nA nontrespasser who comes onto the land without being invited, or if invited, comes for\npurposes unconnected with any business conducted on the premises, is known as alicensee. This\nclass of visitors to the land consists of (1) social guests (people you invite to your home for a\nparty); (2) a salesman, not invited by the owner, who wishes to sell something to the owner or\noccupier of the property; and (3) persons visiting a building for a purpose not connected with\nthe business on the land (e.g., students who visit a factory to see how it works). The landowner\nowes the same duty of care to licensees that he owes to known trespassers. That is, he must warn\nthem against hidden dangers of which he is aware, and he must exercise reasonable care in his\nactivities to ensure that they are not injured.\n\nInvitees\nA final category of persons entering land is that of invitee. This is one who has been invited onto\nthe land, usually, though not necessarily, for a business purpose of potential economic benefit to\nthe owner or occupier of the premises. This category is confusing because it sounds as though it\nshould include social guests (who clearly are invited onto the premises), but traditionally social\nguests are said to be licensees.\nInvitees include customers of stores, users of athletic and other clubs, customers of repair shops,\nstrollers through public parks, restaurant and theater patrons, hotel guests, and the like. From\nthe owner\xe2\x80\x99s perspective, the major difference between licensees and invitees is that he is liable\nfor injuries resulting to the latter from hidden dangers that he should have been aware of, even\nif he is not actually aware of the dangers. How hidden the dangers are and how broad the\nowner\xe2\x80\x99s liability is depends on the circumstances, but liability sometimes can be quite broad.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n408\n\n\x0cDifficult questions arise in lawsuits brought by invitees (or business invitees, as they are\nsometimes called) when the actions of persons other than the landowner contribute to the\ninjury.\nThe foregoing rules dealing with liability for persons entering the land are the traditional rules\nat common law. In recent years, some courts have moved away from the rigidities and\nsometimes perplexing differences between trespassers, licensees, and invitees. By court\ndecision, several states have now abolished such distinctions and hold the proprietor, owner, or\noccupier liable for failing to maintain the premises in a reasonably safe condition. According to\nthe California Supreme Court,\nA man\xe2\x80\x99s life or limb does not become less worthy of protection by the law nor a loss less worthy\nof compensation under the law because he has come upon the land of another without\npermission or with permission but without a business purpose. Reasonable people do not\nordinarily vary their conduct depending upon such matters, and to focus upon the status of the\ninjured party as a trespasser, licensee, or invitee in order to determine the question whether the\nlandowner has a duty of care, is contrary to our modern social mores and humanitarian values.\nWhere the occupier of land is aware of a concealed condition involving in the absence of\nprecautions an unreasonable risk of harm to those coming in contact with it and is aware that a\nperson on the premises is about to come in contact with it, the trier of fact can reasonably\nconclude that a failure to warn or to repair the condition constitutes negligence. Whether or not\na guest has a right to expect that his host will remedy dangerous conditions on his account, he\nshould reasonably be entitled to rely upon a warning of the dangerous condition so that he, like\nthe host, will be in a position to take special precautions when he comes in contact with it. [1]\n\nPrivate Regulation of Land Use by Agreement\nA restrictive covenant is an agreement regarding the use of land that \xe2\x80\x9cruns with the land.\xe2\x80\x9d In\neffect, it is a contractual promise that becomes part of the property and that binds future\nowners. Violations of covenants can be redressed in court in suits for damages or injunctions but\nwill not result in reversion of the land to the seller.\nUsually, courts construe restrictive covenants narrowly\xe2\x80\x94that is, in a manner most conducive to\nfree use of the land by the ultimate owner (the person against whom enforcement of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n409\n\n\x0ccovenant is being sought). Sometimes, even when the meaning of the covenant is clear, the\ncourts will not enforce it. For example, when the character of a neighborhood changes, the\ncourts may declare the covenant a nullity. Thus a restriction on a one-acre parcel to residential\npurposes was voided when in the intervening thirty years a host of businesses grew up around it,\nincluding a bowling alley, restaurant, poolroom, and sewage disposal plant. [2]\nAn important nullification of restrictive covenants came in 1947 when the US Supreme Court\nstruck down as unconstitutional racially restrictive covenants, which barred blacks and other\nminorities from living on land so burdened. The Supreme Court reasoned that when a court\nenforces such a covenant, it acts in a discriminatory manner (barring blacks but not whites from\nliving in a home burdened with the covenant) and thus violates the Fourteenth Amendment\xe2\x80\x99s\nguarantee of equal protection of the laws. [3]\n\nPublic Control of Land Use through Eminent Domain\nThe government may take private property for public purposes. Its power to do so is known as\neminent domain. The power of eminent domain is subject to constitutional limitations. Under\nthe Fifth Amendment, the property must be put to public use, and the owner is entitled to \xe2\x80\x9cjust\ncompensation\xe2\x80\x9d for his loss. These requirements are sometimes difficult to apply.\n\nPublic Use\nThe requirement of public use normally means that the property will be useful to the public once\nthe state has taken possession\xe2\x80\x94for example, private property might be condemned to construct\na highway. Although not allowed in most circumstances, the government could even condemn\nsomeone\xe2\x80\x99s property in order to turn around and sell it to another individual, if a legitimate\npublic purpose could be shown. For example, a state survey in the mid-1960s showed that the\ngovernment owned 49 percent of Hawaii\xe2\x80\x99s land. Another 47 percent was controlled by seventytwo private landowners. Because this concentration of land ownership (which dated back to\nfeudal times) resulted in a critical shortage of residential land, the Hawaiian legislature enacted\na law allowing the government to take land from large private estates and resell it in smaller\nparcels to homeowners. In 1984, the US Supreme Court upheld the law, deciding that the land\nwas being taken for a public use because the purpose was \xe2\x80\x9cto attack certain perceived evils of\nconcentrated property ownership.\xe2\x80\x9d [4] Although the use must be public, the courts will not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n410\n\n\x0cinquire into the necessity of the use or whether other property might have been better suited. It\nis up to government authorities to determine whether and where to build a road, not the courts.\nThe limits of public use were amply illustrated in the Supreme Court\xe2\x80\x99s 2002 decision ofKelo v.\nNew London, [5] in which Mrs. Kelo\xe2\x80\x99s house was condemned so that the city of New London, in\nConnecticut, could create a marina and industrial park to lease to Pfizer Corporation. The city\xe2\x80\x99s\nmotives were to create a higher tax base for property taxes. The Court, following precedent\nin Midkiff and other cases, refused to invalidate the city\xe2\x80\x99s taking on constitutional grounds.\nReaction from states was swift; many states passed new laws restricting the bases for state and\nmunicipal governments to use powers of eminent domain, and many of these laws also provided\nadditional compensation to property owners whose land was taken.\n\nJust Compensation\nThe owner is ordinarily entitled to the fair market value of land condemned under eminent\ndomain. This value is determined by calculating the most profitable use of the land at the time of\nthe taking, even though it was being put to a different use. The owner will have a difficult time\ncollecting lost profits; for instance, a grocery store will not usually be entitled to collect for the\nprofits it might have made during the next several years, in part because it can presumably move\nelsewhere and continue to make profits and in part because calculating future profits is\ninherently speculative.\n\nTaking\nThe most difficult question in most modern cases is whether the government has in fact \xe2\x80\x9ctaken\xe2\x80\x9d\nthe property. This is easy to answer when the government acquires title to the property through\ncondemnation proceedings. But more often, a government action is challenged when a law or\nregulation inhibits the use of private land. Suppose a town promulgates a setback ordinance,\nrequiring owners along city sidewalks to build no closer to the sidewalk than twenty feet. If the\nowner of a small store had only twenty-five feet of land from the sidewalk line, the ordinance\nwould effectively prevent him from housing his enterprise, and the ordinance would be a taking.\nChallenging such ordinances can sometimes be difficult under traditional tort theories because\nthe government is immune from suit in some of these cases. Instead, a theory of inverse\ncondemnation has developed, in which the plaintiff private property owner asserts that the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n411\n\n\x0cgovernment has condemned the property, though not through the traditional mechanism of a\ncondemnation proceeding.\n\nPublic Control of Land Use through Zoning\nZoning is a technique by which a city or other municipality regulates the type of activity to be\npermitted in geographical areas within its boundaries. Though originally limited to residential,\ncommercial, and industrial uses, today\xe2\x80\x99s zoning ordinances are complex sets of regulations. A\ntypical municipality might have the following zones: residential with a host of subcategories\n(such as for single-family and multiple-family dwellings), office, commercial, industrial,\nagricultural, and public lands. Zones may be exclusive, in which case office buildings would not\nbe permitted in commercial zones, or they may be cumulative, so that a more restricted use\nwould be allowed in a less restrictive zone. Zoning regulations do more than specify the type of\nuse: they often also dictate minimum requirements for parking, open usable space, setbacks, lot\nsizes, and the like, and maximum requirements for height, length of side lots, and so on.\n\nNonconforming Uses\nWhen a zoning ordinance is enacted, it will almost always affect existing property owners, many\nof whom will be using their land in ways no longer permitted under the ordinance. To avoid the\ncharge that they have thereby \xe2\x80\x9ctaken\xe2\x80\x9d the property, most ordinances permit previous\nnonconforming uses to continue, though some ordinances limit the nonconforming uses to a\nspecified time after becoming effective. But this permission to continue a nonconforming use is\nnarrow; it extends only to the specific use to which the property was put before the ordinance\nwas enacted. A manufacturer of dresses that suddenly finds itself in an area zoned residential\nmay continue to use its sewing machines, but it could not develop a sideline in woodworking.\n\nVariances\nSometimes an owner may desire to use his property in ways not permitted under an existing\nzoning scheme and will ask the zoning board for a variance\xe2\x80\x94authority to carry on a\nnonconforming use. The board is not free to grant a variance at its whim. The courts apply three\ngeneral tests to determine the validity of a variance: (1) The land must be unable to yield a\nreasonable return on the uses allowed by the zoning regulation. (2) The hardship must be\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n412\n\n\x0cunique to the property, not to property generally in the area. (3) If granted, the variance must\nnot change the essential character of the neighborhood.\n\nKEY TAKEAWAY\n\nLand use regulation can mean (1) restrictions on the use of land through tort law, (2) private\nregulation\xe2\x80\x94by agreement, or (3) regulation through powers of eminent domain or zoning.\n\nEXERCISES\n\n1. Give one example of the exercise of eminent domain. In order to exercise its power under\neminent domain, must the government actually take eventual ownership of the property\nthat is \xe2\x80\x9ctaken\xe2\x80\x9d?\n2. Felix Unger is an adult, trespassing for the first time on Alan Spillborghs\xe2\x80\x99s property. Alan has\nbeen digging a deep grave in his backyard for his beloved Saint Bernard, Maximilian, who has\njust died. Alan stops working on the grave when it gets dark, intending to return to the task\nin the morning. He seldom sees trespassers cutting through his backyard. Felix, in the dark,\nafter visiting the local pub, decides to take a shortcut through Alan\xe2\x80\x99s yard and falls into the\ngrave. He breaks his leg. What is the standard of care for Alan toward Felix or other\ninfrequent trespassers? If Alan has no insurance for this accident, would the law make Alan\nresponsible?\n3. Atlantic Cement owns and operates a cement plant in New York State. Nearby residents are\nexposed to noise, soot, and dust and have experienced lowered property values as a result of\nAtlantic Cement\xe2\x80\x99s operations. Is there a common-law remedy for nearby property owners for\nlosses occasioned by Atlantic\xe2\x80\x99s operations? If so, what is it called?\n\n[1] Rowland v. Christian, 443 P.2d 561 (Cal. 1968).\n[2] Norris v. Williams, 54 A.2d 331 (Md. 1947).\n[3] Shelley v. Kraemer, 334 U.S. 1 (1947).\n[4] Hawaii Housing Authority v. Midkiff, 467 U.S. 229 (1984).\n[5] Kelo v. New London, 545 U.S. 469 (2005).\n\n11.5 Environmental Law\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n413\n\n\x0cLEARNING OBJECTIVES\n1. Describe the major federal laws that govern business activities that may adversely affect air\nquality and water quality.\n2. Describe the major federal laws that govern waste disposal and chemical hazards including\npesticides.\nIn one sense, environmental law is very old. Medieval England had smoke control laws that\nestablished the seasons when soft coal could be burned. Nuisance laws give private individuals a\nlimited control over polluting activities of adjacent landowners. But a comprehensive set of US\nlaws directed toward general protection of the environment is largely a product of the past\nquarter-century, with most of the legislative activity stemming from the late 1960s and later,\nwhen people began to perceive that the environment was systematically deteriorating from\nassaults by rapid population growth and greatly increased automobile driving, vast proliferation\nof factories that generate waste products, and a sharp rise in the production of toxic materials.\nTwo of the most significant developments in environmental law came in 1970, when the\nNational Environmental Policy Act took effect and the Environmental Protection Agency\nbecame the first of a number of new federal administrative agencies to be established during the\ndecade.\n\nNational Environmental Policy Act\nSigned into law by President Nixon on January 1, 1970, the National Environmental Policy Act\n(NEPA) declared that it shall be the policy of the federal government, in cooperation with state\nand local governments, \xe2\x80\x9cto create and maintain conditions under which man and nature can\nexist in productive harmony, and fulfill the social, economic, and other requirements of present\nand future generations of Americans.\xe2\x80\xa6The Congress recognizes that each person should enjoy a\nhealthful environment and that each person has a responsibility to contribute to the\npreservation and enhancement of the environment.\xe2\x80\x9d [1]\nThe most significant aspect of NEPA is its requirement that federal agencies prepare\nanenvironmental impact statement in every recommendation or report on proposals for\nlegislation and whenever undertaking a major federal action that significantly affects\nenvironmental quality. The statement must (1) detail the environmental impact of the proposed\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n414\n\n\x0caction, (2) list any unavoidable adverse impacts should the action be taken, (3) consider\nalternatives to the proposed action, (4) compare short-term and long-term consequences, and\n(5) describe irreversible commitments of resources. Unless the impact statement is prepared,\nthe project can be enjoined from proceeding. Note that NEPA does not apply to purely private\nactivities but only to those proposed to be carried out in some manner by federal agencies.\n\nEnvironmental Protection Agency\nThe Environmental Protection Agency (EPA) has been in the forefront of the news since its\ncreation in 1970. Charged with monitoring environmental practices of industry, assisting the\ngovernment and private business to halt environmental deterioration, promulgating regulations\nconsistent with federal environmental policy, and policing industry for violations of the various\nfederal environmental statutes and regulations, the EPA has had a pervasive influence on\nAmerican business. Business Week noted the following in 1977: \xe2\x80\x9cCars rolling off Detroit\xe2\x80\x99s\nassembly line now have antipollution devices as standard equipment. The dense black\nsmokestack emissions that used to symbolize industrial prosperity are rare, and illegal, sights.\nPlants that once blithely ran discharge water out of a pipe and into a river must apply for\npermits that are almost impossible to get unless the plants install expensive water treatment\nequipment. All told, the EPA has made a sizable dent in man-made environmental filth.\xe2\x80\x9d [2]\nThe EPA is especially active in regulating water and air pollution and in overseeing the\ndisposition of toxic wastes and chemicals. To these problems we now turn.\n\nWater Pollution\nClean Water Act\nLegislation governing the nation\xe2\x80\x99s waterways goes back a long time. The first federal water\npollution statute was the Rivers and Harbors Act of 1899. Congress enacted new laws in 1948,\n1956, 1965, 1966, and 1970. But the centerpiece of water pollution enforcement is the Clean\nWater Act of 1972 (technically, the Federal Water Pollution Control Act Amendments of 1972),\nas amended in 1977 and by the Water Quality Act of 1987. The Clean Water Act is designed to\nrestore and maintain the \xe2\x80\x9cchemical, physical, and biological integrity of the Nation\xe2\x80\x99s\nwaters.\xe2\x80\x9d [3] It operates on the states, requiring them to designate the uses of every significant\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n415\n\n\x0cbody of water within their borders (e.g., for drinking water, recreation, commercial fishing) and\nto set water quality standards to reduce pollution to levels appropriate for each use.\nCongress only has power to regulate interstate commerce, and so the Clean Water Act is\napplicable only to \xe2\x80\x9cnavigable waters\xe2\x80\x9d of the United States. This has led to disputes over whether\nthe act can apply, say, to an abandoned gravel pit that has no visible connection to navigable\nwaterways, even if the gravel pit provides habitat for migratory birds. In Solid Waste Agency of\nNorthern Cook County v. Army Corps of Engineers, the US Supreme Court said no. [4]\n\nPrivate Industry\nThe Clean Water Act also governs private industry and imposes stringent standards on the\ndischarge of pollutants into waterways and publicly owned sewage systems. The act created an\neffluent permit system known as the National Pollutant Discharge Elimination System. To\ndischarge any pollutants into navigable waters from a \xe2\x80\x9cpoint source\xe2\x80\x9d like a pipe, ditch, ship, or\ncontainer, a company must obtain a certification that it meets specified standards, which are\ncontinually being tightened. For example, until 1983, industry had to use the \xe2\x80\x9cbest practicable\ntechnology\xe2\x80\x9d currently available, but after July 1, 1984, it had to use the \xe2\x80\x9cbest available\ntechnology\xe2\x80\x9d economically achievable. Companies must limit certain kinds of \xe2\x80\x9cconventional\npollutants\xe2\x80\x9d (such as suspended solids and acidity) by \xe2\x80\x9cbest conventional control technology.\xe2\x80\x9d\n\nOther EPA Water Activities\nFederal law governs, and the EPA regulates, a number of other water control measures. Ocean\ndumping, for example, is the subject of the Marine Protection, Research, and Sanctuaries Act of\n1972, which gives the EPA jurisdiction over wastes discharged into the oceans. The Clean Water\nAct gives the EPA and the US Army Corps of Engineers authority to protect waters, marshlands,\nand other wetlands against degradation caused by dredging and fills. The EPA also oversees\nstate and local plans for restoring general water quality to acceptable levels in the face of a host\nof non-point-source pollution. The Clean Water Act controls municipal sewage systems, which\nmust ensure that wastewater is chemically treated before being discharged from the sewage\nsystem.\nObviously, of critical importance to the nation\xe2\x80\x99s health is the supply of drinking water. To ensure\nits continuing purity, Congress enacted the Safe Drinking Water Act of 1974, with amendments\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n416\n\n\x0cpassed in 1986 and 1996. This act aims to protect water at its sources: rivers, lakes, reservoirs,\nsprings, and groundwater wells. (The act does not regulate private wells that serve fewer than\ntwenty-five individuals.) This law has two strategies for combating pollution of drinking water.\nIt establishes national standards for drinking water derived from both surface reservoirs and\nunderground aquifers. It also authorizes the EPA to regulate the injection of solid wastes into\ndeep wells (as happens, for instance, by leakage from underground storage tanks).\n\nAir Pollution\nThe centerpiece of the legislative effort to clean the atmosphere is the Clean Air Act of 1970\n(amended in 1975, 1977, and 1990). Under this act, the EPA has set two levels of National\nAmbient Air Quality Standards (NAAQS). The primary standards limit the ambient (i.e.,\ncirculating) pollution that affects human health; secondary standards limit pollution that affects\nanimals, plants, and property. The heart of the Clean Air Act is the requirement that subject to\nEPA approval, the states implement the standards that the EPA establishes. The setting of these\npollutant standards was coupled with directing the states to develop state implementation plans\n(SIPs), applicable to appropriate industrial sources in the state, in order to achieve these\nstandards. The act was amended in 1977 and 1990 primarily to set new goals (dates) for\nachieving attainment of NAAQS since many areas of the country had failed to meet the\ndeadlines.\nBeyond the NAAQS, the EPA has established several specific standards to control different types\nof air pollution. One major type is pollution that mobile sources, mainly automobiles, emit. The\nEPA requires new cars to be equipped with catalytic converters and to use unleaded gasoline to\neliminate the most noxious fumes and to keep them from escaping into the atmosphere. To\nminimize pollution from stationary sources, the EPA also imposes uniform standards on new\nindustrial plants and those that have been substantially modernized. And to safeguard against\nemissions from older plants, states must promulgate and enforce SIPs.\nThe Clean Air Act is even more solicitous of air quality in certain parts of the nation, such as\ndesignated wilderness areas and national parks. For these areas, the EPA has set standards to\nprevent significant deterioration in order to keep the air as pristine and clear as it was centuries\nago.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n417\n\n\x0cThe EPA also worries about chemicals so toxic that the tiniest quantities could prove fatal or\nextremely hazardous to health. To control emission of substances like asbestos, beryllium,\nmercury, vinyl chloride, benzene, and arsenic, the EPA has established or proposed various\nNational Emissions Standards for Hazardous Air Pollutants.\nConcern over acid rain and other types of air pollution prompted Congress to add almost eight\nhundred pages of amendments to the Clean Air Act in 1990. (The original act was fifty pages\nlong.) As a result of these amendments, the act was modernized in a manner that parallels other\nenvironmental laws. For instance, the amendments established a permit system that is modeled\nafter the Clean Water Act. And the amendments provide for felony convictions for willful\nviolations, similar to penalties incorporated into other statutes.\nThe amendments include certain defenses for industry. Most important, companies are\nprotected from allegations that they are violating the law by showing that they were acting in\naccordance with a permit. In addition to this \xe2\x80\x9cpermit shield,\xe2\x80\x9d the law also contains protection\nfor workers who unintentionally violate the law while following their employers\xe2\x80\x99 instructions.\n\nWaste Disposal\nThough pollution of the air by highly toxic substances like benzene or vinyl chloride may seem a\nproblem removed from that of the ordinary person, we are all in fact polluters. Every year, the\nUnited States generates approximately 230 million tons of \xe2\x80\x9ctrash\xe2\x80\x9d\xe2\x80\x94about 4.6 pounds per\nperson per day. Less than one-quarter of it is recycled; the rest is incinerated or buried in\nlandfills. But many of the country\xe2\x80\x99s landfills have been closed, either because they were full or\nbecause they were contaminating groundwater. Once groundwater is contaminated, it is\nextremely expensive and difficult to clean it up. In the 1965 Solid Waste Disposal Act and the\n1970 Resource Recovery Act, Congress sought to regulate the discharge of garbage by\nencouraging waste management and recycling. Federal grants were available for research and\ntraining, but the major regulatory effort was expected to come from the states and\nmunicipalities.\nBut shocking news prompted Congress to get tough in 1976. The plight of homeowners near\nLove Canal in upstate New York became a major national story as the discovery of massive\nunderground leaks of toxic chemicals buried during the previous quarter century led to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n418\n\n\x0cevacuation of hundreds of homes. Next came the revelation that Kepone, an exceedingly toxic\npesticide, had been dumped into the James River in Virginia, causing a major human health\nhazard and severe damage to fisheries in the James and downstream in the Chesapeake Bay.\nThe rarely discussed industrial dumping of hazardous wastes now became an open controversy,\nand Congress responded in 1976 with the Resource Conservation and Recovery Act (RCRA) and\nthe Toxic Substances Control Act (TSCA) and in 1980 with the Comprehensive Environmental\nResponse, Compensation, and Liability Act (CERCLA).\n\nResource Conservation and Recovery Act\nThe RCRA expresses a \xe2\x80\x9ccradle-to-grave\xe2\x80\x9d philosophy: hazardous wastes must be regulated at\nevery stage. The act gives the EPA power to govern their creation, storage, transport, treatment,\nand disposal. Any person or company that generates hazardous waste must obtain a permit\n(known as a \xe2\x80\x9cmanifest\xe2\x80\x9d) either to store it on its own site or ship it to an EPA-approved\ntreatment, storage, or disposal facility. No longer can hazardous substances simply be dumped\nat a convenient landfill. Owners and operators of such sites must show that they can pay for\ndamage growing out of their operations, and even after the sites are closed to further dumping,\nthey must set aside funds to monitor and maintain the sites safely.\nThis philosophy can be severe. In 1986, the Supreme Court ruled that bankruptcy is not a\nsufficient reason for a company to abandon toxic waste dumps if state regulations reasonably\nrequire protection in the interest of public health or safety. The practical effect of the ruling is\nthat trustees of the bankrupt company must first devote assets to cleaning up a dump site, and\nonly from remaining assets may they satisfy creditors. [5]Another severity is RCRA\xe2\x80\x99s imposition\nof criminal liability, including fines of up to $25,000 a day and one-year prison sentences, which\ncan be extended beyond owners to individual employees, as discussed in U.S. v. Johnson &\nTowers, Inc., et al., (seeSection 11.6.2 "Criminal Liability of Employees under RCRA").\n\nComprehensive Environmental Response, Compensation, and Liability Act\nThe CERCLA, also known as the Superfund, gives the EPA emergency powers to respond to\npublic health or environmental dangers from faulty hazardous waste disposal, currently\nestimated to occur at more than seventeen thousand sites around the country. The EPA can\ndirect immediate removal of wastes presenting imminent danger (e.g., from train wrecks, oil\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n419\n\n\x0cspills, leaking barrels, and fires). Injuries can be sudden and devastating; in 1979, for example,\nwhen a freight train derailed in Florida, ninety thousand pounds of chlorine gas escaped from a\npunctured tank car, leaving 8 motorists dead and 183 others injured and forcing 3,500 residents\nwithin a 7-mile radius to be evacuated. The EPA may also carry out \xe2\x80\x9cplanned removals\xe2\x80\x9d when\nthe danger is substantial, even if immediate removal is not necessary.\nThe EPA prods owners who can be located to voluntarily clean up sites they have abandoned.\nBut if the owners refuse, the EPA and the states will undertake the task, drawing on a federal\ntrust fund financed mainly by taxes on the manufacture or import of certain chemicals and\npetroleum (the balance of the fund comes from general revenues). States must finance 10\npercent of the cost of cleaning up private sites and 50 percent of the cost of cleaning up public\nfacilities. The EPA and the states can then assess unwilling owners\xe2\x80\x99 punitive damages up to\ntriple the cleanup costs.\nCleanup requirements are especially controversial when applied to landowners who innocently\npurchased contaminated property. To deal with this problem, Congress enacted the Superfund\nAmendment and Reauthorization Act in 1986, which protects innocent landowners who\xe2\x80\x94at the\ntime of purchase\xe2\x80\x94made an \xe2\x80\x9cappropriate inquiry\xe2\x80\x9d into the prior uses of the property. The act\nalso requires companies to publicly disclose information about hazardous chemicals they use.\nWe now turn to other laws regulating chemical hazards.\n\nChemical Hazards\nToxic Substances Control Act\nChemical substances that decades ago promised to improve the quality of life have lately shown\ntheir negative side\xe2\x80\x94they have serious adverse side effects. For example, asbestos, in use for half\na century, causes cancer and asbestosis, a debilitating lung disease, in workers who breathed in\nfibers decades ago. The result has been crippling disease and death and more than thirty\nthousand asbestos-related lawsuits filed nationwide. Other substances, such as polychlorinated\nbiphenyls (PCBs) and dioxin, have caused similar tragedy. Together, the devastating effects of\nchemicals led to enactment of the TSCA, designed to control the manufacture, processing,\ncommercial distribution, use, and disposal of chemicals that pose unreasonable health or\nenvironmental risks. (The TSCA does not apply to pesticides, tobacco, nuclear materials,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n420\n\n\x0cfirearms and ammunition, food, food additives, drugs, and cosmetics\xe2\x80\x94all are regulated by other\nfederal laws.)\nThe TSCA gives the EPA authority to screen for health and environmental risks by requiring\ncompanies to notify the EPA ninety days before manufacturing or importing new chemicals. The\nEPA may demand that the companies test the substances before marketing them and may\nregulate them in a number of ways, such as requiring the manufacturer to label its products, to\nkeep records on its manufacturing and disposal processes, and to document all significant\nadverse reactions in people exposed to the chemicals. The EPA also has authority to ban certain\nespecially hazardous substances, and it has banned the further production of PCBs and many\nuses of asbestos.\nBoth industry groups and consumer groups have attacked the TSCA. Industry groups criticize\nthe act because the enforcement mechanism requires mountainous paperwork and leads to\nwidespread delay. Consumer groups complain because the EPA has been slow to act against\nnumerous chemical substances. The debate continues.\n\nPesticide Regulation\nThe United States is a major user of pesticides, substances that eliminate troublesome insects,\nrodents, fungi, and bacteria, consuming more than a billion pounds a year in the form of thirtyfive thousand separate chemicals. As useful as they can be, like many chemical substances,\npesticides can have serious side effects on humans and plant and animal life. Beginning in the\nearly 1970s, Congress enacted major amendments to the Federal Insecticide, Fungicide, and\nRodenticide Act of 1947 and the Federal Food, Drug, and Cosmetic Act (FFDCA) of 1906.\nThese laws direct the EPA to determine whether pesticides properly balance effectiveness\nagainst safety. If the pesticide can carry out its intended function without causing unreasonable\nadverse effects on human health or the environment, it may remain on the market. Otherwise,\nthe EPA has authority to regulate or even ban its distribution and use. To enable the EPA to\ncarry out its functions, the laws require manufacturers to provide a wealth of data about the way\nindividual pesticides work and their side effects. The EPA is required to inspect pesticides to\nensure that they conform to their labeled purposes, content, and safety, and the agency is\nempowered to certify pesticides for either general or restricted use. If a pesticide is restricted,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n421\n\n\x0conly those persons certified in approved training programs may use it. Likewise, under the\nPesticide Amendment to the FFDCA, the EPA must establish specific tolerances for the residue\nof pesticides on feed crops and both raw and processed foods. The Food and Drug\nAdministration (for agricultural commodities) and the US Department of Agriculture (for meat,\npoultry, and fish products) enforce these provisions.\n\nOther Types of Environmental Controls\nNoise Regulation\nUnder the Noise Regulation Act of 1972, Congress has attempted to combat a growing menace to\nUS workers, residents, and consumers. People who live close to airports and major highways,\nworkers who use certain kinds of machinery (e.g., air compressors, rock drills, bulldozers), and\nconsumers who use certain products, such as power mowers and air conditioners, often suffer\nfrom a variety of ailments. The Noise Regulation Act delegates to the EPA power to limit \xe2\x80\x9cnoise\nemissions\xe2\x80\x9d from these major sources of noise. Under the act, manufacturers may not sell new\nproducts that fail to conform to the noise standards the EPA sets, and users are forbidden from\ndismantling noise control devices installed on these products. Moreover, manufacturers must\nlabel noisy products properly. Private suits may be filed against violators, and the act also\npermits fines of up to $25,000 per day and a year in jail for those who seek to avoid its terms.\n\nRadiation Controls\nThe terrifying effects of a nuclear disaster became frighteningly clear when the Soviet Union\xe2\x80\x99s\nnuclear power plant at Chernobyl exploded in early 1986, discharging vast quantities of\nradiation into the world\xe2\x80\x99s airstream and affecting people thousands of miles away. In the United\nStates, the most notorious nuclear accident occurred at the Three Mile Island nuclear utility in\nPennsylvania in 1979, crippling the facility for years because of the extreme danger and long life\nof the radiation. Primary responsibility for overseeing nuclear safety rests with the Nuclear\nRegulatory Commission, but many other agencies and several federal laws (including the Clean\nAir Act; the Federal Water Pollution Control Act; the Safe Drinking Water Act; the Uranium Mill\nTailings Radiation Control Act; the Marine Protection, Research, and Sanctuaries Act; the\nNuclear Waste Policy Act of 1982; the CERCLA; and the Ocean Dumping Act) govern the use of\nnuclear materials and the storage of radioactive wastes (some of which will remain severely\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n422\n\n\x0cdangerous for thousands of years). Through many of these laws, the EPA has been assigned the\nresponsibility of setting radiation guidelines, assessing new technology, monitoring radiation in\nthe environment, setting limits on release of radiation from nuclear utilities, developing\nguidance for use of X-rays in medicine, and helping to plan for radiation emergencies.\n\nKEY TAKEAWAY\n\nLaws limiting the use of one\xe2\x80\x99s property have been around for many years; common-law\nrestraints (e.g., the law of nuisance) exist as causes of action against those who would use\ntheir property to adversely affect the life or health of others or the value of their neighbors\xe2\x80\x99\nproperty. Since the 1960s, extensive federal laws governing the environment have been\nenacted. These include laws governing air, water, chemicals, pesticides, solid waste, and\nnuclear activities. Some laws include criminal penalties for noncompliance.\n\nEXERCISES\n\n1. Who is responsible for funding CERCLA? That is, what is the source of funds for cleanups of\nhazardous waste?\n2. Why is it necessary to have criminal penalties for noncompliance with environmental laws?\n3. What is the role of states in setting standards for clean air and clean water?\n4. Which federal act sets up a \xe2\x80\x9ccradle-to-grave\xe2\x80\x9d system for handling waste?\n5. Why are federal environmental laws necessary? Why not let the states exclusively govern in\nthe area of environmental protection?\n\n[1] 42 United States Code, Section 4321 et seq.\n[2] \xe2\x80\x9cThe Tricks of the Trade-off,\xe2\x80\x9d Business Week, April 4, 1977, 72.\n[3] 33 United States Code, Section 1251.\n[4] Solid Waste Agency of Northern Cook County v. Army Corps of Engineers, 531 U.S. 159 (2001).\n[5] Midlantic National Bank v. New Jersey, 474 U.S. 494 (1986).\n\n11.6 Cases\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n423\n\n\x0cReasonable Use Doctrine\nHoover v. Crane\n362 Mich. 36, 106 N.W.2d 563 (1960)\nEDWARDS, JUSTICE\nThis appeal represents a controversy between plaintiff cottage and resort owners on an inland\nMichigan lake and defendant, a farmer with a fruit orchard, who was using the lake water for\nirrigation. The chancellor who heard the matter ruled that defendant had a right to reasonable\nuse of lake water. The decree defined such reasonable use in terms which were unsatisfactory to\nplaintiffs who have appealed.\nThe testimony taken before the chancellor pertained to the situation at Hutchins Lake, in\nAllegan county, during the summer of 1958. Defendant is a fruit farmer who owns a 180-acre\nfarm abutting on the lake. Hutchins Lake has an area of 350 acres in a normal season. Seventyfive cottages and several farms, including defendant\xe2\x80\x99s, abut on it. Defendant\xe2\x80\x99s frontage is\napproximately 1/4 mile, or about 10% of the frontage of the lake.\nHutchins Lake is spring fed. It has no inlet but does have an outlet which drains south.\nFrequently in the summertime the water level falls so that the flow at the outlet ceases.\nAll witnesses agreed that the summer of 1958 was exceedingly dry and plaintiffs\xe2\x80\x99 witnesses\ntestified that Hutchins Lake\xe2\x80\x99s level was the lowest it had ever been in their memory. Early in\nAugust, defendant began irrigation of his 50-acre pear orchard by pumping water out of\nHutchins Lake. During that month the lake level fell 6 to 8 inches\xe2\x80\x94the water line receded 50 to\n60 feet and cottagers experienced severe difficulties with boating and swimming.\n***\nThe tenor of plaintiffs\xe2\x80\x99 testimony was to attribute the 6- to 8-inch drop in the Hutchins Lake\nlevel in that summer to defendant\xe2\x80\x99s irrigation activities. Defendant contended that the decrease\nwas due to natural causes, that the irrigation was of great benefit to him and contributed only\nslightly to plaintiff\xe2\x80\x99s discomfiture. He suggests to us:\nOne could fairly say that because plaintiffs couldn\xe2\x80\x99t grapple with the unknown causes that\nadmittedly occasioned a greater part of the injury complained of, they chose to grapple mightily\nwith the defendant because he is known and visible.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n424\n\n\x0cThe circuit judge found it impossible to determine a normal lake level from the testimony,\nexcept that the normal summer level of the lake is lower than the level at which the lake ceases\nto drain into the outlet. He apparently felt that plaintiffs\xe2\x80\x99 problems were due much more to the\nabnormal weather conditions of the summer of 1958 than to defendant\xe2\x80\x99s irrigation activities.\nHis opinion concluded:\nAccepting the reasonable use theory advanced by plaintiffs it appears to the court that the most\nequitable disposition of this case would be to allow defendant to use water from the lake until\nsuch time when his use interferes with the normal use of his neighbors. One quarter inch of\nwater from the lake ought not to interfere with the rights and uses of defendant\xe2\x80\x99s neighbors and\nthis quantity of water ought to be sufficient in time of need to service 45 acres of pears. A meter\nat the pump, sealed if need be, ought to be a sufficient safeguard. Pumping should not be\npermitted between the hours of 11 p.m. and 7 a.m. Water need be metered only at such times as\nthere is no drainage into the outlet.\nThe decree in this suit may provide that the case be kept open for the submission of future\npetitions and proofs as the conditions permit or require.\n***\nMichigan has adopted the reasonable-use rule in determining the conflicting rights of riparian\nowners to the use of lake water.\nIn 1874, Justice COOLEY said:\nIt is therefore not a diminution in the quantity of the water alone, or an alteration in its flow, or\neither or both of these circumstances combined with injury, that will give a right of action, if in\nview of all the circumstances, and having regard to equality of right in others, that which has\nbeen done and which causes the injury is not unreasonable. In other words, the injury that is\nincidental to a reasonable enjoyment of the common right can demand no\nredress. Dumont v. Kellogg, 29 Mich 420, 425.\nAnd in People v. Hulbert, the Court said:\nNo statement can be made as to what is such reasonable use which will, without variation or\nqualification, apply to the facts of every case. But in determining whether a use is reasonable we\nmust consider what the use is for; its extent, duration, necessity, and its application; the nature\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n425\n\n\x0cand size of the stream, and the several uses to which it is put; the extent of the injury to the one\nproprietor and of the benefit to the other; and all other facts which may bear upon the\nreasonableness of the use. Red River Roller Millsv. Wright, 30 Minn 249, 15 NW 167, and cases\ncited.\nThe Michigan view is in general accord with 4 Restatement, Torts, \xc2\xa7\xc2\xa7 851\xe2\x80\x93853.\n***\nWe interpret the circuit judge\xe2\x80\x99s decree as affording defendant the total metered equivalent in\npumpage of 1/4 inch of the content of Hutchins Lake to be used in any dry period in between the\ncessation of flow from the outlet and the date when such flow recommences. Where the decree\nalso provides for the case to be kept open for future petitions based on changed conditions, it\nwould seem to afford as much protection for plaintiffs as to the future as this record warrants.\nBoth resort use and agricultural use of the lake are entirely legitimate purposes. Neither serves\nto remove water from the watershed. There is, however, no doubt that the irrigation use does\noccasion some water loss due to increased evaporation and absorption. Indeed, extensive\nirrigation might constitute a threat to the very existence of the lake in which all riparian owners\nhave a stake; and at some point the use of the water which causes loss must yield to the common\ngood.\nThe question on this appeal is, of course, whether the chancellor\xe2\x80\x99s determination of this point\nwas unreasonable as to plaintiffs. On this record, we cannot overrule the circuit judge\xe2\x80\x99s view that\nmost of plaintiffs\xe2\x80\x99 1958 plight was due to natural causes. Nor can we say, if this be the only\nirrigation use intended and the only water diversion sought, that use of the amount provided in\nthe decree during the dry season is unreasonable in respect to other riparian owners.\nAffirmed.\n\nCASE QUESTIONS\n\n1. If the defendant has caused a diminution in water flow, an alteration of the water flow, and\nthe plaintiff is adversely affected, why would the Supreme Court of Michigan not provide\nsome remedy?\n2. Is it possible to define an injury that is \xe2\x80\x9cnot unreasonable\xe2\x80\x9d?\n3. Would the case even have been brought if there had not been a drought?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n426\n\n\x0cCriminal Liability of Employees under RCRA\nU.S. v. Johnson & Towers, Inc., Jack W. Hopkins, and Peter Angel\n741 F.2d 662 (1984)\nSLOVITER, Circuit Judge\nBefore us is the government\xe2\x80\x99s appeal from the dismissal of three counts of an indictment\ncharging unlawful disposal of hazardous wastes under the Resource Conservation and Recovery\nAct. In a question of first impression regarding the statutory definition of \xe2\x80\x9cperson,\xe2\x80\x9d the district\ncourt concluded that the Act\xe2\x80\x99s criminal penalty provision imposing fines and imprisonment\ncould not apply to the individual defendants. We will reverse.\nThe criminal prosecution in this case arose from the disposal of chemicals at a plant owned by\nJohnson & Towers in Mount Laurel, New Jersey. In its operations the company, which repairs\nand overhauls large motor vehicles, uses degreasers and other industrial chemicals that contain\nchemicals such as methylene chloride and trichlorethylene, classified as \xe2\x80\x9chazardous wastes\xe2\x80\x9d\nunder the Resource Conservation and Recovery Act (RCRA), 42 U.S.C. \xc2\xa7\xc2\xa7 6901\xe2\x80\x936987 (1982)\nand \xe2\x80\x9cpollutants\xe2\x80\x9d under the Clean Water Act, 33 U.S.C. \xc2\xa7\xc2\xa7 1251\xe2\x80\x931376 (1982). During the period\nrelevant here, the waste chemicals from cleaning operations were drained into a holding tank\nand, when the tank was full, pumped into a trench. The trench flowed from the plant property\ninto Parker\xe2\x80\x99s Creek, a tributary of the Delaware River. Under RCRA, generators of such wastes\nmust obtain a permit for disposal from the Environmental Protection Agency (E.P.A.). The\nE.P.A. had neither issued nor received an application for a permit for Johnson & Towers\xe2\x80\x99\noperations.\nThe indictment named as defendants Johnson & Towers and two of its employees, Jack\nHopkins, a foreman, and Peter Angel, the service manager in the trucking department.\nAccording to the indictment, over a three-day period federal agents saw workers pump waste\nfrom the tank into the trench, and on the third day observed toxic chemicals flowing into the\ncreek.\nCount 1 of the indictment charged all three defendants with conspiracy under 18 U.S.C. \xc2\xa7 371\n(1982). Counts 2, 3, and 4 alleged violations under the RCRA criminal provision, 42 U.S.C. \xc2\xa7\n6928(d) (1982). Count 5 alleged a violation of the criminal provision of the Clean Water Act, 33\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n427\n\n\x0cU.S.C. \xc2\xa7 1319(c) (1982). Each substantive count also charged the individual defendants as aiders\nand abettors under 18 U.S.C. \xc2\xa7 2 (1982).\nThe counts under RCRA charged that the defendants \xe2\x80\x9cdid knowingly treat, store, and dispose of,\nand did cause to be treated, stored and disposed of hazardous wastes without having obtained a\npermit\xe2\x80\xa6in that the defendants discharged, deposited, injected, dumped, spilled, leaked and\nplaced degreasers\xe2\x80\xa6into the trench.\xe2\x80\xa6\xe2\x80\x9d The indictment alleged that both Angel and Hopkins\n\xe2\x80\x9cmanaged, supervised and directed a substantial portion of Johnson & Towers\xe2\x80\x99\noperations\xe2\x80\xa6including those related to the treatment, storage and disposal of the hazardous\nwastes and pollutants\xe2\x80\x9d and that the chemicals were discharged by \xe2\x80\x9cthe defendants and others at\ntheir direction.\xe2\x80\x9d The indictment did not otherwise detail Hopkins\xe2\x80\x99 and Angel\xe2\x80\x99s activities or\nresponsibilities.\nJohnson & Towers pled guilty to the RCRA counts. Hopkins and Angel pled not guilty, and then\nmoved to dismiss counts 2, 3, and 4. The court concluded that the RCRA criminal provision\napplies only to \xe2\x80\x9cowners and operators,\xe2\x80\x9d i.e., those obligated under the statute to obtain a permit.\nSince neither Hopkins nor Angel was an \xe2\x80\x9cowner\xe2\x80\x9d or \xe2\x80\x9coperator,\xe2\x80\x9d the district court granted the\nmotion as to the RCRA charges but held that the individuals could be liable on these three\ncounts under 18 U.S.C. \xc2\xa7 2 for aiding and abetting. The court denied the government\xe2\x80\x99s motion\nfor reconsideration, and the government appealed to this court under 18 U.S.C. \xc2\xa7 3731 (1982).\n***\nThe single issue in this appeal is whether the individual defendants are subject to prosecution\nunder RCRA\xe2\x80\x99s criminal provision, which applies to:\nany person who\xe2\x80\x94\n.\xe2\x80\xa6\n(2) knowingly treats, stores, or disposes of any hazardous waste identified or listed under this\nsubchapter either\xe2\x80\x94\n(A) without having obtained a permit under section 6925 of this title\xe2\x80\xa6or\n(B) in knowing violation of any material condition or requirement of such permit.\n42 U.S.C. \xc2\xa7 6928(d) (emphasis added). The permit provision in section 6925, referred to in\nsection 6928(d), requires \xe2\x80\x9ceach person owning or operating a facility for the treatment, storage,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n428\n\n\x0cor disposal of hazardous waste identified or listed under this subchapter to have a permit\xe2\x80\x9d from\nthe E.P.A.\nThe parties offer contrary interpretations of section 6928(d)(2)(A). Defendants consider it an\nadministrative enforcement mechanism, applying only to those who come within section 6925\nand fail to comply; the government reads it as penalizing anyone who handles hazardous waste\nwithout a permit or in violation of a permit. Neither party has cited another case, nor have we\nfound one, considering the application of this criminal provision to an individual other than an\nowner or operator.\nAs in any statutory analysis, we are obliged first to look to the language and then, if needed,\nattempt to divine Congress\xe2\x80\x99 specific intent with respect to the issue.\nFirst, \xe2\x80\x9cperson\xe2\x80\x9d is defined in the statute as \xe2\x80\x9can individual, trust, firm, joint stock company,\ncorporation (including a government corporation), partnership, association, State, municipality,\ncommission, political subdivision of a State, or any interstate body.\xe2\x80\x9d 42 U.S.C. \xc2\xa7 6903(15)\n(1982). Had Congress meant in section 6928(d)(2)(A) to take aim more narrowly, it could have\nused more narrow language. Since it did not, we attribute to \xe2\x80\x9cany person\xe2\x80\x9d the definition given\nthe term in section 6903(15).\nSecond, under the plain language of the statute the only explicit basis for exoneration is the\nexistence of a permit covering the action. Nothing in the language of the statute suggests that we\nshould infer another provision exonerating persons who knowingly treat, store or dispose of\nhazardous waste but are not owners or operators.\nFinally, though the result may appear harsh, it is well established that criminal penalties\nattached to regulatory statutes intended to protect public health, in contrast to statutes based on\ncommon law crimes, are to be construed to effectuate the regulatory purpose.\n***\nCongress enacted RCRA in 1976 as a \xe2\x80\x9ccradle-to-grave\xe2\x80\x9d regulatory scheme for toxic materials,\nproviding \xe2\x80\x9cnationwide protection against the dangers of improper hazardous waste disposal.\xe2\x80\x9d\nH.R. Rep. No. 1491, 94th Cong., 2d Sess. 11, reprinted in 1976 U.S. Code Cong. & Ad. News\n6238, 6249. RCRA was enacted to provide \xe2\x80\x9ca multifaceted approach toward solving the\nproblems associated with the 3\xe2\x80\x934 billion tons of discarded materials generated each year, and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n429\n\n\x0cthe problems resulting from the anticipated 8% annual increase in the volume of such\nwaste.\xe2\x80\x9d Id. at 2, 1976 U.S. Code Cong. & Ad. News at 6239. The committee reports\naccompanying legislative consideration of RCRA contain numerous statements evincing the\nCongressional view that improper disposal of toxic materials was a serious national problem.\nThe original statute made knowing disposal (but not treatment or storage) of such waste without\na permit a misdemeanor. Amendments in 1978 and 1980 expanded the criminal provision to\ncover treatment and storage and made violation of section 6928 a felony. The fact that Congress\namended the statute twice to broaden the scope of its substantive provisions and enhance the\npenalty is a strong indication of Congress\xe2\x80\x99 increasing concern about the seriousness of the\nprohibited conduct.\nWe conclude that in RCRA, no less than in the Food and Drugs Act, Congress endeavored to\ncontrol hazards that, \xe2\x80\x9cin the circumstances of modern industrialism, are largely beyond selfprotection.\xe2\x80\x9d United States v. Dotterweich, 320 U.S. at 280. It would undercut the purposes of\nthe legislation to limit the class of potential defendants to owners and operators when others\nalso bear responsibility for handling regulated materials. The phrase \xe2\x80\x9cwithout having obtained a\npermit under section 6925\xe2\x80\x9d (emphasis added) merely references the section under which the\npermit is required and exempts from prosecution under section 6928(d)(2)(A) anyone who has\nobtained a permit; we conclude that it has no other limiting effect. Therefore we reject the\ndistrict court\xe2\x80\x99s construction limiting the substantive criminal provision by confining \xe2\x80\x9cany\nperson\xe2\x80\x9d in section 6928(d)(2)(A) to owners and operators of facilities that store, treat or dispose\nof hazardous waste, as an unduly narrow view of both the statutory language and the\ncongressional intent.\n\nCASE QUESTIONS\n\n1. The district court (trial court) accepted the individual defendants\xe2\x80\x99 argument. What was that\nargument?\n2. On what reasoning did the appellate court reject that argument?\n3. If employees of a company that is violating the RCRA carry out disposal of hazardous\nsubstances in violation of the RCRA, they would presumably lose their jobs if they didn\xe2\x80\x99t.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n430\n\n\x0cWhat is the moral justification for applying criminal penalties to such employees (such as\nHopkins and Angel)?\n\n11.7 Summary and Exercises\nSummary\n\nAn estate is an interest in real property; it is the degree to which a thing is owned. Freehold\nestates are those with an uncertain duration; leaseholds are estates due to expire at a definite\ntime. A present estate is one that is currently owned; a future estate is one that is owned now but\nnot yet available for use.\nPresent estates are (1) the fee simple absolute; (2) the fee simple defeasible, which itself may be\ndivided into three types, and (3) the life estate.\nFuture estates are generally of two types: reversion and remainder. A reversion arises whenever\na transferred estate will endure for a shorter time than that originally owned by the transferor. A\nremainder interest arises when the transferor gives the reversion interest to someone else.\nUse of air, earth, and water are the major rights incident to ownership of real property.\nTraditionally, the owner held \xe2\x80\x9cup to the sky\xe2\x80\x9d and \xe2\x80\x9cdown to the depths,\xe2\x80\x9d but these rules have\nbeen modified to balance competing rights in a modern economy. The law governing water\nrights varies with the states; in general, the eastern states with more plentiful water have\nadopted either the natural flow doctrine or the reasonable use doctrine of riparian rights, giving\nthose who live along a waterway certain rights to use the water. By contrast, western states have\ntended to apply the prior appropriation doctrine, which holds that first in time is first in right,\neven if those downstream are disadvantaged.\nAn easement is an interest in land\xe2\x80\x94created by express agreement, prior use, or necessity\xe2\x80\x94that\npermits one person to make use of another\xe2\x80\x99s estate. An affirmative easement gives one person\nthe right to use another\xe2\x80\x99s land; a negative easement prevents the owner from using his land in a\nway that will affect another person\xe2\x80\x99s land. In understanding easement law, the important\ndistinctions are between easements appurtenant and in gross, and between dominant and\nservient owners.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n431\n\n\x0cThe law not only defines the nature of the property interest but also regulates land use. Tort law\nregulates land use by imposing liability for (1) activities that affect those off the land and (2)\ninjuries caused to people who enter it. The two most important theories relating to the former\nare nuisance and trespass. With respect to the latter, the common law confusingly distinguishes\namong trespassers, licensees, and invitees. Some states are moving away from the perplexing\nand rigid rules of the past and simply require owners to maintain their property in a reasonably\nsafe condition.\nLand use may also be regulated by private agreement through the restrictive covenant, an\nagreement that \xe2\x80\x9cruns with the land\xe2\x80\x9d and that will be binding on any subsequent owner. Land use\nis also regulated by the government\xe2\x80\x99s power under eminent domain to take private land for\npublic purposes (upon payment of just compensation), through zoning laws, and through\nrecently enacted environmental statutes, including the National Environmental Policy Act and\nlaws governing air, water, treatment of hazardous wastes, and chemicals.\n\nEXERCISES\n\n1. Dorothy deeded an acre of real estate that she owns to George for the life of Benny and then\nto Ernie. Describe the property interests of George, Benny, Ernie, and Dorothy.\n2. In Exercise 1, assume that George moves into a house on the property. During a tornado, the\nroof is destroyed and a window is smashed. Who is responsible for repairing the roof and\nwindow? Why?\n3. Dennis likes to spend his weekends in his backyard, shooting his rifle across his neighbor\xe2\x80\x99s\nyard. If Dennis never sets foot on his neighbor\xe2\x80\x99s property, and if the bullets strike neither\npersons nor property, has he violated the legal rights of the neighbor? Explain.\n4. Dennis also drills an oil well in his backyard. He \xe2\x80\x9cslant drills\xe2\x80\x9d the well; that is, the well slants\nfrom a point on the surface in his yard to a point four hundred feet beneath the surface of his\nneighbor\xe2\x80\x99s yard. Dennis has slanted the drilling in order to capture his neighbor\xe2\x80\x99s oil. Can he\ndo this legally? Explain.\n5. Wanda is in charge of acquisitions for her company. Realizing that water is important to\ncompany operations, Wanda buys a plant site on a river, and the company builds a plant that\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n432\n\n\x0cuses all of the river water. Downstream owners bring suit to stop the company from using\nany water. What is the result? Why?\n6. Sunny decides to build a solar home. Before beginning construction, she wants to establish\nthe legal right to prevent her neighbors from constructing buildings that will block the\nsunlight. She has heard that the law distinguishes between licenses and easements,\neasements appurtenant and in gross, and affirmative and negative easements. Which of\nthese interests would you recommend for Sunny? Why?\n\nSELF-TEST QUESTIONS\n\n1. A freehold estate is defined as an estate\na.\n\nwith an uncertain duration\nb. due to expire at a definite time\nc. owned now but not yet available for use\nd. that is leased or rented\nA fee simple defeasible is a type of\n\na.\n\npresent estate\nb. future estate\nc. life estate\nd. leasehold estate\nA reversion is\n\na.\n\na present estate that prevents transfer of land out of the family\nb. a form of life estate\nc. a future estate that arises when the estate transferred has a duration less than\nthat originally owned by the transferor\nd. identical to a remainder interest\nAn easement is an interest in land that may be created by\na.\n\nexpress agreement\n\nb. prior use\nc. necessity\nd. all of the above\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n433\n\n\x0cThe prior appropriation doctrine\na.\n\ntends to be applied by eastern states\n\nb. holds that first in time is first in right\nc. gives those that live along a waterway special rights to use the water\nd. all of the above\n\nSELF-TEST ANSWERS\n\n1. a\n2. a\n3. c\n4. d\n5. b\n\nChapter 12\nThe Transfer of Real Estate by Sale\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. The various forms of real estate ownership, including fee simple, tenancy in common, and\njoint tenancy\n2. The mechanics of finding, financing, and closing a real estate transaction\n3. How adverse possession may sometimes vest title in real property despite the nonconsent of\nthe owner\nThis chapter follows the steps taken when real estate is transferred by sale.\n1. The buyer selects a form of ownership.\n2. The buyer searches for the real estate to be purchased. In doing so, the buyer will usually deal\nwith real estate brokers.\n3. After a parcel is selected, the seller and buyer will negotiate and sign a sales agreement.\n4. The seller will normally be required to provide proof of title.\n5. The buyer will acquire property insurance.\n6. The buyer will arrange financing.\n7. The sale and purchase will be completed at a closing.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n434\n\n\x0cDuring this process, the buyer and seller enter into a series of contracts with each other and with\nthird parties such as brokers, lenders, and insurance companies. In this chapter, we focus on the\nunique features of these contracts, with the exception of mortgages (Chapter 17 "Mortgages and\nNonconsensual Liens") and property insurance (Chapter 15 "Insurance"). We conclude by briefly\nexamining adverse possession\xe2\x80\x94a method of acquiring property for free.\n\n12.1 Forms of Ownership\n\nLEARNING OBJECTIVES\n\n1. Be familiar with the various kinds of interest in real property.\n2. Know the ways that two or more people can own property together.\n3. Understand the effect of marriage, divorce, and death on various forms of property\nownership.\n\nOverview\nThe transfer of property begins with the buyer\xe2\x80\x99s selection of a form of ownership. Our emphasis\nhere is not on what is being acquired (the type of property interest) but on how the property is\nowned.\nOne form of ownership of real property is legally quite simple, although lawyers refer to it with a\ncomplicated-sounding name. This is ownership by one individual, known as ownership\nin severalty. In purchasing real estate, however, buyers frequently complicate matters by\ngrouping together\xe2\x80\x94because of marriage, close friendship, or simply in order to finance the\npurchase more easily\nWhen purchasers group together for investment purposes, they often use various forms of\norganization\xe2\x80\x94corporations, partnerships, limited partnerships, joint ventures, and business\ntrusts. The most popular of these forms of organization for owning real estate is the limited\npartnership. A real estate limited partnership is designed to allow investors to take substantial\ndeductions that offset current income from the partnership and other similar investments, while\nat the same time protecting the investor from personal liability if the venture fails.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n435\n\n\x0cBut you do not have to form a limited partnership or other type of business in order to acquire\nproperty with others; many other forms are available for personal or investment purposes. To\nthese we now turn.\n\nJoint Tenancy\nJoint tenancy is an estate in land owned by two or more persons. It is distinguished chiefly by\nthe right of survivorship. If two people own land as joint tenants, then either becomes the sole\nowner when the other dies. For land to be owned jointly, four unities must coexist:\n1. Unity of time. The interests of the joint owners must begin at the same time.\n2. Unity of title. The joint tenants must acquire their title in the same conveyance\xe2\x80\x94that is, the\nsame will or deed.\n3. Unity of interest. Each owner must have the same interest in the property; for example, one may\nnot hold a life estate and the other the remainder interest.\n4. Unity of possession. All parties must have an equal right to possession of the property\n(see Figure 12.1 "Forms of Ownership and Unities").\n\nFigure 12.1 Forms of Ownership and Unities\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n436\n\n\x0cSuppose a woman owns some property and upon marriage wishes to own it jointly with her\nhusband. She deeds it to herself and her husband \xe2\x80\x9cas joint tenants and not tenants in common.\xe2\x80\x9d\nStrictly speaking, the common law would deny that the resulting form of ownership was joint\nbecause the unities of title and time were missing. The wife owned the property first and\noriginally acquired title under a different conveyance. But the modern view in most states is that\nan owner may convey directly to herself and another in order to create a joint estate.\nWhen one or more of the unities is destroyed, however, the joint tenancy lapses. Fritz and Gary\nown a farm as joint tenants. Fritz decides to sell his interest to Jesse (or, because Fritz has gone\nbankrupt, the sheriff auctions off his interest at a foreclosure sale). Jesse and Gary would hold as\ntenants in common and not as joint tenants. Suppose Fritz had made out his will, leaving his\ninterest in the farm to Reuben. On Fritz\xe2\x80\x99s death, would the unities be destroyed, leaving Gary\nand Reuben as tenants in common? No, because Gary, as joint tenant, would own the entire\nfarm on Fritz\xe2\x80\x99s death, leaving nothing behind for Reuben to inherit.\n\nTenancy by the Entirety\nAbout half the states permit husbands and wives to hold property astenants by the entirety. This\nform of ownership is similar to joint tenancy, except that it is restricted to husbands and wives.\nThis is sometimes described as the unity of person. In most of the states permitting tenancy by\nthe entirety, acquisition by husband and wife of property as joint tenants automatically becomes\na tenancy by the entirety. The fundamental importance of tenancy by the entirety is that neither\nspouse individually can terminate it; only a joint decision to do so will be effective. One spouse\nalone cannot sell or lease an interest in such property without consent of the other, and in many\nstates a creditor of one spouse cannot seize the individual\xe2\x80\x99s separate interest in the property,\nbecause the interest is indivisible.\n\nTenancy in Common\nTwo or more people can hold property as tenants in common when the unity of possession is\npresent, that is, when each is entitled to occupy the property. None of the other unities\xe2\x80\x94of time,\ntitle, or interest\xe2\x80\x94is necessary, though their existence does not impair the common ownership.\nNote that the tenants in common do not own a specific portion of the real estate; each has an\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n437\n\n\x0cundivided share in the whole, and each is entitled to occupy the whole estate. One tenant in\ncommon may sell, lease, or mortgage his undivided interest. When a tenant in common dies, his\ninterest in the property passes to his heirs, not to the surviving tenants in common.\nBecause tenancy in common does not require a unity of interest, it has become a popular form of\n\xe2\x80\x9cmingling,\xe2\x80\x9d by which unrelated people pool their resources to purchase a home. If they were\njoint tenants, each would be entitled to an equal share in the home, regardless of how much each\ncontributed, and the survivor would become sole owner when the other owner dies. But with a\ntenancy-in-common arrangement, each can own a share in proportion to the amount invested.\n\nCommunity Property\nIn ten states\xe2\x80\x94Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,\nWashington, and Wisconsin\xe2\x80\x94property acquired during a marriage is said to\nbecommunity property. There are differences among these states, but the general theory is that\nwith certain exceptions, each spouse has an undivided equal interest in property acquired while\nthe husband and wife are married to each other. The major exception is for property acquired by\ngift or inheritance during the marriage. (By definition, property owned by either spouse before\nthe marriage is not community property.) Property acquired by gift of inheritance or owned\nbefore the marriage is known as separate property. Community property states recognize other\nforms of ownership; specifically, husbands and wives may hold property as joint tenants,\npermitting the survivor to own the whole.\nThe consequence of community property laws is that either the husband or the wife may manage\nthe community property, borrow against it, and dispose of community personal property.\nCommunity real estate may only be sold or encumbered by both jointly. Each spouse may\nbequeath only half the community property in his or her will. In the absence of a will, the onehalf property interest will pass in accordance with the laws of intestate succession. If the couple\ndivorces, the states generally provide for an equal or near-equal division of the community\nproperty, although a few permit the court in its discretion to divide in a different proportion.\n\nCondominiums\nIn popular parlance, a condominium is a kind of apartment building, but that is not its technical\nlegal meaning. Condominium is a form of ownership, not a form of structure, and it can even\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n438\n\n\x0capply to space\xe2\x80\x94for example, to parking spaces in a garage. The wordcondominium means joint\nownership or control, and it has long been used whenever land has been particularly scarce or\nexpensive. Condominiums were popular in ancient Rome (especially near the Forum) and in the\nwalled cities of medieval Europe.\nIn its modern usage, condominium refers to a form of housing involving two elements of\nownership. The first is the living space itself, which may be held in common, in joint tenancy, or\nin any other form of ownership. The second is the common space in the building, including the\nroof, land under the structure, hallways, swimming pool, and the like. The common space is held\nby all purchasers as tenants in common. The living space may not be sold apart from the interest\nin the common space.\nTwo documents are necessary in a condominium sale\xe2\x80\x94the master deed and the bylaws. The\nmaster deed (1) describes the condominium units, the common areas, and any restrictions that\napply to them; (2) establishes the unit owner\xe2\x80\x99s interest in the common area, his number of votes\nat owners\xe2\x80\x99 association meetings, and his share of maintenance and operating expenses\n(sometimes unit owners have equal shares, and sometimes their share is determined by\ncomputing the ratio of living area or market price or original price of a single unit to the whole);\nand (3) creates a board of directors to administer the affairs of the whole condominium. The\nbylaws usually establish the owners\xe2\x80\x99 association, set out voting procedures, list the powers and\nduties of the officers, and state the obligations of the owners for the use of the units and the\ncommon areas.\n\nCooperatives\nAnother popular form of owning living quarters with common areas is the cooperative. Unlike\nthe person who lives in a condominium, the tenant of a cooperative does not own a particular\nunit. Instead, he owns a share of the entire building. Since the building is usually owned by a\ncorporation (a cooperative corporation, hence the name), this means that the tenant owns stock\nin the corporation. A tenant occupies a unit under a lease from the corporation. Together, the\nlease and stock in the building corporation are considered personal, not real, property.\nIn a condominium, an owner of a unit who defaults in paying monthly mortgage bills can face\nforeclosure on the unit, but neighbors in the building suffer no direct financial impact, except\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n439\n\n\x0cthat the defaulter probably has not paid monthly maintenance charges either. In a cooperative,\nhowever, a tenant who fails to pay monthly charges can jeopardize the entire building, because\nthe mortgage is on the building as a whole; consequently, the others will be required to make\ngood the payments or face foreclosure.\n\nTime-Shares\nA time-share is an arrangement by which several people can own the same property while being\nentitled to occupy the premises exclusively at different times on a recurring basis. In the typical\nvacation property, each owner has the exclusive right to use the apartment unit or cottage for a\nspecified period of time each year\xe2\x80\x94for example, Mr. and Mrs. Smith may have possession from\nDecember 15 through December 22, Mr. and Mrs. Jones from December 23 through December\n30, and so on. The property is usually owned as a condominium but need not be. The sharers\nmay own the property in fee simple, hold a joint lease, or even belong to a vacation club that\nsells time in the unit.\nTime-share resorts have become popular in recent years. But the lure of big money has brought\nunscrupulous contractors and salespersons into the market. Sales practices can be unusually\ncoercive, and as a result, most states have sets of laws specifically to regulate time-share sales.\nAlmost all states provide a cooling-off period, or rescission period; these periods vary from state\nto state and provide a window where buyers can change their minds without forfeiting payments\nor deposits already made.\n\nKEY TAKEAWAY\n\nProperty is sometimes owned by one person or one entity, but more often two or more\npersons will share in the ownership. Various forms of joint ownership are possible, including\njoint tenancies, tenancy by the entirety, and tenancy in common. Married persons should be\naware of whether the state they live in is a community property state; if it is, the spouse will\ntake some interest in any property acquired during the marriage. Beyond traditional\nlandholdings, modern real estate ownership may include interests in condominiums,\ncooperatives, or time-shares.\n\nEXERCISES\n\n1. Miguel and Maria Ramirez own property in Albuquerque, New Mexico, as tenants by the\nentirety. Miguel is a named defendant in a lawsuit that alleges defamation, and an award is\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n440\n\n\x0cmade for $245,000 against Miguel. The property he owns with Maria is worth $320,000 and\nis owned free of any mortgage interest. To what extent can the successful plaintiff recover\ndamages by forcing a sale of the property?\n2. Miguel and Maria Ramirez own property in Albuquerque, New Mexico, as tenants by the\nentirety. They divorce. At the time of the divorce, there are no new deeds signed or\nrecorded. Are they now tenants in common or joint tenants?\n\n12.2 Brokers, Contracts, Proof of Title, and Closing\nLEARNING OBJECTIVES\n\n1. Know the duties of the real estate broker and how brokers are licensed.\n2. Be able to discuss the impact of constitutonal and statutory law on real estate sellers and\nbrokers.\n3. Describe the various kinds of listing contracts and their import.\n4. Know the elements of a sales agreement and the various types of deeds to real estate.\n5. Understand the closing process and how \xe2\x80\x9cgood title\xe2\x80\x9d is obtained through the title search and\ninsurance process.\nOnce the buyer (or buyers) knows what form of ownership is most desirable, the search for a\nsuitable property can begin. This search often involves contact with a broker hired by the seller.\nThe seller\xe2\x80\x99s contract with the broker, known as the listing agreement, is the first of the series of\ncontracts in a typical real estate transaction. As you consider these contracts, it is important to\nkeep in mind that despite the size of the transaction and the dire financial consequences should\nanything go awry, the typical person (buyer or seller) usually acts as his or her own attorney. An\nAmerican Bar Association committee has noted the following:\nIt is probably safe to say that in a high percentage of cases the seller is unrepresented and signs\nthe contracts of brokerage and sale on the basis of his faith in the broker. The buyer does not\nemploy a lawyer. He signs the contract of sale without reading it and, once financing has been\nobtained, leaves all the details of title search and closing to the lender or broker. The lender or\nbroker may employ an attorney but, where title insurance is furnished by a company\nmaintaining its own title plant, it is possible that no lawyer, not even house counsel, will appear.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n441\n\n\x0cThis being so, the material that follows is especially important for buyers and sellers who are not\nrepresented in the process of buying or selling real estate.\n\nRegulation of the Real Estate Business\nState Licensing\nReal estate brokers, and the search for real estate generally, are subject to state and federal\ngovernment regulation. Every state requires real estate brokers to be licensed. To obtain a\nlicense, the broker must pass an examination covering the principles of real estate practice,\ntransactions, and instruments. Many states additionally insist that the broker take several\ncourses in finance, appraisal, law, and real estate practice and apprentice for two years as a\nsalesperson in a real estate broker\xe2\x80\x99s office.\n\nCivil Rights Act\nTwo federal civil rights laws also play an important role in the modern real estate transaction.\nThese are the Civil Rights Act of 1866 and the Civil Rights Act of 1968 (Fair Housing Act).\nIn Jones v. Alfred H. Mayer Co., [1] the Supreme Court upheld the constitutionality of the 1866\nlaw, which expressly gives all citizens of the United States the same rights to inherit, purchase,\nlease, sell, hold, and convey real and personal property. A minority buyer or renter who is\ndiscriminated against may sue for relief in federal court, which may award damages, stop the\nsale of the house, or even direct the seller to convey the property to the plaintiff.\nThe 1968 Fair Housing Act prohibits discrimination on the grounds of race, color, religion, sex,\nnational origin, handicap, or family status (i.e., no discrimination against families with children)\nby any one of several means, including the following:\n1. Refusing to sell or rent to or negotiate with any person\n2. Discriminating in the terms of sale or renting\n3. Discriminating in advertising\n4. Denying that the housing is available when in fact it is\n5. \xe2\x80\x9cBlockbusting\xe2\x80\x9d (panicking owners into selling or renting by telling them that minority groups\nare moving into the neighborhood)\n6. Creating different terms for granting or denying home loans by commercial lenders\n7. Denying anyone the use of real estate services\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n442\n\n\x0cHowever, the 1968 act contains several exemptions:\n1. Sale or rental of a single-family house if the seller\na.\n\nowns less than four such houses,\n\nb. does not use a broker,\nc. does not use discriminatory advertising,\nd. within two years sells no more than one house in which the seller was not the most recent\noccupant.\ne. Rentals in a building occupied by the owner as long as it houses fewer than five families and the\nowner did not use discriminatory advertising\nf.\n\nSale or rental of space in buildings or land restricted by religious organization owners to people\nof the same religion (assuming that the religion does not discriminate on the basis of race, color,\nor national origin)\n\ng. Private clubs, if they limit their noncommercial rentals to members\nThe net impact of these laws is that discrimination based on color or race is flatly prohibited and\nthat other types of discrimination are also barred unless one of the enumerated exemptions\napplies.\n\nHiring the Broker: The Listing Agreement\nWhen the seller hires a real estate broker, he will sign a listing agreement. (In several states, the\nStatute of Frauds says that the seller must sign a written agreement; however, he should do so in\nall states in order to provide evidence in the event of a later dispute.) This listing agreement sets\nforth the broker\xe2\x80\x99s commission, her duties, the length of time she will serve as broker, and other\nterms of her agency relationship. Whether the seller will owe a commission if he or someone\nother than the broker finds a buyer depends on which of three types of listing agreements has\nbeen signed.\n\nExclusive Right to Sell\nIf the seller agrees to an exclusive-right-to-sell agency, he will owe the broker the stated\ncommission regardless of who finds the buyer. Language such as the following gives the broker\nan exclusive right to sell: \xe2\x80\x9cShould the seller or anyone acting for the seller (including his heirs)\nsell, lease, transfer, or otherwise dispose of the property within the time fixed for the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n443\n\n\x0ccontinuance of the agency, the broker shall be entitled nevertheless to the commission as set out\nherein.\xe2\x80\x9d\n\nExclusive Agency\nSomewhat less onerous from the seller\xe2\x80\x99s perspective (and less generous from the broker\xe2\x80\x99s\nperspective) is the exclusive agency. The broker has the exclusive right to sell and will be entitled\nto the commission if anyone other than the seller finds the buyer (i.e., the seller will owe no\ncommission if he finds a buyer). Here is language that creates an exclusive agency: \xe2\x80\x9cA\ncommission is to be paid the broker whether the purchaser is secured by the broker or by any\nperson other than the seller.\xe2\x80\x9d\n\nOpen Listing\nThe third type of listing, relatively rarely used, is the open listing, which authorizes \xe2\x80\x9cthe broker\nto act as agent in securing a purchaser for my property.\xe2\x80\x9d The open listing calls for payment to\nthe broker only if the broker was instrumental in finding the buyer; the broker is not entitled to\nher commission if anyone else, seller or otherwise, locates the buyer.\nSuppose the broker finds a buyer, but the seller refuses at that point to sell. May the seller\nsimply change his mind and avoid having to pay the broker\xe2\x80\x99s commission? The usual rule is that\nwhen a broker finds a buyer who is \xe2\x80\x9cready, willing, and able\xe2\x80\x9d to purchase or lease the property,\nshe has earned her commission. Many courts have interpreted this to mean that even if the\nbuyers are unable to obtain financing, the commission is owed nevertheless once the prospective\nbuyers have signed a purchase agreement. To avoid this result, the seller should insist on either\na \xe2\x80\x9cno deal, no commission\xe2\x80\x9d clause in the listing agreement (entitling the broker to payment only\nif the sale is actually consummated) or a clause in the purchase agreement making the purchase\nitself contingent on the buyer\xe2\x80\x99s finding financing.\n\nBroker\xe2\x80\x99s Duties\nOnce the listing agreement has been signed, the broker becomes the seller\xe2\x80\x99s agent\xe2\x80\x94or, as\noccasionally happens, the buyer\xe2\x80\x99s agent, if hired by the buyer. A broker is not a general agent\nwith broad authority. Rather, a broker is a special agent with authority only to show the property\nto potential buyers. Unless expressly authorized, a broker may not accept money on behalf of the\nseller from a prospective buyer. Suppose Eunice hires Pete\xe2\x80\x99s Realty to sell her house. They sign a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n444\n\n\x0cstandard exclusive agency listing, and Pete cajoles Frank into buying the house. Frank writes out\na check for $10,000 as a down payment and offers it to Pete, who absconds with the money.\nWho must bear the loss? Ordinarily, Frank would have to bear the loss, because Pete was given\nno authority to accept money. If the listing agreement explicitly said that Pete could accept the\ndown payment from a buyer, then the loss would fall on Eunice.\nAlthough the broker is but a special agent, she owes the seller, her principal, afiduciary duty. A\nfiduciary duty is a duty of the highest loyalty and trust. It means that the broker cannot buy the\nproperty for herself through an intermediary without full disclosure to the seller of her\nintentions. Nor may the broker secretly receive a commission from the buyer or suggest to a\nprospective buyer that the property can be purchased for less than the asking price.\n\nThe Sales Agreement\nOnce the buyer has selected the real estate to be acquired, an agreement of sale will be\nnegotiated and signed. Contract law in general is discussed in Chapter 8 "Contracts"; our\ndiscussion here will focus on specific aspects of the real estate contract. The Statute of Frauds\nrequires that contracts for sale of real estate must be in writing. The writing must contain\ncertain information.\n\nNames of Buyers and Sellers\nThe agreement must contain the names of the buyers and sellers. As long as the parties sign the\nagreement, however, it is not necessary for the names of buyers and sellers to be included within\nthe body of the agreement.\n\nReal Estate Description\nThe property must be described sufficiently for a court to identify the property without having to\nlook for evidence outside the agreement. The proper address, including street, city, and state, is\nusually sufficient.\n\nPrice\nThe price terms must be clear enough for a court to enforce. A specific cash price is always clear\nenough. But a problem can arise when installment payments are to be made. To say \xe2\x80\x9c$50,000,\npayable monthly for fifteen years at 12 percent\xe2\x80\x9d is not sufficiently detailed, because it is\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n445\n\n\x0cimpossible to determine whether the installments are to be equal each month or are to be equal\nprincipal payments with varying interest payments, declining monthly as the balance decreases.\n\nSignature\nAs a matter of prudence, both buyer and seller should sign the purchase agreement. However,\nthe Statute of Frauds requires only the signature of the party against whom the agreement is to\nbe enforced. So if the seller has signed the agreement, he cannot avoid the agreement on the\ngrounds that the buyer has not signed it. However, if the buyer, not having signed, refuses to go\nto closing and take title, the seller would be unable to enforce the agreement against him.\n\nEasements and Restrictive Covenants\nUnless the contract specifically states otherwise, the seller must delivermarketable title. A\nmarketable title is one that is clear of restrictions to which a reasonable buyer would object.\nMost buyers would refuse to close the deal if there were potential third-party claims to all or part\nof the title. But a buyer would be unreasonable if, at closing, he refused to consummate the\ntransaction on the basis that there were utility easements for the power company or a known\nand visible driveway easement that served the neighboring property. As a precaution, a seller\nmust be sure to say in the contract for sale that the property is being sold \xe2\x80\x9csubject to easements\nand restrictions of record.\xe2\x80\x9d A buyer who sees only such language should insist that the particular\neasements and restrictive covenants be spelled out in the agreement before he signs.\n\nRisk of Loss\nSuppose the house burns down after the contract is signed but before the closing. Who bears the\nloss? Once the contract is signed, most states apply the rule of equitable conversion, under\nwhich the buyer\xe2\x80\x99s interest (his executory right to enforce the contract to take title to the\nproperty) is regarded as real property, and the seller\xe2\x80\x99s interest is regarded as personal property.\nThe rule of equitable conversion stems from an old maxim of the equity courts: \xe2\x80\x9cThat which\nought to be done is regarded as done.\xe2\x80\x9d That is, the buyer ought to have the property and the\nseller ought to have the money. A practical consequence of this rule is that the loss of the\nproperty falls on the buyer. Because most buyers do not purchase insurance until they take title,\neleven states have adopted the Uniform Vendor and Purchaser Risk Act, which reverses the\nequitable conversion rule and places risk of loss on the seller. The parties may themselves\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n446\n\n\x0creverse the application of the rule; the buyer should always insist on a clause in a contract\nstating that risk of loss remains with the seller until a specified date, such as the closing.\n\nEarnest Money\nAs protection against the buyer\xe2\x80\x99s default, the seller usually insists on a down payment known as\nearnest money. This is intended to cover such immediate expenses as proof of marketable title\nand the broker\xe2\x80\x99s commission. If the buyer defaults, he forfeits the earnest money, even if the\ncontract does not explicitly say so.\n\nContingencies\nPerformance of most real estate contracts is subject to various contingencies\xe2\x80\x94that is, it is\nconditioned on the happening of certain events. For example, the buyer might wish to condition\nhis agreement to buy the house on his ability to find a mortgage or to find one at a certain rate of\ninterest. Thus the contract for sale might read that the buyer \xe2\x80\x9cagrees to buy the premises for\n$50,000, subject to his obtaining a $40,000 mortgage at 5 percent.\xe2\x80\x9d The person protected by\nthe contingency may waive it; if the lowest interest rate the buyer could find was 5.5 percent, he\ncould either refuse to buy the house or waive the condition and buy it anyway.\n\nTimes for Performance\nA frequent difficulty in contracting to purchase real estate is the length of time it takes to receive\nan acceptance to an offer. If the acceptance is not received in a reasonable time, the offeror may\ntreat the offer as rejected. To avoid the uncertainty, an offeror should always state in his offer\nthat it will be held open for a definite period of time (five working days, two weeks, or whatever).\nThe contract also ought to spell out the times by which the following should be done: (1) seller\xe2\x80\x99s\nproof that he has title, (2) buyer\xe2\x80\x99s review of the evidence of title, (3) seller\xe2\x80\x99s correction of title\ndefects, (4) closing date, and (5) possession by the buyer. The absence of explicit time provisions\nwill not render the contract unenforceable\xe2\x80\x94the courts will infer a reasonable time\xe2\x80\x94but their\nabsence creates the possibility of unnecessary disputes.\n\nTypes of Deeds\nMost real estate transactions involve two kinds of deeds, the general warranty deed and the\nquitclaim deed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n447\n\n\x0c1. General warranty deed. In a warranty deed, the seller warrants to the buyer that he\npossesses certain types of legal rights in the property. In thegeneral warranty deed, the seller\nwarrants that (a) he has good title to convey, (b) the property is free from any encumbrance not\nstated in the deed (the warranty against encumbrances), and (c) the property will not be taken\nby someone with a better title (the warranty of quiet enjoyment). Breach of any of these\nwarranties exposes the seller to damages.\n2. Quitclaim deed. The simplest form of deed is the quitclaim deed, in which the seller makes no\nwarranties. Instead, he simply transfers to the buyer whatever title he had, defects and all. A\nquitclaim deed should not be used in the ordinary purchase and sale transaction. It is usually\nreserved for removing a cloud on the title\xe2\x80\x94for instance, a quitclaim deed by a widow who might\nhave a dower interest in the property.\nIf the purchase agreement is silent about the type of deed, courts in many states will require the\nseller to give the buyer a quitclaim deed. In the contract, the buyer should therefore specify that\nthe seller is to provide a warranty deed at closing.\nWhen buyers move in after the closing, they frequently discover defects (the boiler is broken, a\npipe leaks, the electrical power is inadequate). To obtain recourse against such an eventuality,\nthe buyer could attempt to negotiate a clause in the contract under which the seller gives a\nwarranty covering named defects. However, even without an express warranty, the law implies\ntwo warranties when a buyer purchases a new house from a builder. These are warranties that\n(1) the house is habitable and (2) the builder has completed the house in a workmanlike manner.\nMost states have refused to extend these warranties to subsequent purchasers\xe2\x80\x94for example, to\nthe buyer from a seller who had bought from the original builder. However, a few states have\nbegun to provide limited protection to subsequent purchasers\xe2\x80\x94in particular, for defects that a\nreasonable inspection will not reveal but that will show up only after purchase.\n\nProof of Title\nContracts are often formed and performed simultaneously, but in real estate transactions there\nis more often a gap between contract formation and performance (the closing). The reason is\nsimple: the buyer must have time to obtain financing and to determine whether the seller has\nmarketable title. That is not always easy; at least, it is not as straightforward as looking at a piece\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n448\n\n\x0cof paper. To understand how title relates to the real estate transaction, some background on\nrecording statutes will be useful.\n\nRecording Statutes\nSuppose Slippery Sam owned Whispering Pines, a choice resort hotel on Torch Lake. On\nOctober 1, Slippery deeded Whispering Pines to Lorna for $1,575,000. Realizing the profit\npotential, Slippery decided to sell it again, and did so on November 1, without bothering to tell\nMalvina, the new buyer to whom he gave a new deed, that he had already sold it to Lorna. He\nthen departed for a long sailing trip to the British Virgin Islands.\nWhen Malvina arrives on the doorstep to find Lorna already tidying up, who should prevail? At\ncommon law, the first deed prevailed over subsequent deeds. So in our simple example, if this\nwere a pure common-law state, Lorna would have title and Malvina would be out of luck, stuck\nwith a worthless piece of paper. Her only recourse, probably futile, would be to search out and\nsue Slippery Sam for fraud. Most states, however, have enacted recording statutes, which award\ntitle to the person who has complied with the requirement to place the deed in a publicly\navailable file in a public office in the county, often called the recorder\xe2\x80\x99s office or the register of\ndeeds.\n\nNotice Statute\nUnder the most common type of recording statute, called a notice statute, a deed must be\nrecorded in order for the owner to prevail against a subsequent purchaser. Assume in our\nexample that Lorna recorded her deed on November 2 and that Malvina recorded on November\n4. In a notice-statute state, Malvina\xe2\x80\x99s claim to title would prevail over Lorna\xe2\x80\x99s because on the\nday that Malvina received title (November 1), Lorna had not yet recorded. For this rule to apply,\nMalvina must have been a bona fide purchaser, meaning that she must have (1) paid valuable\nconsideration, (2) bought in good faith, and (3) had no notice of the earlier sale. If Lorna had\nrecorded before Malvina took the deed, Lorna would prevail if Malvina did not in fact check the\npublic records; she should have checked, and the recorded deed is said to put subsequent\npurchasers onconstructive notice.\n\nNotice-Race Statute\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n449\n\n\x0cAnother common type of recording statute is the notice-race statute. To gain priority under this\nstatute, the subsequent bona fide purchaser must also record\xe2\x80\x94that is, win the race to the\nrecorder\xe2\x80\x99s office before the earlier purchaser. So in our example, in a notice-race jurisdiction,\nLorna would prevail, since she recorded before Malvina did.\n\nRace Statute\nA third, more uncommon type is the race statute, which gives title to whoever records first, even\nif the subsequent purchaser is not bona fide and has actual knowledge of the prior sale. Suppose\nthat when she received the deed, Malvina knew of the earlier sale to Lorna. Malvina got to the\nrecording office the day she got the deed, November 1, and Lorna came in the following day. In a\nrace-statute jurisdiction, Malvina would take title.\n\nChain of Title\nGiven the recording statutes, the buyer must check the deed on record to determine (1) whether\nthe seller ever acquired a valid deed to the property\xe2\x80\x94that is, whether a chain of title can be\ntraced from earlier owners to the seller\xe2\x80\x94and (2) whether the seller has already sold the property\nto another purchaser, who has recorded a deed. There are any number of potential \xe2\x80\x9cclouds\xe2\x80\x9d on\nthe title that would defeat a fee simple conveyance: among others, there are potential\njudgments, liens, mortgages, and easements that might affect the value of the property. There\nare two ways to protect the buyer: the abstract of title and opinion, and title insurance.\n\nAbstract and Opinion\nAn abstract of title is a summary of the chain of title, listing all previous deeds, mortgages, tax\nliens, and other instruments recorded in the county land records office. The abstract is prepared\nby either an attorney or a title company. Since the list itself says nothing about whether the\nrecorded instruments are legally valid, the buyer must also have the opinion of an attorney\nreviewing the abstract, or must determine by doing his own search of the public records, that the\nseller has valid title. The attorney\xe2\x80\x99s opinion is known as a title opinion or certificate of title. The\nproblem with this method of proving title is that the public records do not reveal hidden defects.\nOne of the previous owners might have been a minor or an incompetent person who can still\nvoid his sale, or a previous deed might have been forged, or a previous seller might have claimed\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n450\n\n\x0cto be single when in fact he was married and his wife failed to sign away her dower rights. A\nsearch of the records would not detect these infirmities.\n\nTitle Insurance\nTo overcome these difficulties, the buyer should obtain title insurance. This is a one-premium\npolicy issued by a title insurance company after a search through the same public records. When\nthe title company is satisfied that title is valid, it will issue the insurance policy for a premium\nthat could be as high as 1 percent of the selling price. When the buyer is taking out a mortgage,\nhe will ordinarily purchase two policies, one to cover his investment in the property and the\nother to cover the mortgagee lender\xe2\x80\x99s loan. In general, a title policy protects the buyer against\nlosses that would occur if title (1) turns out to belong to someone else; (2) is subject to a lien,\nencumbrance, or other defect; or (3) does not give the owner access to the land. A preferred type\nof title policy will also insure the buyer against losses resulting from an unmarketable title.\nNote that in determining whether to issue a policy, the title company goes through the process of\nsearching through the public records again. The title policy as such does not guarantee that title\nis sound. A buyer could conceivably lose part or all of the property someday to a previous\nrightful owner, but if he does, the title insurance company must reimburse him for his losses.\nAlthough title insurance is usually a sound protection, most policies are subject to various\nexclusions and exceptions. For example, they do not provide coverage for zoning laws that\nrestrict use of the property or for a government\xe2\x80\x99s taking of the property under its power of\neminent domain. Nor do the policies insure against defects created by the insured or known by\nthe insured but unknown to the company. Some companies will not provide coverage for\nmechanics\xe2\x80\x99 liens, public utility easements, and unpaid taxes. (If the accrued taxes are known, the\ninsured will be presented with a list, and if he pays them on or before the closing, they will be\ncovered by the final policy.) Furthermore, as demonstrated in Title and Trust Co. of Florida v.\nBarrows, (seeSection 12.4.1 "Title Insurance"), title insurance covers title defects only, not\nphysical defects in the property.\n\nThe Closing\nClosing can be a confusing process because in most instances several contracts are being\nperformed simultaneously:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n451\n\n\x0c1. The seller and purchaser are performing the sales contract.\n2. The seller is paying off a mortgage, while the buyer is completing arrangements to borrow\nmoney and mortgage the property.\n3. Title and other insurance arrangements will be completed.\n4. The seller will pay the broker.\n5. If buyer and seller are represented, attorneys for each party will be paid.\nFigure 12.2 Closing Process\n\nDespite all these transactions, the critical players are the seller, the purchaser, and the bank. To\nplace the closing process in perspective, assume that one bank holds the existing (seller\xe2\x80\x99s)\nmortgage on the property and is also financing the buyer\xe2\x80\x99s purchase. We can visualize the three\nmain players sitting at a table, ready to close the transaction. The key documents and the money\nwill flow as illustrated in Figure 12.2 "Closing Process".\n\nForm of the Deed\nThe deed must satisfy two fundamental legal requirements: it must be in the proper form, and\nthere must be a valid delivery. Deeds are usually prepared by attorneys, who must include not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n452\n\n\x0conly information necessary for a valid deed but also information required in order to be able to\nrecord the deed. The following information is typically required either for a valid deed or by the\nrecording statutes.\n\nGrantor\nThe grantor\xe2\x80\x94the person who is conveying the property\xe2\x80\x94must be designated in some manner.\nObviously, it is best to give the grantor\xe2\x80\x99s full name, but it is sufficient that the person or persons\nconveying the deed are identifiable from the document. Thus \xe2\x80\x9cthe heirs of Lockewood Filmer\xe2\x80\x9d is\nsufficient identification if each of the heirs signs the deed.\n\nGrantee\nSimilarly, the deed should identify the grantee\xe2\x80\x94the person to whom the property is being\nconveyed. It does not void the deed to misspell a person\xe2\x80\x99s name or to omit part of a name, or\neven to omit the name of one of the grantees (as in \xe2\x80\x9cLockewood Filmer and wife\xe2\x80\x9d). Although not\ntechnically necessary, the deed ought to detail the interests being conveyed to each grantee in\norder to avoid considerable legal difficulty later. \xe2\x80\x9cTo Francis Lucas, a single man, and Joseph\nLucas and Matilda Lucas, his wife\xe2\x80\x9d was a deed of unusual ambiguity. Did each party have a onethird interest? Or did Joseph and Matilda hold half as tenants by the entirety and Francis have a\none-half interest as a tenant in common? Or perhaps Francis had a one-third interest as a tenant\nin common and Joseph and Matilda held two-thirds as tenants by the entirety? Or was there\nsome other possible combination? The court chose the second interpretation, but considerable\ntime and money could have been saved had the deed contained a few simple words of\nexplanation. [2]\n\nAddresses\nAddresses of the parties should be included, although their absence will not usually invalidate\nthe deed. However, in some states, failure to note the addresses will bar the deed from being\nrecorded.\n\nWords of Conveyance\nThe deed must indicate that the grantor presently intends to convey his interest in the property\nto the grantee. The deed may recite that the grantor \xe2\x80\x9cconveys and warrants\xe2\x80\x9d the property\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n453\n\n\x0c(warranty deed) or \xe2\x80\x9cconveys and quitclaims\xe2\x80\x9d the property (quitclaim deed). Some deeds use the\nwords \xe2\x80\x9cbargain and sell\xe2\x80\x9d in place of convey.\n\nDescription\nThe deed must contain an accurate description of the land being conveyed, a description clear\nenough that the land can be identified without resorting to other evidence. Four general\nmethods are used.\n1. The US government survey. This is available west of the Mississippi (except in Texas) and in\nAlabama, Florida, Illinois, Indiana, Michigan, Mississippi, Ohio, and Wisconsin. With this\nsurvey, it is possible to specify with considerable exactitude any particular plot of land in any\ntownship in these states.\n2. Metes and bounds. The description of metes and bounds begins with a particular designated\npoint (called a monument)\xe2\x80\x94for example, a drainpipe, an old oak tree, a persimmon stump\xe2\x80\x94and\nthen defines the boundary with distances and angles until returning to the monument. As you\ncan tell, using monuments that are biological (like trees and stumps) will have a limited utility as\ntime goes on. Most surveyors put in stakes (iron pins), and the metes and bounds description\nwill go from points where stakes have been put in the ground.\n3. Plats. Many land areas have been divided into numbered lots and placed on a map called a plat.\nThe plats are recorded. The deed, then, need only refer to the plat and lot number\xe2\x80\x94for example,\n\xe2\x80\x9cLot 17, Appledale Subdivision, record in Liber 2 of Plats, page 62, Choctaw County Records.\xe2\x80\x9d\n4. Informal description. If none of the preceding methods can be used, an informal description,\ndone precisely enough, might suffice. For instance, \xe2\x80\x9cmy home at 31 Fernwood Street,\nMaplewood, Idaho\xe2\x80\x9d would probably pass muster.\n\nStatement of Consideration\nStatutes usually require that some consideration be stated in the deed, even though a grantor\nmay convey property as a gift. When there is a selling price, it is easy enough to state it, although\nthe actual price need not be listed. When land is being transferred as a gift, a statement of\nnominal consideration\xe2\x80\x94for example, one dollar\xe2\x80\x94is sufficient.\n\nDate\nDates are customary, but deeds without dates will be enforced.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n454\n\n\x0cExecution\nThe deed must be signed by the grantor and, in some states, witnesses, and these signatures\nmust be acknowledged by a notary public in order to make the deed eligible for recording. If\nsomeone is signing for the grantor under a power of attorney, a written instrument authorizing\none person to sign for another, the instrument must be recorded along with the deed.\n\nDelivery\nTo validly convey title to the property, the deed must not only be in proper form but also be\ndelivered. This technical legal requirement is sometimes misunderstood. Deliveryentails (1)\nphysical delivery to the grantee, (2) an intention by the grantor to convey title, and (3)\nacceptance of title by the grantee. Because the grantor must intend to convey title, failure to\nmeet the other two elements during the grantor\xe2\x80\x99s lifetime will void title on his death (since at\nthat point he of course cannot have an intention). Thus when a grantee is unaware of the\ngrantor\xe2\x80\x99s intention to deed the property to him, an executed deed sitting in a safe-deposit box\nwill be invalid if discovered after the grantor\xe2\x80\x99s death.\n\nDelivery to Grantee\nIf the deed is physically delivered to the grantee or recorded, there is a rebuttable presumption\nthat legal delivery has been made. That is, the law presumes, in the absence of evidence to the\ncontrary, that all three conditions have been met if delivery or recording takes place. But this\npresumption can be rebutted, as shown in Havens v. Schoen, (see Section 12.4.2 "Delivery of a\nDeed").\n\nDelivery to Third Party (Commercial Escrow)\nThe grantor may deliver the deed to a third party to hold until certain conditions have been met.\nThus to avoid the problem of the deed sitting in the grantor\xe2\x80\x99s own safe-deposit box, he could\ndeliver it to a third party with instructions to hold it until his death and then to deliver it to the\ngrantee. This would be an effective delivery, even though the grantee could not use the property\nuntil the grantor died. For this method to be effective, the grantor must lose all control over the\ndeed, and the third party must be instructed to deliver the deed when the specified conditions\noccur.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n455\n\n\x0cThis method is most frequently used in the commercial escrow. Escrow is a method by which a\nthird party holds a document or money or both until specified conditions have been met. A\ntypical example would be a sale in which the buyer is afraid of liens that might be filed after the\nclosing. A contractor that has supplied materials for the building of a house, for example, might\nfile a lien against the property for any amounts due but unpaid under the contract. The\neffectiveness of the lien would relate back to the time that the materials were furnished. Thus, at\nclosing, all potential liens might not have been filed. The buyer would prefer to pay the seller\nafter the time for filing materialmen\xe2\x80\x99s liens has lapsed. But sellers ordinarily want to ensure that\nthey will receive their money before delivering a deed. The solution is for the buyer to pay the\nmoney into escrow (e.g., to a bank) and for the seller to deliver the deed to the same escrow\nagent. The bank would be instructed to hold both the money and the deed until the time for\nfiling mechanics\xe2\x80\x99 liens has ended. If no materialmen\xe2\x80\x99s liens have been filed, then the money is\npaid out of escrow to the seller and the deed is released to the buyer. If a lien has been filed, then\nthe money will not be paid until the seller removes the lien (usually by paying it off).\n\nKEY TAKEAWAY\n\nMost real estate is bought and sold through real estate brokers, who must be licensed by the\nstate. Brokers have different kinds of agreements with clients, including exclusive right to\nsell, exclusive agency, and open listing. Brokers will usually arrange a sales agreement that\nincludes standard provisions such as property description, earnest money, and various\ncontingencies. A deed, usually a warranty deed, will be exchanged at the closing, but not\nbefore the buyer has obtained good proof of title, usually by getting an abstract and opinion\nand paying for title insurance. The deed will typically be delivered to the buyer and recorded\nat the county courthouse in the register of deeds\xe2\x80\x99 office.\n\nEXERCISES\n\n1. Kitty Korniotis is a licensed real estate broker. Barney Woodard and his wife, Carol, sign an\nexclusive agency listing with Kitty to sell their house on Woodvale Avenue. At a social\ngathering, Carol mentions to a friend, Helen Nearing, that the house on Woodvale is for sale.\nThe next day, Helen drives by the property and calls the number on Kitty\xe2\x80\x99s sign. Helen and\nScott Nearing sign a contract to buy the house from the Woodards. Is Kitty entitled to the\ncommission?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n456\n\n\x0c2. Deepak Abhishek, a single man, lives in a race-notice state. He contracts to buy a\nlarge parcel of land from his friend, Ron Khurana, for the sum of $280,000.\nSubsequent to the contract, Khurana finds another buyer, who is willing to pay\n$299,000. Khurana arranges for two closings on the same day, within two hours of\neach other. At 10 a.m., he sells the property to Beverly Hanks and her husband,\nJohn, for $299,000. The Hanks are not represented by an attorney. Khurana hands\nthem the deed at closing, but he takes it back from them and says, \xe2\x80\x9cI will record\nthis at the courthouse this afternoon.\xe2\x80\x9d The Hankses take a copy of the deed with\nthem and are satisfied that they have bought the property; moreover, Khurana\ngives them a commitment from Lawyer\xe2\x80\x99s Title Company that the company will\ninsure that they are receiving fee simple title from Khurana, subject to the deed\xe2\x80\x99s\nbeing recorded in the county register of deeds\xe2\x80\x99 office.\nAt noon, Khurana has a closing with Abhishek, who is represented by an attorney.\nThe attorney went to the courthouse earlier, at 11:30 a.m., and saw nothing on\nrecord that would prevent Khurana from conveying fee simple title. As the deal\ncloses, and as Khurana prepares to leave town, Abhishek\xe2\x80\x99s attorney goes to the\ncourthouse and records the deed at 1:15 p.m. At 2:07 p.m., on his way out of\ntown, Abhishek records the deed to the Hankses.\na.\n\nWho has better claim to the property\xe2\x80\x94the Hankses or Deepak Abhishek?\n\nb. Does it matter if the state is a notice jurisdiction or a notice-race jurisdiction?\nc. A warranty deed is given in both closings. What would be the best remedy for\nwhichever buyer did not get the benefit of clear title from these two transactions?\n\n[1] Jones v. Alfred H. Mayer Co., 392 U.S. 409 (1968).\n[2] Heatter v. Lucas, 80 A.2d 749 (Pa. 1951).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n457\n\n\x0c12.3 Adverse Possession\n\nLEARNING OBJECTIVE\n\n1. Explain how it is possible to own land without paying for it.\nIn some instances, real property can be acquired for free\xe2\x80\x94or at least without paying the original\nowner anything. (Considerable cost may be involved in meeting the requisite conditions.) This\nmethod of acquisition\xe2\x80\x94known as adverse possession\xe2\x80\x94is effective when five conditions are met:\n(1) the person claiming title by adverse possession must assert that he has a right to possession\nhostile to the interest of the original owner, (2) he must actually possess the property, (3) his\npossession must be \xe2\x80\x9copen and notorious,\xe2\x80\x9d (4) the possession must be continuous, and (5) the\npossession must be exclusive.\n\nHostile Possession\nSuppose Jean and Jacques are tenants in common of a farm. Jean announces that he no longer\nintends to pursue agricultural habits and leaves for the city. Jacques continues to work on the\nland, making improvements and paying taxes and the mortgage. Years later, Jacques files suit\nfor title, claiming that he now owns the land outright by adverse possession. He would lose,\nsince his possession was not hostile to Jacques. To be hostile, possession of the land must be\nwithout permission and with the intention to claim ownership. Possession by one cotenant is\ndeemed permissive, since either or both are legally entitled to possession. Suppose, instead, that\nJean and Jacques are neighboring farmers, each with title to his own acreage, and that Jean\ndecides to fence in his property. Just to be on the safe side, he knowingly constructs the fence\ntwenty feet over on Jacques\xe2\x80\x99s side. This is adverse possession, since it is clearly hostile to\nJacques\xe2\x80\x99s possession of the land.\n\nActual Possession\nNot only must the possession be hostile but it must also be actual. The possessor must enter\nonto the land and make some use of it. Many state statutes define the permissible type of\npossession\xe2\x80\x94for example, substantial enclosure or cultivation and improvement. In other states,\nthe courts will look to the circumstances of each case to determine whether the claimant had in\nfact possessed the land (e.g., by grazing cattle on the land each summer).\n\nOpen and Notorious Possession\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n458\n\n\x0cThe possessor must use the land in an open way, so that the original owner could determine by\nlooking that his land was being claimed and so that people in the area would know that it was\nbeing used by the adverse possessor. In the melodramatic words of one court, the adverse\npossessor \xe2\x80\x9cmust unfurl his flag on the land, and keep it flying so that the owner may see, if he\nwill, that an enemy has invaded his domains, and planted the standard of\nconquest.\xe2\x80\x9d [1] Construction of a building on the owner\xe2\x80\x99s property would be open and notorious;\ndevelopment of a cave or tunnel under the owner\xe2\x80\x99s property would not be.\n\nContinuous Possession\nThe adverse possessor must use the land continuously, not intermittently. In most states, this\ncontinuous period must last for at least twenty years. If the adverse possession is passed on to\nheirs or the interest is sold, the successor adverse possessors may tack on the time they claim\npossession to reach the twenty years. Should the original owner sell his land, the time needed to\nprove continuous possession will not lapse. Of course, the original owner may interrupt the\nperiod\xe2\x80\x94indeed, may terminate it\xe2\x80\x94by moving to eject the adverse possessor any time before the\ntwenty years has elapsed.\n\nExclusive Possession\nThe adverse possessor must claim exclusive possession of the land. Sharing the land with the\nowner is insufficient to ground a claim of legal entitlement based on adverse possession, since\nthe sharing is not fully adverse or hostile. Jean finds a nice wooded lot to enjoy weekly picnics.\nThe lot belongs to Jacques, who also uses it for picnics. This use would be insufficient to claim\nadverse possession because it is neither continuous nor exclusive.\nIf the five tests are met, then the adverse possessor is entitled to legal title. If any one of the tests\nis missing, the adverse possession claim will fail.\n\nKEY TAKEAWAY\n\nReal property can be acquired without paying the lawful owner if five conditions of adverse\npossession are met: (1) the person claiming title by adverse possession must assert that he\nhas a right to possession hostile to the interest of the original owner, (2) he must actually\npossess the property, (3) his possession must be \xe2\x80\x9copen and notorious,\xe2\x80\x9d (4) the possession\nmust be continuous, and (5) the possession must be exclusive.\n\nEXERCISE\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n459\n\n\x0c1. Tyler decides to camp out on a sandy beach lot near Isle of Palms, South Carolina. The owner,\nwho had hoped to build a large house there, lived out of state. Tyler made no secret of his\ncomings and goings, and after several weeks, when no one challenged his right to be there,\nhe built a sturdy lean-to. After a while, he built a \xe2\x80\x9cmicro house\xe2\x80\x9d and put a propane tank next\nto it. Although there was no running water, Tyler was plenty comfortable. His friends came\noften, they partied on the beach, and life was good. Five years after he first started camping\nout there, an agent of the owner came and told him to deconstruct his shelter and \xe2\x80\x9cmove\non.\xe2\x80\x9d Does Tyler have any rights in the property? Why or why not?\n\n[1] Robin v. Brown, 162 A. 161 (Pa. 1932).\n\n12.4 Cases\nTitle Insurance\nTitle and Trust Co. of Florida v. Barrows\n381 So.2d 1088 (Fla. App. 1979)\nMcCORD, ACTING CHIEF JUDGE.\nThis appeal is from a final judgment awarding money damages to appellees (Barrows) for breach\nof title insurance policy. We reverse.\nThrough a realtor, the Barrowses purchased, for $ 12,500, a lot surrounded on three sides by\nland owned by others, all of which is a part of a beach subdivision. The fourth side of their lot\nborders on a platted street called Viejo Street, the right-of-way for which has been dedicated to\nand accepted by St. Johns County. The right-of-way line opposite their lot abuts a Corps of\nEngineers\xe2\x80\x99 right-of-way in which there is a stone breakwater. The intracoastal waterway flows on\nthe other side of the breakwater.\nThe realtor who sold the lot to the Barrows represented to them that the county would build a\nroad in the right-of-way along Viejo Street when they began plans for building on their lot. There\nhave been no street improvements in the dedicated right-of-way, and St. Johns County has no\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n460\n\n\x0cpresent plans for making any improvements. The \xe2\x80\x9croad\xe2\x80\x9d is merely a continuation of a sandy\nbeach.\nA year after purchasing the land the Barrowses procured a survey which disclosed that the\nelevation of their lot is approximately one to three feet above the mean high water mark. They\nlater discovered that their lot, along with the Viejo Street right-of-way abutting it, is covered by\nhigh tide water during the spring and fall of each year.\nAt the time appellees purchased their lot, they obtained title insurance coverage from appellant.\nThe title policy covered:\nAny defect in or lien or encumbrance on the title to the estate or title covered hereby\xe2\x80\xa6or a lack\nof a right of access to and from the land.\xe2\x80\xa6\nAppellees\xe2\x80\x99 complaint of lack of right of access was founded on the impassable condition of the\nplatted street. After trial without a jury, the trial court entered final judgment finding that\nappellees did not have access to their property and, therefore, were entitled to recover $ 12,500\nfrom appellant the face amount of the policy.\nAppellant and Florida Land Title Association, appearing as amicus curiae, argue that appellant\ncannot be held liable on grounds of \xe2\x80\x9clack of right of access to and from the land\xe2\x80\x9d since there is\nno defect shown by the public record as to their right of access; that the public record shows a\ndedicated and accepted public right-of-way abutting the lot. They contend that title insurance\ndoes not insure against defects in the physical condition of the land or against infirmities in legal\nright of access not shown by the public record. See Pierson v. Bill, 138 Fla. 104, 189 So. 679\n(1939). They argue that defects in the physical condition of the land such as are involved here\nare not covered by title insurance. We agree. Title insurance only insures against title defects.\nThe Supreme Court of North Carolina in Marriott Financial Services, Inc. v. Capitol Funds,\nInc., 288 N.C. 122, 217 S.E.2d 551 (1975), construed \xe2\x80\x9cright of access\xe2\x80\x9d to mean the right to go to\nand from the public right-of-way without unreasonable restrictions.Compare Hocking v. Title\nInsurance & Trust Company, 37 Cal.2d 644, 234 P.2d 625 (1951), where, in ruling that the\nplaintiff failed to state a cause of action in a suit brought under her title policy, the court said:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n461\n\n\x0cShe appears to possess fee simple title to the property for whatever it may be worth; if she has\nbeen damaged by false representations in respect to the condition and value of the land her\nremedy would seem to be against others than the insurers of the title she acquired.\nIn Mafetone, et al., v. Forest Manor Homes, Inc., et al., 34 A.D.2d 566, 310 N.Y.S.2d 17\n(N.Y.1970), the plaintiff brought an action against a title insurance company for damages\nallegedly flowing from a change in the grade of a street. There the court said:\nThe title company is not responsible to plaintiffs for the damages incurred by reason of the\nchange in elevating the abutting street to its legal grade, since the provisions of the standard title\ninsurance policy here in question are concerned with matters affecting title to property and do\nnot concern themselves with physical conditions of the abutting property absent a specific\nrequest by the person ordering a title report and policy.\xe2\x80\xa6\nIn McDaniel v. Lawyers\xe2\x80\x99 Title Guaranty Fund, 327 So.2d 852 (Fla. 2 D.C.A. 1976), our sister\ncourt of the Second District said:\nThe man on the street buys a title insurance policy to insure against defects in the record title.\nThe title insurance company is in the business of guaranteeing the insured\xe2\x80\x99s title to the extent it\nis affected by the public records.\nIn the case here before us, there is no dispute that the public record shows a legal right of access\nto appellant\xe2\x80\x99s property via the platted Viejo Street. The title insurance policy only insured\nagainst record title defects and not against physical infirmities of the platted street.\nReversed.\n\nCASE QUESTIONS\n\n1. Do you think that the seller (or the seller\xe2\x80\x99s agent) actually took the Barrowses to see the\nproperty when it was underwater? Why or why not?\n2. Before buying, should the Barrowses have actually gone to the property to see for\nthemselves \xe2\x80\x9cthe lay of the land\xe2\x80\x9d or made inquiries of neighboring lot owners?\n3. Assuming that they did not make inspection of the property or make other inquiries, do you\nthink the seller or the seller\xe2\x80\x99s agent made any misrepresentations about the property that\nwould give the Barrowses any remedies in law or equity?\n\nDelivery of a Deed\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n462\n\n\x0cHavens v. Schoen\n108 Mich. App. 758; 310 N.W.2d 870 (Mich. App. 1981)\n[Norma Anderson Havens, the owner of certain farm property in Marlette, Michigan, in\ncontemplation of her death executed a quit-claim deed to the property to her only daughter,\nLinda Karen Anderson. The deed was subsequently recorded. Subsequently, Linda Karen\nAnderson married and became Linda Karen Adams and died. Thereafter, Norma Anderson\nHavens and Norman William Scholz, a nephew of Havens who has an interest in the property as\nthe beneficiary of a trust, brought a suit in Sanilac Circuit Court against Ernest E. Schoen,\nAdministrator of the estate of Linda Karen Adams, deceased, and other heirs of James W.\nAnderson, the ex-husband of Norma Anderson Havens, seeking to set aside the deed or to\nimpose a constructive trust on the farm property which was the subject of the deed. Arthur E.\nMoore, J., found no cause of action and entered judgment for defendants. The plaintiffs appeal\nalleging error because there never was a delivery of the deed or an intent by Havens to then\npresently and unconditionally convey an interest in the property.]\nPER CURIAM.\nIn 1962, plaintiff Dr. [Norma Anderson] Havens purchased the Scholz family farm from the\nestate of her twin brother, Norman Scholz. She gave a deed of trust to her other brother Earl\nScholz in 1964, naming her daughter Linda Karen Adams as the principal beneficiary. In 1969,\nshe filed suit against Earl and Inez Scholz and, in settlement of that suit, the property was\nconveyed to Dr. Havens and her daughter, now deceased. On August 13, 1969, Dr. Havens\nexecuted a quit-claim deed to her daughter of her remaining interest in the farm. It is this deed\nwhich Dr. Havens wishes to set aside.\nThe trial court found that plaintiffs failed to meet the burden of proving an invalid conveyance.\nPlaintiffs claim that there was never a delivery or an intent to presently and unconditionally\nconvey an interest in the property to the daughter. The deed was recorded but defendants\npresented no other evidence to prove delivery. The recording of a deed raises a presumption of\ndelivery. Hooker v Tucker, 335 Mich 429, 434; 56 NW2d 246 (1953). The only effect of this\npresumption is to cast upon the opposite party the burden of moving forward with the\nevidence. Hooker v Tucker, supra. The burden of proving delivery by a preponderance of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n463\n\n\x0cevidence remains with the party relying on the deed. Camp v Guaranty Trust Co, 262 Mich 223,\n226; 247 NW 162 (1933). Acknowledging that the deed was recorded, plaintiffs presented\nsubstantial evidence showing no delivery and no intent to presently and unconditionally convey\nan interest in the property. The deed, after recording, was returned to Dr. Havens. She\ncontinued to manage the farm and pay all expenses for it. When asked about renting the farm,\nthe daughter told a witness to ask her mother. Plaintiffs presented sufficient evidence to dispel\nthe presumption. We find that the trial court erred when it stated that plaintiffs had the burden\nof proof on all issues. The defendants had the burden of proving delivery and requisite intent.\nIn Haasjes v Woldring, 10 Mich App 100; 158 NW2d 777 (1968), leave denied 381 Mich 756\n(1968), two grandparents executed a deed to property to two grandchildren. The grandparents\ncontinued to live on the property, pay taxes on it and subsequent to the execution of the deed\nthey made statements which this Court found inconsistent with a prior transfer of property.\nThese circumstances combined with the fact that the deed was not placed beyond the grantors\xe2\x80\x99\ncontrol led the Haasjes Court to conclude that a valid transfer of title had not been effected.\nThe Haasjes Court, citing Wandel v Wandel, 336 Mich 126; 57 NW2d 468 (1953), and Resh v\nFox, 365 Mich 288, 112 NW2d 486 (1961), held that in considering whether there was a present\nintent to pass title, courts may look to the subsequent acts of the grantor.\nThis Court reviews de novo the determinations of a trial court sitting in an equity case.Chapman\nv Chapman, 31 Mich App 576, 579; 188 NW2d 21 (1971). Having reviewed the evidence\npresented by the defendants to prove delivery, we find that the defendants failed to meet their\nburden of proof. Under the circumstances, the recording itself and the language of the deed were\nnot persuasive proof of delivery or intent. Defendants presented no evidence of possession of the\ndeed by anyone but the grantor and presented no evidence showing knowledge of the deed by\nthe grantee. No evidence was presented showing that the daughter was ever aware that she\nowned the property. The showing made by defendants was inadequate to carry their burden of\nproof. The deed must be set aside.\nPlaintiffs alleged none of the grounds which have traditionally been recognized as justifying the\nimposition of a constructive trust. See Chapman v Chapman, supra. A constructive trust is\nimposed only when it would be inequitable to do otherwise. Arndt v Vos, 83 Mich App 484; 268\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n464\n\n\x0cNW2d 693 (1978). Although plaintiffs claim relief for a mutual mistake, plaintiffs have\npresented no facts suggesting a mistake on the part of the grantee. Creation of a constructive\ntrust is not warranted by the facts as found by the trial court. There has been no claim that those\nfindings are erroneous.\nWe remand to the trial court to enter an order setting aside the August 13, 1969, deed from\nNorma Anderson Havens to Linda Karen Anderson Adams purporting to convey the interest of\nDr. Havens in the farm. The decision of the trial court finding no justification for imposing a\ntrust upon the property is affirmed.\nAffirmed in part, reversed in part, and remanded.\nDISSENT BY:\nMacKenzie, J. (dissenting).\nI respectfully dissent. The deed was recorded with the knowledge and assent of the grantor,\nwhich creates a presumption of delivery. See Schmidt v Jennings, 359 Mich 376, 383; 102\nNW2d 589 (1960), Reed v Mack, 344 Mich 391, 397; 73 NW2d 917 (1955). Crucial evidence was\nconflicting and I would disagree that the trial court\xe2\x80\x99s findings were clearly erroneous.\nIn Reed v Mack, the Court affirmed the trial court\xe2\x80\x99s finding that there had been delivery where\nthe grantor defendant, who had owned the property with her husband, recorded a deed\nconveying a property jointly to herself and the two other grantees, stating:\n\xe2\x80\x9cWe are in agreement with the trial court. The defendant-appellant, a grantor in the deed,\ncaused the recording of the deed, the delivery of which she attacks. The recording of a warranty\ndeed may, under some circumstances, be effectual to show delivery. A delivery to one of several\njoint grantees, in absence of proof to the contrary, is delivery to all. Mayhew v Wilhelm, 249\nMich 640 [229 NW 459 (1930)]. While placing a deed on record does not in itself necessarily\nestablish delivery, the recording of a deed raises a presumption of delivery, and the whole object\nof delivery is to indicate an intent by the grantor to give effect to the instrument.\xe2\x80\x9d [Citations]\nIn McMahon v Dorsey, 353 Mich 623, 626; 91 NW2d 893 (1958), the significance of delivery\nwas characterized as the manifestation of the grantor\xe2\x80\x99s intent that the instrument be a\ncompleted act.\n***\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n465\n\n\x0cThe evidence herein indicates that plaintiff Norma Anderson Havens, after she had been told\nshe was dying from cancer, executed a quit-claim deed on August 16, 1969, to her daughter,\nLinda Karen Anderson. Plaintiff Havens testified that the reason she executed the deed was that\nshe felt \xe2\x80\x9cif something should happen to me, at least Karen would be protected\xe2\x80\x9d. The deed was\nrecorded the same day by plaintiff Havens\xe2\x80\x99s attorney. Plaintiff Havens either knew that the deed\nwas recorded then or learned of the recording shortly thereafter. Although plaintiff Havens\ntestified that she intended only a testamentary disposition, she apparently realized that the deed\nwas effective to convey the property immediately because her testimony indicated an intention\nto execute a trust agreement. Linda Karen lived on the farm for five years after the deed was\nrecorded until her death in 1974, yet plaintiff Havens did not attempt to have Linda Karen deed\nthe farm back to her so she could replace the deed with a trust agreement or a will. Plaintiff\nHavens testified that she approached her attorneys regarding a trust agreement, but both\nattorneys denied this. The trial judge specifically found the testimony of the attorneys was\nconvincing and he, of course, had the benefit of observing the witnesses.\nHaasjes v Woldring, 10 Mich App 100; 158 NW2d 777 (1968), relied upon by the majority,\ninvolved unrecorded deeds which remained in a strongbox under control of the grantors until\nafter their deaths. The grantors continued to live alone on the property and pay taxes thereon.\nBased on the lack of recording, I find Haasjesdistinguishable from the present case.\nIn Hooker v Tucker, 335 Mich 429; 56 NW2d 246 (1953), delivery was held not to have occurred\nwhere the grantor handed her attorney a copy of a deed containing a legal description of\nproperty she wished included in a will to be drawn by him and he subsequently mailed the deed\nto the grantee without the grantor\xe2\x80\x99s knowledge or permission. The purported delivery by mailing\nbeing unauthorized distinguishesHooker from this case where there was no indication the\nrecording was done without the grantor\xe2\x80\x99s authorization.\nThe majority relies on the grantee\xe2\x80\x99s purported lack of knowledge of the conveyance but the\nrecord is not at all clear in this regard. Further, if a deed is beneficial to the grantee, its\nacceptance is presumed. Tackaberry v Monteith, 295 Mich 487, 493; 295 NW 236 (1940), see\nalso Holmes v McDonald, 119 Mich 563; 78 NW 647 (1899). While the burden of proving\ndelivery is on the person relying upon the instrument, the burden shifts upon its recordation so\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n466\n\n\x0cthat the grantor must go forward with the evidence of showing nondelivery, once recordation\nand beneficial interest have been shown.Hooker v Tucker, supra, and Tackaberry, supra. The\ntrial court properly found that plaintiffs failed to go forward with the evidence and found that\nthe deed conveyed title to the farm.\nFactually, this is a difficult case because plaintiff Havens executed a deed which she intended to\nbe a valid conveyance at the time it was executed and recorded. Subsequently, when her\ndaughter unexpectedly predeceased her, the deed created a result she had not foreseen. She\nseeks to eradicate the unintended result by this litigation.\nI am reluctant to set aside an unambiguous conveyance which was on record and unchallenged\nfor five years on the basis of the self-serving testimony of the grantor as to her intent at the time\nshe executed the deed and authorized its recordation.\nI would affirm.\n\nCASE QUESTION\n\n1. Which opinion, the majority or the dissenting opinion, do you agree with, and why?\n\n12.5 Summary and Exercises\nSummary\n\nReal property can be held in various forms of ownership. The most common forms are tenancy\nin common, joint tenancy, and tenancy by the entirety. Ten states recognize the community\nproperty form of ownership.\nIn selling real property, various common-law and statutory provisions come into play. Among\nthe more important statutory provisions are the Civil Rights Acts of 1866 and 1968. These laws\ncontrol the manner in which property may be listed and prohibit discrimination in sales. Sellers\nand buyers must also be mindful of contract and agency principles governing the listing\nagreement. Whether the real estate broker has an exclusive right to sell, an exclusive agency, or\nan open listing will have an important bearing on the fee to which the broker will be entitled\nwhen the property is sold.\nThe Statute of Frauds requires contracts for the sale of real property to be in writing. Such\ncontracts must include the names of buyers and sellers, a description of the property, the price,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n467\n\n\x0cand signatures. Unless the contract states otherwise, the seller must deliver marketable title, and\nthe buyer will bear the loss if the property is damaged after the contract is signed but before the\nclosing. The seller will usually insist on being paid earnest money, and the buyer will usually\nprotect himself contractually against certain contingencies, such as failure to obtain financing.\nThe contract should also specify the type of deed to be given to the buyer.\nTo provide protection to subsequent buyers, most states have enacted recording statutes that\nrequire buyers to record their purchases in a county office. The statutes vary: which of two\npurchasers will prevail depends on whether the state has a notice, notice-race, or race statute.\nTo protect themselves, buyers usually purchase an abstract and opinion or title insurance.\nAlthough sale is the usual method of acquiring real property, it is possible to take legal title\nwithout the consent of the owner. That method is adverse possession, by which one who openly,\ncontinuously, and exclusively possesses property and asserts his right to do so in a manner\nhostile to the interest of the owner will take title in twenty years in most states.\n\nEXERCISES\n\n1. Rufus enters into a contract to purchase the Brooklyn Bridge from Sharpy. The contract\nprovides that Sharpy is to give Rufus a quitclaim deed at the closing. After the closing, Rufus\nlearns that Sharpy did not own the bridge and sues him for violating the terms of the deed.\nWhat is the result? Why?\n2. Pancho and Cisco decide to purchase ten acres of real estate. Pancho is to provide 75 percent\nof the purchase price, Cisco the other 25 percent. They want to use either a joint tenancy or\ntenancy in common form of ownership. What do you recommend? Why?\n3. Suppose in Exercise 2 that a friend recommends that Pancho and Cisco use a tenancy by the\nentirety. Would this form of ownership be appropriate? Why?\n4. Richard and Elizabeth, a married couple, live in a community property state. During their\nmarriage, they save $500,000 from Elizabeth\xe2\x80\x99s earnings. Richard does not work, but during\nthe marriage, he inherits $500,000. If Richard and Elizabeth are divorced, how will their\nproperty be divided? Why?\n5. Jack wants to sell his house. He hires Walter, a real estate broker, to sell the house and signs\nan exclusive-right-to-sell listing agreement. Walter finds a buyer, who signs a sales contract\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n468\n\n\x0cwith Jack. However, the buyer later refuses to perform the contract because he cannot\nobtain financing. Does Jack owe a commission to Walter? Why?\n6. Suppose in Exercise 5 that Jack found the buyer, the buyer obtained financing, and the sale\nwas completed. Does Jack owe a commission to Walter, who provided no assistance in\nfinding the buyer and closing the deal? Why?\n7. Suppose in Exercise 5 that Jack\xe2\x80\x99s house is destroyed by fire before the closing. Who bears the\nloss\xe2\x80\x94Jack or the buyer? Must Jack pay a commission to Walter? Why?\n8. Suppose in Exercise 5 that the buyer paid $15,000 in earnest money when the contract was\nsigned. Must Jack return the earnest money when the buyer learns that financing is\nunavailable? Why?\n\nSELF-TEST QUESTIONS\n\n1. A contract for a sale of property must include\na.\n\na description of the property\nb. price\nc. signatures of buyer and seller\nd. all of the above\nIf real property is damaged after a contract for sale is signed but before\nclosing, it is generally true that the party bearing the loss is\n\na.\n\nthe seller\nb. the buyer\nc. both parties, who split the loss evenly\nd. none of the above\nThe following deeds extend warranties to the buyer:\n\na.\n\nquitclaim and special warranty\nb. quitclaim and general warranty\nc. general and special warranty\nd. all of the above\nUnder a notice-race statute,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n469\n\n\x0ca.\n\nwhoever records first is given title, regardless of the good faith of the\n\npurchaser\nb. whoever records first and is a bona fide purchaser is given title\nc. either of the above may be acceptable\nd. none of the above is acceptable\nThe elements of adverse possession do not include\na.\n\nactual possession\n\nb. open and notorious use\nc. consent of the owner\nd. continuous possession\n\nSELF-TEST ANSWERS\n\n1. d\n2. b\n3. c\n4. b\n5. c\n\nChapter 13\nLandlord and Tenant Law\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. The various types of leasehold estates\n2. How leasehold states are created and extended\n3. The rights and duties of landlords\n4. The rights and duties of tenants\n5. The potential tort liability of landlords\n\n13.1 Types and Creation of Leasehold Estates\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n470\n\n\x0c1. Distinguish between the different types of leasehold estates.\n2. Describe how leasehold states can be created, both orally and in writing, and the\nrequirements for creating leases that last for more than one year.\nIn Chapter 11 "The Nature and Regulation of Real Estate and the Environment", we noted that\nreal property can be divided into types of interests: freehold estates and leasehold estates. The\nfreehold estate is characterized by indefinite duration, and the owner has title and the right to\npossess. The leasehold estate, by contrast, lasts for a specific period. The owner of the leasehold\nestate\xe2\x80\x94the tenant\xe2\x80\x94may take possession but does not have title to the underlying real property.\nWhen the period of the leasehold ends, the right to possession reverts to the landlord\xe2\x80\x94hence the\nlandlord\xe2\x80\x99s interest during the tenant\xe2\x80\x99s possession is known as a reversionary interest.\nAlthough a leasehold estate is said to be an interest in real property, the leasehold itself is in fact\npersonal property. The law recognizes three types of leasehold estates: the estate for years, the\nperiodic tenancy, and the tenancy at will.\n\nTypes of Leasehold Estates\nEstate for Years\nThe estate for years is characterized by a definite beginning and a definite end. When you rent\nan apartment for two years, beginning September 1 and ending on the second August 31, you are\nthe owner of an estate for years. Virtually any period will do; although it is called an estate \xe2\x80\x9cfor\nyears,\xe2\x80\x9d it can last but one day or extend one thousand years or more. Some statutes declare that\nany estate for years longer than a specified period\xe2\x80\x94one hundred years in Massachusetts, for\ninstance\xe2\x80\x94is a fee simple estate.\nUnless the lease\xe2\x80\x94the agreement creating the leasehold interest\xe2\x80\x94provides otherwise, the estate\nfor years terminates automatically at midnight of the last day specified in the lease. The lease\nneed not refer explicitly to calendar dates. It could provide that \xe2\x80\x9cthe tenant may occupy the\npremises for six months to commence one week from the date of signing.\xe2\x80\x9d Suppose the landlord\nand tenant sign on June 23. Then the lease term begins at 12:00 a.m. on July 1 and ends just\nbefore midnight of December 31. Unless a statute provides otherwise, the landlord is not\nobligated to send the tenant a notice of termination. Should the tenant die before the lease term\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n471\n\n\x0cends, her property interest can be inherited under her will along with her other personal\nproperty or in accordance with the laws of intestate succession.\n\nPeriodic Tenancy\nAs its name implies, a periodic tenancy lasts for a period that is renewed automatically until\neither landlord or tenant notifies the other that it will end. The periodic tenancy is sometimes\ncalled an estate from year to year (or month to month, or week to week). The lease may provide\nexplicitly for the periodic tenancy by specifying that at the expiration of, say, a one-year lease, it\nwill be deemed renewed for another year unless one party notifies the other to the contrary\nwithin six months prior to the expiration of the term. Or the periodic tenancy may be created by\nimplication, if the lease fails to state a term or is defective in some other way, but the tenant\ntakes possession and pays rent. The usual method of creating a periodic tenancy occurs when\nthe tenant remains on the premises (\xe2\x80\x9cholds over\xe2\x80\x9d) when an estate for years under a lease has\nended. The landlord may either reject or accept the implied offer by the tenant to rent under a\nperiodic tenancy. If he rejects the implied offer, the tenant may be ejected, and the landlord is\nentitled to rent for the holdover period. If he accepts the offer, the original lease determines the\nrent and length of the renewable period, except that no periodic tenancy may last longer than\nfrom year to year\xe2\x80\x94that is, the renewable period may never be any longer than twelve months.\nAt common law, a party was required to give notice at least six months prior to the end of a yearto-year tenancy, and notice equal to the term for any other periodic tenancy. In most states\ntoday, the time period for giving notice is regulated by statute. In most instances, a year-to-year\ntenancy requires a month\xe2\x80\x99s notice, and shorter tenancies require notice equal to the term. To\nillustrate the approach typically used, suppose Simone rents from Anita on a month-to-month\ntenancy beginning September 15. On March 30, Simone passes the orals for her doctorate and\ndecides to leave town. How soon may she cancel her tenancy? If she calls Anita that afternoon,\nshe will be two weeks shy of a full month\xe2\x80\x99s notice for the period ending April 15, so the earliest\nshe can finish her obligation to pay rent is May 15. Suppose her term had been from the first of\neach month. On April 1, she notifies Anita of her intention to leave at the end of April, but she is\nstuck until the end of May, because notice on the first of the month is not notice for a full month.\nShe would have had to notify Anita by March 31 to terminate the tenancy by April 30.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n472\n\n\x0cTenancy at Will\nIf the landlord and tenant agree that the lease will last only as long as both want it to, then they\nhave created a tenancy at will. Statutes in most states require some notice of intention to\nterminate. Simone comes to the university to study, and Anita gives her a room to stay in for\nfree. The arrangement is a tenancy at will, and it will continue as long as both want it to. One\nFriday night, after dinner with classmates, Simone decides she would rather move in with Bob.\nShe goes back to her apartment, packs her suitcase, and tells Anita she\xe2\x80\x99s leaving. The tenancy at\nwill terminates that day.\n\nCreation of Leasehold Estates\nOral Leases\nLeases can be created orally, unless the term of the lease exceeds the period specified by the\nStatute of Frauds. In most states, that period is one year. Any oral lease for a period longer than\nthe statutory period is invalid. Suppose that Simone, in a state with a one-year Statute of Frauds\nperiod, orally agrees with Anita to rent Anita\xe2\x80\x99s apartment for two years, at a monthly rent of\n$250. The lease is invalid, and either could repudiate it.\n\nWritten Leases\nA lease required to be in writing under the Statute of Frauds must contain the following items or\nprovisions: (1) it must identify the parties, (2) it must identify the premises, (3) it must specify\nthe duration of the lease, (4) it must state the rent to be paid, and (5) it must be signed by the\nparty against whom enforcement is sought (known as \xe2\x80\x9cthe party to be charged\xe2\x80\x9d).\nThe provisions need not be perfectly stated. As long as they satisfy the five requirements, they\nwill be adequate to sustain the lease under the Statute of Frauds. For instance, the parties need\nnot necessarily be named in the lease itself. Suppose that the prospective tenant gives the\nlandlord a month\xe2\x80\x99s rent in advance and that the landlord gives the tenant a receipt listing the\nproperty and the terms of the lease but omitting the name of the tenant. The landlord\nsubsequently refuses to let the tenant move in. Who would prevail in court? Since the tenant had\nthe receipt in her possession, that would be sufficient to identify her as the tenant to whom the\nterms of the lease were meant to apply. Likewise, the lease need not specify every aspect of the\npremises to be enjoyed. Thus the tenant who rents an apartment in a building will be entitled to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n473\n\n\x0cthe use of the common stairway, the roof, and so on, even though the lease is silent on these\npoints. And as long as a specific amount is ascertainable, the rent may be stated in other than\nabsolute dollar terms. For example, it could be expressed in terms of a cost-of-living index or as\na percentage of the tenant\xe2\x80\x99s dollar business volume.\n\nKEY TAKEAWAY\n\nA leasehold estate, unlike a freehold estate, has a definite duration. The landlord\xe2\x80\x99s interest\nduring the term of a leasehold estate is a reversionary interest. Leasehold estates can last for\nshort terms or very long terms; in the case of long-term leases, a property right is created\nthat can be passed to heirs. The usual landlord-tenant relationship is a periodic tenancy,\nwhich carries with it various common-law and statutory qualifications regarding renewal and\ntermination. In a tenancy at will, either landlord or tenant can end the leasehold estate as\nsoon as notice is provided by either party.\n\nEXERCISES\n\n1. What is the difference between a periodic tenancy and a tenancy at will?\n2. What are the essential terms that must be in a written lease?\n\n13.2 Rights and Duties of Landlords and Tenants\nLEARNING OBJECTIVES\n\n1. Itemize and explain the rights and duties of landlords.\n2. List and describe the rights and duties of tenants.\n3. Understand the available remedies for tenants when a landlord is in breach of his or her\nduties.\n\nRights and Duties of Landlords\nThe law imposes a number of duties on the landlord and gives the tenant a number of\ncorresponding rights. These include (1) possession, (2) habitable condition, and (3)\nnoninterference with use.\n\nPossession\nThe landlord must give the tenant the right of possession of the property. This duty is breached\nif, at the time the tenant is entitled to take possession, a third party has paramount title to the\nproperty and the assertion of this title would deprive the tenant of the use contemplated by the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n474\n\n\x0cparties. Paramount title means any legal interest in the premises that is not terminable at the\nwill of the landlord or at the time the tenant is entitled to take possession.\nIf the tenant has already taken possession and then discovers the paramount title, or if the\nparamount title only then comes into existence, the landlord is not automatically in breach.\nHowever, if the tenant thereafter is evicted from the premises and thus deprived of the property,\nthen the landlord is in breach. Suppose the landlord rents a house to a doctor for ten years,\nknowing that the doctor intends to open a medical office in part of the home and knowing also\nthat the lot is restricted to residential uses only. The doctor moves in. The landlord is not yet in\ndefault. The landlord will be in default if a neighbor obtains an injunction against maintaining\nthe office. But if the landlord did not know (and could not reasonably have known) that the\ndoctor intended to use his home for an office, then the landlord would not be in default under\nthe lease, since the property could have been put to normal\xe2\x80\x94that is, residential\xe2\x80\x94use without\njeopardizing the tenant\xe2\x80\x99s right to possession.\n\nWarranty of Habitability\nAs applied to leases, the old common-law doctrine of caveat emptor said that once the tenant\nhas signed the lease, she must take the premises as she finds them. Since she could inspect them\nbefore signing the lease, she should not complain later. Moreover, if hidden defects come to\nlight, they ought to be easy enough for the tenant herself to fix. Today this rule no longer applies,\nat least to residential rentals. Unless the parties specifically agree otherwise, the landlord is in\nbreach of his lease if the conditions are unsuitable for residential use when the tenant is due to\nmove in. The landlord is held to an implied warranty of habitability.\nThe change in the rule is due in part to the conditions of the modern urban setting: tenants have\nlittle or no power to walk away from an available apartment in areas where housing is scarce. It\nis also due to modem construction and technology: few tenants are capable of fixing most types\nof defects. A US court of appeals has said the following:\nToday\xe2\x80\x99s urban tenants, the vast majority of whom live in multiple dwelling houses, are\ninterested not in the land, but solely in \xe2\x80\x9ca house suitable for occupation.\xe2\x80\x9d Furthermore, today\xe2\x80\x99s\ncity dweller usually has a single, specialized skill unrelated to maintenance work; he is unable to\nmake repairs like the \xe2\x80\x9cjack-of-all-trades\xe2\x80\x9d farmer who was the common law\xe2\x80\x99s model of the lessee.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n475\n\n\x0cFurther, unlike his agrarian predecessor who often remained on one piece of land for his entire\nlife, urban tenants today are more mobile than ever before. A tenant\xe2\x80\x99s tenure in a specific\napartment will often not be sufficient to justify efforts at repairs. In addition, the increasing\ncomplexity of today\xe2\x80\x99s dwellings renders them much more difficult to repair than the structures\nof earlier times. In a multiple dwelling, repairs may require access to equipment and areas in\ncontrol of the landlord. Low and middle income tenants, even if they were interested in making\nrepairs, would be unable to obtain financing for major repairs since they have no long-term\ninterest in the property. [1]\nAt common law, the landlord was not responsible if the premises became unsuitable once the\ntenant moved in. This rule was often harshly applied, even for unsuitable conditions caused by a\nsudden act of God, such as a tornado. Even if the premises collapsed, the tenant would be liable\nto pay the rent for the duration of the lease. Today, however, many states have statutorily\nabolished the tenant\xe2\x80\x99s obligation to pay the rent if a non-man-made force renders the premises\nunsuitable. Moreover, most states today impose on the landlord, after the tenant has moved in,\nthe responsibility for maintaining the premises in a safe, livable condition, consistent with the\nsafety, health, and housing codes of the jurisdiction.\nThese rules apply only in the absence of an express agreement between the parties. The landlord\nand tenant may allocate in the lease the responsibility for repairs and maintenance. But it is\nunlikely that any court would enforce a lease provision waiving the landlord\xe2\x80\x99s implied warranty\nof habitability for residential apartments, especially in areas where housing is relatively scarce.\n\nNoninterference with Use\nIn addition to maintaining the premises in a physically suitable manner, the landlord has an\nobligation to the tenant not to interfere with a permissible use of the premises. Suppose Simone\nmoves into a building with several apartments. One of the other tenants consistently plays music\nlate in the evening, causing Simone to lose sleep. She complains to the landlord, who has a\nprovision in the lease permitting him to terminate the lease of any tenant who persists in\ndisturbing other tenants. If the landlord does nothing after Simone has notified him of the\ndisturbance, he will be in breach. This right to be free of interference with permissible uses is\nsometimes said to arise from the landlord\xe2\x80\x99s implied covenant of quiet enjoyment.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n476\n\n\x0cTenant\xe2\x80\x99s Remedies\nWhen the landlord breaches one of the foregoing duties, the tenant has a choice of three basic\nremedies: termination, damages, or rent adjustment.\nIn virtually all cases where the landlord breaches, the tenant may terminate the lease, thus\nending her obligation to continue to pay rent. To terminate, the tenant must (1) actually vacate\nthe premises during the time that she is entitled to terminate and (2) either comply with lease\nprovisions governing the method of terminating or else take reasonable steps to ensure that the\nlandlord knows she has terminated and why.\nWhen the landlord physically deprives the tenant of possession, he has evicted the tenant;\nwrongful eviction permits the tenant to terminate the lease. Even if the landlord\xe2\x80\x99s conduct falls\nshort of actual eviction, it may interfere substantially enough with the tenant\xe2\x80\x99s permissible use\nso that they are tantamount to eviction. This is known as constructive eviction, and it covers a\nwide variety of actions by both the landlord and those whose conduct is attributable to him, as\nillustrated by Fidelity Mutual Life Insurance Co. v Kaminsky, (see Section 13.5.1 "Constructive\nEviction").\n\nDamages\nAnother traditional remedy is money damages, available whenever termination is an\nappropriate remedy. Damages may be sought after termination or as an alternative to\ntermination. Suppose that after the landlord had refused Simone\xe2\x80\x99s request to repair the\nelectrical system, Simone hired a contractor to do the job. The cost of the repair work would be\nrecoverable from the landlord. Other recoverable costs can include the expense of relocating if\nthe lease is terminated, moving costs, expenses connected with finding new premises, and any\nincrease in rent over the period of the terminated lease for comparable new space. A business\nmay recover the loss of anticipated business profits, but only if the extent of the loss is\nestablished with reasonable certainty. In the case of most new businesses, it would be almost\nimpossible to prove loss of profits.\nIn all cases, the tenant\xe2\x80\x99s recovery will be limited to damages that would have been incurred by a\ntenant who took all reasonable steps to mitigate losses. That is, the tenant must take reasonable\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n477\n\n\x0csteps to prevent losses attributable to the landlord\xe2\x80\x99s breach, to find new space if terminating, to\nmove efficiently, and so on.\n\nRent Remedies\nUnder an old common-law rule, the landlord\xe2\x80\x99s obligation to provide the tenant with habitable\nspace and the tenant\xe2\x80\x99s obligation to pay rent wereindependent covenants. If the landlord\nbreached, the tenant was still legally bound to pay the rent; her only remedies were termination\nand suit for damages. But these are often difficult remedies for the tenant. Termination means\nthe aggravation of moving, assuming that new quarters can be found, and a suit for damages is\ntime consuming, uncertain, and expensive. The obvious solution is to permit the tenant to\nwithhold rent, or what we here call rent adjustment. The modern rule, adopted in several states\n(but not yet in most), holds that the mutual obligations of landlord and tenant are dependent.\nStates following this approach have developed three types of remedies: rent withholding, rent\napplication, and rent abatement.\nThe simplest approach is for the tenant to withhold the rent until the landlord remedies the\ndefect. In some states, the tenant may keep the money. In other states, the rent must be paid\neach month into an escrow account or to the court, and the money in the escrow account\nbecomes payable to the landlord when the default is cured.\nSeveral state statutes permit the tenant to apply the rent money directly to remedy the defect or\notherwise satisfy the landlord\xe2\x80\x99s performance. Thus Simone might have deducted from her rent\nthe reasonable cost of hiring an electrician to repair the electrical system.\nIn some states, the rent may be reduced or even eliminated if the landlord fails to cure specific\ntypes of defects, such as violations of the housing code. The abatement will continue until the\ndefault is eliminated or the lease is terminated.\n\nRights and Duties of Tenants\nIn addition to the duties of the tenant set forth in the lease itself, the common law imposes three\nother obligations: (1) to pay the rent reserved (stated) in the lease, (2) to refrain from\ncommitting waste (damage), and (3) not to use the premises for an illegal purpose.\n\nDuty to Pay Rent\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n478\n\n\x0cWhat constitutes rent is not necessarily limited to the stated periodic payment usually\ndenominated \xe2\x80\x9crent.\xe2\x80\x9d The tenant may also be responsible for such assessments as taxes and\nutilities, payable to the landlord as rent. Simone\xe2\x80\x99s lease calls for her to pay taxes of $500 per\nyear, payable in quarterly installments. She pays the rent on the first of each month and the first\ntax bill on January 1. On April 1, she pays the rent but defaults on the next tax bill. She has failed\nto pay the rent reserved in the lease.\nThe landlord in the majority of states is not obligated to mitigate his losses should the tenant\nabandon the property and fail thereafter to pay the rent. As a practical matter, this means that\nthe landlord need not try to rent out the property but instead can let it sit vacant and sue the\ndefaulting tenant for the balance of the rent as it becomes due. However, the tenant might notify\nthe landlord that she has abandoned the property or is about to abandon it and offer to\nsurrender it. If the landlord accepts the surrender, the lease then terminates. Unless the lease\nspecifically provides for it, a landlord who accepts the surrender will not be able to recover from\nthe tenant the difference between the amount of her rent obligation and the new tenant\xe2\x80\x99s rent\nobligation.\nMany leases require the tenant to make a security deposit\xe2\x80\x94a payment of a specific sum of\nmoney to secure the tenant\xe2\x80\x99s performance of duties under the lease. If the tenant fails to pay the\nrent or otherwise defaults, the landlord may use the money to make good the tenant\xe2\x80\x99s\nperformance. Whatever portion of the money is not used to satisfy the tenant\xe2\x80\x99s obligations must\nbe repaid to the tenant at the end of the lease. In the absence of an agreement to the contrary,\nthe landlord must pay interest on the security deposit when he returns the sum to the tenant at\nthe end of the lease.\n\nAlteration and Restoration of the Premises\nIn the absence of a specific agreement in the lease, the tenant is entitled to physically change the\npremises in order to make the best possible permissible use of the property, but she may not\nmake structural alterations or damage (waste) the property. A residential tenant may add\ntelephone lines, put up pictures, and affix bookshelves to the walls, but she may not remove a\nwall in order to enlarge a room.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n479\n\n\x0cThe tenant must restore the property to its original condition when the lease ends, but this\nrequirement does not include normal wear and tear. Simone rents an apartment with newly\npolished wooden floors. Because she likes the look of oak, she decides against covering the floors\nwith rugs. In a few months\xe2\x80\x99 time, the floors lose their polish and become scuffed. Simone is not\nobligated to refinish the floors, because the scuffing came from normal walking, which is\nordinary wear and tear.\n\nUse of the Property for an Illegal Purpose\nIt is a breach of the tenant\xe2\x80\x99s obligation to use the property for an illegal purpose. A landlord who\nfound a tenant running a numbers racket, for example, or making and selling moonshine whisky\ncould rightfully evict her.\n\nLandlord\xe2\x80\x99s Remedies\nIn general, when the tenant breaches any of the three duties imposed by the common law, the\nlandlord may terminate the lease and seek damages. One common situation deserves special\nmention: the holdover tenant. When a tenant improperly overstays her lease, she is said to be\na tenant at sufferance, meaning that she is liable to eviction. Some cultures, like the Japanese,\nexhibit a considerable bias toward the tenant, making it exceedingly difficult to move out\nholdover tenants who decide to stay. But in the United States, landlords may remove tenants\nthrough summary (speedy) proceedings available in every state or, in some cases, through selfhelp. Self-help is a statutory remedy for landlords or incoming tenants in some states and\ninvolves the peaceful removal of a holdover tenant\xe2\x80\x99s belongings. If a state has a statute providing\na summary procedure for removing a holdover tenant, neither the landlord nor the incoming\ntenant may resort to self-help, unless the statute specifically allows it. A provision in the lease\npermitting self-help in the absence of statutory authority is unenforceable. Self-help must be\npeaceful, must not cause physical harm or even the expectation of harm to the tenant or anyone\non the premises with his permission, and must not result in unreasonable damage to the\ntenant\xe2\x80\x99s property. Any clause in the lease attempting to waive these conditions is void.\nSelf-help can be risky, because some summary proceeding statutes declare it to be a criminal act\nand because it can subject the landlord to tort liability. Suppose that Simone improperly holds\nover in her apartment. With a new tenant scheduled to arrive in two days, the landlord knocks\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n480\n\n\x0con her door the evening after her lease expires. When Simone opens the door, she sees the\nlandlord standing between two 450-pound Sumo wrestlers with menacing expressions. He\ndemands that she leave immediately. Fearing for her safety, she departs instantly. Since she had\na reasonable expectation of harm had she not complied with the landlord\xe2\x80\x99s demand, Simone\nwould be entitled to recover damages in a tort suit against her landlord, although she would not\nbe entitled to regain possession of the apartment.\nBesides summary judicial proceedings and self-help, the landlord has another possible remedy\nagainst the holdover tenant: to impose another rental term. In order to extend the lease in this\nmanner, the landlord need simply notify the holdover tenant that she is being held to another\nterm, usually measured by the periodic nature of the rent payment. For example, if rent was\npaid each month, then imposition of a new term results in a month-to-month tenancy. One year\nis the maximum tenancy that the landlord can create by electing to hold the tenant to another\nterm.\n\nKEY TAKEAWAY\n\nBoth landlords and tenants have rights and duties. The primary duty of a landlord is to meet\nthe implied warranty of habitability: that the premises are in a safe, livable condition. The\ntenant has various remedies available if the landlord fails to meet that duty, or if the landlord\nfails to meet the implied covenant of quiet enjoyment. These include termination, damages,\nand withholding of rent. The tenant has duties as well: to pay the rent, refrain from\ncommitting waste, and not use the property for an illegal purpose.\n\nEXERCISES\n\n1. Consistent with the landlord\xe2\x80\x99s implied warranty of habitability, can the landlord and tenant\nagree in a lease that the tenant bear any and all expenses to repair the refrigerator, the\nstove, and the microwave?\n2. Under what conditions is it proper for a tenant to withhold rent from the landlord?\n[1] Javins v. First National Realty Corp., 428 F.2d 1071, 1078-79 (D.C. Cir.), cert. denied, 400 U.S. 925\n(1970).\n\n13.3 Transfer of Landlord\xe2\x80\x99s or Tenant\xe2\x80\x99s Interest\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n481\n\n\x0c1. Explain how the landlord\xe2\x80\x99s reversionary interest works and how it may be assigned.\n2. Describe the two ways in which a tenant\xe2\x80\x99s leasehold interest may be transferred to another\nparty.\n\nGeneral Rule\nAt common law, the interests of the landlord and tenant may be transferred freely unless (1) the\ntenancy is at will; (2) the lease requires either party to perform significant personal services,\nwhich would be substantially less likely to be performed if the interest was transferred; or (3)\nthe parties agree that the interest may not be transferred.\n\nLandlord\xe2\x80\x99s Interest\nWhen the landlord sells his interest, the purchaser takes subject to the lease. If there are tenants\nwith leases in an apartment building, the new landlord may not evict them simply because he\nhas taken title. The landlord may divide his interest as he sees fit, transferring all or only part of\nhis entire interest in the property. He may assign his right to the rent or sell his reversionary\ninterest in the premises. For instance, Simone takes a three-year lease on an apartment near the\nuniversity. Simone\xe2\x80\x99s landlord gives his aged uncle his reversionary interest for life. This means\nthat Simone\xe2\x80\x99s landlord is now the uncle, and she must pay him rent and look to him for repairs\nand other performances owed under the lease. When Simone\xe2\x80\x99s lease terminates, the uncle will\nbe entitled to rent the premises. He does so, leasing to another student for three years. One year\nlater, the uncle dies. His nephew (Simone\xe2\x80\x99s original landlord) has the reversionary interest and\nso once again becomes the landlord. He must perform the lease that the uncle agreed to with the\nnew student, but when that lease expires, he will be free to rent the premises as he sees fit.\n\nTenant\xe2\x80\x99s Interest\nWhy would a tenant be interested in transferring her leasehold interest? For at least two\nreasons: she might need to move before her lease expired, or she might be able to make money\non the leasehold itself. In recent years, many companies in New York have discovered that their\npresent leases were worth far more to them by moving out than staying in. They had signed\nlong-term leases years ago when the real estate market was glutted and were paying far less than\ncurrent market prices. By subletting the premises and moving to cheaper quarters, they could\npocket the difference between their lease rate and the market rate they charged their subtenants.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n482\n\n\x0cThe tenant can transfer her interest in the lease by assigning or by subletting. In anassignment,\nthe tenant transfers all interest in the premises and all obligations. Thus the assignee-tenant is\nduty bound to pay the landlord the periodic rental and to perform all other provisions in the\nlease. If the assignee defaulted, however, the original tenant would remain liable to the landlord.\nIn short, with an assignment, both assignor and assignee are liable under the lease unless the\nlandlord releases the assignor. By contrast, a sublease is a transfer of something less than the\nentire leasehold interest (see Figure 13.1 "Assignment vs. Sublease"). For instance, the tenant\nmight have five years remaining on her lease and sublet the premises for two years, or she might\nsublet the ground floor of a four-story building. Unlike an assignee, the subtenant does not step\ninto the shoes of the tenant and is not liable to the landlord for performance of the tenant\xe2\x80\x99s\nduties. The subtenant\xe2\x80\x99s only obligations are to the tenant. What distinguishes the assignment\nfrom the sublease is not the name but whether or not the entire leasehold interest has been\ntransferred. If not, the transfer is a sublease.\n\nFigure 13.1 Assignment vs. Sublease\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n483\n\n\x0cMany landlords include clauses in their leases prohibiting assignments or subleases, and these\nclauses are generally upheld. But the courts construe them strictly, so that a provision barring\nsubleases will not be interpreted to bar assignments.\n\nKEY TAKEAWAY\n\nThe interests of landlords and tenants can be freely transferred unless the parties agree\notherwise or unless there is a tenancy at will. If the tenant assigns her leasehold interest, she\nremains liable under the lease unless the landlord releases her. If less than the entire\nleasehold interest is transferred, it is a sublease rather than an assignment. But the original\nlease may prohibit either or both.\n\nEXERCISES\n\n1. What is the difference between an assignment and a sublease?\n2. Are the duties of the tenant any different if the reversionary interest is assigned? Suppose\nthat Simone is in year one of a three-year lease and that Harry is the landlord. If Harry assigns\nhis reversionary interest to Louise, can Louise raise the rent for the next two years beyond\nwhat is stated in the original lease?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n484\n\n\x0c13.4 Landlord\xe2\x80\x99s Tort Liability\n\nLEARNING OBJECTIVES\n\n1. State the general common-law rule as to the liability of the landlord for injuries occurring on\nthe leased premises.\n2. State the exceptions to the general rule, and explain the modern trend toward increased\nliability of the landlord.\nIn Chapter 11 "The Nature and Regulation of Real Estate and the Environment", we discussed\nthe tort liability of the owner or occupier of real estate to persons injured on the property. As a\ngeneral rule, when injury occurs on premises rented to a tenant, it is the tenant\xe2\x80\x94an occupier\xe2\x80\x94\nwho is liable. The reason for this rule seems clear: The landlord has given up all but a\nreversionary interest in the property; he has no further control over the premises. Indeed, he is\nnot even permitted on the property without the tenant\xe2\x80\x99s permission. But over the years, certain\nexceptions have developed to the rule that the landlord is not liable. The primary reason for this\nchange is the recognition that the landlord is better able to pay for repairs to his property than\nhis relatively poorer tenants and that he has ultimate control over the general conditions\nsurrounding the apartment or apartment complex.\n\nExceptions to the General Rule\nHidden Dangers Known to Landlord\nThe landlord is liable to the tenant, her family, or guests who are injured by hidden and\ndangerous conditions that the landlord knew about or should have known about but failed to\ndisclose to the tenant.\n\nDangers to People off the Premises\nThe landlord is liable to people injured outside the property by defects that existed when the\nlease was signed. Simone rents a dilapidated house and agrees with the landlord to keep the\nbuilding repaired. She neglects to hire contractors to repair the cracked and sagging wall on the\nstreet. The building soon collapses, crushing several automobiles parked alongside. Simone can\nbe held responsible and so can the landlord; the tenant\xe2\x80\x99s contractual agreement to maintain the\nproperty is not sufficient to shift the liability away from the landlord. In a few cases, the landlord\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n485\n\n\x0chas even been held liable for activities carried on by the tenant, but only because he knew about\nthem when the lease was signed and should have known that the injuries were probable results.\n\nPremises Leased for Admitting the Public\nA landlord is responsible for injuries caused by dangerous conditions on property to be used by\nthe public if the danger existed when the lease was made. Thus an uneven floor that might cause\npeople to trip or a defective elevator that stops a few inches below the level of each floor would\nbe sufficiently dangerous to pin liability on the landlord.\n\nLandlord Retaining Control of Premises\nFrequently, a landlord will retain control over certain areas of the property\xe2\x80\x94for example, the\ncommon hallways and stairs in an apartment building. When injuries occur as a result of faulty\nand careless maintenance of these areas, the landlord will be responsible. In more than half the\nstates, the landlord is liable for failure to remove ice and snow from a common walkway and\nstairs at the entrance. In one case, the tenant even recovered damages for a broken hip caused\nwhen she fell in fright from seeing a mouse that jumped out of her stove; she successfully\ncharged the landlord with negligence in failing to prevent mice from entering the dwelling in\nareas under his control.\n\nFaulty Repair of Premises\nLandlords often have a duty to repair the premises. The duty may be statutory or may rest on an\nagreement in the lease. In either case, the landlord will be liable to a tenant or others for injury\nresulting from defects that should have been repaired. No less important, a landlord will be\nliable even if he has no duty to repair but negligently makes repairs that themselves turn out to\nbe dangerous.\n\nKEY TAKEAWAY\n\nAt common law, injuries taking place on leased premises were the responsibility of the\ntenant. There were notable exceptions, including situations where hidden dangers were\nknown to the landlord but not the tenant, where the premises\xe2\x80\x99 condition caused injury to\npeople off the premises, or where faulty repairs caused the injuries. The modern trend is to\nadopt general negligence principles to determine landlord liability. Thus where the landlord\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n486\n\n\x0cdoes not use reasonable care and subjects others to an unreasonable risk of harm, there may\nbe liability for the landlord. This varies from state to state.\n\nEXERCISES\n\n1. What was the basic logic of the common law in having tenants be responsible for all injuries\nthat took place on leased premises?\n2. Does the modern trend of applying general negligence principles to landlords make more\nsense? Explain your answer.\n\n13.5 Cases\nConstructive Eviction\nFidelity Mutual Life Insurance Co. v. Kaminsky\n768 S.W.2d 818 (Tx. Ct. App. 1989)\nMURPHY, JUSTICE\nThe issue in this landlord-tenant case is whether sufficient evidence supports the jury\xe2\x80\x99s findings\nthat the landlord and appellant, Fidelity Mutual Life Insurance Company [\xe2\x80\x9cFidelity\xe2\x80\x9d],\nconstructively evicted the tenant, Robert P. Kaminsky, M.D., P.A. [\xe2\x80\x9cDr. Kaminsky\xe2\x80\x9d] by breaching\nthe express covenant of quiet enjoyment contained in the parties\xe2\x80\x99 lease. We affirm.\nDr. Kaminsky is a gynecologist whose practice includes performing elective abortions. In May\n1983, he executed a lease contract for the rental of approximately 2,861 square feet in the Red\nOak Atrium Building for a two-year term which began on June 1, 1983. The terms of the lease\nrequired Dr. Kaminsky to use the rented space solely as \xe2\x80\x9can office for the practice of medicine.\xe2\x80\x9d\nFidelity owns the building and hires local companies to manage it. At some time during the lease\nterm, Shelter Commercial Properties [\xe2\x80\x9cShelter\xe2\x80\x9d] replaced the Horne Company as managing\nagents. Fidelity has not disputed either management company\xe2\x80\x99s capacity to act as its agent.\nThe parties agree that: (1) they executed a valid lease agreement; (2) Paragraph 35 of the lease\ncontains an express covenant of quiet enjoyment conditioned on Dr. Kaminsky\xe2\x80\x99s paying rent\nwhen due, as he did through November 1984; Dr. Kaminsky abandoned the leased premises on\nor about December 3, 1984 and refused to pay additional rent; anti-abortion protestors began\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n487\n\n\x0cpicketing at the building in June of 1984 and repeated and increased their demonstrations\noutside and inside the building until Dr. Kaminsky abandoned the premises.\nWhen Fidelity sued for the balance due under the lease contract following Dr. Kaminsky\xe2\x80\x99s\nabandonment of the premises, he claimed that Fidelity constructively evicted him by breaching\nParagraph 35 of the lease. Fidelity apparently conceded during trial that sufficient proof of the\nconstructive eviction of Dr. Kaminsky would relieve him of his contractual liability for any\nremaining rent payments. Accordingly, he assumed the burden of proof and the sole issue\nsubmitted to the jury was whether Fidelity breached Paragraph 35 of the lease, which reads as\nfollows:\n\nQuiet Enjoyment\nLessee, on paying the said Rent, and any Additional Rental, shall and may peaceably and quietly\nhave, hold and enjoy the Leased Premises for the said term.\nA constructive eviction occurs when the tenant leaves the leased premises due to conduct by the\nlandlord which materially interferes with the tenant\xe2\x80\x99s beneficial use of the premises. Texas law\nrelieves the tenant of contractual liability for any remaining rentals due under the lease if he can\nestablish a constructive eviction by the landlord.\nThe protests took place chiefly on Saturdays, the day Dr. Kaminsky generally scheduled\nabortions. During the protests, the singing and chanting demonstrators picketed in the\nbuilding\xe2\x80\x99s parking lot and inner lobby and atrium area. They approached patients to speak to\nthem, distributed literature, discouraged patients from entering the building and often accused\nDr. Kaminsky of \xe2\x80\x9ckilling babies.\xe2\x80\x9d As the protests increased, the demonstrators often occupied\nthe stairs leading to Dr. Kaminsky\xe2\x80\x99s office and prevented patients from entering the office by\nblocking the doorway. Occasionally they succeeded in gaining access to the office waiting room\narea.\nDr. Kaminsky complained to Fidelity through its managing agents and asked for help in keeping\nthe protestors away, but became increasingly frustrated by a lack of response to his requests.\nThe record shows that no security personnel were present on Saturdays to exclude protestors\nfrom the building, although the lease required Fidelity to provide security service on Saturdays.\nThe record also shows that Fidelity\xe2\x80\x99s attorneys prepared a written statement to be handed to the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n488\n\n\x0cprotestors soon after Fidelity hired Shelter as its managing agent. The statement tracked TEX.\nPENAL CODE ANN. \xc2\xa730.05 (Vernon Supp. 1989) and generally served to inform trespassers\nthat they risked criminal prosecution by failing to leave if asked to do so. Fidelity\xe2\x80\x99s attorneys\ninstructed Shelter\xe2\x80\x99s representative to \xe2\x80\x9chave several of these letters printed up and be ready to\ndistribute them and verbally demand that these people move on and off the property.\xe2\x80\x9d The same\nrepresentative conceded at trial that she did not distribute these notices. Yet when Dr. Kaminsky\nenlisted the aid of the Sheriff\xe2\x80\x99s office, officers refused to ask the protestors to leave without a\ndirective from Fidelity or its agent. Indeed, an attorney had instructed the protestors to\nremain unless the landlord or its representative ordered them to leave. It appears that Fidelity\xe2\x80\x99s\nonly response to the demonstrators was to state, through its agents, that it was aware of Dr.\nKaminsky\xe2\x80\x99s problems.\nBoth action and lack of action can constitute \xe2\x80\x9cconduct\xe2\x80\x9d by the landlord which amounts to a\nconstructive eviction.\xe2\x80\xa6\nThis case shows ample instances of Fidelity\xe2\x80\x99s failure to act in the fact of repeated requests for\nassistance despite its having expressly covenanted Dr. Kaminsky\xe2\x80\x99s quiet enjoyment of the\npremises. These instances provided a legally sufficient basis for the jury to conclude that Dr.\nKaminsky abandoned the leased premises, not because of the trespassing protestors, but\nbecause of Fidelity\xe2\x80\x99s lack of response to his complaints about the protestors. Under the\ncircumstances, while it is undisputed that Fidelity did not \xe2\x80\x9cencourage\xe2\x80\x9d the demonstrators, its\nconduct essentially allowed them to continue to trespass.\n[The trial court judgment is affirmed.]\n\nCASE QUESTIONS\n\nA constructive eviction occurs when the tenant leaves the leased premises because of\nconduct by the landlord that materially interferes with the tenant\xe2\x80\x99s beneficial use of the\npremises.\n1. At the trial, who concluded that Fidelity\xe2\x80\x99s \xe2\x80\x9cconduct\xe2\x80\x9d constituted constructive eviction? Is this\na question of fact, an interpretation of the contract, or both?\n2. How can failure to act constitute \xe2\x80\x9cconduct\xe2\x80\x9d? What could explain Fidelity\xe2\x80\x99s apparent\nreluctance to give notice to protestors that they might be arrested for trespass?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n489\n\n\x0cLandlord\xe2\x80\x99s Tort Liability\nStephens v. Stearns\n106 Idaho 249; 678 P.2d 41 (Idaho Sup. Ct. 1984)\nDonaldson, Chief Justice\nPlaintiff-appellant Stephens filed this suit on October 2, 1978, for personal injuries she\nsustained on July 15, 1977, from a fall on an interior stairway of her apartment. Plaintiff\xe2\x80\x99s\napartment, located in a Boise apartment complex, was a \xe2\x80\x9ctownhouse\xe2\x80\x9d consisting of two separate\nfloors connected by an internal stairway.\nThe apartments were built by defendant Koch and sold to defendant Stearns soon after\ncompletion in 1973. Defendant Stearns was plaintiff\xe2\x80\x99s landlord from the time she moved into the\napartment in 1973 through the time of plaintiff\xe2\x80\x99s fall on July 15, 1977. Defendant Albanese was\nthe architect who designed and later inspected the apartment complex.\n***\nWhen viewed in the light most favorable to appellant, the facts are as follows: On the evening of\nJuly 15, 1977, Mrs. Stephens went to visit friends. While there she had two drinks. She returned\nto her apartment a little past 10:00 p.m. Mrs. Stephens turned on the television in the living\nroom and went upstairs to change clothes. After changing her clothes, she attempted to go\ndownstairs to watch television. As Mrs. Stephens reached the top of the stairway, she either\nslipped or fell forward. She testified that she \xe2\x80\x9cgrabbed\xe2\x80\x9d in order to catch herself. However, Mrs.\nStephens was unable to catch herself and she fell to the bottom of the stairs. As a result of the\nfall, she suffered serious injury. The evidence further showed that the stairway was\napproximately thirty-six inches wide and did not have a handrail although required by a Boise\nordinance.\n***\nIn granting defendant Stearns\xe2\x80\x99 motion for directed verdict, the trial judge concluded that there\nwas \xe2\x80\x9can absolute lack of evidence\xe2\x80\x9d and that \xe2\x80\x9cto find a proximate cause between the absence of\nthe handrail and the fall suffered by the plaintiff would be absolutely conjecture and\nspeculation.\xe2\x80\x9d (Although the trial judge\xe2\x80\x99s conclusion referred to \xe2\x80\x9cproximate cause,\xe2\x80\x9d it is apparent\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n490\n\n\x0cthat he was referring to factual or actual cause. See Munson v. State, Department of Highways,\n96 Idaho 529, 531 P.2d 1174 (1975).) We disagree with the conclusion of the trial judge.\nWe have considered the facts set out above in conjunction with the testimony of Chester\nShawver, a Boise architect called as an expert in the field of architecture, that the primary\npurpose of a handrail is for user safety. We are left with the firm conviction that there is\nsufficient evidence from which reasonable jurors could have concluded that the absence of a\nhandrail was the actual cause of plaintiff\xe2\x80\x99s injuries; i.e., that plaintiff would not have fallen, or at\nleast would have been able to catch herself, had there been a handrail available for her to grab.\nIn addition, we do not believe that the jury would have had to rely on conjecture and speculation\nto find that the absence of the handrail was the actual cause. To the contrary, we believe that\nreasonable jurors could have drawn legitimate inferences from the evidence presented to\ndetermine the issue. This comports with the general rule that the factual issue of causation is for\nthe jury to decide. McKinley v. Fanning, 100 Idaho 189, 595 P.2d 1084 (1979); Munson v. State,\nDepartment of Highways, supra. In addition, courts in several other jurisdictions, when faced\nwith similar factual settings, have held that this issue is a question for the jury.\n***\nRather than attempt to squeeze the facts of this case into one of the common-law exceptions,\nplaintiff instead has brought to our attention the modern trend of the law in this area. Under the\nmodern trend, landlords are simply under a duty to exercise reasonable care under the\ncircumstances. The Tennessee Supreme Court had the foresight to grasp this concept many\nyears ago when it stated: \xe2\x80\x9cThe ground of liability upon the part of a landlord when he demises\ndangerous property has nothing special to do with the relation of landlord and tenant. It is the\nordinary case of liability for personal misfeasance, which runs through all the relations of\nindividuals to each other.\xe2\x80\x9d Wilcox v. Hines, 100 Tenn. 538, 46 S.W. 297, 299 (1898). Seventyfive years later, the Supreme Court of New Hampshire followed the lead of Wilcox. Sargent v.\nRoss, 113 N.H. 388, 308 A.2d 528 (1973). The Sargent court abrogated the common-law rule\nand its exceptions, and adopted the reasonable care standard by stating:\nWe thus bring up to date the other half of landlord-tenant law. Henceforth, landlords as other\npersons must exercise reasonable care not to subject others to an unreasonable risk of harm.\xe2\x80\xa6A\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n491\n\n\x0clandlord must act as a reasonable person under all of the circumstances including the likelihood\nof injury to others, the probable seriousness of such injuries, and the burden of reducing or\navoiding the risk.\nId. at 534 [Citations]\nTennessee and New Hampshire are not alone in adopting this rule. As of this date, several other\nstates have also judicially adopted a reasonable care standard for landlords.\n***\nIn commenting on the common-law rule, A. James Casner, Reporter of Restatement (Second) of\nProperty\xe2\x80\x94Landlord and Tenant, has stated: \xe2\x80\x9cWhile continuing to pay lip service to the general\nrule, the courts have expended considerable energy and exercised great ingenuity in attempting\nto fit various factual settings into the recognized exceptions.\xe2\x80\x9d Restatement (Second) of\nProperty\xe2\x80\x94Landlord and Tenant ch. 17 Reporter\xe2\x80\x99s Note to Introductory Note (1977). We believe\nthat the energies of the courts of Idaho should be used in a more productive manner. Therefore,\nafter examining both the common-law rule and the modern trend, we today decide to leave the\ncommon-law rule and its exceptions behind, and we adopt the rule that a landlord is under a\nduty to exercise reasonable care in light of all the circumstances.\nWe stress that adoption of this rule is not tantamount to making the landlord an insurer for all\ninjury occurring on the premises, but merely constitutes our removal of the landlord\xe2\x80\x99s commonlaw cloak of immunity. Those questions of hidden danger, public use, control, and duty to\nrepair, which under the common-law were prerequisites to the consideration of the landlord\xe2\x80\x99s\nnegligence, will now be relevant only inasmuch as they pertain to the elements of negligence,\nsuch as foreseeability and unreasonableness of the risk. We hold that defendant Stearns did owe\na duty to plaintiff Stephens to exercise reasonable care in light of all the circumstances, and that\nit is for a jury to decide whether that duty was breached. Therefore, we reverse the directed\nverdict in favor of defendant Stearns and remand for a new trial of plaintiff\xe2\x80\x99s negligence action\nagainst defendant Stearns.\n\nCASE QUESTIONS\n\n1. Why should actual cause be a jury question rather than a question that the trial judge\ndecides on her own?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n492\n\n\x0c2. Could this case have fit one of the standard exceptions to the common-law rule that injuries\non the premises are the responsibility of the tenant?\n3. Does it mean anything at all to say, as the court does, that persons (including landlords) must\n\xe2\x80\x9cexercise reasonable care not to subject others to an unreasonable risk of harm?\xe2\x80\x9d Is this a\nrule that gives very much direction to landlords who may wonder what the limit of their\nliabilities might be?\n\n13.6 Summary and Exercises\nSummary\n\nA leasehold is an interest in real property that terminates on a certain date. The leasehold itself\nis personal property and has three major forms: (1) the estate for years, (2) the periodic tenancy,\nand (3) the tenancy at will. The estate for years has a definite beginning and end; it need not be\nmeasured in years. A periodic tenancy\xe2\x80\x94sometimes known as an estate from year to year or\nmonth to month\xe2\x80\x94is renewed automatically until either landlord or tenant notifies the other that\nit will end. A tenancy at will lasts only as long as both landlord and tenant desire. Oral leases are\nsubject to the Statute of Frauds. In most states, leases to last longer than a year must be in\nwriting, and the lease must identify the parties and the premises, specify the duration, state the\nrent, and be signed by the party to be charged.\nThe law imposes on the landlord certain duties toward the tenant and gives the tenant\ncorresponding rights, including the right of possession, habitable condition, and\nnoninterference with use. The right of possession is breached if a third party has paramount title\nat the time the tenant is due to take possession. In most states, a landlord is obligated to provide\nthe tenant with habitable premises not only when the tenant moves in but also during the entire\nperiod of the lease. The landlord must also refrain from interfering with a tenant\xe2\x80\x99s permissible\nuse of the premises.\nIf the landlord breaches an obligation, the tenant has several remedies. He may terminate the\nlease, recover damages, or (in several states) use a rent-related remedy (by withholding rent, by\napplying it to remedy the defect, or by abatement).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n493\n\n\x0cThe tenant has duties also. The tenant must pay the rent. If she abandons the property and fails\nto pay, most states do not require the landlord to mitigate damages, but several states are\nmoving away from this general rule. The tenant may physically change the property to use it to\nher best advantage, but she may not make structural alterations or commit waste. The tenant\nmust restore the property to its original condition when the lease ends. This rule does not\ninclude normal wear and tear.\nShould the tenant breach any of her duties, the landlord may terminate the lease and seek\ndamages. In the case of a holdover tenant, the landlord may elect to hold the tenant to another\nrental term.\nThe interest of either landlord or tenant may be transferred freely unless the tenancy is at will,\nthe lease requires either party to perform significant personal services that would be\nsubstantially less likely to be performed, or the parties agree that the interest may not be\ntransferred.\nDespite the general rule that the tenant is responsible for injuries caused on the premises to\noutsiders, the landlord may have significant tort liability if (1) there are hidden dangers he\nknows about, (2) defects that existed at the time the lease was signed injure people off the\npremises, (3) the premises are rented for public purposes, (4) the landlord retains control of the\npremises, or (5) the landlord repairs the premises in a faulty manner.\n\nEXERCISES\n\n1. Lanny orally agrees to rent his house to Tenny for fifteen months, at a monthly rent of\n$1,000. Tenny moves in and pays the first month\xe2\x80\x99s rent. Lanny now wants to cancel the lease.\nMay he? Why?\n2. Suppose in Exercise 1 that Tenny had an option to cancel after one year. Could Lanny cancel\nbefore the end of the year? Why?\n3. Suppose in Exercise 1 that Lanny himself is a tenant and has leased the house for six months.\nHe subleases the house to Tenny for one year. The day before Tenny is to move into the\nhouse, he learns of Lanny\xe2\x80\x99s six-month lease and attempts to terminate his one-year lease.\nMay he? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n494\n\n\x0c4. Suppose in Exercise 3 that Tenny learned of Lanny\xe2\x80\x99s lease the day after he moved into the\nhouse. May he terminate? Why?\n5. Simon owns a four-story building and rents the top floor to a college student. Simon is in the\nhabit of burning refuse in the backyard, and the smoke from the refuse is so noxious that it\ncauses the student\xe2\x80\x99s eyes to water and his throat to become raw. Has Simon breached a duty\nto the student? Explain.\n6. In Exercise 5, if other tenants (but not Simon) were burning refuse in the backyard, would\nSimon be in breach? Why?\n7. Assume in Exercise 5 that Simon was in breach. Could the student move out of the apartment\nand terminate the lease? What effect would this have on the student\xe2\x80\x99s duty to pay rent?\nExplain.\n\nSELF-TEST QUESTIONS\n\n1. An estate for years\na.\n\nhas a definite beginning and end\nb. is a leasehold estate\nc. usually terminates automatically at midnight of the last day specified in the lease\nd. includes all of the above\nNot included among the rights given to a tenant is\n\na.\n\nparamount title\nb. possession\nc. habitable condition\nd. noninterference with use\nThe interest of either landlord or tenant may be transferred freely\n\na.\n\nunless the tenancy is at will\nb. unless the lease requires significant personal services unlikely to be performed by\nsomeone else\nc. unless either of the above apply\nd. under no circumstances\nWhen injuries are caused on the premises to outsiders,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n495\n\n\x0ca.\n\nthe tenant is always liable\n\nb. the landlord is always liable\nc. the landlord may be liable if there are hidden dangers the landlord knows about\nd. they have no cause of action against the landlord or tenant since they have no\ndirect contractual relationship with either party\nLegally a tenant may\na.\n\ncommit waste\n\nb. make some structural alterations to the property\nc. abandon the property at any time\nd. physically change the property to suit it to her best advantage, as long as no\nstructural alterations are made\n\nSELF-TEST ANSWERS\n\n1. d\n2. a\n3. c\n4. c\n5. d\n\nChapter 14\nEstate Planning: Wills, Estates, and Trusts\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. How property, both real and personal, can be devised and bequeathed to named heirs in a\nwill\n2. What happens to property of a decedent when there is no will\n3. The requirements for \xe2\x80\x9ctestamentary capacity\xe2\x80\x9d\xe2\x80\x94what it takes to make a valid will that can be\nadmitted to probate\n4. The steps in the probate and administration of a will\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n496\n\n\x0c5. How a will is distinguished from a trust, and how a trust is created, how it functions, and how\nit may come to an end\n6. The various kinds of trusts, as well as factors that affect both estates and trusts\nBroadly defined, estate planning is the process by which someone decides how his assets are to\nbe passed on to others at his death. Estate planning has two general objectives: to ensure that\nthe assets are transferred according to the owner\xe2\x80\x99s wishes and to minimize state and federal\ntaxes.\nPeople have at their disposal four basic estate planning tools: (1) wills, (2) trusts, (3) gifts, and\n(4) joint ownership (see Figure 14.1 "Estate Planning"). The rules governing gifts are discussed\nin Chapter 9 "Introduction to Property: Personal Property and Fixtures", and joint ownership is\ntreated in Chapter 11 "The Nature and Regulation of Real Estate and the Environment".\nConsequently, we focus on the first two tools here. In addition to these tools, certain assets, such\nas insurance (discussed in Chapter 15 "Insurance"), are useful in estate planning.\n\nFigure 14.1 Estate Planning\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n497\n\n\x0cEstate planning not only provides for the spouses and children, other relatives and friends, the\nchildren\xe2\x80\x99s education, payoff of the mortgage, and so on, but also serves as the principal means\nby which liquidity can be guaranteed for taxes, expenses for administering the estate, and the\nlike, while preserving the assets of the estate. And whenever a business is formed, estate\nplanning consequences should always be considered, because the form and structure of the\nbusiness can have important tax ramifications for the individual owners.\n\n14.1 Wills and Estate Administration\n\nLEARNING OBJECTIVES\n\n1. Describe how property, both real and personal, can be devised and bequeathed to named\nheirs in a will.\n2. Understand what happens to property of a decedent when there is no will.\n3. Explain the requirements for \xe2\x80\x9ctestamentary capacity\xe2\x80\x9d\xe2\x80\x94what it takes to make a valid will that\ncan be admitted to probate.\n4. Describe the steps in the probate and administration of a will.\n\nDefinition\nA will is the declaration of a person\xe2\x80\x99s wishes about the disposition of his assets on his death.\nNormally a written document, the will names the persons who are to receive specific items of\nreal and personal property. Unlike a contract or a deed, a will is not binding as long as the\nperson making the will lives. He may revoke it at any time. Wills have served their present\nfunction for virtually all of recorded history. The earliest known will is from 1800 BC (see Figure\n14.2 "An Ancient Will"). Even if somewhat different in form, it served the same basic function as\na modern will.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n498\n\n\x0cFigure 14.2 An Ancient Will\n\nSource: John H. Wigmore, A Panorama of the World\xe2\x80\x99s Legal Systems, vol. 1, p. 22.\n\nAlthough most wills are written in a standardized form, some special types of wills are\nenforceable in many states.\n1. A nuncupative will is one that is declared orally in front of witnesses. In states where allowed,\nthe statutes permit it to be used only when the testator is dying as he declares his will. (A\ntestator is one who dies with a will.)\n2. A holographic will is one written entirely by the testator\xe2\x80\x99s hand and not witnessed. At common\nlaw, a holographic will was invalid if any part of the paper on which it was written contained\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n499\n\n\x0cprinting. Modern statutes tend to validate holographic wills, even with printing, as long as the\ntestator who signs it puts down material provisions in his own hand.\n3. Soldiers\xe2\x80\x99 and sailors\xe2\x80\x99 wills are usually enforceable, no matter how informal the document, if\nmade while the soldier is on service or the sailor is at sea (although they cannot usually transfer\nreal property without observing certain formalities).\n4. A conditional will is one that will take effect only on the happening of a particular named event.\nFor example, a man intending to marry might write, \xe2\x80\x9cThis will is contingent on my marrying\nAlexa Jansey.\xe2\x80\x9d If he and Ms. Jansey do not marry, the will can have no operational effect.\n5. A joint will is one in which two (or more) people use the same instrument to dispose of their\nassets. It must be signed by each person whose assets it is to govern.\n6. Mutual or reciprocal wills are two or more instruments with reciprocal terms, each written by a\nperson who intends to dispose of his or her assets in favor of the others.\n\nThe Uniform Probate Code\nProbate is the process by which a deceased\xe2\x80\x99s estate is managed under the supervision of a court.\nIn most states, the court supervising this process is a specialized one and is often called the\nprobate court. Probate practices vary widely from state to state, although they follow a general\npattern in which the assets of an estate are located, added up, and disbursed according to the\nterms of the will or, if there is no will, according to the law of intestate succession. To attempt to\nbring uniformity into the conflicting sets of state laws the National Conference of\nCommissioners on Uniform State Laws issued the Uniform Probate Code (UPC) in 1969, and by\n2011 it had been adopted in its entirety in sixteen states. Several other states have adopted\nsignificant parts of the UPC, which was revised in 2006. Our discussion of wills and estate\nadministration is drawn primarily from the UPC, but you should note that there are variations\namong the states in some of the procedures standardized in the UPC.\n\nWill Requirements and Interpretation\nCapacity\nAny person who is over eighteen and of \xe2\x80\x9csound mind\xe2\x80\x9d may make a will. One who is insane may\nnot make an enforceable will, although the degree of mental capacity necessary to sustain a will\nis generally said to be a \xe2\x80\x9cmodest level of competence\xe2\x80\x9d and is lower than the degree of capacity\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n500\n\n\x0cpeople must possess to manage their own affairs during their life. In other words, a court might\norder a guardian to manage the affairs of one who is mentally deficient but will uphold a will\nthat the person has written. Insanity is not the only type of mental deficiency that will disqualify\na will; medication of a person for serious physical pain might lead to the conclusion that the\nperson\xe2\x80\x99s mind was dulled and he did not understand what he was doing when writing his will.\nThe case Estate of Seymour M. Rosen, (see Section 14.4.1 "Testamentary Capacity"), considers\njust such a situation.\n\nWriting\nUnder the UPC, wills must be in writing. The will is not confined to the specific piece of paper\ncalled \xe2\x80\x9cwill\xe2\x80\x9d and signed by the testator. It may incorporate by reference any other writing in\nexistence when the will is made, as long as the will sufficiently identifies the other writing and\nmanifests an intent to incorporate it. Although lawyers prepare neatly typed wills, the document\ncan be written in pencil or pen and on any kind of paper or even on the back of an envelope.\nTypically, the written will has the following provisions: (1) a \xe2\x80\x9cpublication clause,\xe2\x80\x9d listing the\ntestator\xe2\x80\x99s name and his or her intention to make a will; (2) a \xe2\x80\x9crevocation clause,\xe2\x80\x9d revoking all\npreviously made wills; (3) burial instructions; (4) debt payments, listing specific assets to be\nused; (5)bequests, which are gifts of personal property by will; (6) devises, which are gifts of real\nproperty by will; (7) a \xe2\x80\x9cresiduary clause,\xe2\x80\x9d disposing of all property not covered by a specific\nbequest or devise; (8) a \xe2\x80\x9cpenalty clause,\xe2\x80\x9d stating a penalty for anyone named in the will who\ncontests the will; (9) the name of minor children\xe2\x80\x99s guardian; and (10) the name of the executor.\nThe executor\xe2\x80\x99s job is to bring in all the assets of an estate, pay all just claims, and make\ndistribution to beneficiaries in accord with the testator\xe2\x80\x99s wishes. Beginning with California in\n1983, several states have adopted statutory wills\xe2\x80\x94simple fill-in-the-blank will forms that can be\ncompleted without consulting an attorney.\n\nSignature\nThe testator must sign the will, and the proper place for the signature is at the end of the entire\ndocument. The testator need not sign his full name, although that is preferable; his initials or\nsome other mark in his own hand, intended as an execution of the document, will suffice. The\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n501\n\n\x0cUPC permits someone else to sign for the testator as long as the signing is done in the testator\xe2\x80\x99s\npresence and by his or her direction.\n\nWitnesses\nMost states require two or three witnesses to sign the will. The UPC requires two witnesses. The\nwitnesses should observe the testator sign the will and then sign it themselves in the presence of\neach other. Since the witnesses might be asked to attest in court to the testator\xe2\x80\x99s signature, it is\nsound practice to avoid witnesses who are unduly elderly and to use an extra witness or two.\nMost states forbid a person who has an interest in the will\xe2\x80\x94that is, one who is a beneficiary\nunder the will\xe2\x80\x94from witnessing.\nIn some states, a beneficiary who serves as a witness will lose his or her right to a bequest or\ndevise. The UPC differs from the usual rule: no will or any provision of a will is invalid because\nan interested party witnesses it, nor does the interested witness forfeit a bequest or devise.\n\nRevocation and Modification\nSince wills are generally effective only at death, the testator may always revoke or amend a will\nduring his lifetime. He may do so by tearing, burning, obliterating, or otherwise destroying it. A\nsubsequent will has the effect of revoking an inconsistent prior will, and most wills expressly\nstate that they are intended to revoke all prior wills. A written modification of or supplement to\na prior will is called a codicil. The codicil is often necessary, because circumstances are\nconstantly changing. The testator may have moved to a new state where he must meet different\nformal requirements for executing the will; one of his beneficiaries may have died; his property\nmay have changed. Or the law, especially the tax law, may have changed.\nOne exception to the rule that wills are effective only at death is the so-calledliving will.\nBeginning with California in 1976, most states have adopted legislation permitting people to\ndeclare that they refuse further treatment should they become terminally ill and unable to tell\nphysicians not to prolong their lives if they can survive only by being hooked up to lifepreserving machines. This living will takes effect during the patient\xe2\x80\x99s life and must be honored\nby physicians unless the patient has revoked it. The patient may revoke at any time, even as he\nsees the doctor moving to disconnect the plug.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n502\n\n\x0cIn most states, a later marriage revokes a prior will, but divorce does not. Under the UPC,\nhowever, a divorce or annulment revokes any disposition of property bequeathed or devised to\nthe former spouse under a will executed prior to the divorce or annulment. A will is at least\npartially revoked if children are born after it is executed, unless it has either provided for\nsubsequently born children or stated the testator\xe2\x80\x99s intention to disinherit such children.\n\nAbatement\nSpecific bequests listed in a will might not be available in the estate when the testator or\ntestatrix dies. Abatement of a bequest happens when there are insufficient assets to pay the\nbequest. Suppose the testatrix leaves $10,000 each to \xe2\x80\x9cmy four roommates,\xe2\x80\x9d but when she dies,\nher estate is worth only $20,000. The gift to each of the roommates is said to have abated, and\neach will take only $5,000.\nAbatement can pose a serious problem in wills not carefully drafted. Since circumstances can\nalways change, a general provision in a father\xe2\x80\x99s will, providing \xe2\x80\x9cmy dear daughter with all the\nrest, residue, and remainder of my estate,\xe2\x80\x9d will do her little good if business reverses mean that\nthe $10,000 bequest to the local hospital exhausts the estate of its assets\xe2\x80\x94even though at the\ntime the will was made, the testator had assets of $1 million and supposed his daughter would\nbe getting the bulk of it. Since specific gifts must be paid out ahead of general bequests or\ndevises, abatement can cause the residual legatee (the person taking all assets not specifically\ndistributed to named individuals) to suffer.\n\nAdemption\nSuppose that a testator bequeathed her 1923 Rolls Royce to \xe2\x80\x9cmy faithful secretary,\xe2\x80\x9d but that the\ncar had been sold and she owned only a 1980 Volkswagen when she died. Since the Rolls was\nnot part of the estate, it is said to have adeemed (to have been taken away). Ademption of a gift\nin a will means that the intended legatee (the person named in the will) forfeits the object\nbecause it no longer exists. An object used as a substitute by the testator will not pass to the\nlegatee unless it is clear that she intended the legatee to have it.\n\nIntestacy\nIntestacy means dying without a will. Intestacy happens all too frequently; even those who know\nthe consequences for their heirs often put off making a will until it is too late\xe2\x80\x94Abraham Lincoln,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n503\n\n\x0cfor one, who as an experienced lawyer knew very well the hazards to heirs of dying intestate. On\nhis death, Lincoln\xe2\x80\x99s property was divided, with one-third going to his widow, one-third to a\ngrown son, and one-third to a twelve-year-old son. Statistics show that in New York, about onethird of the people who die with estates of $5,000 or more die without wills. In every state,\nstatutes provide for the disposition of property of decedents dying without wills. If you die\nwithout a will, the state in effect has made one for you. Although the rules vary by statute from\nstate to state, a common distribution pattern prevails.\n\nUnmarried Decedent\nAt common law, parents of an intestate decedent could not inherit his property. Today, however,\nmany states provide that parents will share in the property. If the parents have already died,\nthen the estate will pass to collateral heirs (siblings, nieces, nephews, aunts, and uncles). If there\nare no collateral heirs, most state laws provide that the next surviving kin of equal degree will\nshare the property equally (e.g., first cousins). If there are no surviving kin, the\nestate escheats (es CHEETS) to the state, which is then the sole owner of the assets of the estate.\n\nMarried with No Children\nIn some states, the surviving spouse without children will inherit the entire estate. In other\nstates, the spouse must share the property with the decedent\xe2\x80\x99s parents or, if they are deceased,\nwith the collateral heirs.\n\nMarried with Children\nIn general, the surviving spouse will be entitled to one-third of the estate, and the remainder will\npass in equal shares to living children of the decedent. The share of any child who died before\nthe decedent will be divided equally among that child\xe2\x80\x99s offspring. These grandchildren of the\ndecedent are said to take per stirpes (per STIR peas), meaning that they stand in the shoes of\ntheir parent. Suppose that the decedent left a wife, three children, and eight grandchildren (two\nchildren each of the three surviving children and two children of a fourth child who predeceased\nthe decedent), and that the estate was worth $300,000. Under a typical intestate succession law,\nthe widow would receive property worth $100,000. The balance of the property would be\ndivided into four equal parts, one for each of the four children. The three surviving children\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n504\n\n\x0cwould each receive $50,000. The two children of the fourth child would each receive $25,000.\nThe other grandchildren would receive nothing.\nA system of distribution in which all living descendants share equally, regardless of generation,\nis said to be a distribution per capita. In the preceding example, after the widow took her share,\nthe remaining sum would be divided into eleven parts, three for the surviving children and eight\nfor the surviving grandchildren.\n\nUnmarried with Children\nIf the decedent was a widow or widower with children, then the surviving children generally will\ntake the entire estate.\n\nEstate Administration\nTo carry on the administration of an estate, a particular person must be responsible for locating\nthe estate property and carrying out the decedent\xe2\x80\x99s instructions. If named in the will, this person\nis called an executor. When a woman serves, she is still known in many jurisdictions as\nan executrix. If the decedent died intestate, the court will appoint an administrator (or\nadministratrix, if a woman), usually a close member of the family. The UPC refers to the person\nperforming the function of executor or administrator as a personal representative. Unless\nexcused by the will from doing so, the personal representative must post a bond, usually in an\namount that exceeds the value of the decedent\xe2\x80\x99s personal property.\nThe personal representative must immediately become familiar with the decedent\xe2\x80\x99s business,\npreserve the assets, examine the books and records, check on insurance, and notify the\nappropriate banks.\nWhen confirmed by the court (if necessary), the personal representative must offer the will in\nprobate\xe2\x80\x94that is, file the will with the court, prove its authenticity through witnesses, and defend\nit against any challenges. Once the court accepts the will, it will enter a formal decree admitting\nthe will to probate.\nTraditionally, a widow could make certain elections against the will; for example, she could\nchoose dower and homestead rights. The right of dower entitled the widow to a life estate in\none-third of the husband\xe2\x80\x99s inheritable land, while a homestead right is the right to the family\nhome as measured by an amount of land (e.g., 160 acres of rural land or 1 acre of urban land in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n505\n\n\x0cKansas) or a specific dollar amount. In some states, this amount is quite low (e.g., $4,000 in\nKansas) where the legislature has not upwardly adjusted the dollar amount for many years.\nToday, most states have eliminated traditional dower rights. These states give the surviving\nspouse (widow or widower) the right to reject provisions made in a will and to take a share of the\ndecedent\xe2\x80\x99s estate instead.\nOnce the will is admitted to probate, the personal representative must assemble and inventory\nall assets. This task requires the personal representative to collect debts and rent due, supervise\nthe decedent\xe2\x80\x99s business, inspect the real estate, store personal and household effects, prove the\ndeath and collect proceeds of life insurance policies, take securities into custody, and ascertain\nwhether the decedent held property in other states. Next, the assets must be appraised as of the\ndate of death. When inventory and appraisal are completed, the personal representative must\ndecide how and when to dispose of the assets by answering the following sorts of questions:\nShould a business be liquidated, sold, or allowed to continue to operate? Should securities be\nsold, and if so, when? Should the real estate be kept intact under the will or sold? To whom must\nthe personal effects be given?\nThe personal representative must also handle claims against the estate. If the decedent had\nunpaid debts while alive, the estate will be responsible for paying them. In most states, the\npersonal representative is required to advertise that the estate is in probate. When all claims\nhave been gathered and authenticated, the personal representative must pay just claims in order\nof priority. In general (though by no means in every state), the order of priority is as follows: (1)\nfuneral expenses, (2) administration expenses (cost of bond, advertising expenses, filing fees,\nlawsuit costs, etc.), (3) family allowance, (4) claims of the federal government, (5) hospital and\nother expenses associated with the decedent\xe2\x80\x99s last illness, (6) claims of state and local\ngovernments, (7) wage claims, (8) lien claims, (9) all other debts. If the estate is too small to\ncover all these claims, every claim in the first category must be satisfied before the claims in the\nsecond category may be paid, and so on.\nBefore the estate can be distributed, the personal representative must take care of all taxes owed\nby the estate. She will have to file returns for both estate and income taxes and pay from assets\nof the estate the taxes due. (She may have to sell some assets to obtain sufficient cash to do\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n506\n\n\x0cso.) Estate taxes\xe2\x80\x94imposed by the federal government and based on the value of the estate\xe2\x80\x94are\nnearly as old as the Republic; they date back to 1797. They were instituted originally to raise\nrevenue, but in our time they serve also to break up large estates.\nAs of 2011, the first $1 million of an estate is exempt from taxation, lowering the threshold from\nan earlier standard. The Tax Policy Institute of the Brookings Institution estimates that 108,200\nestates of people dying in 2011 will file estate tax returns, and 44,200 of those estates will pay\ntaxes totaling $34.4 billion.\nAlthough a unified tax is imposed on gifts during life and transfers at death, everyone is\npermitted to give away $13,000 per donee each year without paying any tax on the gift. A tax on\nsizable gifts is imposed to prevent people with large estates from giving away during their lives\nportions of their estate in order to escape estate taxes. Thus two grandparents with two married\nchildren and four grandchildren may give away $26,000 ($13,000 from each grandparent) to\ntheir eight descendants (children, spouses, grandchildren) each year, for a total of $208,000,\nwithout paying any tax.\nState governments also impose taxes at death. In many states, these are known\nasinheritance taxes and are taxes on the heir\xe2\x80\x99s right to receive the property. The tax rate depends\non the relationship to the decedent: the closer the relation, the smaller the tax. Thus a child will\npay less than a nephew or niece, and either of them will pay less than an unrelated friend who is\nnamed in the will.\nOnce the taxes are paid, a final accounting must be prepared, showing the remaining principal,\nincome, and disbursements. Only at this point may the personal representative actually\ndistribute the assets of the estate according to the will.\n\nKEY TAKEAWAY\n\nAny person with the requisite capacity may make a will and bequeath personal property to\nnamed heirs. A will can also devise real property. Throughout the United States, there are\nfairly common requirements to be met for a will to qualify for probate.\nIntestacy statutes will govern where there is no will, and an administrator will be appointed\nby the probate court. Intestacy statutes will dictate which relatives will get what portion of\nthe decedent\xe2\x80\x99s estate, portions that are likely to differ from what the decedent would have\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n507\n\n\x0cdone had he or she left a valid will. Where there are no heirs, the decedent\xe2\x80\x99s property\nescheats to the state.\nAn executor (or executrix) is the person named in the will to administer the estate and\nrender a final accounting. Estate and inheritance taxes may be owed if the estate is large\nenough.\n\nEXERCISES\n\n1. Donald Trump is married to Ivanna Trump, but they divorce. Donald neglects to change his\nwill, which leaves everything to Ivanna. If he were to die before remarrying, would the will\nstill be valid?\n2. Tom Tyler, married to Tina Tyler, dies without a will. If his legal state of residence is\nCalifornia, how will his estate be distributed? (This will require a small amount of Internet\nbrowsing.)\n3. Suppose Tom Tyler is very wealthy. When he dies at age sixty-three, there are two wills: one\nleaves everything to his wife and family, and the other leaves everything to his alma mater,\nthe University of Colorado. The family wishes to dispute the validity of the second (later in\ntime) will. What, in general, are the bases on which a will can be challenged so that it does\nnot enter into probate?\n\n14.2 Trusts\n\nLEARNING OBJECTIVES\n\n1. Distinguish a will from a trust, and describe how a trust is created, how it functions, and how\nit may come to an end.\n2. Compare the various kinds of trusts, as well as factors that affect both estates and trusts.\n\nDefinitions\nWhen the legal title to certain property is held by one person while another has the use and\nbenefit of it, a relationship known as a trust has been created. The trust developed centuries ago\nto get around various nuances and complexities, including taxes, of English real property law.\nThe trustee has legal title and the beneficiary has \xe2\x80\x9cequitable title,\xe2\x80\x9d since the courts of equity\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n508\n\n\x0cwould enforce the obligations of the trustee to honor the terms by which the property was\nconveyed to him. A typical trust might provide for the trustee to manage an estate for the\ngrantor\xe2\x80\x99s children, paying out income to the children until they are, say, twenty-one, at which\ntime they would become legal owners of the property.\nTrusts may be created by bequest in a will, by agreement of the parties, or by a court decree.\nHowever created, the trust is governed by a set of rules that grew out of the courts of equity.\nEvery trust involves specific property, known as the res (rees; Latin for \xe2\x80\x9cthing\xe2\x80\x9d), and three\nparties, though the parties may be the same person.\n\nSettlor or Grantor\nAnyone who has legal capacity to make a contract may create a trust. The creator is known as\nthe settlor or grantor. Trusts are created for many reasons; for example, so that a minor can\nhave the use of assets without being able to dissipate them or so that a person can have a\nprofessional manage his money.\n\nTrustee\nThe trustee is the person or legal entity that holds the legal title to the res. Banks do\nconsiderable business as trustees. If the settlor should neglect to name a trustee, the court may\nname one. The trustee is a fiduciary of the trust beneficiary and will be held to the highest\nstandard of loyalty. Not even an appearance of impropriety toward the trust property will be\npermitted. Thus a trustee may not loan trust property to friends, to a corporation of which he is\na principal, or to himself, even if he is scrupulous to account for every penny and pays the\nprincipal back with interest. The trustee must act prudently in administering the trust.\n\nBeneficiary\nThe beneficiary is the person, institution, or other thing for which the trust has been created.\nBeneficiaries are not limited to one\xe2\x80\x99s children or close friends; an institution, a corporation, or\nsome other organization, such as a charity, can be a beneficiary of a trust, as can one\xe2\x80\x99s pet dogs,\ncats, and the like. The beneficiary may usually sell or otherwise dispose of his interest in a trust,\nand that interest likewise can usually be reached by creditors. Note that the settlor may create a\ntrust of which he is the beneficiary, just as he may create a trust of which he is the trustee.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n509\n\n\x0cContinental Bank & Trust Co. v. Country Club Mobile Estates, Ltd., (see Section 14.4.2\n"Settlor\xe2\x80\x99s Limited Power over the Trust"), considers a basic element of trust law: the settlor\xe2\x80\x99s\npower over the property once he has created the trust.\n\nExpress Trusts\nTrusts are divided into two main categories: express and implied. Express trusts\nincludetestamentary trusts and inter vivos (or living) trusts. The testamentary trust is one\ncreated by will. It becomes effective on the testator\xe2\x80\x99s death. The inter vivos trust is one created\nduring the lifetime of the grantor. It can be revocable or irrevocable (seeFigure 14.3 "Express\nTrusts").\nFigure 14.3 Express Trusts\n\nA revocable trust is one that the settlor can terminate at his option. On termination, legal title to\nthe trust assets returns to the settlor. Because the settlor can reassert control over the assets\nwhenever he wishes, the income they generate is taxed to him.\nBy contrast, an irrevocable trust is permanent, and the settlor may not revoke or modify its\nterms. All income to the trust must be accumulated in the trust or be paid to the beneficiaries in\naccordance with the trust agreement. Because income does not go to the settlor, the irrevocable\ntrust has important income tax advantages, even though it means permanent loss of control over\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n510\n\n\x0cthe assets (beyond the instructions for its use and disposition that the settlor may lay out in the\ntrust agreement). A hybrid form is the reversionary trust: until the end of a fixed period, the\ntrust is irrevocable and the settlor may not modify its terms, but thereafter the trust assets revert\nto the settlor. The reversionary trust combines tax advantages with ultimate possession of the\nassets.\nOf the possible types of express trusts, five are worth examining briefly: (1) Totten trusts, (2),\nblind trusts, (3) Clifford trusts, (4) charitable trusts, and (5) spendthrift trusts. The use of\nexpress trusts in business will also be noted.\n\nTotten Trust\nThe Totten trust, which gets its name from a New York case, In re Totten, [1] is a tentative trust\ncreated when someone deposits funds in a bank as trustee for another person as beneficiary.\n(Usually, the account will be named in the following form: \xe2\x80\x9cMary, in trust for Ed.\xe2\x80\x9d) During the\nbeneficiary\xe2\x80\x99s lifetime, the grantor-depositor may withdraw funds at his discretion or revoke the\ntrust altogether. But if the grantor-depositor dies before the beneficiary and had not revoked the\ntrust, then the beneficiary is entitled to whatever remains in the account at the time of the\ndepositor\xe2\x80\x99s death.\n\nBlind Trust\nIn a blind trust, the grantor transfers assets\xe2\x80\x94usually stocks and bonds\xe2\x80\x94to trustees who hold\nand manage them for the grantor as beneficiary. The trustees are not permitted to tell the\ngrantor how they are managing the portfolio. The blind trust is used by high government\nofficials who are required by the Ethics in Government Act of 1978 to put their assets in blind\ntrusts or abstain from making decisions that affect any companies in which they have a financial\nstake. Once the trust is created, the grantor-beneficiary is forbidden from discussing financial\nmatters with the trustees or even to give the trustees advice. All that the grantor-beneficiary sees\nis a quarterly statement indicating by how much the trust net worth has increased or decreased.\n\nClifford Trust\nThe Clifford trust, named after the settlor in a Supreme Court case, Helvering v. Clifford, [2] is\nreversionary: the grantor establishes a trust irrevocable for at least ten years and a day. By so\ndoing, the grantor shifts the tax burden to the beneficiary. So a person in a higher bracket can\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n511\n\n\x0csave considerable money by establishing a Clifford trust to benefit, say, his or her children. The\ntax savings will apply as long as the income from the trust is not devoted to needs of the children\nthat the grantor is legally required to supply. At the expiration of the express period in the trust,\nlegal title to the res reverts to the grantor. However, the Tax Reform Act of 1986 removed the tax\nadvantages for Clifford trusts established after March 1986. As a result, all income from such\ntrusts is taxed to the grantor. Existing Clifford trusts were not affected by the 1986 tax law.\n\nCharitable Trust\nA charitable trust is one devoted to any public purpose. The definition is broad; it can\nencompass funds for research to conquer disease, to aid battered wives, to add to museum\ncollections, or to permit a group to proselytize on behalf of a particular political or religious\ndoctrine. The law in all states recognizes the benefits to be derived from encouraging charitable\ntrusts, and states use the cy pres (see press; \xe2\x80\x9cas near as possible\xe2\x80\x9d) doctrine to further the intent\nof the grantor. The most common type of trust is the charitable remainder trust. You would\ndonate property\xe2\x80\x94usually intangible property such as stock\xe2\x80\x94in trust to an approved charitable\norganization, usually one that has tax-exempt 501(c)(3) status from the IRS. The organization\nserves as trustee during your life and provides you or someone you designate with a specified\nlevel of income from the property that you donated. This could be for a number of years or for\nyour lifetime. After your death or the period that you set, the trust ends and the charitable\norganization owns the assets that were in the trust.\nThere are important tax reasons why people set up charitable trusts. The trustor gets five years\'\nworth of tax deductions for the value of the assets in the charitable trust. Capital gains are\ntreated favorably, as well: charitable trusts are irrevocable, which means that the person setting\nup the trust (the \xe2\x80\x9ctrustor\xe2\x80\x9d) permanently gives up control of the assets to the charitable\norganization. Thus, the charitable organization could sell an asset in the trust that would\nordinarily incur significant capital gains taxes, but since the trustor no longer owns the asset,\nthere is no capital gains tax: as a tax-exempt organization, the charity will not pay capital gains,\neither.\n\nSpendthrift Trust\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n512\n\n\x0cA spendthrift trust is established when the settlor believes that the beneficiary is not to be\ntrusted with whatever rights she might possess to assign the income or assets of the trust. By\nexpress provision in a trust instrument, the settlor may ensure that the trustees are legally\nobligated to pay only income to the beneficiary; no assignment of the assets may be made, either\nvoluntarily by the beneficiary or involuntarily by operation of law. Hence the spendthrift\nbeneficiary cannot gamble away the trust assets nor can they be reached by creditors to pay her\ngambling (or other) debts.\n\nExpress Trusts in Business\nIn addition to their use in estate planning, express trusts are also created for business purposes.\nThe business trust was popular late in the nineteenth century as a way of getting around state\nlimitations on the corporate form and is still used today. By giving their shares to a voting trust,\nshareholders can ensure that their agreement to vote as a bloc will be carried out. But voting\ntrusts can be dangerous. Agreements that result in price fixing or other restraints of trade violate\nthe antitrust laws; for example, companies are in violation when they act collusively to fix prices\nby pooling voting stock under a trust agreement, as happened frequently at the turn of the\ncentury.\n\nImplied Trusts\nTrusts can be created by courts without any intent by a settlor to do so. For various reasons, a\ncourt will declare that particular property is to be held by its owner in trust for someone else.\nSuch trusts are implied trusts and are usually divided into two\ntypes:constructive trusts and resulting trusts. A constructive trust is one created usually to\nredress a fraud or to prevent unjust enrichment. Suppose you give $1 to an agent to purchase a\nlottery ticket for you, but the agent buys the ticket in his own name instead and wins\n$1,000,000, payable into an account in amounts of $50,000 per year for twenty years. Since the\nagent had violated his fiduciary obligation and unjustly enriched himself, the court would\nimpose a constructive trust on the account, and the agent would find himself holding the funds\nas trustee for you as beneficiary. By contrast, a resulting trust is one imposed to carry out the\nsupposed intent of the parties. You give an agent $100,000 to purchase a house for you. Title is\nput in your agent\xe2\x80\x99s name at the closing, although it is clear that since she was paid for her\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n513\n\n\x0cservices, you did not intend to give the house to her as a gift. The court would declare that the\nhouse was to be held by the agent as trustee for you during the time that it takes to have the title\nput in your name.\n\nKEY TAKEAWAY\n\nA trust can be created during the life of the settlor of the trust. A named trustee and\nbeneficiary are required, as well as some assets that the trustee will administer. The trustee\nhas a fiduciary duty to administer the trust with the utmost care. Inter vivos trusts can be\nrevocable or irrevocable. Testamentary trusts are, by definition, not revocable, as they take\neffect on the death of the settlor.\n\nEXERCISES\n\n1. Karen Vreeland establishes a testamentary trust for her son, Brian, who has a gambling\naddiction. What kind of trust should she have established?\n2. A group of ten coworkers \xe2\x80\x9cinvests\xe2\x80\x9d in the Colorado Lottery when the jackpot reaches $200\nmillion. Each puts in $10 for five tickets. Dan Connelly purchases fifty Colorado Lottery tickets\non behalf of the group and holds them. As luck would have it, one of the tickets is a winner.\nDan takes the ticket, claims the $200 million, quits his job, and refuses to share. Do the\ncoworkers have any legal recourse? Was a trust created in this situation?\n3. Laura Sarazen has two sisters, Lana and Linda. Laura deposits $50,000 at the Bank of America\nand creates an account that names her sister, Linda, in the following form: \xe2\x80\x9cLaura Sarazen, in\ntrust for Linda Sarazen.\xe2\x80\x9d Laura dies two years later and has not withdrawn funds from the\nbank. The executrix, Lana Sarazen, wants to include those funds in the estate. Linda wants to\nclaim the $50,000 plus accumulated interest in addition to whatever share she gets in the\nwill. Can she?\n\n[1] In re Totten, 71 N.E. 748 (N.Y. 1904).\n[2] Helvering v. Clifford, 309 U.S. 331 (1940).\n\n14.3 Factors Affecting Estates and Trusts\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n514\n\n\x0c1. Know how principal and income are distinguished in administering a trust.\n2. Explain how estates and trusts are taxed, and the utility of powers of appointment.\n\nPrincipal and Income\nOften, one person is to receive income from a trust or an estate and another person, the\nremainderman, is to receive the remaining property when the trust or estate is terminated. In\nthirty-six states, a uniform act, the Uniform Principal and Income Act (UPIA), defines principal\nand income and specifies how expenses are to be paid. If the trust agreement expressly gives the\ntrustee power to determine what is income and what is principal, then his decision is usually\nunreviewable. If the agreement is silent, the trustee is bound by the provisions of the UPIA.\nThe general rule is that ordinary receipts are income, whereas extraordinary receipts are\nadditions to principal. Ordinary receipts are defined as the return of money or property derived\nfrom the use of the principal, including rent, interest, and cash dividends. Extraordinary\nreceipts include stock dividends, revenues or other proceeds from the sale or exchange of trust\nassets, proceeds from insurance on assets, all income accrued at the testator\xe2\x80\x99s death, proceeds\nfrom the sale or redemption of bonds, and awards or judgments received in satisfaction of\ninjuries to the trust property. Expenses or obligations incurred in producing or preserving\nincome\xe2\x80\x94including ordinary repairs and ordinary taxes\xe2\x80\x94are chargeable to income. Expenses\nincurred in making permanent improvements to the property, in investing the assets, and in\nselling or purchasing trust property are chargeable to principal, as are all obligations incurred\nbefore the decedent\xe2\x80\x99s death.\n\nTaxation\nEstates and trusts are taxable entities under the federal income tax statute. The general rule is\nthat all income paid out to the beneficiaries is taxable to the beneficiaries and may be deducted\nfrom the trust\xe2\x80\x99s or estate\xe2\x80\x99s gross income in arriving at its net taxable income. The trust or estate\nis then taxed on the balance left over\xe2\x80\x94that is, on any amounts accumulated. This is known as\nthe conduit rule, because the trust or estate is seen as a conduit for the income.\n\nPower of Appointment\nA power of appointment is the authority given by one person (the donor) to another (the donee)\nto dispose of the donor\xe2\x80\x99s property according to whatever instructions the donor provides. A\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n515\n\n\x0cpower of appointment can be created in a will, in a trust, or in some other writing. The writing\nmay imply the power of appointment rather than specifically calling it a power of appointment.\nFor example, a devise or bequest of property to a person that allows that person to receive it or\ntransfer it gives that person a power of appointment. The person giving the power is the donor,\nand the person receiving it is the donee.\nThere are three classes of powers of appointment. General powers of appointment give donees\nthe power to dispose of the property in any way they see fit. Limited powers of appointment,\nalso known as special powers of appointment, give donees the power to transfer the property to\na specified class of persons identified in the instrument creating the power. Testamentary\npowers of appointment are powers of appointment that typically are created by wills.\nIf properly used, the power of appointment is an important tool, because it permits the donee to\nreact flexibly to circumstances that the donor could not have foreseen. Suppose you desire to\nbenefit your children when they are thirty-five or forty according to whether they are wealthy or\npoor. The poorer children will be given more from the estate or trust than the wealthier ones.\nSince you will not know when you write the will or establish the trust which children will be\npoorer, a donee with a power of appointment will be able to make judgments impossible for the\ndonor to make years or decades before.\n\nKEY TAKEAWAY\n\nAdministering either an estate or a trust requires knowing the distinction between principal\nand income in a variety of situations. For example, knowing which receipts are ordinary and\nwhich are extraordinary is essential to knowing whether to allocate the receipts as income or\nas an addition to principal. Knowing which expenses are chargeable to principal and which\nare chargeable to income is also important. Both estates and trusts are taxable entities,\nsubject to federal and state laws on estate and trust taxation. Powers of appointment can be\nused in both trusts and estates in order to give flexibility to named donees.\n\nEXERCISES\n\n1. In his will, Hagrid leaves his pet dragon, Norberta, to Ron Weasley as donee with power of\nappointment. He intends to restrict Ron\xe2\x80\x99s power as donee to give or sell Norberta only to\nwizards or witches. What kind of power of appointment should Hagrid use?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n516\n\n\x0c2. In a testamentary trust, Baxter Black leaves Hilda Garde both real and personal property to\nadminister as she sees fit as trustee \xe2\x80\x9cfor the benefit of the Michigan Militia.\xe2\x80\x9d Hilda intends to\nsell the house, but meanwhile she rents it out at $1,200 a month and incurs repairs to the\nproperty to prepare it for sale in the amount of $4,328.45. Is the expense chargeable to\nincome or principal? Is the rent to be characterized as ordinary receipts or extraordinary\nreceipts?\n\n14.4 Cases\nTestamentary Capacity\nEstate of Seymour M. Rosen\nSupreme Judicial Court of Maine\n447 A.2d 1220 (1982)\nGODFREY, JUSTICE\nPhoebe Rosen and Jeffrey Rosen, widow and son of the decedent, Seymour M. Rosen, appeal\nfrom an order of the Knox County Probate Court admitting the decedent\xe2\x80\x99s will to probate.\nAppellants argue that the decedent lacked the testamentary capacity necessary to execute a valid\nwill and that the Probate Court\xe2\x80\x99s finding that he did have the necessary capacity is clearly\nerroneous. On direct appeal from the Probate Court pursuant to section 1-308 of the Probate\nCode (18-A M.R.S.A. \xc2\xa7 1-308), this Court reviews for clear error the findings of fact by the\nProbate Court. Estate of Mitchell, Me., 443 A.2d 961 (1982). We affirm the judgment.\nDecedent, a certified public accountant, had an accounting practice in New York City, where he\nhad been married to Phoebe for about thirty years. Their son, Jeffrey, works in New York City.\nIn 1973, the decedent was diagnosed as having chronic lymphatic leukemia, a disease that, as it\nprogresses, seriously impairs the body\xe2\x80\x99s ability to fight infection. From 1973 on, he understood\nthat he might die within six months. In June, 1978, he left his home and practice and moved to\nMaine with his secretary of two months, Robin Gordon, the appellee. He set up an accounting\npractice in Camden.\nThe leukemia progressed. The decedent was on medication and was periodically hospitalized for\ninfections, sometimes involving septic shock, a condition described by the treating physician as\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n517\n\n\x0cakin to blood poisoning. The infections were treated with antibiotics with varying degrees of\nsuccess. Despite his medical problems, the decedent continued his accounting practice, working\nusually three days a week, until about two months before his death on December 4, 1980. Robin\nGordon lived with him and attended him until his death.\nWhile living in New York, the decedent had executed a will leaving everything to his wife or, if\nshe should not survive him, to his son. In November, 1979, decedent employed the services of\nSteven Peterson, a lawyer whose office was in the same building as decedent\xe2\x80\x99s, to execute a\ncodicil to the New York will leaving all his Maine property to Robin. At about this time, decedent\nnegotiated a property settlement with his wife, who is now living in Florida. He executed the will\nat issue in this proceeding on July 25, 1980, shortly after a stay in the hospital with a number of\ninfections, and shortly before a hospitalization that marked the beginning of the decedent\xe2\x80\x99s final\ndecline. This will, which revoked all earlier wills and codicils, left all his property, wherever\nlocated, to Robin, or to Jeffrey if Robin did not survive him.\nThe court admitted the 1980 will to probate over the objections of Phoebe and son, making\nextensive findings to support its conclusion that \xe2\x80\x9cthe decedent clearly had testamentary capacity\nwhen he executed his Will.\xe2\x80\x9d\nThe Probate Court applied the standard heretofore declared by this Court for determining\nwhether a decedent had the mental competence necessary to execute a valid will:\nA \xe2\x80\x98disposing mind\xe2\x80\x99 involves the exercise of so much mind and memory as would enable a person\nto transact common and simple kinds of business with that intelligence which belongs to the\nweakest class of sound minds; and a disposing memory exists when one can recall the general\nnature, condition and extent of his property, and his relations to those to whom he gives, and\nalso to those from whom he excludes, his bounty. He must have active memory enough to bring\nto his mind the nature and particulars of the business to be transacted, and mental power\nenough to appreciate them, and act with sense and judgment in regard to them. He must have\nsufficient capacity to comprehend the condition of his property, his relations to the persons who\nwere or should have been the objects of his bounty, and the scope and bearing of the provisions\nof his will. He must have sufficient active memory to collect in his mind, without prompting, the\nparticulars or elements of the business to be transacted, and to hold them in his mind a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n518\n\n\x0csufficient length of time to perceive at least their obvious relations to each other, and be able to\nform some rational judgment in relation to them.\nIn re Leonard, Me., 321 A.2d 486, 488-89 (1974), quoting Hall v. Perry, 87 Me. 569, 572, 33 A.\n160, 161 (1895).\nAppellants portray the decedent as \xe2\x80\x9ca man ravaged by cancer and dulled by medication,\xe2\x80\x9d and it\nis true that some evidence in the record tends to support this characterization. However, the law\nas set out in In re Leonard requires only a modest level of competence (\xe2\x80\x9cthe weakest class of\nsound minds\xe2\x80\x9d), and there is considerable evidence of record that the decedent had at least that\nlevel of mental ability and probably more:\n1. The three women who witnessed the will all testified that decedent was of sound mind. They\nworked in the same building as the decedent, knew him, and saw him regularly. Such testimony\nis admissible to show testamentary capacity. In re Leonard, 321 A.2d at 489.\n2. Lawyer Peterson, who saw the decedent daily, testified that he was of sound mind. Peterson\nused the decedent as a tax adviser, and the decedent did accounting work for Peterson\xe2\x80\x99s clients.\nPeterson had confidence in the decedent\xe2\x80\x99s tax abilities and left the tax aspects of the will to the\ndecedent\xe2\x80\x99s own consideration.\n3. Dr. Weaver, the treating physician, testified that although the decedent would be mentally\ndeadened for a day or two while in shock in the hospital, he would then regain \xe2\x80\x9cnormal mental\nfunction.\xe2\x80\x9d Though on medication, the decedent was able to conduct his business until soon\nbefore his death. Dr. Weaver testified without objection that on one occasion he had offered a\nwritten opinion that the decedent was of sound mind.\nAppellants\xe2\x80\x99 principal objection to the will is that the decedent lacked the necessary knowledge of\n\xe2\x80\x9cthe general nature, condition and extent of his property.\xe2\x80\x9d In re Leonard, 321 A.2d at 488. The\nrecord contains testimony of Robin Gordon and lawyer Peterson that decedent did not know\nwhat his assets were or their value. However, there is other evidence, chiefly Peterson\xe2\x80\x99s\ntestimony about his discussions with the decedent preliminary to the drafting of the 1980 will\nand, earlier, when the 1979 codicil to the New York will was being prepared, that the decedent\ndid have knowledge of the contents of his estate. He knew that he had had a Florida\ncondominium, although he was unsure whether this had been turned over to his wife as part of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n519\n\n\x0cthe recent property settlement; he knew that he had an interest in an oil partnership, and,\nalthough he was unable to place a value on that interest, he knew the name of an individual who\ncould supply further information about it; he knew he had stocks and bonds, two motor vehicles,\nan account at the Camden National Bank, and accounts receivable from his accounting practice.\nThe law does not require that a testator\xe2\x80\x99s knowledge of his estate be highly specific in order for\nhim to execute a valid will. It requires only that the decedent be able to recall \xe2\x80\x9cthe general\nnature, condition and extent of his property.\xe2\x80\x9d In re Leonard, 321 A.2d at 488. Such knowledge\nof one\xe2\x80\x99s property is an aspect of mental soundness, not an independent legal requirement as the\nappellants seem to suggest. Here, there was competent evidence that the decedent had a general\nknowledge of his estate. The Probate Court was justified in concluding that, in the\ncircumstances, the decedent\xe2\x80\x99s ignorance of the precise extent of his property did not establish\nhis mental incompetence. The decedent\xe2\x80\x99s uncertainty about his property was understandable in\nview of the fact that some of his property had been transferred to his wife in the recent property\nnegotiations in circumstances rendering it possible that the decedent might have wanted to put\nthe matter out of his mind. Also, there was evidence from which the court could have inferred\nthat much of the property was of uncertain or changing value.\nOn the evidence of record, this Court cannot hold that the findings of the Probate Court were\nclearly erroneous. Where, as here, there is a choice between two permissible views of the weight\nof the evidence, the findings of the Probate Court must stand. Estate of Mitchell, Me., 443 A.2d\n961 (1982).\n\nCASE QUESTIONS\n\n1. Based on what is written in this opinion, did the decedent\xe2\x80\x99s widow get nothing as a result of\nher husband\xe2\x80\x99s death? What did she get, and how?\n2. If Phoebe Rosen\xe2\x80\x99s appeal had resulted in a reversal of the probate court, what would\nhappen?\n3. Is it possible that Seymour Rosen lacked testamentary capacity? Could the probate court\nhave ruled that he did and refuse to admit the will to probate? If so, what would happen,\nusing the court\xe2\x80\x99s language and cited opinions?\n\nSettlor\xe2\x80\x99s Limited Power over the Trust\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n520\n\n\x0cContinental Bank & Trust Co. v. Country Club Mobile Estates, Ltd.\n632 P.2d 869 (Utah 1981)\nOaks, Justice\nThe issue in this appeal is whether a settlor who has created a trust by conveying property that is\nsubject to an option to sell can thereafter extend the period of the option without the\nparticipation or consent of the trustee. We hold that he cannot. For ease of reference, this\nopinion will refer to the plaintiff-appellant, Continental Bank & Trust Co., as the \xe2\x80\x9ctrustee,\xe2\x80\x9d to\ndefendant-respondent, Country Club Mobile Estates, Ltd., as the \xe2\x80\x9clessee-optionee,\xe2\x80\x9d and to\nMarshall E. Huffaker, deceased, as the \xe2\x80\x9csettlor.\xe2\x80\x9d\nThe sequence of events is critical. On September 29, 1965, the settlor gave the lessee-optionee a\nfifty-year lease and an option to purchase, during the sixth year of the lease, the 31 acres of land\nat issue in this litigation. On March 1, 1971, the settlor granted the lessee-optionee a five-year\nextension of its option, to September 29, 1976. On December 6, 1973, the settlor conveyed the\nsubject property to the trustee in trust for various members of his family, signing a trust\nagreement and conveying the property to the trustee by a warranty deed, which was promptly\nrecorded. The lessee-optionee had actual as well as constructive notice of the creation of this\ntrust by at least April, 1975, when it began making its monthly lease payments directly to the\ntrustee. On March 1, 1976, the settlor signed an instrument purporting to grant the lesseeoptionee another five-year extension of its option, to September 29, 1981. The trustee was\nunaware of this action and did not participate in it. On October 30, 1978, approximately one\nweek after the settlor\xe2\x80\x99s death, the trustee learned of the March 1, 1976, attempted extension and\ndemanded and obtained a copy of the instrument.\nOn July 3, 1979, the trustee brought this action against the lessee-optionee and other interested\nparties to quiet title to the 31 acres of trust property and to determine the validity of the\nattempted extension of the option. Both parties moved for summary judgment on the issue of\nthe validity of the extended option. The district court denied the trustee\xe2\x80\x99s motion and granted\nthe lessee-optionee\xe2\x80\x99s motion, and the trustee appealed. We reverse.\nA settlor admittedly could reserve power to extend the duration of an option on trust property,\nand do so without the consent or involvement of the trustee. The question is whether this settlor\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n521\n\n\x0cdid so. The issue turns on the terms of the trust instrument, which, in this case, gave the trustee\nbroad powers, including the power to grant options, but also reserved to the settlor the right to\nrevoke the trust or to direct the trustee to sell trust property. The relevant clauses are as follows:\n\nARTICLE IV.\n\nTo carry out the Trust purposes of the Trust created hereby\xe2\x80\xa6the Trustee is vested with the\nfollowing powers\xe2\x80\xa6:\nB. To manage, control, sell, convey\xe2\x80\xa6; to grant options\xe2\x80\xa6\nK.\xe2\x80\xa6The enumeration of certain powers of the Trustee herein shall not be construed as a\nlimitation of the Trustee\xe2\x80\x99s power, it being intended that the Trustee shall have all rights, powers\nand privileges that an absolute owner of the property would have.\n\nARTICLE V.\n\nThe Trustor by an instrument in writing filed with the Trustee may modify, alter or revoke this\nAgreement in whole or in part, and may withdraw any property subject to the agreement;\xe2\x80\xa6\nThere is hereby reserved to the Trustor the power to direct the trustee, in writing, from time to\ntime, to retain, sell, exchange or lease any property of the trust estate.\xe2\x80\xa6Upon receipt of such\ndirections, the Trustee shall comply therewith. The lessee-optionee argues, and the district court\nheld, that in the foregoing provisions of the trust agreement the settlor reserved the power to\ndirect the trustee in regard to the leased property, and that the effect of his executing the\nextension of the option on March 1, 1976, was to direct the trustee to sell the property to the\nlessee-optionee upon its exercise of the option. We disagree. We are unable to find an exercise of\nthe \xe2\x80\x9cpower to direct the trustee, in writing,\xe2\x80\x9d in an act that was not intended to communicate and\ndid not in fact communicate anything to the trustee. We are likewise unable to construe the\nextension agreement signed by the settlor and the lessee-optionee as \xe2\x80\x9can instrument in writing\nfiled with the Trustee\xe2\x80\x9d to \xe2\x80\x9cmodify, alter or revoke this Agreement.\xe2\x80\xa6\xe2\x80\x9d Nor can we agree with the\ndissent\xe2\x80\x99s argument for \xe2\x80\x9cliberal construction\xe2\x80\xa6to the reserved powers of a settlor\xe2\x80\x9d in a trust\nagreement which expressly vests the trustee with the power \xe2\x80\x9cto grant options\xe2\x80\x9d and explicitly\nstates its intention that the trustee \xe2\x80\x9cshall have all rights, powers and privileges that an\nabsolute owner of the property would have.\xe2\x80\x9d Article IV, quoted above. (emphases in original)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n522\n\n\x0cA trust is a form of ownership in which the legal title to property is vested in a trustee, who has\nequitable duties to hold and manage it for the benefit of the beneficiaries.Restatement of Trusts,\nSecond, \xc2\xa7 2 (1959). It is therefore axiomatic in trust law that the trustee under a valid trust deed\nhas exclusive control of the trust property, subject only to the limitations imposed by law or the\ntrust instrument, and that once the settlor has created the trust he is no longer the owner of the\ntrust property and has only such ability to deal with it as is expressly reserved to him in the trust\ninstrument. Boone v. Davis, 64 Miss. 133, 8 So. 202 (1886); Marvin v. Smith, 46 N.Y. 571\n(1871). As stated in Bogert,Trusts & Trustees, \xc2\xa742 (2d ed. 1965):\nAfter a settlor has completed the creation of a trust he is, with small exceptions noted below, and\nexcept as expressly provided otherwise by the trust instrument or by statute, not in any legal\nrelationship with the beneficiaries or the trustee, and has no liabilities or powers with regard to\nthe trust administration.\nNone of the exceptions identified by Bogert applies in this case.\nThis is a case where a settlor created a trust and then chose to ignore it. He could have modified\nor revoked the trust, or directed the trustee in writing to sell or lease the trust property, but he\ntook neither of these actions. Instead, more than two years after the creation and recording of\nthe trust, and without any direction or notice to the trustee, the settlor gave the lessee-optionee\na signed instrument purporting to extend its option to buy the trust property for another five\nyears. The trustee did not learn of this instrument until two and one-half years later,\nimmediately following the death of the settlor.\nAn extension of the option to buy would obviously have a limiting effect on the value of the\nreversion owned by the trust (and thus on the rights of the trust beneficiaries), which the trustee\nhas a duty to protect. Even a revocable trust clothes beneficiaries, for the duration of the trust,\nwith a legally enforceable right to insist that the terms of the trust be adhered to. If we gave legal\neffect to the settlor\xe2\x80\x99s extension of this option in contravention of the existence and terms of the\ntrust, we would prejudice the interests of the beneficiaries, blur some fundamental principles of\ntrust law, and cast doubt upon whether it is the trustee or the settlor who is empowered to\nmanage and dispose of the trust property in a valid revocable trust.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n523\n\n\x0cThe judgment of the district court is reversed and the cause is remanded with instructions to\nenter judgment for the plaintiff. Costs to appellant.\nHOWE, Justice: (Dissenting)\nI dissent. The majority opinion has overlooked the cardinal principle of construction of a trust\nagreement which is that the settlor\xe2\x80\x99s intent should be followed. See Leggroan v. Zion\xe2\x80\x99s Savings\nBank & Trust Co., 120 Utah 93, 232 P.2d 746 (1951). Instead, the majority places a strict and\nrigid interpretation on the language of the trust agreement which defeats the settlor\xe2\x80\x99s intent and\ndenies him an important power he specifically reserved to himself. All of this is done in a fact\nsituation where there is no adverse interest asserted and no one will be prejudiced in any way by\nfollowing the undisputed and obvious intent of the settlor.\nUnlike the situation found with many trusts, Huffaker in establishing his trust reserved to\nhimself broad powers in Article V.:\n\nARTICLE V.\n\nThe Trustor by an instrument in writing filed with the Trustee may modify, alter or revoke this\nAgreement in whole or in part, and may withdraw any property subject to the\nAgreement; Provided, however, that the duties, powers and limitations of the Trustee shall not\nbe substantially changed without its written consent, except as to revocation or withdrawal.\n(emphasis added)\n****\nThere is hereby reserved to the Trustor the power to direct the trustee, in writing, from time to\ntime, to retain, sell, exchange or lease any property of the Trust estate, to invest Trust funds, or\nto purchase for the Trust any property which they [sic] may designate and which is acceptable to\nthe Trustee. Upon receipt of such directions, the Trustee shall comply therewith. (emphasis\nadded)\nThus while Huffaker committed the property into the management and control of the trustee, he\nretained the right in Article V. to direct the trustee from time to time with regard to the property,\nand the trustee agreed that upon receipt of any such directions it would comply. It is significant\nthat the consent of the trustee was not required. These broad reserved powers in effect gave him\ngreater power over the property than the trustee possessed since he had the final word.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n524\n\n\x0cThe property in question was subject to defendant\xe2\x80\x99s option when it was placed in trust. The\ntrustee took title subject to that option and subject to future directions from Huffaker. The\nextension granted by Huffaker to the defendant was in effect a directive that the trustee sell the\nproperty to the defendant if and when it elected to purchase the property. At that time, the\ndefendant could deliver the directive to the trustee which held legal title and the sale could be\nconsummated. Contrary to what is said in the majority opinion, the extension was intended to\ncommunicate and did communicate to the trustee the settlor\xe2\x80\x99s intention to sell to the defendant.\nThe trustee does not claim to have any doubt as to what the settlor intended.\nThere was no requirement in the trust agreement as to when the directive to sell had to be\ndelivered to the trustee nor was there any requirement that the settlor must himself deliver the\ndirection to sell to the trustee rather than the buyer deliver it. The majority opinion concedes\nthat Huffaker had the power to extend the option but denies him that power because he did not\ncommunicate his intention to exercise that power to the trustee at the time he extended the\noption. It ignores the fact that the lessee had five years to decide whether it wanted to buy the\nproperty, at which time it could deliver the direction to sell to the trustee. The majority opinion\nreads into the trust agreement rigidity and strictness which is unwarranted.\nThe majority opinion contains a quote from Bogert, Trust and Trustees, \xc2\xa7 42, for authority that\nafter a settlor has completed the creation of a trust he is not in any legal relationship with the\nbeneficiaries or the trustee, and has no liabilities or power with regard to the trust\nadministration. However, as will be seen in that quote, it is there recognized that those rules do\nnot apply where it has been expressly provided otherwise by the trust instrument. Such is the\ncase here where the settlor reserved extensive powers and was himself the primary beneficiary.\nHuffaker\xe2\x80\x99s extension agreement apparently would not have been challenged by his trustee if he\nhad given written directions to the trustee to extend the option instead of executing the\nextension with the defendant himself, and apparently would not have been challenged had he\nnot died. Yet, although the trustee did not itself extend the option nor receive a copy of the\nagreement until after Huffaker\xe2\x80\x99s death, it had not in the meantime dealt with third parties\nconcerning the property or made any commitments that were inconsistent with Huffaker\xe2\x80\x99s\naction. Since there were no intervening third-party rights and it is not unfair to the trust\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n525\n\n\x0cbeneficiaries to require them to abide by the intention of their donor and benefactor, I see no\njustification for the refusal of the trustee to accept the extension agreement as a valid direction\nto sell the property as provided for by the terms of the trust. This is not a case where the trustee\nin ignorance of the action of the settlor in granting an option had also granted an option or dealt\nwith the property in a manner inconsistent with the actions of the settlor so that there are\nconflicting claims of innocent third-parties presented. In such a case there would be some\njustification for applying a strict construction so that there can be orderliness in trust\nadministration. After all, the reason for the provisions of the trust agreement defining the\npowers of the trustee and the reserved powers of the settlor was to provide for the exercise of\nthose powers in a manner that would be orderly and without collision between the trustee and\nsettlor. In the instant case the trustee has not even suggested how it will be prejudiced by\nfollowing Huffaker\xe2\x80\x99s directions. The majority opinion makes reference to protecting the interest\nof the contingent beneficiaries but overlooks that Huffaker was not only the settlor but also the\nprimary beneficiary both when the trust was established and when the option was extended.\nThe majority opinion treats the relationship between Huffaker and his trustee as an adversary\nrelationship instead of recognizing that the trustee was Huffaker\xe2\x80\x99s fiduciary to assist him in\nmanaging his property. Therefore, there is no reason to construe the trust agreement as if it\nwere meant to deal with a relationship between two adverse parties.\nMy view that a liberal construction should be given to the reserved powers of a settlor under\nthese circumstances finds support in a decision of the Supreme Judicial Court of\nMassachusetts, Trager v. Schwartz, 345 Mass. 653, 189 N.E.2d 509 (1963). There the settlor on\nJuly 15, 1942, executed as donor a declaration of trust. The property was 65 shares of stock and\n4 lots of land. In that instrument he reserved the right to alter, amend or revoke the instrument\nin whole or in part. However, it was specifically provided in the declaration of trust that \xe2\x80\x9cany\nsuch alterations, amendments or revocations of this trust shall be by an instrument in writing\nsigned by the donor, and shall become effective only upon being recorded in the South District\nRegistry of Deeds for Middlesex County.\xe2\x80\x9d\nLater, on February 4, 1954, the trustor executed a document entitled \xe2\x80\x9cModification and\nAmendment of Trust\xe2\x80\x9d whereby he withdrew the 65 shares of stock from the trust and sold them\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n526\n\n\x0cto his son and told him that he had arranged for the recording of that instrument by his lawyer.\nHowever, he did not record the document nor instruct his attorney to do so. On August 25, 1960,\nthe settlor executed a document entitled \xe2\x80\x9cRevocation of Declaration of Trust,\xe2\x80\x9d in which he\nrevoked in whole the declaration of trust of July 15, 1942. This revocation was recorded on\nAugust 26th. He thereupon directed the trustees to deliver to him the 65 shares of stock and the\n4 lots of real estate. His son received notice of the revocation on August 30, 1960, and recorded\nthe following day the modification and amendment dated February 4, 1954, by which he had\nobtained the 165 shares of stock.\nIn a suit brought by the settlor to regain ownership of the stock, he contended that the recording\nof his complete revocation on August 26, 1960, rendered ineffective the recording of the partial\nrevocation on August 31, 1960. He relied upon the principle that \xe2\x80\x9cA valid trust once created\ncannot be revoked or altered except by the exercise of a reserve power to do so, which must be\nexercised in strict conformity to its terms.\xe2\x80\x9d The court upheld the earlier sale of stock stating:\nThe provision of the declaration of trust that amendments and revocations \xe2\x80\x98shall become\neffective only upon being recorded\xe2\x80\x99 shall not be interpreted, where there are no intervening\nrights of third-parties, as preventing the carrying out of the earlier amendment once it has been\nrecorded. This should be the result, particularly where there was an express undertaking by one\nof the parties to see to the recording.\nIn the instant case, defendant will be greatly prejudiced, and the settlor\xe2\x80\x99s intention thwarted, as\na result of following the majority opinion\xe2\x80\x99s interpretation of the trust terms as they relate to a\nwritten direction to the trustee to sell trust property. Defendant gave up the opportunity to\npurchase the property within the original option period in reliance on Huffaker\xe2\x80\x99s execution of\nthe extension agreement, a document prepared by his attorney. I am not persuaded that because\ndefendant was making its rental payments to the trustee it was unreasonable in obtaining the\nextension of the option, which previously had been granted it by Huffaker, to again deal with\nhim and rely on him since he was the final power respecting his property, and since neither he\nnor his attorney who had full and complete knowledge of the trust apparently raised any\nquestion as to the propriety of what they were doing. Just as the settlor in Trager v. Schwartz,\nsupra, was not permitted to gain advantage by his failure to record as required by the trust\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n527\n\n\x0cagreement, I think the settlor\xe2\x80\x99s beneficiaries in the instant case should not gain by Huffaker\xe2\x80\x99s\nomissions and to the extreme prejudice of defendant.\nThe trustee has based its arguments on cases and principles that are distinguishable or\ninapplicable to the instant case. It regards the trust agreement as expressly allowing only it, as\ntrustee and holder of the legal title to the property, to sell, option, or otherwise dispose of it. But\nthe language of the trust regarding powers retained by Huffaker is inclusive enough to\nencompass his action in this case, for he expressly retained the right to direct the plaintiff to sell\nthe property, a right that is compatible with his granting of the option extension.\nThe trustee also asserts that the written instrument received after Huffaker\xe2\x80\x99s death was\nineffective as a directive to the trustee. Plaintiff cites authority for the principle that a revocable\ntrust can only be modified during the settlor\xe2\x80\x99s lifetime, e.g., Chase National Bank of City of N.Y.\nv. Tomagno, 172 Misc. 63, 14 N.Y.S.2d 759 (1939). We are not dealing with an attempted\ntestamentary disposition in this case, however. The option extension agreement was executed\nduring Huffaker\xe2\x80\x99s lifetime, and the fact that it was received by plaintiff only after he died does\nnot deprive it of its effect.\nI would affirm the judgment below.\n\nCASE QUESTIONS\n\n1. Does the decision effectively deprive Country Club Mobile Estates, Ltd. of anything? What?\n2. Why would the trustee (Continental Bank & Trust Co.) object to giving Country Club Mobile\nEstates, Ltd. another two and a half years on the lease?\n3. Which opinion seems better reasoned\xe2\x80\x94the majority or the dissent? Why do you think so?\n\n14.5 Summary and Exercises\nSummary\n\nEstate planning is the process by which an owner decides how her property is to be passed on to\nothers. The four basic estate planning tools are wills, trusts, gifts, and joint ownership. In this\nchapter, we examined wills and trusts. A will is the declaration of a person\xe2\x80\x99s wishes about the\ndisposition of her assets on her death. The law of each state sets forth certain formalities, such\nas the number of witnesses, to which written wills must adhere. Wills are managed through the\nprobate process, which varies from state to state, although many states have now adopted the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n528\n\n\x0cUniform Probate Code. In general, anyone over eighteen and of sound mind may make a will. It\nmust be signed by the testator, and two or three others must witness the signature. A will may\nalways be modified or revoked during the testator\xe2\x80\x99s lifetime, either expressly through a codicil or\nthrough certain actions, such as a subsequent marriage and the birth of children, not\ncontemplated by the will. Wills must be carefully drafted to avoid abatement and ademption.\nThe law provides for distribution in the case of intestacy. The rules vary from state to state and\ndepend on whether the decedent was married when she died, had children or parents who\nsurvived her, or had collateral heirs.\nOnce a will is admitted to probate, the personal representative must assemble and inventory all\nassets, have them appraised, handle claims against the estate, pay taxes, prepare a final\naccounting, and only then distribute the assets according to the will.\nA trust is a relationship in which one person holds legal title to certain property and another\nperson has the use and benefit of it. The settlor or grantor creates the trust, giving specific\nproperty (the res) to the trustee for the benefit of the beneficiary. Trusts may be living or\ntestamentary, revocable or irrevocable. Express trusts come in many forms, including Totten\ntrusts, blind trusts, Clifford trusts, charitable trusts, and spendthrift trusts. Trusts may also be\nimposed by law; constructive and resulting trusts are designed to redress frauds, prevent unjust\nenrichment, or see to it that the intent of the parties is carried out.\n\nEXERCISES\n\n1. Seymour deposits $50,000 in a bank account, ownership of which is specified as \xe2\x80\x9cSeymour, in\ntrust for Fifi.\xe2\x80\x9d What type of trust is this? Who is the settlor? The beneficiary? The trustee?\nMay Seymour spend the money on himself? When Seymour dies, does the property pass\nunder the laws of intestacy, assuming he has no will?\n2. Seymour, a resident of Rhode Island, signed a will in which he left all his property to his close\nfriend, Fifi. Seymour and Fifi then moved to Alabama, where Seymour eventually died.\nSeymour\xe2\x80\x99s wife Hildegarde, who stayed behind in Rhode Island and who was not named in\nthe will, claimed that the will was revoked when Seymour moved from one state to another.\nIs she correct? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n529\n\n\x0c3. Assume in Exercise 2 that Seymour\xe2\x80\x99s Rhode Island will is valid in Alabama. Is Hildegarde\nentitled to a part of Seymour\xe2\x80\x99s estate? Explain.\n4. Assume in Exercise 2 that Seymour\xe2\x80\x99s Rhode Island will is valid in Alabama. Seymour and\nHildegarde own, as tenants by the entirety, a cottage on the ocean. In the will, Seymour\nspecifically states that the cottage goes to Fifi on his death. Does Fifi or Hildegarde get the\ncottage? Or do they share it? Explain?\n5. Assume in Exercise 2 that Seymour\xe2\x80\x99s Rhode Island will is not valid. Seymour\xe2\x80\x99s only relative\nbesides Hildegarde is his nephew, Chauncey, whom Seymour detests. Who is entitled to\nSeymour\xe2\x80\x99s property when he dies\xe2\x80\x94Fifi, Hildegarde, or Chauncey? Explain.\n6. Scrooge is in a high tax bracket. He has set aside in a savings account $100,000, which he\neventually wants to use to pay the college expenses of his tiny son, Tim, who is three. The\naccount earns $10,000 a year, of which $5,000 goes to the government in taxes. How could\nScrooge lower the tax payments while retaining control of the $100,000?\n7. Assume in Exercise 6 that Scrooge considers placing the $100,000 in trust for Tim. But he is\nworried that when Tim comes of age, he might sell his interest in the trust. Could the trust be\nstructured to avoid this possibility? Explain.\n8. Assume that Scrooge has a substantial estate and no relatives. Is there any reason for him to\nconsider a will or trust? Why? If he dies without a will, what will happen to his property?\n\nSELF-TEST QUESTIONS\n\n1. A will written by the testator\xe2\x80\x99s hand and not witnessed is called\na.\n\na conditional will\nb. a nuncupative will\nc. a holographic will\nd. a reciprocal will\nA written modification or supplement to a prior will is called\n\na.\n\na revocation clause\nb. an abatement\nc. a codicil\nd. none of the above\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n530\n\n\x0cA trust created by will is called\na.\n\nan inter vivos trust\nb. a reversionary trust\nc. a Totten trust\nd. a testamentary trust\nTrustees are not permitted to tell the grantor how they are managing their\nportfolio of assets in\na.\n\na Clifford trust\n\nb. a spendthrift trust\nc. a blind trust\nd. a voting trust\nAn example of an implied trust is\na.\n\na spendthrift trust\n\nb. a Clifford trust\nc. a resulting trust\nd. none of the above\n\nSELF-TEST ANSWERS\n\n1. c\n2. c\n3. d\n4. c\n5. c\n\nChapter 15\nInsurance\n\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1. The basic terms and distinctions in the law of insurance\n2. The basic types of insurance for property, liability, and life\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n531\n\n\x0c3. The basic defenses to claims against insurance companies by the insured: representation,\nconcealment, and warranties\nWe conclude our discussions about property with a focus on insurance law, not only because\ninsurance is a means of compensating an owner for property losses but also because the\ninsurance contract itself represents a property right. In this chapter, we begin by examining\nregulation of the insurance industry. We then look at legal issues relating to specific types of\ninsurance. Finally, we examine defenses that insurance companies might raise to avoid making\npayments under insurance policies.\n\n15.1 Definitions and Types of Insurance\nLEARNING OBJECTIVES\n\n1. Know the basic types of insurance for individuals.\n2. Name and describe the various kinds of business insurance.\nCertain terms are usefully defined at the outset. Insurance is a contract of reimbursement. For\nexample, it reimburses for losses from specified perils, such as fire, hurricane, and earthquake.\nAn insurer is the company or person who promises to reimburse. The insured (sometimes called\nthe assured) is the one who receives the payment, except in the case of life insurance, where\npayment goes to the beneficiary named in the life insurance contract. The premium is the\nconsideration paid by the insured\xe2\x80\x94usually annually or semiannually\xe2\x80\x94for the insurer\xe2\x80\x99s promise\nto reimburse. The contract itself is called the policy. The events insured against are known\nas risks orperils.\nRegulation of insurance is left mainly in the hands of state, rather than federal, authorities.\nUnder the McCarran-Ferguson Act, Congress exempted state-regulated insurance companies\nfrom the federal antitrust laws. Every state now has an insurance department that oversees\ninsurance rates, policy standards, reserves, and other aspects of the industry. Over the years,\nthese departments have come under fire in many states for being ineffective and \xe2\x80\x9ccaptives\xe2\x80\x9d of\nthe industry. Moreover, large insurers operate in all states, and both they and consumers must\ncontend with fifty different state regulatory schemes that provide very different degrees of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n532\n\n\x0cprotection. From time to time, attempts have been made to bring insurance under federal\nregulation, but none have been successful.\nWe begin with an overview of the types of insurance, from both a consumer and a business\nperspective. Then we examine in greater detail the three most important types of insurance:\nproperty, liability, and life.\n\nPublic and Private Insurance\nSometimes a distinction is made between public and private insurance. Public (or social)\ninsurance includes Social Security, Medicare, temporary disability insurance, and the like,\nfunded through government plans. Private insurance plans, by contrast, are all types of coverage\noffered by private corporations or organizations. The focus of this chapter is private insurance.\n\nTypes of Insurance for the Individual\nLife Insurance\nLife insurance provides for your family or some other named beneficiaries on your death. Two\ngeneral types are available: term insurance provides coverage only during the term of the policy\nand pays off only on the insured\xe2\x80\x99s death; whole-life insurance provides savings as well as\ninsurance and can let the insured collect before death.\n\nHealth Insurance\nHealth insurance covers the cost of hospitalization, visits to the doctor\xe2\x80\x99s office, and prescription\nmedicines. The most useful policies, provided by many employers, are those that cover 100\npercent of the costs of being hospitalized and 80 percent of the charges for medicine and a\ndoctor\xe2\x80\x99s services. Usually, the policy will contain a deductible amount; the insurer will not make\npayments until after the deductible amount has been reached. Twenty years ago, the deductible\nmight have been the first $100 or $250 of charges; today, it is often much higher.\n\nDisability Insurance\nA disability policy pays a certain percentage of an employee\xe2\x80\x99s wages (or a fixed sum) weekly or\nmonthly if the employee becomes unable to work through illness or an accident. Premiums are\nlower for policies with longer waiting periods before payments must be made: a policy that\nbegins to pay a disabled worker within thirty days might cost twice as much as one that defers\npayment for six months.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n533\n\n\x0cHomeowner\xe2\x80\x99s Insurance\nA homeowner\xe2\x80\x99s policy provides insurance for damages or losses due to fire, theft, and other\nnamed perils. No policy routinely covers all perils. The homeowner must assess his needs by\nlooking to the likely risks in his area\xe2\x80\x94earthquake, hailstorm, flooding, and so on. Homeowner\xe2\x80\x99s\npolicies provide for reduced coverage if the property is not insured for at least 80 percent of its\nreplacement costs. In inflationary times, this requirement means that the owner must adjust the\npolicy limits upward each year or purchase a rider that automatically adjusts for inflation.\nWhere property values have dropped substantially, the owner of a home (or a commercial\nbuilding) might find savings in lowering the policy\xe2\x80\x99s insured amount.\n\nAutomobile Insurance\nAutomobile insurance is perhaps the most commonly held type of insurance. Automobile\npolicies are required in at least minimum amounts in all states. The typical automobile policy\ncovers liability for bodily injury and property damage, medical payments, damage to or loss of\nthe car itself, and attorneys\xe2\x80\x99 fees in case of a lawsuit.\n\nOther Liability Insurance\nIn this litigious society, a person can be sued for just about anything: a slip on the walk, a harsh\nand untrue word spoken in anger, an accident on the ball field. A personal liability policy covers\nmany types of these risks and can give coverage in excess of that provided by homeowner\xe2\x80\x99s and\nautomobile insurance. Such umbrella coverage is usually fairly inexpensive, perhaps $250 a year\nfor $1 million in liability.\n\nTypes of Business Insurance\nWorkers\xe2\x80\x99 Compensation\nAlmost every business in every state must insure against injury to workers on the job. Some may\ndo this through self-insurance\xe2\x80\x94that is, by setting aside certain reserves for this contingency.\nMost smaller businesses purchase workers\xe2\x80\x99 compensation policies, available through\ncommercial insurers, trade associations, or state funds.\n\nAutomobile Insurance\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n534\n\n\x0cAny business that uses motor vehicles should maintain at least a minimum automobile\ninsurance policy on the vehicles, covering personal injury, property damage, and general\nliability.\n\nProperty Insurance\nNo business should take a chance of leaving unprotected its buildings, permanent fixtures,\nmachinery, inventory, and the like. Various property policies cover damage or loss to a\ncompany\xe2\x80\x99s own property or to property of others stored on the premises.\n\nMalpractice Insurance\nProfessionals such as doctors, lawyers, and accountants will often purchase malpractice\ninsurance to protect against claims made by disgruntled patients or clients. For doctors, the cost\nof such insurance has been rising over the past thirty years, largely because of larger jury awards\nagainst physicians who are negligent in the practice of their profession.\n\nBusiness Interruption Insurance\nDepending on the size of the business and its vulnerability to losses resulting from damage to\nessential operating equipment or other property, a company may wish to purchase insurance\nthat will cover loss of earnings if the business operations are interrupted in some way\xe2\x80\x94by a\nstrike, loss of power, loss of raw material supply, and so on.\n\nLiability Insurance\nBusinesses face a host of risks that could result in substantial liabilities. Many types of policies\nare available, including policies for owners, landlords, and tenants (covering liability incurred\non the premises); for manufacturers and contractors (for liability incurred on all premises); for a\ncompany\xe2\x80\x99s products and completed operations (for liability that results from warranties on\nproducts or injuries caused by products); for owners and contractors (protective liability for\ndamages caused by independent contractors engaged by the insured); and for contractual\nliability (for failure to abide by performances required by specific contracts).\nSome years ago, different types of individual and business coverage had to be purchased\nseparately and often from different companies. Today, most insurance is available on a package\nbasis, through single policies that cover the most important risks. These are often called\nmultiperil policies.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n535\n\n\x0cKEY TAKEAWAY\nAlthough insurance is a need for every US business, and many businesses operate in all fifty\nstates, regulation of insurance has remained at the state level. There are several forms of\npublic insurance (Social Security, disability, Medicare) and many forms of private insurance.\nBoth individuals and businesses have significant needs for various types of insurance, to\nprovide protection for health care, for their property, and for legal claims made against them\nby others.\n\nEXERCISES\n\n1. Theresa Conley is joining the accounting firm of Hunter and Patton in Des Moines, Iowa. She\nis a certified public accountant. What kind of insurance will she (or the firm, on her behalf)\nneed to buy because of her professional activities?\n2. Nate Johnson has just signed a franchise agreement with Papa Luigi\xe2\x80\x99s Pizza and will be\noperating his own Papa Luigi\xe2\x80\x99s store in Lubbock, Texas. The franchise agreement requires\nthat he personally contract for \xe2\x80\x9call necessary insurance\xe2\x80\x9d for the successful operation of the\nfranchise. He expects to have twelve employees, five full-time and seven part-time (the\ndelivery people), at his location, which will be on a busy boulevard in Lubbock and will offer\ntake-out only. Pizza delivery employees will be using their own automobiles to deliver orders.\nWhat kinds of insurance will be \xe2\x80\x9cnecessary\xe2\x80\x9d?\n\n15.2 Property Insurance, Liability Insurance, and Life\nInsurance\nLEARNING OBJECTIVES\n\n1. Distinguish and define the basic types of insurance for property, liability, and life.\n2. Explain the concepts of subrogation and assignment.\nWe turn now to a more detailed discussion of the law relating to the three most common types of\ninsurance: property, liability, and life insurance.\n\nProperty Insurance\nIt is sometimes said that property is the foundation for a system of free market capitalism. If so,\nthen protecting property is a necessary part of being part of that system, whether as an\nindividual or as a business entity.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n536\n\n\x0cCoverage\nAs we have noted, property insurance provides coverage for real and personal property owned\nby a business or an individual. Property insurance is also part of automobile policies covering\ndamage to the car caused by an accident (collision coverage) or by other events such as\nvandalism or fire (comprehensive coverage). Different levels of coverage are available. For\nexample, many basic homeowners\xe2\x80\x99 policies cover damage resulting from the following types of\nperils only: fire and lightning, windstorm and hail, explosions, riots and civil commotions,\naircraft and vehicular accidents, smoke, vandalism and malicious mischief, theft, and breakage\nof glass that is part of a building.\nA broader policy, known as broad coverage, also includes these perils: falling objects; weight of\nice, snow, and sleet; collapse of buildings; sudden and accidental damage to heating systems;\naccidental discharge from plumbing, heating, or air-conditioning systems; freezing of heating,\nplumbing, and air conditioning systems; and sudden and accidental injury from excess currents\nto electrical appliances and wiring. Even with the broadest form of coverage, known as\ncomprehensive, which covers all perils except for certain named exclusions, the homeowner can\nbe left without protection. For example, comprehensive policies do not usually cover damage\nresulting from flooding, earthquakes, war, or nuclear radiation. The homeowner can purchase\nseparate coverage for these perils but usually at a steep premium.\n\nInsurable Interest in Property\nTo purchase property insurance, the would-be insured must have aninsurable interest in the\nproperty. Insurable interest is a real and substantial interest in specific property such that a loss\nto the insured would ensue if the property were damaged. You could not, for instance, take out\nan insurance policy on a motel down the block with which you have no connection. If a fire\ndestroyed it, you would suffer no economic loss. But if you helped finance the motel and had an\ninvestment interest in it, you would be permitted to place an insurance policy on it. This\nrequirement of an insurable interest stems from the public policy against wagering. If you could\ninsure anything, you would in effect be betting on an accident.\nTo insure property, therefore, you must have a legal interest and run the risk of a pecuniary loss.\nAny legal interest is sufficient: a contractual right to purchase, for instance, or the right of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n537\n\n\x0cpossession (a bailee may insure). This insurable interest must exist both at the time you take out\nthe policy and at the time the loss occurs. Moreover, coverage is limited to the extent of the\ninterest. As a mortgagee, you could ensure only for the amount still due.\nPrior to the financial meltdown of 2008, many investment banks took insurance against\npossible losses from collateralized debt obligations (CDOs) and other financial products based\non subprime loans. The principal insurer was American International Group, Inc. (AIG), which\nneeded a US government bailout when the risks covered by AIG turned out to be riskier than\nAIG\xe2\x80\x99s models had projected.\n\nSubrogation\nFigure 15.1 Subrogation\n\nSubrogation is the substitution of one person for another in pursuit of a legal claim. When an\ninsured is entitled to recover under a policy for property damage, the insurer is said to be\nsubrogated to the insured\xe2\x80\x99s right to sue any third party who caused the damage. For example, a\nwrecking company negligently destroys an insured\xe2\x80\x99s home, mistaking it for the building it was\nhired to tear down. The insured has a cause of action against the wrecking company. If the\ninsured chooses instead to collect against a homeowner\xe2\x80\x99s policy, the insurance company may\nsue the wrecking company in the insured\xe2\x80\x99s place to recover the sum it was obligated to pay out\nunder the policy (seeFigure 15.1 "Subrogation").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n538\n\n\x0cAssignment\nAssignment is the transfer of any property right to another. In property insurance, a distinction\nis made between assignment of the coverage and assignment of the proceeds. Ordinarily, the\ninsured may not assign the policy itself without the insurer\xe2\x80\x99s permission\xe2\x80\x94that is, he may not\ncommit the insurer to insure someone else. But the insured may assign any claims against the\ninsurer\xe2\x80\x94for example, the proceeds not yet paid out on a claim for a house that has already\nburned down.\n\nIntentional Losses\nInsurance is a means of spreading risk. It is economically feasible because not every house burns\ndown and not every car is stolen. The number that do burn down or that are stolen can be\ncalculated and the premium set accordingly. Events that will certainly happen, like ordinary\nwear and tear and the destruction of property through deliberate acts such as arson, must be\nexcluded from such calculations. The injury must result from accidental, not deliberate, causes.\n\nCoinsurance Clause\nMost commercial property policies contain a so-called coinsurance clause, which requires the\ninsured to maintain insurance equal to a specified percentage of the property value. It is often\n80 percent but may be higher or lower. If the property owner insures for less than that\npercentage, the recovery will be reduced. In effect, the owner becomes a coinsurer with the\ninsurance company. The usual formula establishes the proportion that the insurer must pay by\ncalculating the ratio of (1) the amount of insurance actually taken to (2) the coinsurance\npercentage multiplied by the total dollar value of the property. Suppose a fire causes $160,000\ndamage to a plant worth $1,000,000. The plant should have been insured for 80 percent\n($800,000), but the insured took out only a $500,000 policy. He will recover only $100,000. To\nsee why, multiply the total damages of $160,000 by the coinsurance proportion of five-eighths\n($500,000 of insurance on the required minimum of $800,000). Five-eighths of $160,000\nequals $100,000, which would be the insured\xe2\x80\x99s recovery where the policy has a coinsurance\nclause.\n\nLiability Insurance\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n539\n\n\x0cLiability insurance has taken on great importance for both individuals and businesses in\ncontemporary society. Liability insurance covers specific types of legal liabilities that a\nhomeowner, driver, professional, business executive, or business itself might incur in the round\nof daily activities. A business is always at risk in sending products into the marketplace. Doctors,\naccountants, real estate brokers, insurance agents, and lawyers should obtain liability insurance\nto cover the risk of being sued for malpractice. A prudent homeowner will acquire liability\ninsurance as part of homeowner\xe2\x80\x99s policy and a supplemental umbrella policy that insures for\nliability in excess of a limit of, say, $100,000 in the regular homeowner\xe2\x80\x99s policy. And businesses,\nprofessionals, and individuals typically acquire liability insurance for driving-related activities\nas part of their automobile insurance. In all cases, liability policies cover not only any settlement\nor award that might ultimately have to be paid but also the cost of lawyers and related expenses\nin defending any claims.\nLiability insurance is similar in several respects to property insurance and is often part of the\nsame package policy. As with property insurance, subrogation is allowed with liability insurance,\nbut assignment of the policy is not allowed (unless permission of the insurer is obtained), and\nintentional losses are not covered. For example, an accountant who willfully helps a client\nconceal fraud will not recover from his malpractice insurance policy if he is found guilty of\nparticipating in the fraud.\n\nNo-Fault Trends\nThe major legal development of the century relating to liability insurance has been the\nelimination of liability in the two areas of greatest exposure: in the workplace and on the\nhighway. In the next unit on agency law, we discuss the no-fault system of workers\xe2\x80\x99\ncompensation, under which a worker receives automatic benefits for workplace injuries and\ngives up the right to sue the employer under common-law theories of liability. Here we will look\nbriefly at the other major type of no-fault system: recovery for damages stemming from motor\nvehicle accidents.\n\xe2\x80\x9cNo-fault\xe2\x80\x9d means that recovery for damages in an accident no longer depends on who was at\nfault in causing it. A motorist will file a claim to recover his actual damages (medical expenses,\nincome loss) directly from his own insurer. The no-fault system dispenses with the costly and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n540\n\n\x0cuncertain tort system of having to prove negligence in court. Many states have adopted one form\nor another of no-fault automobile insurance, but even in these states the car owner must still\ncarry other insurance. Some no-fault systems have a dollar \xe2\x80\x9cthreshold\xe2\x80\x9d above which a victim\nmay sue for medical expenses or other losses. Other states use a \xe2\x80\x9cverbal threshold,\xe2\x80\x9d which\npermits suits for \xe2\x80\x9cserious\xe2\x80\x9d injury, defined variously as \xe2\x80\x9cdisfigurement,\xe2\x80\x9d \xe2\x80\x9cfracture,\xe2\x80\x9d or\n\xe2\x80\x9cpermanent disability.\xe2\x80\x9d These thresholds have prevented no-fault from working as efficiently as\ntheory predicts. Inflation has reduced the power of dollar thresholds (in some states as low as\n$200) to deter lawsuits, and the verbal thresholds have standards that can only be defined in\ncourt, so much litigation continues.\nNo state has adopted a \xe2\x80\x9cpure\xe2\x80\x9d no-fault system. A pure no-fault system trades away entirely the\nright to sue in return for the prompt payment of \xe2\x80\x9cfirst-party\xe2\x80\x9d insurance benefits\xe2\x80\x94that is,\npayment by the victim\xe2\x80\x99s own insurance company instead of traditional \xe2\x80\x9cthird-party\xe2\x80\x9d coverage, in\nwhich the victim collects from the defendant\xe2\x80\x99s insurance company.\nAmong the criticisms of no-fault insurance is the argument that it fails to strengthen the central\npurpose of the tort system: to deter unsafe conduct that causes accidents. No-fault lessens, it is\nsaid, the incentive to avoid accidents. In any event, no-fault automobile insurance has been a\nmajor development in the insurance field since 1970 and seems destined to be a permanent\nfixture of insurance law.\n\nLife Insurance\nInsurable Interest\nThe two types of life insurance mentioned in Section 15.1.2 "Types of Insurance for the\nIndividual", term and whole-life policies, are important both to individuals and to businesses\n(insurance for key employees). As with property insurance, whoever takes out a life insurance\npolicy on a person\xe2\x80\x99s life must have an insurable interest. Everyone has an insurable interest in\nhis own life and may name whomever he pleases as beneficiary; the beneficiary need not have an\ninsurable interest. But the requirement of insurable interest restricts those who may take out\ninsurance on someone else\xe2\x80\x99s life. A spouse or children have an insurable interest in a spouse or\nparent. Likewise, a parent has an insurable interest in any minor child. That means that a wife,\nfor example, may take out a life insurance policy on her husband without his consent. But she\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n541\n\n\x0ccould not take out a policy on a friend or neighbor. As long as the insurable interest existed\nwhen the policy was taken out, the owner may recover when the insured dies, even if the\ninsurable interest no longer exists. Thus a divorced wife who was married when the policy was\nobtained may collect when her ex-husband dies as long as she maintained the payments.\nLikewise, an employer has an insurable interest in his key employees and partners; such\ninsurance policies help to pay off claims of a partner\xe2\x80\x99s estate and thus prevent liquidation of the\nbusiness.\n\nSubrogation\nUnlike property insurance, life insurance does not permit subrogation. The insurer must pay the\nclaim when the insured dies and may not step into the shoes of anyone entitled to file a wrongful\ndeath claim against a person who caused the death. Of course, if the insured died of natural\ncauses, there would be no one to sue anyway.\n\nChange of Beneficiary and Assignment\nUnless the insured reserves the right to change beneficiaries, his or her initial designation is\nirrevocable. These days, however, most policies do reserve the right if certain formalities are\nobserved, including written instructions to the insurer\xe2\x80\x99s home office to make the change and\nendorsement of the policy. The insured may assign the policy, but the beneficiary has priority to\ncollect over the assignee if the right to change beneficiaries has not been reserved. If the policy\npermits beneficiaries to be changed, then the assignee will have priority over the original\nbeneficiary.\n\nIntentional Losses\nTwo types of intentional losses are especially important in life insurance: suicide and murder of\nthe insured by the beneficiary.\n\nSuicide\nIn a majority of states, in the absence of a suicide clause in the policy, when an insured commits\nsuicide, the insurer need not pay out if the policy is payable to the insured\xe2\x80\x99s estate. However, if\nthe policy is payable to a third person (e.g., the insured\xe2\x80\x99s company), payment will usually be\nallowed. And if an insured kills himself while insane, all states require payment, whether to the\nestate or a third party. Most life insurance policies today have a provision that explicitly excepts\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n542\n\n\x0csuicide from coverage for a limited period, such as two years, after the policy is issued. In other\nwords, if the insured commits suicide within the first two years, the insurer will refund the\npremiums to his estate but will not pay the policy amount. After two years, suicide is treated as\nany other death would be.\n\nMurder\nUnder the law in every state, a beneficiary who kills the insured in order to collect the life\ninsurance is barred from receiving it. But the invocation of that rule does not absolve the insurer\nof liability to pay the policy amount. An alternate beneficiary must be found. Sometimes the\npolicy will name contingent beneficiaries, and many, but not all, states require the insurer to pay\nthe contingent beneficiaries. When there are no contingent beneficiaries or the state law\nprohibits paying them, the insurer will pay the insured\xe2\x80\x99s estate. Not every killing is murder; the\ncritical question is whether the beneficiary intended his conduct to eliminate the insured in\norder to collect the insurance.\nThe willful, unlawful, and felonious killing of the insured by the person named as beneficiary in\na life policy results in the forfeiture of all rights of such person therein. It is unnecessary that\nthere should be an express exception in the contract of insurance forbidding a recovery in favor\nof such a person in such an event. On considerations of public policy, the death of the insured,\nwillfully and intentionally caused by the beneficiary of the policy, is an excepted risk so far as the\nperson thus causing the death is concerned.\n\nKEY TAKEAWAY\n\nMany kinds of insurance are available for individuals and businesses. For individuals, life\ninsurance, homeowner\xe2\x80\x99s insurance, and automobile insurance are common, with health\ninsurance considered essential but often expensive. Businesses with sufficient employees will\nobtain workers\xe2\x80\x99 compensation insurance, property insurance, and liability insurance, and\nauto insurance for any employees driving company vehicles. Insurance companies will often\npay a claim for their insured and take over the insured\xe2\x80\x99s claim against a third party.\nLiability insurance is important for individuals, companies, and licensed professionals. A trend\ntoward no-fault in liability insurance is seen in claims for work-related injuries (workers\xe2\x80\x99\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n543\n\n\x0ccompensation) and in automobile insurance. Life insurance is common for most families and\nfor businesses that want to protect against the loss of key employees.\n\nEXERCISES\n\n1. Helen Caldicott raises a family and then begins a career as a caterer. As her business grows,\nshe hires several employees and rents space near downtown that has a retail space, parking,\nand a garage for the three vehicles that bear her business\xe2\x80\x99s name. What kinds of insurance\ndoes Helen need for her business?\n2. One of Helen\xe2\x80\x99s employees, Bob Zeek, is driving to a catered event when another car fails to\nstop at a red light and severely injures Bob and nearly totals the van Bob was driving. The\npolice issue a ticket for careless and reckless driving to the other driver, who pleads guilty to\nthe offense. The other driver is insured, but Helen\xe2\x80\x99s automobile insurance carrier goes ahead\nand pays for the damages to the company vehicle. What will her insurance company likely do\nnext?\n3. The health insurance provider for Helen\xe2\x80\x99s employees pays over $345,000 of Bob\xe2\x80\x99s medical\nand hospitalization bills. What will Helen\xe2\x80\x99s insurance company likely do next?\n4. Many homeowners live on floodplains but have homeowner\xe2\x80\x99s insurance nonetheless. Must\ninsurance companies write such policies? Do homeowners on floodplains pay more in\npremiums? If insurance companies are convinced that global climate change is happening,\nwith rising sea levels and stronger storms, can they simply avoid writing policies for homes\nand commercial buildings in coastal areas?\n\n15.3 Insurer\xe2\x80\x99s Defenses\n\nLEARNING OBJECTIVES\n\n1. Understand the principal defenses available to insurers when claims are made.\n2. Recognize that despite these defenses, insurance companies must act in good faith.\n\nTypes of Defenses\nIt is a common perception that because insurance contracts are so complex, many insureds who\nbelieve they are covered end up with uninsured losses. In other words, the large print giveth,\nand the small print taketh away. This perception is founded, to some extent, on the use by\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n544\n\n\x0cinsurance companies of three common defenses, all of which relate to a duty of good faith on the\npart of the insured: (1) representation, (2) concealment, and (3) warranties.\n\nRepresentation\nA representation is a statement made by someone seeking an insurance policy\xe2\x80\x94for example, a\nstatement that the applicant did (or did not) consult a doctor for any illness during the previous\nfive years. An insurer has grounds to avoid the contract if the applicant makes a false\nrepresentation. The misrepresentation must have been material; that is, a false description of a\nperson\xe2\x80\x99s hair coloring should not defeat a claim under an automobile accident policy. But a false\nstatement, even if innocent, about a material fact\xe2\x80\x94for instance, that no one in the family uses\nthe car to go to work, when unbeknownst to the applicant, his wife uses the car to commute to a\npart-time job she hasn\xe2\x80\x99t told him about\xe2\x80\x94will at the insurer\xe2\x80\x99s option defeat a claim by the\ninsured to collect under the policy. The accident need not have arisen out of the\nmisrepresentation to defeat the claim. In the example given, the insurance company could\nrefuse to pay a claim for any accident in the car, even one occurring when the car was driven by\nthe husband to go to the movies, if the insurer discovered that the car was used in a manner in\nwhich the insured had declared it was not used. This chapter\xe2\x80\x99s case, Mutual Benefit Life\nInsurance Co. v. JMR Electronics Corp., (see Section 15.4.1 "Misrepresentation to Insurer"),\nillustrates what happens when an insured misrepresents his smoking habits.\n\nConcealment\nAn insured is obligated to volunteer to the insurer all material facts that bear on insurability.\nThe failure of an insured to set forth such information is a concealment, which is, in effect, the\nmirror image of a false representation. But the insured must have had a fraudulent intent to\nconceal the material facts. For example, if the insured did not know that gasoline was stored in\nhis basement, the insurer may not refuse to pay out on a fire insurance policy.\n\nWarranties\nMany insurance policies covering commercial property will contain warranties. For example, a\npolicy may have a warranty that the insured bank has installed or will install a particular type of\nburglar alarm system. Until recently, the rule was strictly enforced: any breach of a warranty\nvoided the contract, even if the breach was not material. A nonmaterial breach might be, for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n545\n\n\x0cexample, that the bank obtained the alarm system from a manufacturer other than the one\nspecified, even though the alarm systems are identical. In recent years, courts or legislatures\nhave relaxed the application of this rule. But a material breach still remains absolute grounds for\nthe insurer to avoid the contract and refuse to pay.\n\nIncontestable Clause\nIn life insurance cases, the three common defenses often are unavailable to the insurer because\nof the so-called incontestable clause. This states that if the insured has not died during a\nspecified period of time in which the life insurance policy has been in effect (usually two years),\nthen the insurer may not refuse to pay even if it is later discovered that the insured committed\nfraud in applying for the policy. Few nonlife policies contain an incontestable clause; it is used in\nlife insurance because the effect on many families would be catastrophic if the insurer claimed\nmisrepresentation or concealment that would be difficult to disprove years later when the\ninsured himself would no longer be available to give testimony about his intentions or\nknowledge.\n\nRequirement of Insurer\xe2\x80\x99s Good Faith\nLike the insured, the insurer must act in good faith. Thus defenses may be unavailable to an\ninsurer who has waived them or acted in such a manner as to create an estoppel. Suppose that\nwhen an insured seeks to increase the amount on his life insurance policy, the insurance\ncompany learns that he lied about his age on his original application. Nevertheless, the company\naccepts his application for an increase. The insured then dies, and the insurer refuses to pay his\nwife any sum. A court would hold that the insurer had waived its right to object, since it could\nhave cancelled the policy when it learned of the misrepresentation. Finally, an insurer that acts\nin bad faith by denying a claim that it knows it should pay may find itself open to punitive\ndamage liability.\n\nKEY TAKEAWAY\n\nSome claims by insured parties can be legally denied by insurance companies where the\ninsured has made a material misrepresentation. Some claims can be legally denied if the\ninsured has deliberately concealed important matters in applying for insurance coverage.\nBecause insurance coverage is by contract, courts often strictly construe the contract\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n546\n\n\x0clanguage, and if the language does not cover the insured, the courts will typically not bend\nthe language of the contract to help the insured.\n\nEXERCISES\n\n1. Amir Labib gets a reduced rate from his auto insurance company because he represents in his\napplication that he commutes less than ten miles a day to work. Three years later, he and his\nwife buy a new residence, farther away from work, and he begins a fifteen-mile-a-day\ncommute. The rate would be raised if he were to mention this to his insurance company. The\ninsurance company sees that he has a different address, because they are mailing invoices to\nhis new home. But the rate remains the same. Amir has a serious accident on a vacation to\nYellowstone National Park, and his automobile is totaled. His insurance policy is a no-fault\npolicy as it relates to coverage for vehicle damage. Is the insurance company within its rights\nto deny any payment on his claim? How so, or why not?\n2. In 2009, Peter Calhoun gets a life insurance policy from Northwest Mutual Life Insurance\nCompany, and the death benefit is listed as $250,000. The premiums are paid up when he\ndies in 2011 after a getaway car being chased by the police slams into his car at fifty miles per\nhour on a street in suburban Chicago. The life insurance company gets information that he\nsmoked two packs of cigarettes a day, whereas in his application in 2009, he said he smoked\nonly one pack a day. In fact, he had smoked about a pack and a half every day since 1992. Is\nthe insurance company within its rights to deny any payment on his claim? How so, or why\nnot?\n\n15.4 Case\nMisrepresentation to Insurer\nMutual Benefit Life Insurance Co. v. JMR Electronics Corp.\n848 F.2d 30 (2nd Cir. 1988)\nPER CURIAM\nJMR Electronics Corporation (\xe2\x80\x9cJMR\xe2\x80\x9d) appeals from a judgment of the District Court for the\nSouthern District of New York (Robert W. Sweet, Judge) ordering rescission of a life insurance\npolicy issued by plaintiff-appellant The Mutual Benefit Life Insurance Company (\xe2\x80\x9cMutual\xe2\x80\x9d) and\ndismissing JMR\xe2\x80\x99s counterclaim for the policy\xe2\x80\x99s proceeds. Judge Sweet ruled that a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n547\n\n\x0cmisrepresentation made in the policy application concerning the insured\xe2\x80\x99s history of cigarette\nsmoking was material as a matter of law. Appellant contends that the misrepresentation was not\nmaterial because Mutual would have provided insurance\xe2\x80\x94albeit at a higher premium rate\xe2\x80\x94even\nif the insured\xe2\x80\x99s smoking history had been disclosed. We agree with the District Court that\nsummary judgment was appropriate and therefore affirm.\nThe basic facts are not in dispute. On June 24, 1985, JMR submitted an application to Mutual\nfor a $ 250,000 \xe2\x80\x9ckey man\xe2\x80\x9d life insurance policy on the life of its president, Joseph Gaon, at the\nnon-smoker\xe2\x80\x99s discounted premium rate. Mutual\xe2\x80\x99s 1985 Ratebook provides: \xe2\x80\x9cThe Non-Smoker\nrates are available when the proposed insured is at least 20 years old and has not smoked a\ncigarette for at least twelve months prior to the date of the application.\xe2\x80\x9d Question 13 of the\napplication inquired about the proposed insured\xe2\x80\x99s smoking history. Question 13(a) asked, \xe2\x80\x9cDo\nyou smoke cigarettes? How many a day?\xe2\x80\x9d Gaon answered this question, \xe2\x80\x9cNo.\xe2\x80\x9d Question 13(b)\nasked, \xe2\x80\x9cDid you ever smoke cigarettes? \xe2\x80\x9c Gaon again answered, \xe2\x80\x9cNo.\xe2\x80\x9d Based on these\nrepresentations, Mutual issued a policy on Gaon\xe2\x80\x99s life at the non-smoker premium rate.\nGaon died on June 22, 1986, within the period of contestability contained in policy, seeN.Y. Ins.\nLaw \xc2\xa7 3203 (a)(3) (McKinney 1985). Upon routine investigation of JMR\xe2\x80\x99s claim for proceeds\nunder the policy, Mutual discovered that the representations made in the insurance application\nconcerning Gaon\xe2\x80\x99s smoking history were untrue. JMR has stipulated that, at the time the\napplication was submitted, Gaon in fact \xe2\x80\x9chad been smoking one-half of a pack of cigarettes per\nday for a continuous period of not less than 10 years.\xe2\x80\x9d Mutual brought this action seeking a\ndeclaration that the policy is void. Judge Sweet granted Mutual\xe2\x80\x99s motion for summary\njudgment, dismissed JMR\xe2\x80\x99s counterclaim for the proceeds of the policy, and ordered rescission\nof the insurance policy and return of JMR\xe2\x80\x99s premium payments, with interest.\nUnder New York law, which governs this diversity suit, \xe2\x80\x9cit is the rule that even an innocent\nmisrepresentation as to [the applicant\xe2\x80\x99s medical history], if material, is sufficient to allow the\ninsurer to avoid the contract of insurance or defeat recovery thereunder.\xe2\x80\x9d Process Plants Corp.\nv. Beneficial National Life Insurance Co., 366 N.E.2d 1361 (1977). A \xe2\x80\x9cmisrepresentation\xe2\x80\x9d is\ndefined by statute as a false \xe2\x80\x9cstatement as to past or present fact, made to the insurer\xe2\x80\xa6at or\nbefore the making of the insurance contract as an inducement to the making thereof.\xe2\x80\x9d N.Y. Ins.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n548\n\n\x0cLaw \xc2\xa7 3105(a) (McKinney 1985). A misrepresentation is \xe2\x80\x9cmaterial\xe2\x80\x9d if \xe2\x80\x9cknowledge by the insurer\nof the facts misrepresented would have led to a refusal by the insurer to make such\ncontract.\xe2\x80\x9d Id. \xc2\xa7 3105(b).\xe2\x80\xa6\nIn the present case JMR has stipulated that Gaon\xe2\x80\x99s smoking history was misrepresented in the\ninsurance application. However, JMR disputes that this misrepresentation is material as a\nmatter of law. JMR argues that under New York law a misrepresentation is not material unless\nthe insurer can demonstrate that, had the applicant provided complete and accurate\ninformation, coverage either would have been refused or at the very least withheld pending a\nmore detailed underwriting examination. In JMR\xe2\x80\x99s view summary judgment was inappropriate\non the facts of this case because a jury could reasonably have found that even \xe2\x80\x9chad appellee been\naware of Gaon\xe2\x80\x99s smoking history, a policy at the smoker\xe2\x80\x99s premium rate would have been\nissued.\xe2\x80\x9d JMR takes the position that the appropriate remedy in this situation is to permit\nrecovery under the policy in the amount that the premium actually paid would have purchased\nfor a smoker.\nWe agree with Judge Sweet that this novel theory is without basis in New York law. The plain\nlanguage of the statutory definition of \xe2\x80\x9cmateriality,\xe2\x80\x9d found in section 3105(b), permits avoidance\nof liability under the policy where \xe2\x80\x9cknowledge by the insurer of the facts misrepresented would\nhave led to a refusal by the insurer to make such contract.\xe2\x80\x9d (emphasis added) Moreover,\nnumerous courts have observed that the materiality inquiry under New York law is made with\nrespect to the particular policy issued in reliance upon the misrepresentation.\n***\nThere is no doubt that Mutual was induced to issue the non-smoker, discounted-premium policy\nto JMR precisely as a result of the misrepresentations made by Gaon concerning his smoking\nhistory. That Mutual might not have refused the risk on anyterms had it known the undisclosed\nfacts is irrelevant. Most risks are insurable at some price. The purpose of the materiality inquiry\nis not to permit the jury to rewrite the terms of the insurance agreement to conform to the newly\ndisclosed facts but to make certain that the risk insured was the risk covered by the policy\nagreed upon. If a fact is material to the risk, the insurer may avoid liability under a policy if that\nfact was misrepresented in an application for that policy whether or not the parties might have\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n549\n\n\x0cagreed to some other contractual arrangement had the critical fact been disclosed. As observed\nby Judge Sweet, a contrary result would reward the practice of misrepresenting facts critical to\nthe underwriter\xe2\x80\x99s task because the unscrupulous (or merely negligent) applicant \xe2\x80\x9cwould have\neverything to gain and nothing to lose\xe2\x80\x9d from making material misrepresentations in his\napplication for insurance. Such a claimant could rest assured not only that he may demand full\ncoverage should he survive the contestability period, N.Y. Ins. Law \xc2\xa7 3203 (a)(3), but that even\nin the event of a contested claim, he would be entitled to the coverage that he might have\ncontracted for had the necessary information been accurately disclosed at the outset. New York\nlaw does not permit this anomalous result. The judgment of the District Court is affirmed.\n\nCASE QUESTIONS\n\n1. When you read this case, did you assume that Gaon died from lung cancer or some other\nsmoking-related cause? Does the court actually say that?\n2. Can you reasonably infer from the facts here that Gaon himself filled out the form and signed\nit? That is, can you know with some degree of certainty that he lied to the insurance\ncompany? Would it make any difference if he merely signed a form that his secretary filled\nout? Why or why not?\n3. What if Gaon died of causes unrelated to smoking (e.g., he was in a fatal automobile\naccident), and the insurance company was looking for ways to deny the claim? Does the\ncourt\xe2\x80\x99s opinion and language still seem reasonable (e.g., the statement \xe2\x80\x9cthere is no doubt\nthat Mutual was induced to issue the non-smoker, discounted-premium policy to JMR\nprecisely as a result of the misrepresentations made by Gaon concerning his smoking\nhistory\xe2\x80\x9d)?\n4. If Gaon had accurately disclosed his smoking history, is it clear that the insurance company\nwould have refused to write any policy at all? Why is this question important? Do you agree\nwith the court that the question is irrelevant?\n\n15.5 Summary and Exercises\nSummary\n\nInsurance is an inescapable cost of doing business in a modern economy and an important\nservice for any individual with dependents or even a modest amount of property. Most readers\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n550\n\n\x0cof this book will someday purchase automobile, homeowner\xe2\x80\x99s, and life insurance, and many\nreaders will deal with insurance in the course of a business career.\nMost insurance questions are governed by contract law, since virtually all insurance is voluntary\nand entered into through written agreements. This means that the insured must pay careful\nattention to the wording of the policies to determine what is excluded from coverage and to\nensure that he makes no warranties that he cannot keep and no misrepresentations or\nconcealments that will void the contract. But beyond contract law, some insurance law\nprinciples\xe2\x80\x94such as insurable interest and subrogation rights\xe2\x80\x94are important to bear in mind.\nDefenses available to an insurance company may be based upon representation, concealment, or\nwarranties, but an insurer that is overzealous in denying coverage may find itself subject to\npunitive damages.\n\nEXERCISES\n\n1. Martin and Williams, two business partners, agreed that each would insure his life for the\nbenefit of the other. On his application for insurance, Martin stated that he had never had\nany heart trouble when in fact he had had a mild heart attack some years before. Martin\xe2\x80\x99s\npolicy contained a two-year incontestable clause. Three years later, after the partnership had\nbeen dissolved but while the policy was still in force, Martin\xe2\x80\x99s car was struck by a car being\nnegligently driven by Peters. Although Martin\xe2\x80\x99s injuries were superficial, he suffered a fatal\nheart attack immediately after the accident\xe2\x80\x94an attack, it was established, that was caused\nby the excitement. The insurer has refused to pay the policy proceeds to Williams. Does the\ninsurer have a valid defense based on Martin\xe2\x80\x99s misrepresentation? Explain.\n2. In Exercise 1, was it necessary for Williams to have an insurable interest in Martin\xe2\x80\x99s life to\nrecover under the policy? Why?\n3. In Exercise 1, if Williams had taken out the policy rather than Martin, could the insurer\ndefend the claim on the ground that at the time of Martin\xe2\x80\x99s death, Williams had no insurable\ninterest? Why?\n4. If Williams had no insurable interest, would the incontestable clause prevent the company\nfrom asserting this defense? Why?\n5. If the insurer pays Williams\xe2\x80\x99s claim, may it recover from Peters? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n551\n\n\x0c6. Skidmore Trucking Company decided to expand its operations into the warehousing field.\nAfter examining several available properties, it decided to purchase a carbarn for $100,000\nfrom a local bus company and to convert it into a warehouse. The standard contract for a\nreal estate purchase was signed by the parties. The contract obligated Skidmore to pay the\nseller on an apportioned basis for the prepaid premiums on the existing fire insurance policy\n($100,000 extended coverage). The policy expired two years and one month from the closing\ndate. At the closing, the seller duly assigned the fire insurance policy to Skidmore in return\nfor the payment of the apportioned amount of the prepaid premiums, but Skidmore failed to\nnotify the insurance company of the change in ownership. Skidmore took possession of the\npremises and, after extensive renovation, began to use the building as a warehouse. Soon\nafterward, one of Skidmore\xe2\x80\x99s employees negligently dropped a lighted cigarette into a trash\nbasket and started a fire that totally destroyed the building. Was the assignment of the policy\nto Skidmore valid? Why?\n7. In Exercise 6, assuming the assignment is valid, would the insurer be obligated to pay for the\nloss resulting from the employee\xe2\x80\x99s negligence? Why?\n\nSELF-TEST QUESTIONS\n\n1. The substitution of one person for another in pursuit of a legal claim is called\na.\n\nassignment\nb. coinsurance\nc. subrogation\nd. none of the above\nMost insurance questions are covered by\n\na.\n\ntort law\nb. criminal law\nc. constitutional law\nd. contract law\nCommon defenses used by insurance companies include\n\na.\n\nconcealment\nb. false representation\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n552\n\n\x0cc. breach of warranty\nd. all of the above\nA coinsurance clause\na.\n\nrequires the insured to be insured by more than one policy\n\nb. requires the insured to maintain insurance equal to a certain percentage of the\nproperty\xe2\x80\x99s value\nc. allows another beneficiary to be substituted for the insured\nd. is none of the above\nProperty insurance typically covers\na.\n\nordinary wear and tear\n\nb. damage due to theft\nc. intentional losses\nd. damage due to earthquakes\n\nSELF-TEST ANSWERS\n\n1. c\n2. d\n3. d\n4. b\n5. b\n\nChapter 16\nSecured Transactions and Suretyship\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. The basic concepts of secured transactions\n2. The property subject to the security interest\n3. Creation and perfection of the security interest\n4. Priorities for claims on the security interest\n5. Rights of creditors on default\n6. The basic concepts of suretyship\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n553\n\n\x0c7. The relationship between surety and principal\n8. Rights among cosureties\n\n16.1 Introduction to Secured Transactions\nLEARNING OBJECTIVES\n\n1. Recognize, most generally, the two methods by which debtors\xe2\x80\x99 obligations may be secured.\n2. Know the source of law for personal property security.\n3. Understand the meaning of security interest and other terminology necessary to discuss the\nissues.\n4. Know what property is subject to the security interest.\n5. Understand how the security interest is created\xe2\x80\x94\xe2\x80\x9dattached\xe2\x80\x9d\xe2\x80\x94and perfected.\n\nThe Problem of Security\nCreditors want assurances that they will be repaid by the debtor. An oral promise to pay is no\nsecurity at all, and\xe2\x80\x94as it is oral\xe2\x80\x94it is difficult to prove. A signature loan is merely a written\npromise by the debtor to repay, but the creditor stuck holding a promissory note with a\nsignature loan only\xe2\x80\x94while he may sue a defaulting debtor\xe2\x80\x94will get nothing if the debtor is\ninsolvent. Again, that\xe2\x80\x99s no security at all. Real security for the creditor comes in two forms: by\nagreement with the debtor or by operation of law without an agreement.\n\nBy Agreement with the Debtor\nSecurity obtained through agreement comes in three major types: (1) personal property security\n(the most common form of security); (2) suretyship\xe2\x80\x94the willingness of a third party to pay if the\nprimarily obligated party does not; and (3) mortgage of real estate.\n\nBy Operation of Law\nSecurity obtained through operation of law is known as a lien. Derived from the French for\n\xe2\x80\x9cstring\xe2\x80\x9d or \xe2\x80\x9ctie,\xe2\x80\x9d a lien is the legal hold that a creditor has over the property of another in order\nto secure payment or discharge an obligation.\nIn this chapter, we take up security interests in personal property and suretyship. In the next\nchapter, we look at mortgages and nonconsensual liens.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n554\n\n\x0cBasics of Secured Transactions\nThe law of secured transactions consists of five principal components: (1) the nature of property\nthat can be the subject of a security interest; (2) the methods of creating the security interest; (3)\nthe perfection of the security interest against claims of others; (4) priorities among secured and\nunsecured creditors\xe2\x80\x94that is, who will be entitled to the secured property if more than one\nperson asserts a legal right to it; and (5) the rights of creditors when the debtor defaults. After\nconsidering the source of the law and some key terminology, we examine each of these\ncomponents in turn.\nHere is the simplest (and most common) scenario: Debtor borrows money or obtains credit\nfrom Creditor, signs a note and security agreement putting up collateral, and promises to pay\nthe debt or, upon Debtor\xe2\x80\x99s default, let Creditor (secured party) take possession of (repossess) the\ncollateral and sell it. Figure 16.1 "The Grasping Hand"illustrates this scenario\xe2\x80\x94the\ngrasping hand is Creditor\xe2\x80\x99s reach for the collateral, but the hand will not close around the\ncollateral and take it (repossess) unless Debtor defaults.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n555\n\n\x0cFigure 16.1 The Grasping Hand\n\nSource of Law and Definitions\nSource of Law\nArticle 9 of the Uniform Commercial Code (UCC) governs security interests in personal\nproperty. The UCC defines the scope of the article (here slightly truncated): [1]\nThis chapter applies to the following:\n1. A transaction, regardless of its form, that creates a security interest in personal property or\nfixtures by contract;\n2. An agricultural lien;\n3. A sale of accounts, chattel paper, payment intangibles, or promissory notes;\n4. A consignment\xe2\x80\xa6\n\nDefinitions\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n556\n\n\x0cAs always, it is necessary to review some definitions so that communication on the topic at hand\nis possible. The secured transaction always involves a debtor, a secured party, a security\nagreement, a security interest, and collateral.\nArticle 9 applies to any transaction \xe2\x80\x9cthat creates a security interest.\xe2\x80\x9d The UCC in Section 1201(35) defines security interest as \xe2\x80\x9can interest in personal property or fixtures which secures\npayment or performance of an obligation.\xe2\x80\x9d\nSecurity agreement is \xe2\x80\x9can agreement that creates or provides for a security interest.\xe2\x80\x9d It is the\ncontract that sets up the debtor\xe2\x80\x99s duties and the creditor\xe2\x80\x99s rights in event the debtor defaults. [2]\nCollateral \xe2\x80\x9cmeans the property subject to a security interest or agricultural lien.\xe2\x80\x9d [3]\nPurchase-money security interest (PMSI) is the simplest form of security interest. Section 9103(a) of the UCC defines \xe2\x80\x9cpurchase-money collateral\xe2\x80\x9d as \xe2\x80\x9cgoods or software that secures a\npurchase-money obligation with respect to that collateral.\xe2\x80\x9d A PMSI arises where the debtor gets\ncredit to buy goods and the creditor takes a secured interest in those goods. Suppose you want to\nbuy a big hardbound textbook on credit at your college bookstore. The manager refuses to\nextend you credit outright but says she will take back a PMSI. In other words, she will retain a\nsecurity interest in the book itself, and if you don\xe2\x80\x99t pay, you\xe2\x80\x99ll have to return the book; it will be\nrepossessed. Contrast this situation with a counteroffer you might make: because she tells you\nnot to mark up the book (in the event that she has to repossess it if you default), you would\nrather give her some other collateral to hold\xe2\x80\x94for example, your gold college signet ring. Her\nsecurity interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the\nparticular goods purchased. A PMSI would also be created if you borrowed money to buy the\nbook and gave the lender a security interest in the book.\nWhether a transaction is a lease or a PMSI is an issue that frequently arises. The answer\ndepends on the facts of each case. However, a security interest is created if (1) the lessee is\nobligated to continue payments for the term of the lease; (2) the lessee cannot terminate the\nobligation; and (3) one of several economic tests, which are listed in UCC Section 1-201 (37), is\nmet. For example, one of the economic tests is that \xe2\x80\x9cthe lessee has an option to become owner of\nthe goods for no additional consideration or nominal additional consideration upon compliance\nwith the lease agreement.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n557\n\n\x0cThe issue of lease versus security interest gets litigated because of the requirements of Article 9\nthat a security interest be perfected in certain ways (as we will see). If the transaction turns out\nto be a security interest, a lessor who fails to meet these requirements runs the risk of losing his\nproperty to a third party. And consider this example. Ferrous Brothers Iron Works \xe2\x80\x9cleases\xe2\x80\x9d a\n$25,000 punch press to Millie\xe2\x80\x99s Machine Shop. Under the terms of the lease, Millie\xe2\x80\x99s must pay a\nyearly rental of $5,000 for five years, after which time Millie\xe2\x80\x99s may take title to the machine\noutright for the payment of $1. During the period of the rental, title remains in Ferrous\nBrothers. Is this \xe2\x80\x9clease\xe2\x80\x9d really a security interest? Since ownership comes at nominal charge\nwhen the entire lease is satisfied, the transaction would be construed as one creating a security\ninterest. What difference does this make? Suppose Millie\xe2\x80\x99s goes bankrupt in the third year of the\nlease, and the trustee in bankruptcy wishes to sell the punch press to satisfy debts of the\nmachine shop. If it were a true lease, Ferrous Brothers would be entitled to reclaim the machine\n(unless the trustee assumed the lease). But if the lease is really intended as a device to create a\nsecurity interest, then Ferrous Brothers can recover its collateral only if it has otherwise\ncomplied with the obligations of Article 9\xe2\x80\x94for example, by recording its security interest, as we\nwill see.\nNow we return to definitions.\nDebtor is \xe2\x80\x9ca person (1) having an interest in the collateral other than a security interest or a lien;\n(2) a seller of accounts, chattel paper, payment intangibles, or promissory notes; or (3) a\nconsignee.\xe2\x80\x9d [4]\nObligor is \xe2\x80\x9ca person that, with respect to an obligation secured by a security interest in or an\nagricultural lien on the collateral, (i) owes payment or other performance of the obligation, (ii)\nhas provided property other than the collateral to secure payment or other performance of the\nobligation, or (iii) is otherwise accountable in whole or in part for payment or other performance\nof the obligation.\xe2\x80\x9d [5] Here is example 1 from the Official Comment to UCC Section 9-102:\n\xe2\x80\x9cBehnfeldt borrows money and grants a security interest in her Miata to secure the debt.\nBehnfeldt is a debtor and an obligor.\xe2\x80\x9d\nBehnfeldt is a debtor because she has an interest in the car\xe2\x80\x94she owns it. She is an obligor\nbecause she owes payment to the creditor. Usually the debtor is the obligor.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n558\n\n\x0cA secondary obligor is \xe2\x80\x9can obligor to the extent that: (A) [the] obligation is secondary; or (b)\n[the person] has a right of recourse with respect to an obligation secured by collateral against\nthe debtor, another obligor, or property of either.\xe2\x80\x9d [6] The secondary obligor is a guarantor\n(surety) of the debt, obligated to perform if the primary obligor defaults. Consider example 2\nfrom the Official Comment to Section 9-102: \xe2\x80\x9cBehnfeldt borrows money and grants a security\ninterest in her Miata to secure the debt. Bruno cosigns a negotiable note as maker. As before,\nBehnfeldt is the debtor and an obligor. As an accommodation party, Bruno is a secondary\nobligor. Bruno has this status even if the note states that her obligation is a primary obligation\nand that she waives all suretyship defenses.\xe2\x80\x9d\nAgain, usually the debtor is the obligor, but consider example 3 from the same Official\nComment: \xe2\x80\x9cBehnfeldt borrows money on an unsecured basis. Bruno cosigns the note and grants\na security interest in her Honda to secure her [Behnfeldt\xe2\x80\x99s] obligation. Inasmuch as Behnfeldt\ndoes not have a property interest in the Honda, Behnfeldt is not a debtor. Having granted the\nsecurity interest, Bruno is the debtor. Because Behnfeldt is a principal obligor, she is not a\nsecondary obligor. Whatever the outcome of enforcement of the security interest against the\nHonda or Bruno\xe2\x80\x99s secondary obligation, Bruno will look to Behnfeldt for her losses. The\nenforcement will not affect Behnfeldt\xe2\x80\x99s aggregate obligations.\xe2\x80\x9d\nSecured party is \xe2\x80\x9ca person in whose favor a security interest is created or provided for under a\nsecurity agreement,\xe2\x80\x9d and it includes people to whom accounts, chattel paper, payment\nintangibles, or promissory notes have been sold; consignors; and others under Section 9102(a)(72).\nChattel mortgage means \xe2\x80\x9ca debt secured against items of personal property rather than against\nland, buildings and fixtures.\xe2\x80\x9d [7]\n\nProperty Subject to the Security Interest\nNow we examine what property may be put up as security\xe2\x80\x94collateral. Collateral is\xe2\x80\x94again\xe2\x80\x94\nproperty that is subject to the security interest. It can be divided into four broad categories:\ngoods, intangible property, indispensable paper, and other types of collateral.\n\nGoods\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n559\n\n\x0cTangible property as collateral is goods. Goods means \xe2\x80\x9call things that are movable when a\nsecurity interest attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and\nremoved under a conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops\ngrown, growing, or to be grown, even if the crops are produced on trees, vines, or bushes, and\n(v) manufactured homes. The term also includes a computer program embedded in\ngoods.\xe2\x80\x9d [8] Goods are divided into several subcategories; six are taken up here.\n\nConsumer Goods\nThese are \xe2\x80\x9cgoods used or bought primarily for personal, family, or household purposes.\xe2\x80\x9d [9]\n\nInventory\n\xe2\x80\x9cGoods, other than farm products, held by a person for sale or lease or consisting of raw\nmaterials, works in progress, or material consumed in a business.\xe2\x80\x9d [10]\n\nFarm Products\n\xe2\x80\x9cCrops, livestock, or other supplies produced or used in farming operations,\xe2\x80\x9d including aquatic\ngoods produced in aquaculture. [11]\n\nEquipment\nThis is the residual category, defined as \xe2\x80\x9cgoods other than inventory, farm products, or\nconsumer goods.\xe2\x80\x9d [12]\n\nFixtures\nThese are \xe2\x80\x9cgoods that have become so related to particular real property that an interest in them\narises under real property law.\xe2\x80\x9d [13] Examples would be windows, furnaces, central air\nconditioning, and plumbing fixtures\xe2\x80\x94items that, if removed, would be a cause for significant\nreconstruction.\n\nAccession\nThese are \xe2\x80\x9cgoods that are physically united with other goods in such a manner that the identity\nof the original goods is lost.\xe2\x80\x9d [14] A new engine installed in an old automobile is an accession.\n\nIntangible Property\nTwo types of collateral are neither goods nor indispensible paper: accounts and general\nintangibles.\n\nAccounts\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n560\n\n\x0cThis type of intangible property includes accounts receivable (the right to payment of money),\ninsurance policy proceeds, energy provided or to be provided, winnings in a lottery, health-careinsurance receivables, promissory notes, securities, letters of credit, and interests in business\nentities. [15] Often there is something in writing to show the existence of the right\xe2\x80\x94such as a right\nto receive the proceeds of somebody else\xe2\x80\x99s insurance payout\xe2\x80\x94but the writing is merely evidence\nof the right. The paper itself doesn\xe2\x80\x99t have to be delivered for the transfer of the right to be\neffective; that\xe2\x80\x99s done by assignment.\n\nGeneral Intangibles\nGeneral intangibles refers to \xe2\x80\x9cany personal property, including things in action, other than\naccounts, commercial tort claims, deposit accounts, documents, goods, instruments, investment\nproperty, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before\nextraction.\xe2\x80\x9d General intangibles include payment intangibles and software. [16]\n\nIndispensable Paper\nThis oddly named category is the middle ground between goods\xe2\x80\x94stuff you can touch\xe2\x80\x94and\nintangible property. It\xe2\x80\x99s called \xe2\x80\x9cindispensable\xe2\x80\x9d because although the right to the value\xe2\x80\x94such as a\nwarehouse receipt\xe2\x80\x94is embodied in a written paper, the paper itself is indispensable for the\ntransferee to access the value. For example, suppose Deborah Debtor borrows $3,000 from Carl\nCreditor, and Carl takes a security interest in four designer chairs Deborah owns that are being\nstored in a warehouse. If Deborah defaults, Carl has the right to possession of the warehouse\nreceipt: he takes it to the warehouser and is entitled to take the chairs and sell them to satisfy\nthe obligation. The warehouser will not let Carl have the chairs without the warehouse receipt\xe2\x80\x94\nit\xe2\x80\x99s indispensable paper. There are four kinds of indispensable paper.\n\nChattel Paper\nChattel is another word for goods. Chattel paper is a record (paper or electronic) that\ndemonstrates both \xe2\x80\x9ca monetary obligation and a security interest either in certain goods or in a\nlease on certain goods.\xe2\x80\x9d [17] The paper represents a valuable asset and can itself be used as\ncollateral. For example, Creditor Car Company sells David Debtor an automobile and takes back\na note and security agreement (this is a purchase-money security agreement; the note and\nsecurity agreement is chattel paper). The chattel paper is not yet collateral; the automobile is.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n561\n\n\x0cNow, though, Creditor Car Company buys a new hydraulic lift from Lift Co., and grants Lift Co. a\nsecurity interest in Debtor\xe2\x80\x99s chattel paper to secure Creditor Car\xe2\x80\x99s debt to Lift Co. The chattel\npaper is now collateral. Chattel paper can be tangible (actual paper) or electronic.\n\nDocuments\nThis category includes documents of title\xe2\x80\x94bills of lading and warehouse receipts are examples.\n\nInstruments\nAn \xe2\x80\x9cinstrument\xe2\x80\x9d here is \xe2\x80\x9ca negotiable instrument (checks, drafts, notes, certificates of deposit)\nor any other writing that evidences a right to the payment of a monetary obligation, is not itself a\nsecurity agreement or lease, and is of a type that in the ordinary course of business is transferred\nby delivery with any necessary indorsement or assignment.\xe2\x80\x9d \xe2\x80\x9cInstrument\xe2\x80\x9d does not include (i)\ninvestment property, (ii) letters of credit, or (iii) writings that evidence a right to payment\narising out of the use of a credit or charge card or information contained on or for use with the\ncard. [18]\n\nInvestment Property\nThis includes securities (stock, bonds), security accounts, commodity accounts, and commodity\ncontracts. [19] Securities may be certified (represented by a certificate) or uncertified (not\nrepresented by a certificate). [20]\n\nOther Types of Collateral\nAmong possible other types of collateral that may be used as security is thefloating lien. This is a\nsecurity interest in property that was not in the possession of the debtor when the security\nagreement was executed. The floating lien creates an interest that floats on the river of present\nand future collateral and proceeds held by\xe2\x80\x94most often\xe2\x80\x94the business debtor. It is especially\nuseful in loans to businesses that sell their collateralized inventory. Without the floating lien, the\nlender would find its collateral steadily depleted as the borrowing business sells its products to\nits customers. Pretty soon, there\xe2\x80\x99d be no security at all. The floating lien includes the following:\n\xe2\x80\xa2\n\nAfter-acquired property. This is property that the debtor acquires after the original deal was set\nup. It allows the secured party to enhance his security as the debtor (obligor) acquires more\nproperty subject to collateralization.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n562\n\n\x0c\xe2\x80\xa2\n\nSale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a\nsecured interest in Deborah Debtor\xe2\x80\x99s sailboat. She sells the boat and buys a garden tractor. The\nsecured interest attaches to the garden tractor.\n\n\xe2\x80\xa2\n\nFuture advances. Here the security agreement calls for the collateral to stand for both present\nand future advances of credit without any additional paperwork.\nHere are examples of future advances:\n\no\n\nExample 1: A debtor enters into a security agreement with a creditor that contains a future\nadvances clause. The agreement gives the creditor a security interest in a $700,000 inventorypicking robot to secure repayment of a loan made to the debtor. The parties contemplate that\nthe debtor will, from time to time, borrow more money, and when the debtor does, the machine\nwill stand as collateral to secure the further indebtedness, without new paperwork.\n\no\n\nExample 2: A debtor signs a security agreement with a bank to buy a car. The security agreement\ncontains a future advances clause. A few years later, the bank sends the debtor a credit card.\nTwo years go by: the car is paid for, but the credit card is in default. The bank seizes the car.\n\xe2\x80\x9cWhoa!\xe2\x80\x9d says the debtor. \xe2\x80\x9cI paid for the car.\xe2\x80\x9d \xe2\x80\x9cYes,\xe2\x80\x9d says the bank, \xe2\x80\x9cbut it was collateral for all\nfuture indebtedness you ran up with us. Check out your loan agreement with us and UCC\nSection 9-204(c), especially Comment 5.\xe2\x80\x9d\nSee Figure 16.2 "Tangibles and Intangibles as Collateral".\nFigure 16.2 Tangibles and Intangibles as Collateral\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n563\n\n\x0cAttachment of the Security Interest\nIn General\nAttachment is the term used to describe when a security interest becomes enforceable against\nthe debtor with respect to the collateral. In Figure 16.1 "The Grasping Hand", \xe2\x80\x9dAttachment\xe2\x80\x9d is\nthe outreached hand that is prepared, if the debtor defaults, to grasp the collateral. [21]\n\nRequirements for Attachment\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n564\n\n\x0cThere are three requirements for attachment: (1) the secured party gives value; (2) the debtor\nhas rights in the collateral or the power to transfer rights in it to the secured party; (3) the\nparties have a security agreement \xe2\x80\x9cauthenticated\xe2\x80\x9d (signed) by the debtor, or the creditor has\npossession of the collateral.\n\nCreditor Gives Value\nThe creditor, or secured party, must give \xe2\x80\x9cvalue\xe2\x80\x9d for the security interest to attach. The UCC, in\nSection 1-204, provides that\na person gives \xe2\x80\x98value\xe2\x80\x99 for rights if he acquires them\n(1) in return for a binding commitment to extend credit or for the extension of immediately\navailable credit whether or not drawn upon and whether or not a charge-back is provided for in\nthe event of difficulties in collection; or\n(2) as security for or in total or partial satisfaction of a pre-existing claim; or\n(3) by accepting delivery pursuant to a pre-existing contract for purchase; or\n(4) generally, in return for any consideration sufficient to support a simple contract.\nSuppose Deborah owes Carl $3,000. She cannot repay the sum when due, so she agrees to give\nCarl a security interest in her automobile to the extent of $3,000 in return for an extension of\nthe time to pay. That is sufficient value.\n\nDebtor\xe2\x80\x99s Rights in Collateral\nThe debtor must have rights in the collateral. Most commonly, the debtor owns the collateral (or\nhas some ownership interest in it). The rights need not necessarily be the immediate right to\npossession, but they must be rights that can be conveyed. [22] A person can\xe2\x80\x99t put up as collateral\nproperty she doesn\xe2\x80\x99t own.\n\nSecurity Agreement (Contract) or Possession of Collateral by Creditor\nThe debtor most often signs the written security agreement, or contract. The UCC says that \xe2\x80\x9cthe\ndebtor [must have] authenticated a security agreement that provides a description of the\ncollateral.\xe2\x80\xa6\xe2\x80\x9d \xe2\x80\x9cAuthenticating\xe2\x80\x9d (or \xe2\x80\x9csigning,\xe2\x80\x9d \xe2\x80\x9cadopting,\xe2\x80\x9d or \xe2\x80\x9caccepting\xe2\x80\x9d) means to sign or, in\nrecognition of electronic commercial transactions, \xe2\x80\x9cto execute or otherwise adopt a symbol, or\nencrypt or similarly process a record\xe2\x80\xa6with the present intent of the authenticating person to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n565\n\n\x0cidentify the person and adopt or accept a record.\xe2\x80\x9d The \xe2\x80\x9crecord\xe2\x80\x9d is the modern UCC\xe2\x80\x99s substitution\nfor the term \xe2\x80\x9cwriting.\xe2\x80\x9d It includes information electronically stored or on paper. [23]\nThe \xe2\x80\x9cauthenticating record\xe2\x80\x9d (the signed security agreement) is not required in some cases. It is\nnot required if the debtor makes a pledge of the collateral\xe2\x80\x94that is, delivers it to the creditor for\nthe creditor to possess. For example, upon a creditor\xe2\x80\x99s request of a debtor for collateral to secure\na loan of $3,000, the debtor offers up his stamp collection. The creditor says, \xe2\x80\x9cFine, have it\nappraised (at your expense) and show me the appraisal. If it comes in at $3,000 or more, I\xe2\x80\x99ll\ntake your stamp collection and lock it in my safe until you\xe2\x80\x99ve repaid me. If you don\xe2\x80\x99t repay me,\nI\xe2\x80\x99ll sell it.\xe2\x80\x9d A creditor could take possession of any goods and various kinds of paper, tangible or\nintangible. In commercial transactions, it would be common for the creditor to have possession\nof\xe2\x80\x94actually or virtually\xe2\x80\x94certified securities, deposit accounts, electronic chattel paper,\ninvestment property, or other such paper or electronic evidence of value. [24]\nAgain, Figure 16.1 "The Grasping Hand" diagrams the attachment, showing the necessary\nelements: the creditor gives value, the debtor has rights in collateral, and there is a security\nagreement signed (authenticated) by the debtor. If the debtor defaults, the creditor\xe2\x80\x99s \xe2\x80\x9chand\xe2\x80\x9d will\ngrab (repossess) the collateral.\n\nPerfection of the Security Interest\nAs between the debtor and the creditor, attachment is fine: if the debtor defaults, the creditor\nwill repossess the goods and\xe2\x80\x94usually\xe2\x80\x94sell them to satisfy the outstanding obligation. But\nunless an additional set of steps is taken, the rights of the secured party might be subordinated\nto the rights of other secured parties, certain lien creditors, bankruptcy trustees, and buyers who\ngive value and who do not know of the security interest. Perfection is the secured party\xe2\x80\x99s way of\nannouncing the security interest to the rest of the world. It is the secured party\xe2\x80\x99s claim on the\ncollateral.\nThere are five ways a creditor may perfect a security interest: (1) by filing a financing statement,\n(2) by taking or retaining possession of the collateral, (3) by taking control of the collateral, (4)\nby taking control temporarily as specified by the UCC, or (5) by taking control automatically.\n\nPerfection by Filing\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n566\n\n\x0c\xe2\x80\x9cExcept as otherwise provided\xe2\x80\xa6a financing statement must be filed to perfect all security\nagreements.\xe2\x80\x9d [25]\n\nThe Financing Statement\nA financing statement is a simple notice showing the creditor\xe2\x80\x99s general interest in the collateral.\nIt is what\xe2\x80\x99s filed to establish the creditor\xe2\x80\x99s \xe2\x80\x9cdibs.\xe2\x80\x9d\n\nContents of the Financing Statement\nIt may consist of the security agreement itself, as long as it contains the information required by\nthe UCC, but most commonly it is much less detailed than the security agreement: it \xe2\x80\x9cindicates\nmerely that a person may have a security interest in the collateral[.]\xe2\x80\xa6Further inquiry from the\nparties concerned will be necessary to disclose the full state of affairs.\xe2\x80\x9d [26] The financing\nstatement must provide the following information:\n\xe2\x80\xa2\n\nThe debtor\xe2\x80\x99s name. Financing statements are indexed under the debtor\xe2\x80\x99s name, so getting that\ncorrect is important. Section 9-503 of the UCC describes what is meant by \xe2\x80\x9cname of debtor.\xe2\x80\x9d\n\n\xe2\x80\xa2\n\nThe secured party\xe2\x80\x99s name.\n\n\xe2\x80\xa2\n\nAn \xe2\x80\x9cindication\xe2\x80\x9d of what collateral is covered by the financing statement. [27] It may describe the\ncollateral or it may \xe2\x80\x9cindicate that the financing statement covers all assets or all personal\nproperty\xe2\x80\x9d (such generic references are not acceptable in the security agreement but are OK in\nthe financing statement). [28] If the collateral is real-property-related, covering timber to be cut\nor fixtures, it must include a description of the real property to which the collateral is related. [29]\nThe form of the financing statement may vary from state to state, but see Figure 16.3 "UCC-1\nFinancing Statement" for a typical financing statement. Minor errors or omissions on the form\nwill not make it ineffective, but the debtor\xe2\x80\x99s signature is required unless the creditor is\nauthorized by the debtor to make the filing without a signature, which facilitates paperless\nfiling. [30]\nFigure 16.3 UCC-1 Financing Statement\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n567\n\n\x0cDuration of the Financing Statement\nGenerally, the financing statement is effective for five years; acontinuation statement may be\nfiled within six months before the five-year expiration date, and it is good for another five\nyears. [31] Manufactured-home filings are good for thirty years. When the debtor\xe2\x80\x99s obligation is\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n568\n\n\x0csatisfied, the secured party files a termination statement if the collateral was consumer goods;\notherwise\xe2\x80\x94upon demand\xe2\x80\x94the secured party sends the debtor a termination statement. [32]\n\nDebtor Moves out of State\nThe UCC also has rules for continued perfection of security interests when the debtor\xe2\x80\x94whether\nan individual or an association (corporation)\xe2\x80\x94moves from one state to another. Generally, an\ninterest remains perfected until the earlier of when the perfection would have expired or for four\nmonths after the debtor moves to a new jurisdiction. [33]\n\nWhere to File the Financing Statement\nFor most real-estate-related filings\xe2\x80\x94ore to be extracted from mines, agricultural collateral, and\nfixtures\xe2\x80\x94the place to file is with the local office that files mortgages, typically the county\nauditor\xe2\x80\x99s office. [34] For other collateral, the filing place is as duly authorized by the state. In some\nstates, that is the office of the Secretary of State; in others, it is the Department of Licensing; or\nit might be a private party that maintains the state\xe2\x80\x99s filing system. [35] The filing should be made\nin the state where the debtor has his or her primary residence for individuals, and in the state\nwhere the debtor is organized if it is a registered organization. [36] The point is, creditors need to\nknow where to look to see if the collateral offered up is already encumbered. In any event, filing\nthe statement in more than one place can\xe2\x80\x99t hurt. The filing office will provide instructions on\nhow to file; these are available online, and electronic filing is usually available for at least some\ntypes of collateral.\n\nExemptions\nSome transactions are exempt from the filing provision. The most important category of exempt\ncollateral is that covered by state certificate of title laws. For example, many states require\nautomobile owners to obtain a certificate of title from the state motor vehicle office. Most of\nthese states provide that it is not necessary to file a financing statement in order to perfect a\nsecurity interest in an automobile. The reason is that the motor vehicle regulations require any\nsecurity interests to be stated on the title, so that anyone attempting to buy a car in which a\nsecurity interest had been created would be on notice when he took the actual title certificate. [37]\n\nTemporary Perfection\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n569\n\n\x0cThe UCC provides that certain types of collateral are automatically perfected but only for a\nwhile: \xe2\x80\x9cA security interest in certificated securities, or negotiable documents, or instruments is\nperfected without filing or the taking of possession for a period of twenty days from the time it\nattaches to the extent that it arises for new value given under an authenticated security\nagreement.\xe2\x80\x9d [38] Similar temporary perfection covers negotiable documents or goods in\npossession of a bailee, and when a security certificate or instrument is delivered to the debtor for\nsale, exchange, presentation, collection, enforcement, renewal, or registration. [39] After the\ntwenty-day period, perfection would have to be by one of the other methods mentioned here.\n\nPerfection by Possession\nA secured party may perfect the security interest by possession where the collateral is negotiable\ndocuments, goods, instruments, money, tangible chattel paper, or certified securities. [40] This is\na pledge of assets (mentioned in the example of the stamp collection). No security agreement is\nrequired for perfection by possession.\nA variation on the theme of pledge is field warehousing. When the pawnbroker lends money, he\ntakes possession of the goods\xe2\x80\x94the watch, the ring, the camera. But when large manufacturing\nconcerns wish to borrow against their inventory, taking physical possession is not necessarily so\neasy. The bank does not wish to have shipped to its Wall Street office several tons of copper\nmined in Colorado. Bank employees perhaps could go west to the mine and take physical control\nof the copper, but banks are unlikely to employ people and equipment necessary to build a\nwarehouse on the spot. Thus this so-called field pledge is rare.\nMore common is the field warehouse. The field warehouse can take one of two forms. An\nindependent company can go to the site and put up a temporary structure\xe2\x80\x94for example, a fence\naround the copper\xe2\x80\x94thus establishing physical control of the collateral. Or the independent\ncompany can lease the warehouse facilities of the debtor and post signs indicating that the goods\ninside are within its sale custody. Either way, the goods are within the physical possession of the\nfield warehouse service. The field warehouse then segregates the goods secured to the particular\nbank or finance company and issues a warehouse receipt to the lender for those goods. The\nlender is thus assured of a security interest in the collateral.\n\nPerfection by Control\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n570\n\n\x0c\xe2\x80\x9cA security interest in investment property, deposit accounts, letter-of-credit rights, or\nelectronic chattel paper may be perfected by control of the collateral.\xe2\x80\x9d [41] \xe2\x80\x9cControl\xe2\x80\x9d depends on\nwhat the collateral is. If it\xe2\x80\x99s a checking account, for example, the bank with which the deposit\naccount is maintained has \xe2\x80\x9ccontrol\xe2\x80\x9d: the bank gets a security interest automatically because, as\nOfficial Comment 3 to UCC Section 9-104 puts it, \xe2\x80\x9call actual and potential creditors of the debtor\nare always on notice that the bank with which the debtor\xe2\x80\x99s deposit account is maintained may\nassert a claim against the deposit account.\xe2\x80\x9d \xe2\x80\x9cControl\xe2\x80\x9d of electronic chattel paper of investment\nproperty, and of letter-of-credit rights is detailed in Sections 9-105, 9-106, and 9-107. Obtaining\n\xe2\x80\x9ccontrol\xe2\x80\x9d means that the creditor has taken whatever steps are necessary, given the manner in\nwhich the items are held, to place itself in a position where it can have the items sold, without\nfurther action by the owner. [42]\n\nAutomatic Perfection\nThe fifth mechanism of perfection is addressed in Section 9-309 of the UCC: there are several\ncircumstances where a security interest is perfected upon mere attachment. The most important\nhere is automatic perfection of a purchase-money security interest given in consumer goods. If a\nseller of consumer goods takes a PMSI in the goods sold, then perfection of the security interest\nis automatic. But the seller may file a financial statement and faces a risk if he fails to file and\nthe consumer debtor sells the goods. Under Section 9-320(b), a buyer of consumer goods takes\nfree of a security interest, even though perfected, if he buys without knowledge of the interest,\npays value, and uses the goods for his personal, family, or household purposes\xe2\x80\x94unless the\nsecured party had first filed a financing statement covering the goods.\nFigure 16.4 Attachment and Perfection\n\nKEY TAKEAWAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n571\n\n\x0cA creditor may be secured\xe2\x80\x94allowed to take the debtor\xe2\x80\x99s property upon debtor\xe2\x80\x99s default\xe2\x80\x94by\nagreement between the parties or by operation of law. The law governing agreements for\npersonal property security is Article 9 of the UCC. The creditor\xe2\x80\x99s first step is to attach the\nsecurity interest. This is usually accomplished when the debtor, in return for value (a loan or\ncredit) extended from the creditor, puts up as collateral some valuable asset in which she has\nan interest and authenticates (signs) a security agreement (the contract) giving the creditor a\nsecurity interest in collateral and allowing that the creditor may take it if the debtor defaults.\nThe UCC lists various kinds of assets that can be collateralized, ranging from tangible\nproperty (goods), to assets only able to be manifested by paper (indispensable paper), to\nintangible assets (like patent rights). Sometimes no security agreement is necessary, mostly if\nthe creditor takes possession of the collateral. After attachment, the prudent creditor will\nwant to perfect the security interest to make sure no other creditors claim an interest in the\ncollateral. Perfection is most often accomplished by filing a financing statement in the\nappropriate place to put the world on notice of the creditor\xe2\x80\x99s interest. Perfection can also be\nachieved by a pledge (possession by the secured creditor) or by \xe2\x80\x9ccontrol\xe2\x80\x9d of certain assets\n(having such control over them as to be able to sell them if the debtor defaults). Perfection is\nautomatic temporarily for some items (certified securities, instruments, and negotiable\ndocuments) but also upon mere attachment to purchase-money security interests in\nconsumer goods.\n\nEXERCISES\n\n1. Why is a creditor ill-advised to be unsecured?\n2. Elaine bought a computer for her use as a high school teacher, the school contributing onethird of its cost. Elaine was compelled to file for bankruptcy. The computer store claimed it\nhad perfected its interest by mere attachment, and the bankruptcy trustee claimed the\ncomputer as an asset of Elaine\xe2\x80\x99s bankruptcy estate. Who wins, and why?\n3. What is the general rule governing where financing statements should be filed?\n4. If the purpose of perfection is to alert the world to the creditor\xe2\x80\x99s claim in the collateral, why\nis perfection accomplishable by possession alone in some cases?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n572\n\n\x0c5. Contractor pawned a power tool and got a $200 loan from Pawnbroker. Has there been a\nperfection of a security interest?\n[1] Uniform Commercial Code, Section 9-109.\n[2] Uniform Commercial Code, Section 9-102(a)(73).\n[3] Uniform Commercial Code, Section 9-102(12).\n[4] Uniform Commercial Code, Section 9-102(a)(28).\n[5] Uniform Commercial Code, Section 9-102 (59).\n[6] Uniform Commercial Code, Section 9-102(a)(71).\n[7] Commercial Brokers, Inc., \xe2\x80\x9cGlossary of Real Estate\nTerms,\xe2\x80\x9dhttp://www.cbire.com/index.cfm/fuseaction/terms.list/letter/C/contentid/32302EC3-81D547DF-A9CBA32FAE38B22A.\n[8] Uniform Commercial Code, Section 9-102(44).\n[9] Uniform Commercial Code, Section 9-102(a)(48).\n[10] Uniform Commercial Code, Section 9-102(a)(48).\n[11] Uniform Commercial Code, Section 9-102(a)(34).\n[12] Uniform Commercial Code, Section 9-102(a)(33).\n[13] Uniform Commercial Code, Section 9-102(a)(41).\n[14] Uniform Commercial Code, Section 9-102(a)(1).\n[15] Uniform Commercial Code, Section 9-102(a)(2).\n[16] Uniform Commercial Code, Section 9-102(42).\n[17] Uniform Commercial Code, Section 9-102(11).\n[18] Uniform Commercial Code, Section 9-102(a)(47).\n[19] Uniform Commercial Code, Section 9-102(a)(49).\n[20] Uniform Commercial Code, Section 8-102(a)(4) and (a)(18).\n[21] Uniform Commercial Code, Section 9-203(a).\n[22] Uniform Commercial Code, Section 9-203(b)(2).\n[23] Uniform Commercial Code, Section 9-102, Official Comment 9. Here is a free example of a security\nagreement online: Docstoc, \xe2\x80\x9cFree Business Templates\xe2\x80\x94Sample Open-Ended Security\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n573\n\n\x0cAgreement,\xe2\x80\x9d http://www.docstoc.com/docs/271920/Free-Business-Templates\xe2\x80\x94-Sample-Open-EndedSecurity-Agreement.\n[24] Uniform Commercial Code, Section 9-203(b)(3)(B-D).\n[25] Uniform Commercial Code, Section 9-310(a).\n[26] Uniform Commercial Code, Section 9-502, Official Comment 2.\n[27] Uniform Commercial Code, Section 9-502(a).\n[28] Uniform Commercial Code, Section 9-504.\n[29] Uniform Commercial Code, Section 9-502(b).\n[30] Uniform Commercial Code, Section 9-506; Uniform Commercial Code, Section, 9-502, Comment 3.\n[31] Uniform Commercial Code, Section 9-515.\n[32] Uniform Commercial Code, Section 9-513.\n[33] Uniform Commercial Code, Section 9-316.\n[34] Uniform Commercial Code, Section 9-501.\n[35] Uniform Commercial Code, Section 9-501(a)(2).\n[36] Uniform Commercial Code, Section 9-307(b).\n[37] Uniform Commercial Code, Section 9-303.\n[38] Uniform Commercial Code, Section 9-312(e).\n[39] Uniform Commercial Code, Section 9-312(f) and (g).\n[40] Uniform Commercial Code, Section 9-313.\n[41] Uniform Commercial Code, Section 9-314.\n[42] Uniform Commercial Code, Section 8-106, Official Comment 1.\n\n16.2 Priorities\n\nLEARNING OBJECTIVES\n\n1. Understand the general rule regarding who gets priority among competing secured parties.\n2. Know the immediate exceptions to the general rule\xe2\x80\x94all involving PMSIs.\n3. Understand the basic ideas behind the other exceptions to the general rule.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n574\n\n\x0cPriorities: this is the money question. Who gets what when a debtor defaults? Depending on\nhow the priorities in the collateral were established, even a secured creditor may walk away with\nthe collateral or with nothing. Here we take up the general rule and the exceptions.\n\nGeneral Rule\nThe general rule regarding priorities is, to use a quotation attributed to a Southern Civil War\ngeneral, the one who wins \xe2\x80\x9cgets there firstest with the mostest.\xe2\x80\x9d The first to do the best job of\nperfecting wins. The Uniform Commercial Code (UCC) creates a race of diligence among\ncompetitors.\n\nApplication of the Rule\nIf both parties have perfected, the first to perfect wins. If one has perfected and one attached,\nthe perfected party wins. If both have attached without perfection, the first to attach wins. If\nneither has attached, they are unsecured creditors. Let\xe2\x80\x99s test this general rule against the\nfollowing situations:\n1. Rosemary, without having yet lent money, files a financing statement on February 1 covering\ncertain collateral owned by Susan\xe2\x80\x94Susan\xe2\x80\x99s fur coat. Under UCC Article 9, a filing may be made\nbefore the security interest attaches. On March 1, Erika files a similar statement, also without\nhaving lent any money. On April 1, Erika loans Susan $1,000, the loan being secured by the fur\ncoat described in the statement she filed on March 1. On May 1, Rosemary also loans Susan\n$1,000, with the same fur coat as security. Who has priority? Rosemary does, since she filed\nfirst, even though Erika actually first extended the loan, which was perfected when made\n(because she had already filed). This result is dictated by the rule even though Rosemary may\nhave known of Erika\xe2\x80\x99s interest when she subsequently made her loan.\n2. Susan cajoles both Rosemary and Erika, each unknown to the other, to loan her $1,000 secured\nby the fur coat, which she already owns and which hangs in her coat closet. Erika gives Susan\nthe money a week after Rosemary, but Rosemary has not perfected and Erika does not either. A\nweek later, they find out they have each made a loan against the same coat. Who has priority?\nWhoever perfects first: the rule creates a race to the filing office or to Susan\xe2\x80\x99s closet. Whoever\ncan submit the financing statement or actually take possession of the coat first will have priority,\nand the outcome does not depend on knowledge or lack of knowledge that someone else is\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n575\n\n\x0cclaiming a security interest in the same collateral. But what of the rule that in the absence of\nperfection, whichever security interest first attached has priority? This is \xe2\x80\x9cthought to be of\nmerely theoretical interest,\xe2\x80\x9d says the UCC commentary, \xe2\x80\x9csince it is hard to imagine a situation\nwhere the case would come into litigation without [either party] having perfected his interest.\xe2\x80\x9d\nAnd if the debtor filed a petition in bankruptcy, neither unperfected security interest could\nprevail against the bankruptcy trustee.\nTo rephrase: An attached security interest prevails over other unsecured creditors (unsecured\ncreditors lose to secured creditors, perfected or unperfected). If both parties are secured (have\nattached the interest), the first to perfect wins. [1] If both parties have perfected, the first to have\nperfected wins. [2]\n\nExceptions to the General Rule\nThere are three immediate exceptions to the general rule, and several other exceptions, all of\nwhich\xe2\x80\x94actually\xe2\x80\x94make some straightforward sense even if it sounds a little complicated to\nexplain them.\n\nImmediate Exceptions\nWe call the following three exceptions \xe2\x80\x9cimmediate\xe2\x80\x9d ones because they allow junior filers\nimmediate priority to take their collateral before the debtor\xe2\x80\x99s other creditors get it. They all\ninvolve purchase-money security interests (PMSIs), so if the debtor defaults, the creditor\nrepossesses the very goods the creditor had sold the debtor.\n(1) Purchase-money security interest in goods (other than inventory or livestock).The UCC\nprovides that \xe2\x80\x9ca perfected purchase-money security interest in goods other than inventory or\nlivestock has priority over a conflicting security interest in the same goods\xe2\x80\xa6if the purchasemoney security interest is perfected when debtor receives possession of the collateral or within\n20 days thereafter.\xe2\x80\x9d [3] The Official Comment to this UCC section observes that \xe2\x80\x9cin most cases,\npriority will be over a security interest asserted under an after-acquired property clause.\xe2\x80\x9d\nSuppose Susan manufactures fur coats. On February 1, Rosemary advances her $10,000 under a\nsecurity agreement covering all Susan\xe2\x80\x99s machinery and containing an after-acquired property\nclause. Rosemary files a financing statement that same day. On March 1, Susan buys a new\nmachine from Erika for $5,000 and gives her a security interest in the machine; Erika files a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n576\n\n\x0cfinancing statement within twenty days of the time that the machine is delivered to Susan. Who\nhas priority if Susan defaults on her loan payments? Under the PMSI rule, Erika has priority,\nbecause she had a PMSI. Suppose, however, that Susan had not bought the machine from Erika\nbut had merely given her a security interest in it. Then Rosemary would have priority, because\nher filing was prior to Erika\xe2\x80\x99s.\nWhat would happen if this kind of PMSI in noninventory goods (here, equipment) did not get\npriority status? A prudent Erika would not extend credit to Susan at all, and if the new machine\nis necessary for Susan\xe2\x80\x99s business, she would soon be out of business. That certainly would not\ninure to the benefit of Rosemary. It is, mostly, to Rosemary\xe2\x80\x99s advantage that Susan gets the\nmachine: it enhances Susan\xe2\x80\x99s ability to make money to pay Rosemary.\n(2) Purchase-money security interest in inventory. The UCC provides that a perfected PMSI in\ninventory has priority over conflicting interests in the same inventory, provided that the PMSI is\nperfected when the debtor receives possession of the inventory, the PMSI-secured party sends\nan authenticated notification to the holder of the conflicting interest and that person receives\nthe notice within five years before the debtor receives possession of the inventory, and the notice\nstates that the person sending it has or expects to acquire a PMSI in the inventory and describes\nthe inventory. [4] The notice requirement is aimed at protecting a secured party in the typical\nsituation in which incoming inventory is subject to a prior agreement to make advances against\nit. If the original creditor gets notice that new inventory is subject to a PMSI, he will be\nforewarned against making an advance on it; if he does not receive notice, he will have priority.\nIt is usually to the earlier creditor\xe2\x80\x99s advantage that her debtor is able to get credit to \xe2\x80\x9cfloor\xe2\x80\x9d\n(provide) inventory, without selling which, of course, the debtor cannot pay back the earlier\ncreditor.\n(3) Purchase-money security interest in fixtures. Under UCC Section 9-334(e), a perfected\nsecurity in fixtures has priority over a mortgage if the security interest is a PMSI and the security\ninterest is perfected by a fixture filing before the goods become fixtures or within twenty days\nafter. A mortgagee is usually a bank (the mortgagor is the owner of the real estate, subject to the\nmortgagee\xe2\x80\x99s interest). The bank\xe2\x80\x99s mortgage covers the real estate and fixtures, even fixtures\nadded after the date of the mortgage (after-acquired property clause). In accord with the general\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n577\n\n\x0crule, then, the mortgagee/bank would normally have priority if the mortgage is recorded first, as\nwould a fixture filing if made before the mortgage was recorded. But with the exception noted,\nthe bank\xe2\x80\x99s interest is subordinate to the fixture-seller\xe2\x80\x99s later-perfected PMSI. Example: Susan\nbuys a new furnace from Heating Co. to put in her house. Susan gave a bank a thirty-year\nmortgage on the house ten years before. Heating Co. takes back a PMSI and files the appropriate\nfinancing statement before or within twenty days of installation. If Susan defaults on her loan to\nthe bank, Heating Co. would take priority over the bank. And why not? The mortgagee has, in\nthe long run, benefited from the improvement and modernization of the real estate. (Again,\nthere are further nuances in Section 9-334 beyond our scope here.) A non-PMSI in fixtures or\nPMSIs perfected more than twenty days after goods become a fixture loses out to prior recorded\ninterests in the realty.\n\nOther Exceptions\nWe have noted the three immediate exceptions to the general rule that \xe2\x80\x9cthe firstest with the\nmostest\xe2\x80\x9d prevails. There are some other exceptions.\nThink about how these other exceptions might arise: who might want to take property subject to\na security agreement (not including thieves)? That is, Debtor gives Creditor a security interest\nin, say, goods, while retaining possession. First, buyers of various sorts might want the goods if\nthey paid for them; they usually win. Second, lien creditors might want the goods\n(a lien creditor is one whose claim is based on operation of law\xe2\x80\x94involuntarily against Debtor,\nand including a trustee in bankruptcy\xe2\x80\x94as opposed to one whose claim is based on agreement);\nlien creditors may be statutory (landlords, mechanics, bailees) or judicial. Third, a bankruptcy\ntrustee representing Debtor\xe2\x80\x99s creditors (independent of the trustee\xe2\x80\x99s role as a lien creditor)\nmight want to take the goods to sell and satisfy Debtor\xe2\x80\x99s obligations to the creditors. Fourth,\nunsecured creditors; fifth, secured creditors; and sixth, secured and perfected creditors. We will\nexamine some of the possible permutations but are compelled to observe that this area of law\nhas many fine nuances, not all of which can be taken up here.\nFirst we look at buyers who take priority over, or free of, unperfected security interests. Buyers\nwho take delivery of many types of collateral covered by an unperfected security interest win out\nover the hapless secured party who failed to perfect if they give value and don\xe2\x80\x99t know of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n578\n\n\x0csecurity interest or agricultural lien. [5] A buyer who doesn\xe2\x80\x99t give value or who knows of the\nsecurity interest will not win out, nor will a buyer prevail if the seller\xe2\x80\x99s creditor files a financing\nstatement before or within twenty days after the debtor receives delivery of the collateral.\nNow we look at buyers who take priority over perfected security interests. Sometimes people\nwho buy things even covered by a perfected security interest win out (the perfected secured\nparty loses).\n\xe2\x80\xa2\n\nBuyers in the ordinary course of business. \xe2\x80\x9cA buyer in the ordinary course of business, other\nthan [one buying farm products from somebody engaged in farming] takes free of a security\ninterest created by the buyer\xe2\x80\x99s seller, even if the security interest is perfected and the buyer\nknows [it].\xe2\x80\x9d [6] Here the buyer is usually purchasing inventory collateral, and it\xe2\x80\x99s OK if he knows\nthe inventory is covered by a security interest, but it\xe2\x80\x99s not OK if he knows \xe2\x80\x9cthat the sale violates a\nterm in an agreement with the secured party.\xe2\x80\x9d [7] It would not be conducive to faith in\ncommercial transactions if buyers of inventory generally had to worry whether their seller\xe2\x80\x99s\ncreditors were going to repossess the things the buyers had purchased in good faith. For\nexample (based on example 1 to the same comment, UCC 9-320, Official Comment 3),\nManufacturer makes appliances and owns manufacturing equipment covered by a perfected\nsecurity agreement in favor of Lender. Manufacturer sells the equipment to Dealer, whose\nbusiness is buying and selling used equipment; Dealer, in turn, sells the stuff to Buyer, a buyer\nin the ordinary course. Does Buyer take free of the security interest? No, because Dealer didn\xe2\x80\x99t\ncreate it; Manufacturer did.\n\n\xe2\x80\xa2\n\nBuyers of consumer goods purchased for personal, family, or household use take free of security\ninterests, even if perfected, so long as they buy without knowledge of the security interest, for\nvalue, for their own consumer uses, and before the filing of a financing statement covering the\ngoods. This\xe2\x80\x94again\xe2\x80\x94is the rub when a seller of consumer goods perfects by \xe2\x80\x9cmere attachment\xe2\x80\x9d\n(automatic perfection) and the buyer of the goods turns around and sells them. For example,\nTom buys a new refrigerator from Sears, which perfects by mere attachment. Tom has cash flow\nproblems and sells the fridge to Ned, his neighbor. Ned doesn\xe2\x80\x99t know about Sears\xe2\x80\x99s security\ninterest and pays a reasonable amount for it. He puts it in his kitchen for home use. Sears\ncannot repossess the fridge from Ned. If it wanted to protect itself fully, Sears would have filed a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n579\n\n\x0cfinancing statement; then Ned would be out the fridge when the repo men came. [8] The \xe2\x80\x9cvalue\xe2\x80\x9d\nissue is interestingly presented in the Nicolosi case (Section 16.5 "Cases").\n\xe2\x80\xa2\n\nBuyers of farm products. The UCC itself does not protect buyers of farm products from security\ninterests created by \xe2\x80\x9cthe person engaged in farming operations who is in the business of selling\nfarm products,\xe2\x80\x9d and the result was that sometimes the buyer had to pay twice: once to the\nfarmer and again to the lender whom the farmer didn\xe2\x80\x99t pay. As a result, Congress included in its\n1985 Farm Security Act, 7 USC 1631, Section 1324, this language: \xe2\x80\x9cA buyer who in the ordinary\ncourse of business buys a farm product from a seller engaged in farming operations shall take\nfree of a security interest created by the seller, even though the security interest is perfected; and\nthe buyer knows of the existence of such interest.\xe2\x80\x9d\nThere are some other exceptions, beyond our scope here.\n\nLien Creditors\nPersons (including bankruptcy trustees) who become lien creditors before the security interest is\nperfected win out\xe2\x80\x94the unperfected security interest is subordinate to lien creditors. Persons\nwho become lien creditors after the security interest is perfected lose (subject to some nuances\nin situations where the lien arises between attachment by the creditor and the filing, and\ndepending upon the type of security interest and the type of collateral). [9] More\nstraightforwardly, perhaps, a lien securing payment or performance of an obligation for services\nor materials furnished with respect to goods by a person in the ordinary course of business has\npriority over other security interests (unless a statute provides otherwise). [10] This is the bailee\nor \xe2\x80\x9cmaterial man\xe2\x80\x9d (one who supplies materials, as to build a house) with a lien situation. Garage\nMechanic repairs a car in which Owner has previously given a perfected security interest to\nBank. Owner doesn\xe2\x80\x99t pay Bank. Bank seeks to repossess the car from Mechanic. It will have to\npay the Mechanic first. And why not? If the car was not running, Bank would have to have it\nrepaired anyway.\n\nBankruptcy Trustee\nTo what extent can the bankruptcy trustee take property previously encumbered by a security\ninterest? It depends. If the security interest was not perfected at the time of filing for\nbankruptcy, the trustee can take the collateral. [11] If it was perfected, the trustee can\xe2\x80\x99t take it,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n580\n\n\x0csubject to rules on preferential transfers: the Bankruptcy Act provides that the trustee can avoid\na transfer of an interest of the debtor in property\xe2\x80\x94including a security interest\xe2\x80\x94(1) to or for the\nbenefit of a creditor, (2) on or account of an antecedent debt, (3) made while the debtor was\ninsolvent, (4) within ninety days of the bankruptcy petition date (or one year, for \xe2\x80\x9cinsiders\xe2\x80\x9d\xe2\x80\x94like\nrelatives or business partners), (5) which enables the creditor to receive more than it would have\nin the bankruptcy. [12] There are further bankruptcy details beyond our scope here, but the short\nof it is that sometimes creditors who think they have a valid, enforceable security interest find\nout that the bankruptcy trustee has snatched the collateral away from them.\nDeposit accounts perfected by control. A security interest in a deposit account (checking\naccount, savings account, money-market account, certificate of deposit) takes priority over\nsecurity interests in the account perfected by other means, and under UCC Section 9-327(3), a\nbank with which the deposit is made takes priority over all other conflicting security\nagreements. [13] For example, a debtor enters into a security agreement with his sailboat as\ncollateral. The creditor perfects. The debtor sells the sailboat and deposits the proceeds in his\naccount with a bank; normally, the creditor\xe2\x80\x99s interest would attach to the proceeds. The debtor\nnext borrows money from the bank, and the bank takes a security interest in the debtor\xe2\x80\x99s\naccount by control. The debtor defaults. Who gets the money representing the sailboat\xe2\x80\x99s\nproceeds? The bank does. The rationale: \xe2\x80\x9cthis\xe2\x80\xa6enables banks to extend credit to their\ndepositors without the need to examine [records] to determine whether another party might\nhave a security interest in the deposit account.\xe2\x80\x9d [14]\n\nKEY TAKEAWAY\n\nWho among competing creditors gets the collateral if the debtor defaults? The general rule\non priorities is that the first to secure most completely wins: if all competitors have\nperfected, the first to do so wins. If one has perfected and the others have not, the one who\nperfects wins. If all have attached, the first to attach wins. If none have attached, they\xe2\x80\x99re all\nunsecured creditors. To this general rule there are a number of exceptions. Purchase-money\nsecurity interests in goods and inventory prevail over previously perfected secured parties in\nthe same goods and inventory (subject to some requirements); fixture financers who file\nproperly have priority over previously perfected mortgagees. Buyers in the ordinary course of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n581\n\n\x0cbusiness take free of a security interest created by their seller, so long as they don\xe2\x80\x99t know\ntheir purchase violates a security agreement. Buyers of consumer goods perfected by mere\nattachment win out over the creditor who declined to file. Buyers in the ordinary course of\nbusiness of farm products prevail over the farmer\xe2\x80\x99s creditors (under federal law, not the\nUCC). Lien creditors who become such before perfection win out; those who become such\nafter perfection usually lose. Bailees in possession and material men have priority over\nprevious perfected claimants. Bankruptcy trustees win out over unperfected security\ninterests and over perfected ones if they are considered voidable transfers from the debtor\nto the secured party. Deposit accounts perfected by control prevail over previously perfected\nsecured parties in the same deposit accounts.\n\nEXERCISES\n\n1. What is the general rule regarding priorities for the right to repossess goods encumbered by\na security interest when there are competing creditors clamoring for that right?\n2. Why does it make good sense to allow purchase-money security creditors in (1) inventory, (2)\nequipment, and (3) fixtures priority over creditors who perfected before the PMSI was\nperfected?\n3. A buyer in the ordinary course of business is usually one buying inventory. Why does it make\nsense that such a buyer should take free of a security interest created by his seller?\n[1] Uniform Commercial Code, Section 9-322(a)(2).\n[2] Uniform Commercial Code, Section 9-322(a)(1).\n[3] Uniform Commercial Code, Section 9-324(a).\n[4] Uniform Commercial Code, Section 9-324(b).\n[5] Uniform Commercial Code, Section 9-317(b).\n[6] Uniform Commercial Code, Section 9-320(a).\n[7] Uniform Commercial Code, Section 9-320, Comment 3.\n[8] Uniform Commercial Code, Section 9-320(b).\n[9] Uniform Commercial Code, Section 9-317(a)(2)(B) and 9-317(e).\n[10] Uniform Commercial Code, Section 9-333.\n[11] 11 United States Code, Section 544 (Bankruptcy Act).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n582\n\n\x0c[12] United States Code, Section 547.\n[13] Uniform Commercial Code, Section 9-327(1).\n[14] Uniform Commercial Code, Section 9-328, Official Comment 3 and 4.\n\n16.3 Rights of Creditor on Default and Disposition after\nRepossession\nLEARNING OBJECTIVES\n\n1. Understand that the creditor may sue to collect the debt.\n2. Recognize that more commonly the creditor will realize on the collateral\xe2\x80\x94repossess it.\n3. Know how collateral may be disposed of upon repossession: by sale or by strict foreclosure.\n\nRights of Creditor on Default\nUpon default, the creditor must make an election: to sue, or to repossess.\n\nResort to Judicial Process\nAfter a debtor\xe2\x80\x99s default (e.g., by missing payments on the debt), the creditor could ignore the\nsecurity interest and bring suit on the underlying debt. But creditors rarely resort to this remedy\nbecause it is time-consuming and costly. Most creditors prefer to repossess the collateral and\nsell it or retain possession in satisfaction of the debt.\n\nRepossession\nSection 9-609 of the Uniform Commercial Code (UCC) permits the secured party to take\npossession of the collateral on default (unless the agreement specifies otherwise):\n(a) After default, a secured party may (1) take possession of the collateral; and (2) without\nremoval, may render equipment unusable and dispose of collateral on a debtor\xe2\x80\x99s premises.\n(b) A secured party may proceed under subsection (a): (1) pursuant to judicial process; or (2)\nwithout judicial process, if it proceeds without breach of the peace.\nThis language has given rise to the flourishing business of professional \xe2\x80\x9crepo men\xe2\x80\x9d (and\nwomen). \xe2\x80\x9cRepo\xe2\x80\x9d companies are firms that specialize in repossession collateral. They have\ntrained car-lock pickers, in-house locksmiths, experienced repossession teams, damage-free\ntowing equipment, and the capacity to deliver repossessed collateral to the client\xe2\x80\x99s desired\ndestination. Some firms advertise that they have 360-degree video cameras that record every\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n583\n\n\x0caspect of the repossession. They have \xe2\x80\x9cskip chasers\xe2\x80\x9d\xe2\x80\x94people whose business it is to track down\nthose who skip out on their obligations, and they are trained not to breach the\npeace. [1] See Pantoja-Cahue v. Ford Motor Credit Co., a case discussing repossession, in Section\n16.5 "Cases".\nThe reference in Section 9-609(a)(2) to \xe2\x80\x9crender equipment unusable and dispose of collateral on\na debtor\xe2\x80\x99s premises\xe2\x80\x9d gets to situations involving \xe2\x80\x9cheavy equipment [when] the physical removal\nfrom the debtor\xe2\x80\x99s plant and the storage of collateral pending disposition may be impractical or\nunduly expensive.\xe2\x80\xa6Of course\xe2\x80\xa6all aspects of the disposition must be commercially\nreasonable.\xe2\x80\x9d [2] Rendering the equipment unusable would mean disassembling some critical part\nof the machine\xe2\x80\x94letting it sit there until an auction is set up on the premises.\nThe creditor\xe2\x80\x99s agents\xe2\x80\x94the repo people\xe2\x80\x94charge for their service, of course, and if possible the\ncost of repossession comes out of the collateral when it\xe2\x80\x99s sold. A debtor would be better off\nvoluntarily delivering the collateral according to the creditor\xe2\x80\x99s instructions, but if that doesn\xe2\x80\x99t\nhappen, \xe2\x80\x9cself-help\xe2\x80\x9d\xe2\x80\x94repossession\xe2\x80\x94is allowed because, of course, the debtor said it would be\nallowed in the security agreement, so long as the repossession can be accomplished without\nbreach of peace. \xe2\x80\x9cBreach of peace\xe2\x80\x9d is language that can cover a wide variety of situations over\nwhich courts do not always agree. For example, some courts interpret a creditor\xe2\x80\x99s taking of the\ncollateral despite the debtor\xe2\x80\x99s clear oral protest as a breach of the peace; other courts do not.\n\nDisposition after Repossession\nAfter repossession, the creditor has two options: sell the collateral or accept it in satisfaction of\nthe debt (see Figure 16.5 "Disposition after Repossession").\nFigure 16.5 Disposition after Repossession\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n584\n\n\x0cSale\nSale is the usual method of recovering the debt. Section 9-610 of the UCC permits the secured\ncreditor to \xe2\x80\x9csell, lease, license, or otherwise dispose of any or all of the collateral in its present\ncondition or following any commercially reasonable preparation or processing.\xe2\x80\x9d The collateral\nmay be sold as a whole or in parcels, at one time or at different times. Two requirements limit\nthe creditor\xe2\x80\x99s power to resell: (1) it must send notice to the debtor and secondary obligor, and\n(unless consumer goods are sold) to other secured parties; and (2) all aspects of the sale must be\n\xe2\x80\x9ccommercially reasonable.\xe2\x80\x9d [3] Most frequently the collateral is auctioned off.\nSection 9-615 of the UCC describes how the proceeds are applied: first, to the costs of the\nrepossession, including reasonable attorney\xe2\x80\x99s fees and legal expenses as provided for in the\nsecurity agreement (and it will provide for that!); second, to the satisfaction of the obligation\nowed; and third, to junior creditors. This again emphasizes the importance of promptly\nperfecting the security interest: failure to do so frequently subordinates the tardy creditor\xe2\x80\x99s\ninterest to junior status. If there is money left over from disposing of the collateral\xe2\x80\x94a surplus\xe2\x80\x94\nthe debtor gets that back. If there is still money owing\xe2\x80\x94a deficiency\xe2\x80\x94the debtor is liable for that.\nIn Section 9-616, the UCC carefully explains how the surplus or deficiency is calculated; the\nexplanation is required in a consumer goods transaction, and it has to be sent to the debtor after\nthe disposition.\n\nStrict Foreclosure\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n585\n\n\x0cBecause resale can be a bother (or the collateral is appreciating in value), the secured creditor\nmay wish simply to accept the collateral in full satisfaction or partial satisfaction of the debt, as\npermitted in UCC Section 9-620(a). This is known asstrict foreclosure. The debtor must consent\nto letting the creditor take the collateral without a sale in a \xe2\x80\x9crecord authenticated after default,\xe2\x80\x9d\nor after default the creditor can send the debtor a proposal for the creditor to accept the\ncollateral, and the proposal is effective if not objected to within twenty days after it\xe2\x80\x99s sent.\nThe strict foreclosure provisions contain a safety feature for consumer goods debtors. If the\ndebtor has paid at least 60 percent of the debt, then the creditor may not use strict foreclosure\xe2\x80\x94\nunless the debtor signs a statement after default renouncing his right to bar strict foreclosure\nand to force a sale. [4] A consumer who refuses to sign such a statement thus forces the secured\ncreditor to sell the collateral under Section 9-610. Should the creditor fail to sell the goods\nwithin ninety days after taking possession of the goods, he is liable to the debtor for the value of\nthe goods in a conversion suit or may incur the liabilities set forth in Section 9-625, which\nprovides for minimum damages for the consumer debtor. Recall that the UCC imposes a duty to\nact in good faith and in a commercially reasonable manner, and in most cases with reasonable\nnotification. [5] See Figure 16.5 "Disposition after Repossession".\n\nForeclosure on Intangible Collateral\nA secured party\xe2\x80\x99s repossession of inventory or equipment can disrupt or even close a debtor\xe2\x80\x99s\nbusiness. However, when the collateral is intangible\xe2\x80\x94such as accounts receivable, general\nintangibles, chattel paper, or instruments\xe2\x80\x94collection by a secured party after the debtor\xe2\x80\x99s\ndefault may proceed without interrupting the business. Section 9-607 of the UCC provides that\non default, the secured party is entitled to notify the third party\xe2\x80\x94for example, a person who\nowes money on an account\xe2\x80\x94that payment should be made to him. The secured party is\naccountable to the debtor for any surplus, and the debtor is liable for any deficiency unless the\nparties have agreed otherwise.\nAs always in parsing the UCC here, some of the details and nuances are necessarily omitted\nbecause of lack of space or because a more detailed analysis is beyond this book\xe2\x80\x99s scope.\n\nKEY TAKEAWAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n586\n\n\x0cUpon default, the creditor may bring a lawsuit against the debtor to collect a judgment. But\nthe whole purpose of secured transactions is to avoid this costly and time-consuming\nlitigation. The more typical situation is that the creditor repossesses the collateral and then\neither auctions it off (sale) or keeps it in satisfaction of the debt (strict foreclosure). In the\nformer situation, the creditor may then proceed against the debtor for the deficiency. In\nconsumer cases, the creditor cannot use strict foreclosure if 60 percent of the purchase price\nhas been paid.\n\nEXERCISES\n\n1. Although a creditor could sue the debtor, get a judgment against it, and collect on the\njudgment, usually the creditor repossesses the collateral. Why is repossession the preferred\nmethod of realizing on the security?\n2. Why is repossession allowed so long as it can be done without a breach of the peace?\n3. Under what circumstances is strict foreclosure not allowed?\n[1] Here is an example of sophisticated online advertising for a repossession firm: SSR, \xe2\x80\x9cSouthern &\nCentral Coast California Repossession Services,\xe2\x80\x9dhttp://www.simonsrecovery.com/index.htm.\n[2] Uniform Commercial Code, Section 9-609(a)(2), Official Comment 6.\n[3] Uniform Commercial Code, Section 9-611; Uniform Commercial Code, Section 9-610.\n[4] Uniform Commercial Code, 9-620(e); Uniform Commercial Code, Section 9-624.\n[5] Uniform Commercial Code, Section 1-203.\n\n16.4 Suretyship\n\nLEARNING OBJECTIVES\n\n1. Understand what a surety is and why sureties are used in commercial transactions.\n2. Know how suretyships are created.\n3. Recognize the general duty owed by the surety to the creditor, and the surety\xe2\x80\x99s defenses.\n4. Recognize the principal obligor\xe2\x80\x99s duty to the surety, and the surety\xe2\x80\x99s rights against the surety.\n5. Understand the rights among cosureties.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n587\n\n\x0cDefinition, Types of Sureties, and Creation of the Suretyship\nDefinition\nSuretyship is the second of the three major types of consensual security arrangements noted at\nthe beginning of this chapter (personal property security, suretyship, real property security)\xe2\x80\x94\nand a common one. Creditors frequently ask the owners of small, closely held companies to\nguarantee their loans to the company, and parent corporations also frequently are guarantors of\ntheir subsidiaries\xe2\x80\x99 debts. The earliest sureties were friends or relatives of the principal debtor\nwho agreed\xe2\x80\x94for free\xe2\x80\x94to lend their guarantee. Today most sureties in commercial transaction\nare insurance companies (but insurance is not the same as suretyship).\nA surety is one who promises to pay or perform an obligation owed by theprincipal debtor, and,\nstrictly speaking, the surety is primarily liable on the debt: the creditor can demand payment\nfrom the surety when the debt is due. The creditor is the person to whom the principal debtor\n(and the surety, strictly speaking) owes an obligation. Very frequently, the creditor requires first\nthat the debtor put up collateral to secure indebtedness, and\xe2\x80\x94in addition\xe2\x80\x94that the debtor\nengage a surety to make extra certain the creditor is paid or performance is made. For example,\nDavid Debtor wants Bank to loan his corporation, David Debtor, Inc., $100,000. Bank says,\n\xe2\x80\x9cOkay, Mr. Debtor, we\xe2\x80\x99ll loan the corporation money, but we want its computer equipment as\nsecurity, and we want you personally to guarantee the debt if the corporation can\xe2\x80\x99t pay.\xe2\x80\x9d\nSometimes, though, the surety and the principal debtor may have no agreement between each\nother; the surety might have struck a deal with the creditor to act as surety without the consent\nor knowledge of the principal debtor.\nA guarantor also is one who guarantees an obligation of another, and for practical purposes,\ntherefore, guarantor is usually synonymous with surety\xe2\x80\x94the terms are used pretty much\ninterchangeably. But here\xe2\x80\x99s the technical difference: a surety is usually a party to the original\ncontract and signs her (or his, or its) name to the original agreement along with the surety; the\nconsideration for the principal\xe2\x80\x99s contract is the same as the surety\xe2\x80\x99s consideration\xe2\x80\x94she is bound\non the contract from the very start, and she is also expected to know of the principal debtor\xe2\x80\x99s\ndefault so that the creditor\xe2\x80\x99s failure to inform her of it does not discharge her of any liability. On\nthe other hand, a guarantor usually does not make his agreement with the creditor at the same\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n588\n\n\x0ctime the principal debtor does: it\xe2\x80\x99s a separate contract requiring separate consideration, and if\nthe guarantor is not informed of the principal debtor\xe2\x80\x99s default, the guarantor can claim\ndischarge on the obligation to the extent any failure to inform him prejudices him. But, again, as\nthe terms are mostly synonymous, surety is used here to encompass both.\n\nFigure 16.6 Defenses of Principal Debtor and Surety\n\nTypes of Suretyship\nWhere there is an interest, public or private, that requires protection from the possibility of a\ndefault, sureties are engaged. For example, a landlord might require that a commercial tenant\nnot only put up a security deposit but also show evidence that it has a surety on line ready to\nstand for three months\xe2\x80\x99 rent if the tenant defaults. Often, a municipal government will want its\nroad contractor to show it has a surety available in case, for some reason, the contractor cannot\ncomplete the project. Many states require general contractors to have bonds, purchased from\ninsurance companies, as a condition of getting a contractor\xe2\x80\x99s license; the insurance company is\nthe surety\xe2\x80\x94it will pay out if the contractor fails to complete work on the client\xe2\x80\x99s house. These are\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n589\n\n\x0ctypes of a performance bond. A judge will often require that a criminal defendant put up a bond\nguaranteeing his appearance in court\xe2\x80\x94that\xe2\x80\x99s a type of suretyship where the bail-bonder is the\nsurety\xe2\x80\x94or that a plaintiff put up a bond indemnifying the defendant for the costs of delays\ncaused by the lawsuit\xe2\x80\x94a judicial bond. A bank will take out a bond on its employees in case they\nsteal money from the bank\xe2\x80\x94the bank teller, in this case, is the principal debtor (a fidelity bond).\nHowever, as we will see, sureties do not anticipate financial loss like insurance companies do:\nthe surety expects, mostly, to be repaid if it has to perform. The principal debtor goes to an\ninsurance company and buys the bond\xe2\x80\x94the suretyship policy. The cost of the premium depends\non the surety company, the type of bond applied for, and the applicant\xe2\x80\x99s financial history. A\nsound estimate of premium costs is 1 percent to 4 percent, but if a surety company classifies an\napplicant as high risk, the premium falls between 5 percent and 20 percent of the bond amount.\nWhen the purchaser of real estate agrees to assume the seller\xe2\x80\x99s mortgage (promises to pay the\nmortgage debt), the seller then becomes a surety: unless the mortgagee releases the seller (not\nlikely), the seller has to pay if the buyer defaults.\n\nCreation of the Suretyship\nSuretyship can arise only through contract. The general principles of contract law apply to\nsuretyship. Thus a person with the general capacity to contract has the power to become a\nsurety. Consideration is required for a suretyship contract: if Debtor asks a friend to act as a\nsurety to induce Creditor to make Debtor a loan, the consideration Debtor gives Creditor also\nacts as the consideration Friend gives. Where the suretyship arises after Creditor has already\nextended credit, new consideration would be required (absent application of the doctrine of\npromissory estoppel [1]). You may recall from the chapters on contracts that the promise by one\nperson to pay or perform for the debts or defaults of another must be evidenced by a writing\nunder the statute of frauds (subject to the \xe2\x80\x9cmain purpose\xe2\x80\x9d exception).\nSuretyship contracts are affected to some extent by government regulation. Under a 1985\nFederal Trade Commission Credit Practices Rule, creditors are prohibited from misrepresenting\na surety\xe2\x80\x99s liability. Creditors must also give the surety a notice that explains the nature of the\nobligation and the potential liability that can arise if a person cosigns on another\xe2\x80\x99s debt. [2]\n\nDuties and Rights of the Surety\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n590\n\n\x0cDuties of the Surety\nUpon the principal debtor\xe2\x80\x99s default, the surety is contractually obligated to perform unless the\nprincipal herself or someone on her behalf discharges the obligation. When the surety performs,\nit must do so in good faith. Because the principal debtor\xe2\x80\x99s defenses are generally limited, and\nbecause\xe2\x80\x94as will be noted\xe2\x80\x94the surety has the right to be reimbursed by the debtor, debtors not\ninfrequently claim the surety acted in bad faith by doing things like failing to make an adequate\ninvestigation (to determine if the debtor really defaulted), overpaying claims, interfering with\nthe contact between the surety and the debtor, and making unreasonable refusals to let the\ndebtor complete the project. The case Fidelity and Deposit Co. of Maryland v. Douglas Asphalt\nCo., in Section 16.5 "Cases", is typical.\n\nRights of the Surety\nThe surety has four main rights stemming from its obligation to answer for the debt or default of\nthe principal debtor.\n\nExoneration\nIf, at the time a surety\xe2\x80\x99s obligation has matured, the principal can satisfy the obligation but\nrefuses to do so, the surety is entitled to exoneration\xe2\x80\x94a court order requiring the principal to\nperform. It would be inequitable to force the surety to perform and then to have to\nseek reimbursement from the principal if all along the principal is able to perform.\n\nReimbursement\nIf the surety must pay the creditor because the principal has defaulted, the principal is obligated\nto reimburse the surety. The amount required to be reimbursed includes the surety\xe2\x80\x99s reasonable,\ngood-faith outlays, including interest and legal fees.\n\nSubrogation\nSuppose the principal\xe2\x80\x99s duty to the creditor is fully satisfied and that the surety has contributed\nto this satisfaction. Then the surety is entitled to be subrogated to the rights of the creditor\nagainst the principal. In other words, the surety stands in the creditor\xe2\x80\x99s shoes and may assert\nagainst the principal whatever rights the creditor could have asserted had the duty not been\ndischarged. The right of subrogation includes the right to take secured interests that the creditor\nobtained from the principal to cover the duty. Sarah\xe2\x80\x99s Pizzeria owes Martha $5,000, and Martha\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n591\n\n\x0chas taken a security interest in Sarah\xe2\x80\x99s Chevrolet. Eva is surety for the debt. Sarah defaults, and\nEva pays Martha the $5,000. Eva is entitled to have the security interest in the car transferred to\nher.\n\nContribution\nTwo or more sureties who are bound to answer for the principal\xe2\x80\x99s default and who should share\nbetween them the loss caused by the default are known as cosureties. A surety who in\nperforming its own obligation to the creditor winds up paying more than its proportionate share\nis entitled to contribution from the cosureties.\n\nDefenses of the Parties\nThe principal and the surety may have defenses to paying.\n\nDefenses of the Principal\nThe principal debtor may avail itself of any standard contract defenses as against the creditor,\nincluding impossibility, illegality, incapacity, fraud, duress, insolvency, or bankruptcy discharge.\nHowever, the surety may contract with the creditor to be liable despite the principal\xe2\x80\x99s defenses,\nand a surety who has undertaken the suretyship with knowledge of the creditor\xe2\x80\x99s fraud or duress\nremains obligated, even though the principal debtor will be discharged. When the surety turns\nto the principal debtor and demands reimbursement, the latter may have defenses against the\nsurety\xe2\x80\x94as noted\xe2\x80\x94for acting in bad faith.\nOne of the main reasons creditors want the promise of a surety is to avoid the risk that the\nprincipal debtor will go bankrupt: the debtor\xe2\x80\x99s bankruptcy is a defense to the debtor\xe2\x80\x99s liability,\ncertainly, but that defense cannot be used by the surety. The same is true of the debtor\xe2\x80\x99s\nincapacity: it is a defense available to the principal debtor but not to the surety.\n\nDefenses of the Surety\nGenerally, the surety may exercise defenses on a contract that would have been available to the\nprincipal debtor (e.g., creditor\xe2\x80\x99s breach; impossibility or illegality of performance; fraud, duress,\nor misrepresentation by creditor; statute of limitations; refusal of creditor to accept tender or\nperformance from either debtor or surety.) Beyond that, the surety has some defenses of its own.\nCommon defenses raised by sureties include the following:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n592\n\n\x0c\xe2\x80\xa2\n\nRelease of the principal. Whenever a creditor releases the principal, the surety is discharged,\nunless the surety consents to remain liable or the creditor expressly reserves her rights against\nthe surety. The creditor\xe2\x80\x99s release of the surety, though, does not release the principal debtor\nbecause the debtor is liable without regard to the surety\xe2\x80\x99s liability.\n\n\xe2\x80\xa2\n\nModification of the contract. If the creditor alters the instrument sufficiently to discharge the\nprincipal, the surety is discharged as well. Likewise, when the creditor and principal modify\ntheir contract, a surety who has not consented to the modification is discharged if the surety\xe2\x80\x99s\nrisk is materially increased (but not if it is decreased). Modifications include extension of the\ntime of payment, release of collateral (this releases the surety to the extent of the impairment),\nchange in principal debtor\xe2\x80\x99s duties, and assignment or delegation of the debtor\xe2\x80\x99s obligations to a\nthird party. The surety may consent to modifications.\n\n\xe2\x80\xa2\n\nCreditor\xe2\x80\x99s failure to perfect. A creditor who fails to file a financing statement or record a\nmortgage risks losing the security for the loan and might also inadvertently release a surety, but\nthe failure of the creditor to resort first to collateral is no defense.\n\n\xe2\x80\xa2\n\nStatute of frauds. Suretyship contracts are among those required to be evidenced by some\nwriting under the statute of frauds, and failure to do so may discharge the surety from liability.\n\n\xe2\x80\xa2\n\nCreditor\xe2\x80\x99s failure to inform surety of material facts within creditor\xe2\x80\x99s knowledge affecting\ndebtor\xe2\x80\x99s ability to perform (e.g., that debtor has defaulted several times before).\n\n\xe2\x80\xa2\n\nGeneral contract defenses. The surety may raise common defenses like incapacity (infancy), lack\nof consideration (unless promissory estoppel can be substituted or unless no separate\nconsideration is necessary because the surety\xe2\x80\x99s and debtor\xe2\x80\x99s obligations arise at the same time),\nand creditor\xe2\x80\x99s fraud or duress on surety. However, fraud by the principal debtor on the surety to\ninduce the suretyship will not release the surety if the creditor extended credit in good faith; if\nthe creditor knows of the fraud perpetrated by the debtor on the surety, the surety may avoid\nliability. See Figure 16.6 "Defenses of Principal Debtor and Surety".\nThe following are defenses of principal debtor only:\n\n\xe2\x80\xa2\n\nDeath or incapacity of principal debtor\n\n\xe2\x80\xa2\n\nBankruptcy of principal debtor\n\n\xe2\x80\xa2\n\nPrincipal debtor\xe2\x80\x99s setoffs against creditor\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n593\n\n\x0cThe following are defenses of both principal debtor and surety:\n\xe2\x80\xa2\n\nMaterial breach by creditor\n\n\xe2\x80\xa2\n\nLack of mutual assent, failure of consideration\n\n\xe2\x80\xa2\n\nCreditor\xe2\x80\x99s fraud, duress, or misrepresentation of debtor\n\n\xe2\x80\xa2\n\nImpossibility or illegality of performance\n\n\xe2\x80\xa2\n\nMaterial and fraudulent alteration of the contract\n\n\xe2\x80\xa2\n\nStatute of limitations\nThe following are defenses of surety only:\n\n\xe2\x80\xa2\n\nFraud or duress by creditor on surety\n\no\n\nIllegality of suretyship contract\n\no\n\nSurety\xe2\x80\x99s incapacity\n\no\n\nFailure of consideration for surety contract (unless excused)\n\no\n\nStatute of frauds\n\no\n\nActs of creditor or debtor materially affecting surety\xe2\x80\x99s obligations:\n\n\xef\x82\xa7\n\nRefusal by creditor to accept tender of performance\n\n\xef\x82\xa7\n\nRelease of principal debtor without surety\xe2\x80\x99s consent\n\n\xef\x82\xa7\n\nRelease of surety\n\n\xef\x82\xa7\n\nRelease, surrender, destruction, or impairment of collateral\n\n\xef\x82\xa7\n\nExtension of time on principal debtor\xe2\x80\x99s obligation\n\n\xef\x82\xa7\n\nModification of debtor\xe2\x80\x99s duties, place, amount, or manner of debtor\xe2\x80\x99s obligations\n\nKEY TAKEAWAY\n\nCreditors often require not only the security of collateral from the debtor but also that the\ndebtor engage a surety. A contract of suretyship is a type of insurance policy, where the\nsurety (insurance company) promises the creditor that if the principal debtor fails to perform,\nthe surety will undertake good-faith performance instead. A difference between insurance\nand suretyship, though, is that the surety is entitled to reimbursement by the principal\ndebtor if the surety pays out. The surety is also entitled, where appropriate, to exoneration,\nsubrogation, and contribution. The principal debtor and the surety both have some defenses\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n594\n\n\x0cavailable: some are personal to the debtor, some are joint defenses, and some are personal\nto the surety.\n\nEXERCISES\n\n1. Why isn\xe2\x80\x99t collateral put up by the debtor sufficient security for the creditor\xe2\x80\x94why is a surety\noften required?\n2. How can it be said that sureties do not anticipate financial losses like insurance companies\ndo? What\xe2\x80\x99s the difference, and how does the surety avoid losses?\n3. Why does the creditor\xe2\x80\x99s failure to perfect a security interest discharge the surety from\nliability? Why doesn\xe2\x80\x99t failure of the creditor to resort first to perfected collateral discharge\nthe surety?\n4. What is the difference between a guarantor and a surety?\n[1] American Druggists\xe2\x80\x99 Ins. Co. v. Shoppe, 448 N.W.2d 103, Minn. App. (1989).\n[2] Here is an example of the required notice: Federal Trade Commission, \xe2\x80\x9cFacts for Consumers: The\nCredit Practices Rule,\xe2\x80\x9dhttp://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre12.shtm.\n\n16.5 Cases\nPerfection by Mere Attachment; Priorities\nIn re NICOLOSI\n4 UCC Rep. 111 (Ohio 1966)\n\nPreliminary Statement and Issues\nThis matter is before the court upon a petition by the trustee to sell a diamond ring in his\npossession free of liens.\xe2\x80\xa6Even though no pleadings were filed by Rike-Kumler Company, the\nissue from the briefs is whether or not a valid security interest was perfected in this chattel as\nconsumer goods, superior to the statutory title and lien of the trustee in bankruptcy.\n\nFindings of Fact\nThe [debtor] purchased from the Rike-Kumler Company, on July 7, 1964, the diamond ring in\nquestion, for $1237.35 [about $8,500 in 2010 dollars], as an engagement ring for his fianc\xc3\xa9e. He\nexecuted a purchase money security agreement, which was not filed. Also, no financing\nstatement was filed. The chattel was adequately described in the security agreement.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n595\n\n\x0cThe controversy is between the trustee in bankruptcy and the party claiming a perfected security\ninterest in the property. The recipient of the property has terminated her relationship with the\n[debtor], and delivered the property to the trustee.\n\nConclusion of Law, Decision, and Order\nIf the diamond ring, purchased as an engagement ring by the bankrupt, cannot be categorized as\nconsumer goods, and therefore exempted from the notice filing requirements of the Uniform\nCommercial Code as adopted in Ohio, a perfected security interest does not exist.\nNo judicial precedents have been cited in the briefs.\nUnder the commercial code, collateral is divided into tangible, intangible, and documentary\ncategories. Certainly, a diamond ring falls into the tangible category. The classes of tangible\ngoods are distinguished by the primary use intended. Under [the UCC] the four classes [include]\n\xe2\x80\x9cconsumer goods,\xe2\x80\x9d \xe2\x80\x9cequipment,\xe2\x80\x9d \xe2\x80\x9cfarm products\xe2\x80\x9d and \xe2\x80\x9cinventory.\xe2\x80\x9d\nThe difficulty is that the code provisions use terms arising in commercial circles which have\ndifferent semantical values from legal precedents. Does the fact that the purchaser bought the\ngoods as a special gift to another person signify that it was not for his own \xe2\x80\x9cpersonal, family or\nhousehold purposes\xe2\x80\x9d? The trustee urges that these special facts control under the express\nprovisions of the commercial code.\nBy a process of exclusion, a diamond engagement ring purchased for one\xe2\x80\x99s fianc\xc3\xa9e is not\n\xe2\x80\x9cequipment\xe2\x80\x9d bought or used in business, \xe2\x80\x9cfarm products\xe2\x80\x9d used in farming operations, or\n\xe2\x80\x9cinventory\xe2\x80\x9d held for sale, lease or service contracts. When the [debtor] purchased the ring,\ntherefore, it could only have been \xe2\x80\x9cconsumer goods\xe2\x80\x9d bought \xe2\x80\x9cprimarily for personal use.\xe2\x80\x9d There\ncould be no judicial purpose to create a special class of property in derogation of the statutory\nprinciples.\nAnother problem is implicit, although not covered by the briefs.\nBy the foregoing summary analysis, it is apparent that the diamond ring, when the interest of\nthe debtor attached, was consumer goods since it could have been no other class of goods.\nUnless the fianc\xc3\xa9e had a special status under the code provision protecting a bona fide buyer,\nwithout knowledge, for value, of consumer goods, the failure to file a financing statement is not\ncrucial. No evidence has been adduced pertinent to the scienter question.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n596\n\n\x0cIs a promise, as valid contractual consideration, included under the term \xe2\x80\x9cvalue\xe2\x80\x9d? In other\nwords, was the ring given to his betrothed in consideration of marriage (promise for a promise)?\nIf so, and \xe2\x80\x9cvalue\xe2\x80\x9d has been given, the transferee is a \xe2\x80\x9cbuyer\xe2\x80\x9d under traditional concepts.\nThe Uniform Commercial Code definition of \xe2\x80\x9cvalue\xe2\x80\x9d\xe2\x80\xa6very definitely covers a promise for a\npromise. The definition reads that \xe2\x80\x9ca person gives \xe2\x80\x98value\xe2\x80\x99 for rights if he acquires\nthem\xe2\x80\xa6generally in return for any consideration sufficient to support a simple contract.\xe2\x80\x9d\nIt would seem unrealistic, nevertheless, to apply contract law concepts historically developed\ninto the law of marriage relations in the context of new concepts developed for uniform\ncommercial practices. They are not, in reality, the same juristic manifold. The purpose of\nuniformity of the code should not be defeated by the obsessions of the code drafters to be all\ninclusive for secured creditors.\nEven if the trustee, in behalf of the unsecured creditors, would feel inclined to insert love,\nromance and morals into commercial law, he is appearing in the wrong era, and possibly the\nwrong court.\nOrdered, that the Rike-Kumler Company holds a perfected security interest in the diamond\nengagement ring, and the security interest attached to the proceeds realized from the sale of the\ngoods by the trustee in bankruptcy.\n\nCASE QUESTIONS\n\n1. Why didn\xe2\x80\x99t the jewelry store, Rike-Kumler, file a financing statement to protect its security\ninterest in the ring?\n2. How did the bankruptcy trustee get the ring?\n3. What argument did the trustee make as to why he should be able to take the ring as an asset\nbelonging to the estate of the debtor? What did the court determine on this issue?\n\nRepossession and Breach of the Peace\nPantoja-Cahue v. Ford Motor Credit Co.\n872 N.E.2d 1039 (Ill. App. 2007)\nPlaintiff Mario Pantoja-Cahue filed a six-count complaint seeking damages from defendant Ford\nMotor Credit Company for Ford\xe2\x80\x99s alleged breach of the peace and \xe2\x80\x9cillegal activities\xe2\x80\x9d in\nrepossessing plaintiff\xe2\x80\x99s automobile from his locked garage.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n597\n\n\x0cIn August 2000, plaintiff purchased a 2000 Ford Explorer from auto dealer Webb Ford.\nPlaintiff, a native Spanish speaker, negotiated the purchase with a Spanish-speaking salesperson\nat Webb. Plaintiff signed what he thought was a contract for the purchase and financing of the\nvehicle, with monthly installment payments to be made to Ford. The contract was in English.\nSome years later, plaintiff discovered the contract was actually a lease, not a purchase\nagreement. Plaintiff brought suit against Ford and Webb on August 22, 2003, alleging fraud.\nFord brought a replevin action against plaintiff asserting plaintiff was in default on his\nobligations under the lease. In the late night/early morning hours of March 11\xe2\x80\x9312, 2004,\nrepossession agents [from Doe Repossession Services] entered plaintiff\xe2\x80\x99s locked garage and\nremoved the car\xe2\x80\xa6\nPlaintiff sought damages for Ford and Doe\xe2\x80\x99s \xe2\x80\x9cunlawful activities surrounding the wrongful\nrepossession of Plaintiff\xe2\x80\x99s vehicle.\xe2\x80\x9d He alleged Ford and Doe\xe2\x80\x99s breaking into plaintiff\xe2\x80\x99s locked\ngarage to effectuate the repossession and Ford\xe2\x80\x99s repossession of the vehicle knowing that title to\nthe car was the subject of ongoing litigation variously violated section 2A-525(3) of the [Uniform\nCommercial] Code (count I against Ford), the [federal] Fair Debt Collection Practices Act (count\nII against Doe),\xe2\x80\xa6Ford\xe2\x80\x99s contract with plaintiff (count V against Ford) and section 2A-108 of the\nCode (count VI against Ford and Doe).\xe2\x80\xa6\n\nUniform Commercial Code Section 2A-525(3)\nIn count I, plaintiff alleged \xe2\x80\x9ca breach of the peace occurred as [Ford]\xe2\x80\x99s repossession agent broke\ninto Plaintiff\xe2\x80\x99s locked garage in order to take the vehicle\xe2\x80\x9d and Ford\xe2\x80\x99s agent \xe2\x80\x9crepossessed the\nsubject vehicle by, among other things, breaking into Plaintiff\xe2\x80\x99s locked garage and causing\nsubstantial damage to Plaintiff\xe2\x80\x99s personal property in violation of [section 2A-525(3)]\xe2\x80\x9d:\n\xe2\x80\x9cAfter a default by the lessee under the lease contract * * * or, if agreed, after other default by the\nlessee, the lessor has the right to take possession of the goods. * * *\nThe lessor may proceed under subsection (2) without judicial process if it can be done without\nbreach of the peace or the lessor may proceed by action.\xe2\x80\x9d [emphasis added.]\n[U]pon a lessee\xe2\x80\x99s default, a lessor has the right to repossess the leased goods in one of two ways:\nby using the judicial process or, if repossession could be accomplished without a breach of the\npeace, by self-help [UCC Section 2A-525(3)]. \xe2\x80\x9cIf a breach of the peace is likely, a properly\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n598\n\n\x0cinstituted civil action is the appropriate remedy.\xe2\x80\x9d [Citation] (interpreting the term \xe2\x80\x9cbreach of the\npeace\xe2\x80\x9d in the context of section 9-503 of the Code, which provides for the same self-help\nrepossession as section 2A-525 but for secured creditors rather than lessors).\nTaking plaintiff\xe2\x80\x99s well-pleaded allegations as true, Ford resorted to self-help, by employing an\nagent to repossess the car and Ford\xe2\x80\x99s agent broke into plaintiff\xe2\x80\x99s locked garage to effectuate the\nrepossession. Although plaintiff\xe2\x80\x99s count I allegations are minimal, they are sufficient to plead a\ncause of action for a violation of section 2A-525(3) if breaking into a garage to repossess a car is,\nas plaintiff alleged, a breach of the peace. Accordingly, the question here is whether breaking\ninto a locked garage to effectuate a repossession is a breach of the peace in violation of section\n2A-525(3).\nThere are no Illinois cases analyzing the meaning of the term \xe2\x80\x9cbreach of the peace\xe2\x80\x9d as used in\nthe lessor repossession context in section 2A-525(3). However, there are a few Illinois cases\nanalyzing the term as used in section 9-503 of the Code, which contains a similar provision\nproviding that a secured creditor may, upon default by a debtor, repossess its collateral either\n\xe2\x80\x9c(1) pursuant to judicial process; or (2) without judicial process, if it proceeds without breach of\nthe peace.\xe2\x80\x9d The seminal case, and the only one of any use in resolving the issue, is Chrysler\nCredit Corp. v. Koontz, 277 Ill.App.3d 1078, 214 Ill.Dec. 726, 661 N.E.2d 1171 (1996).\nIn Koontz, Chrysler, the defendant creditor, sent repossession agents to repossess the plaintiff\xe2\x80\x99s\ncar after the plaintiff defaulted on his payments. The car was parked in the plaintiff\xe2\x80\x99s front yard.\nThe plaintiff heard the repossession in progress and ran outside in his underwear shouting\n\xe2\x80\x9cDon\xe2\x80\x99t take it\xe2\x80\x9d to the agents. The agents did not respond and proceeded to take the car. The\nplaintiff argued the repossession breached the peace and he was entitled to the statutory remedy\nfor violation of section 9-503, denial of a deficiency judgment to the secured party, Chrysler.\xe2\x80\xa6\nAfter a thorough analysis of the term \xe2\x80\x9cbreach of the peace,\xe2\x80\x9d the court concluded the term\n\xe2\x80\x9cconnotes conduct which incites or is likely to incite immediate public turbulence, or which\nleads to or is likely to lead to an immediate loss of public order and tranquility. Violent conduct\nis not a necessary element. The probability of violence at the time of or immediately prior to the\nrepossession is sufficient.\xe2\x80\x9d\xe2\x80\xa6[The Koontz court] held the circumstances of the repossession did\nnot amount to a breach the peace.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n599\n\n\x0cThe court then considered the plaintiff\xe2\x80\x99s argument that Chrysler breached the peace by\nrepossessing the car under circumstances constituting criminal trespass to property. Looking to\ncases in other jurisdictions, the court determined that, \xe2\x80\x9cin general, a mere trespass, standing\nalone, does not automatically constitute a breach of the peace.\xe2\x80\x9d [Citation] (taking possession of\ncar from private driveway does not, without more, constitute breach of the peace), [Citation] (no\nbreach of the peace occurred where car repossessed from debtor\xe2\x80\x99s driveway without entering\n\xe2\x80\x9cany gates, doors, or other barricades to reach\xe2\x80\x9d car), [Citation] (no breach of the peace occurred\nwhere car was parked partially under carport and undisputed that no door, \xe2\x80\x9cnot even one to a\ngarage,\xe2\x80\x9d on the debtor\xe2\x80\x99s premises was opened, much less broken, to repossess the car),\n[Citation] (although secured party may not break into or enter homes or buildings or enclosed\nspaces to effectuate a repossession, repossession of vehicle from parking lot of debtor\xe2\x80\x99s\napartment building was not breach of the peace), [Citation] (repossession of car from debtor\xe2\x80\x99s\ndriveway without entering any gates, doors or other barricades was accomplished without\nbreach of the peace).\xe2\x80\xa6\nAlthough the evidence showed the plaintiff notified Chrysler prior to the repossession that it was\nnot permitted onto his property, the court held Chrysler\xe2\x80\x99s entry onto the property to take the car\ndid not constitute a breach of the peace because there was no evidence Chrysler entered through\na barricade or did anything other than drive the car away. [Citation] \xe2\x80\x9cChrysler enjoyed a limited\nprivilege to enter [the plaintiff\xe2\x80\x99s] property for the sole and exclusive purpose of effectuating the\nrepossession. So long as the entry was limited in purpose (repossession), and so long as no\ngates, barricades, doors, enclosures, buildings, or chains were breached or cut, no breach of the\npeace occurred by virtue of the entry onto his property.\xe2\x80\x9d\n\xe2\x80\xa6[W]e come to essentially the same conclusion: where a repossession is effectuated by an actual\nbreaking into the lessee/debtor\xe2\x80\x99s premises or breaching or cutting of chains, gates, barricades,\ndoors or other barriers designed to exclude trespassers, the likelihood that a breach of the peace\noccurred is high.\nDavenport v. Chrysler Credit Corp., [Citation] (Tenn.App.1991), a case analyzing Tennessee\xe2\x80\x99s\nversion of section 9-503 is particularly helpful, holding that \xe2\x80\x9c\xe2\x80\x98[a] breach of the peace is almost\ncertain to be found if the repossession is accompanied by the unauthorized entry into a closed or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n600\n\n\x0clocked garage.\xe2\x80\x99\xe2\x80\x9d\xe2\x80\xa6This is so because \xe2\x80\x9cpublic policy favors peaceful, non-trespassory\nrepossessions when the secured party has a free right of entry\xe2\x80\x9d and \xe2\x80\x9cforced entries onto the\ndebtor\xe2\x80\x99s property or into the debtor\xe2\x80\x99s premises are viewed as seriously detrimental to the\nordinary conduct of human affairs.\xe2\x80\x9d Davenportheld that the creditor\xe2\x80\x99s repossession of a car by\nentering a closed garage and cutting a chain that would have prevented it from removing the car\namounted to a breach of the peace, \xe2\x80\x9c[d]espite the absence of violence or physical confrontation\xe2\x80\x9d\n(because the debtor was not at home when the repossession occurred). Davenport recognized\nthat the secured creditors\xe2\x80\x99 legitimate interest in obtaining possession of collateral without\nhaving to resort to expensive and cumbersome judicial procedures must be balanced against the\ndebtors\xe2\x80\x99 legitimate interest in being free from unwarranted invasions of their property and\nprivacy interests.\n\xe2\x80\x9cRepossession is a harsh procedure and is, essentially, a delegation of the State\xe2\x80\x99s exclusive\nprerogative to resolve disputes. Accordingly, the statutes governing the repossession of collateral\nshould be construed in a way that prevents abuse and discourages illegal conduct which might\notherwise go unchallenged because of the debtor\xe2\x80\x99s lack of knowledge of legally proper\nrepossession techniques\xe2\x80\x9d [Citation].\nWe agree with [this] analysis of the term \xe2\x80\x9cbreach of the peace\xe2\x80\x9d in the context of repossession\nand hold, with regard to section 2A-525(3) of the Code, that breaking into a locked garage to\neffectuate a repossession may constitute a breach of the peace.\nHere, plaintiff alleges more than simply a trespass. He alleges Ford, through Doe, broke into his\ngarage to repossess the car. Given our determination that breaking into a locked garage to\nrepossess a car may constitute a breach of the peace, plaintiff\xe2\x80\x99s allegation is sufficient to state a\ncause of action under section 2A-525(3) of the Code. The court erred in dismissing count I of\nplaintiff\xe2\x80\x99s second amended complaint and we remand for further proceedings.\n\nUniform Commercial Code Section 2A-108\nIn count VI, plaintiff alleged the lease agreement was unconscionable because it was formed in\nviolation of [the Illinois Consumer Fraud Statute, requiring that the customer verify that the\nnegotiations were conducted in the consumer\xe2\x80\x99s native language and that the document was\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n601\n\n\x0ctranslated so the customer understood it.]\xe2\x80\xa6Plaintiff does not quote [this] or explain how the\nagreement violates [it]. Instead, he quotes UCC section 2A-108 of the Code, as follows:\n\xe2\x80\x9cWith respect to a consumer lease, if the court as a matter of law finds that a lease contract or\nany clause of a lease contract has been induced by unconscionable conduct or that\nunconscionable conduct has occurred in the collection of a claim arising from a lease contract,\nthe court may grant appropriate relief.\nBefore making a finding of unconscionability under subsection (1) or (2), the court, on its own\nmotion or that of a party, shall afford the parties a reasonable opportunity to present evidence as\nto the setting, purpose, and effect of the lease contract or clause thereof, or of the conduct.\xe2\x80\x9d\nHe then, in \xe2\x80\x9cviolation one\xe2\x80\x9d under count VI, alleges the lease was made in violation of [the\nIllinois Consumer Fraud Statute] because it was negotiated in Spanish but he was only given a\ncopy of the contract in English; he could not read the contract and, as a result, Webb Ford was\nable to trick him into signing a lease, rather than a purchase agreement; such contract was\ninduced by unconscionable conduct; and, because it was illegal, the contract was unenforceable.\nThis allegation is insufficient to state a cause of action against Ford under section 2A108.\xe2\x80\xa6First, Ford is an entirely different entity than Webb Ford and plaintiff does not assert\notherwise. Nor does plaintiff assert that Webb Ford was acting as Ford\xe2\x80\x99s agent in inducing\nplaintiff to sign the lease. Plaintiff asserts no basis on which Ford can be found liable for\nsomething Webb Ford did. Second, there is no allegation as to how the contract violates [the\nstatute], merely the legal conclusion that it does, as well as the unsupported legal conclusion\nthat a violation of [it] is necessarily unconscionable.\xe2\x80\xa6[Further discussion omitted.]\nFor the reasons stated above, we affirm the trial court\xe2\x80\x99s dismissal of counts IV, V and VI of\nplaintiff\xe2\x80\x99s second amended complaint. We reverse the court\xe2\x80\x99s dismissal of count I and remand\nfor further proceedings. Affirmed in part and reversed in part; cause remanded.\n\nCASE QUESTIONS\n\n1. Under what circumstances, if any, would breaking into a locked garage to repossess a\ncar not be considered a breach of the peace?\n2. The court did not decide that a breach of the peace had occurred. What would determine\nthat such a breach had occurred?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n602\n\n\x0c3. Why did the court dismiss the plaintiff\xe2\x80\x99s claim (under UCC Article 2A) that it was\nunconscionable of Ford to trick him into signing a lease when he thought he was signing a\npurchase contract? Would that section of Article 2A make breaking into his garage\nunconscionable?\n4. What alternatives had Ford besides taking the car from the plaintiff\xe2\x80\x99s locked garage?\n5. If it was determined on remand that a breach of the peace had occurred, what happens to\nFord?\n\nDefenses of the Principal Debtor as against Reimbursement to Surety\nFidelity and Deposit Co. of Maryland v. Douglas Asphalt Co.\n338 Fed.Appx. 886, 11th Cir. Ct. (2009)\n\nPer Curium: [1]\nThe Georgia Department of Transportation (\xe2\x80\x9cGDOT\xe2\x80\x9d) contracted with Douglas Asphalt\nCompany to perform work on an interstate highway. After Douglas Asphalt allegedly failed to\npay its suppliers and subcontractors and failed to perform under the contract, GDOT defaulted\nand terminated Douglas Asphalt. Fidelity and Deposit Company of Maryland and Zurich\nAmerican Insurance Company had executed payment and performance bonds in connection\nwith Douglas Asphalt\xe2\x80\x99s work on the interstate, and after Douglas Asphalt\xe2\x80\x99s default, Fidelity and\nZurich spent $15,424,798 remedying the default.\nFidelity and Zurich, seeking to recover their losses related to their remedy of the default,\nbrought this suit against Douglas Asphalt, Joel Spivey, and Ronnie Spivey. The Spiveys and\nDouglas Asphalt had executed a General Indemnity Agreement in favor of Fidelity and Zurich. [2]\nAfter a bench trial, the district court entered judgment in favor of Fidelity and Zurich for\n$16,524,798. Douglas Asphalt and the Spiveys now appeal.\nDouglas Asphalt and the Spiveys argue that the district court erred in entering judgment in favor\nof Fidelity and Zurich because Fidelity and Zurich acted in bad faith in three ways.\nFirst, Douglas Asphalt and the Spiveys argue that the district court erred in not finding that\nFidelity and Zurich acted in bad faith because they claimed excessive costs to remedy the\ndefault. Specifically, Douglas Asphalt and the Spiveys argue that they introduced evidence that\nthe interstate project was 98% complete, and that only approximately $3.6 million was needed\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n603\n\n\x0cto remedy any default. But, the district court found that the interstate project was only 90%\xe2\x80\x93\n92% complete and that approximately $2 million needed to be spent to correct defective work\nalready done by Douglas Asphalt. Douglas Asphalt and the Spiveys have not shown that the\ndistrict court\xe2\x80\x99s finding was clearly erroneous, and accordingly, their argument that Fidelity and\nZurich showed bad faith in claiming that the project was only 90% complete and therefore\nrequired over $15 million to remedy the default fails.\nSecond, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich acted in bad faith by\nfailing to contest the default. However, the district court concluded that the indemnity\nagreement required Douglas Asphalt and the Spiveys to request a contest of the default, and to\npost collateral security to pay any judgment rendered in the course of contesting the default. The\ncourt\xe2\x80\x99s finding that Douglas Asphalt and the Spiveys made no such request and posted no\ncollateral security was not clearly erroneous, and the sureties had no independent duty to\ninvestigate a default. Accordingly, Fidelity and Zurich\xe2\x80\x99s failure to contest the default does not\nshow bad faith.\nFinally, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich\xe2\x80\x99s refusal to permit them\nto remain involved with the interstate project, either as a contractor or consultant, was evidence\nof bad faith. Yet, Douglas Asphalt and the Spiveys did not direct the district court or this court to\nany case law that holds that the refusal to permit a defaulting contractor to continue working on\na project is bad faith. As the district court concluded, Fidelity and Zurich had a contractual right\nto take possession of all the work under the contract and arrange for its completion. Fidelity and\nZurich exercised that contractual right, and, as the district court noted, the exercise of a\ncontractual right is not evidence of bad faith.\nFinding no error, we affirm the judgment of the district court.\n\nCASE QUESTIONS\n\n1. Why were Douglas Asphalt and the Spiveys supposed to pay the sureties nearly $15.5\nmillion?\n2. What did the plaintiffs claim the defendant sureties did wrong as relates to how much money\nthey spent to cure the default?\n3. What is a \xe2\x80\x9ccontest of the default\xe2\x80\x9d?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n604\n\n\x0c4. Why would the sureties probably not want the principal involved in the project?\n[1] Latin for \xe2\x80\x9cby the court.\xe2\x80\x9d A decision of an appeals court as a whole in which no judge is identified as\nthe specific author.\n[2] They promised to reimburse the surety for its expenses and hold it harmless for further liability.\n\n16.6 Summary and Exercises\nSummary\n\nThe law governing security interests in personal property is Article 9 of the UCC, which defines a\nsecurity interest as an interest in personal property or fixtures that secures payment or\nperformance of an obligation. Article 9 lumps together all the former types of security devices,\nincluding the pledge, chattel mortgage, and conditional sale.\nFive types of tangible property may serve as collateral: (1) consumer goods, (2) equipment, (3)\nfarm products, (4) inventory, and (5) fixtures. Five types of intangibles may serve as collateral:\n(1) accounts, (2) general intangibles (e.g., patents), (3) documents of title, (4) chattel paper, and\n(5) instruments. Article 9 expressly permits the debtor to give a security interest in afteracquired collateral.\nTo create an enforceable security interest, the lender and borrower must enter into an\nagreement establishing the interest, and the lender must follow steps to ensure that the security\ninterest first attaches and then is perfected. There are three general requirements for\nattachment: (1) there must be an authenticated agreement (or the collateral must physically be\nin the lender\xe2\x80\x99s possession), (2) the lender must have given value, and (3) the debtor must have\nsome rights in the collateral. Once the interest attaches, the lender has rights in the collateral\nsuperior to those of unsecured creditors. But others may defeat his interest unless he perfects\nthe security interest. The three common ways of doing so are (1) filing a financing statement, (2)\npledging collateral, and (3) taking a purchase-money security interest (PMSI) in consumer\ngoods.\nA financing statement is a simple notice, showing the parties\xe2\x80\x99 names and addresses, the\nsignature of the debtor, and an adequate description of the collateral. The financing statement,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n605\n\n\x0ceffective for five years, must be filed in a public office; the location of the office varies among the\nstates.\nSecurity interests in instruments and negotiable documents can be perfected only by the secured\nparty\xe2\x80\x99s taking possession, with twenty-one-day grace periods applicable under certain\ncircumstances. Goods may also be secured through pledging, which is often done through field\nwarehousing. If a seller of consumer goods takes a PMSI in the goods sold, then perfection is\nautomatic and no filing is required, although the lender may file and probably should, to avoid\nlosing seniority to a bona fide purchaser of consumer goods without knowledge of the security\ninterest, if the goods are used for personal, family, or household purposes.\nThe general priority rule is \xe2\x80\x9cfirst in time, first in right.\xe2\x80\x9d Priority dates from the earlier of two\nevents: (1) filing a financing statement covering the collateral or (2) other perfection of the\nsecurity interest. Several exceptions to this rule arise when creditors take a PMSI, among them,\nwhen a buyer in the ordinary course of business takes free of a security interest created by the\nseller.\nOn default, a creditor may repossess the collateral. For the most part, self-help private\nrepossession continues to be lawful but risky. After repossession, the lender may sell the\ncollateral or accept it in satisfaction of the debt. Any excess in the selling price above the debt\namount must go to the debtor.\nSuretyship is a legal relationship that is created when one person contracts to be responsible for\nthe proper fulfillment of another\xe2\x80\x99s obligation, in case the latter (the principal debtor) fails to\nfulfill it. The surety may avail itself of the principal\xe2\x80\x99s contract defenses, but under various\ncircumstances, defenses may be available to the one that are not available to the other. One\ngeneral defense often raised by sureties is alteration of the contract. If the surety is required to\nperform, it has rights for reimbursement against the principal, including interest and legal fees;\nand if there is more than one surety, each standing for part of the obligation, one who pays a\ndisproportionate part may seek contribution from the others.\n\nEXERCISES\n\n1. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit shop and\nsigned a security agreement listing as collateral the entire present and future inventory in the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n606\n\n\x0cshop, including proceeds from the sale of inventory. Bank filed no financing statement. A\nmonth later, Knittle borrowed $5,000 from Creditor, who was aware of Bank\xe2\x80\x99s security\ninterest. Knittle then declared bankruptcy. Who has priority, Bank or Creditor?\n2. Assume the same facts as in Exercise 1, except Creditor\xe2\x80\x94again, aware of Bank\xe2\x80\x99s security\ninterest\xe2\x80\x94filed a financing statement to perfect its interest. Who has priority, Bank or\nCreditor?\n3. Harold and Wilma are married. First Bank has a mortgage on their house, and it covers afteracquired property. Because Harold has a new job requiring travel to neighboring cities, they\npurchase a second car for Wilma\xe2\x80\x99s normal household use, financed by Second Bank. They\nsign a security agreement; Second Bank files nothing. If they were to default on their house\npayments, First Bank could repossess the house; could it repossess the car, too?\n4.\na. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit\nshop and signed a security agreement listing her collateral\xe2\x80\x94present and future\xe2\x80\x94\nas security for the loan. Carlene Customer bought yarn and a tabletop loom from\nKnittle. Shortly thereafter, Knittle declared bankruptcy. Can Bank get the loom\nfrom Customer?\nb. Assume that the facts are similar to those in Exercise 4a, except that the loom\nthat Knittle sold had been purchased from Larry Loomaker, who had himself given\na secured interest in it (and the other looms he manufactured) from Fine Lumber\nCompany (FLC) to finance the purchase of the lumber to make the looms.\nCustomer bought the loom from Knittle (unaware of Loomaker\xe2\x80\x99s situation);\nLoomaker failed to pay FLC. Why can FLC repossess the loom from Customer?\nc. What recourse does Customer have now?\nCreditor loaned Debtor $30,000 with the provision that the loan was callable by Creditor\nwith sixty days\xe2\x80\x99 notice to Debtor. Debtor, having been called for repayment, asked for a\nninety-day extension, which Creditor assented to, provided that Debtor would put up a\nsurety to secure repayment. Surety agreed to serve as surety. When Debtor defaulted,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n607\n\n\x0cCreditor turned to Surety for payment. Surety asserted that Creditor had given no\nconsideration for Surety\xe2\x80\x99s promise, and therefore Surety was not bound. Is Surety correct?\n\na. Mrs. Ace said to University Bookstore: \xe2\x80\x9cSell the books to my daughter. I\xe2\x80\x99ll\npay for them.\xe2\x80\x9d When University Bookstore presented Mrs. Ace a statement\nfor $900, she refused to pay, denying she\xe2\x80\x99d ever promised to do so, and she\nraised the statute of frauds as a defense. Is this a good defense?\nb. Defendant ran a stop sign and crashed into Plaintiff\xe2\x80\x99s car, causing $8,000 damage.\nPlaintiff\xe2\x80\x99s attorney orally negotiated with Defendant\xe2\x80\x99s insurance company,\nGoodhands Insurance, to settle the case. Subsequently, Goodhands denied\nliability and refused to pay, and it raised the statute of frauds as a defense,\nasserting that any promise by it to pay for its insured\xe2\x80\x99s negligence would have to\nbe in writing to be enforceable under the statute\xe2\x80\x99s suretyship clause. Is\nGoodhands\xe2\x80\x99s defense valid?\n\na. First Bank has a security interest in equipment owned by Kathy Knittle in her Knit Shop.\nIf Kathy defaults on her loan and First Bank lawfully repossesses, what are the bank\xe2\x80\x99s\noptions? Explain.\nb. Suppose, instead, that First Bank had a security interest in Kathy\xe2\x80\x99s home knitting\nmachine, worth $10,000. She paid $6,200 on the machine and then defaulted.\nNow what are the bank\xe2\x80\x99s options?\n\nSELF-TEST QUESTIONS\n\n1. Creditors may obtain security\na.\n\nby agreement with the debtor\n\nb. through operation of law\nc. through both of the above\nd. through neither of the above\nUnder UCC Article 9, when the debtor has pledged collateral to the creditor,\nwhat other condition is required for attachment of the security interest?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n608\n\n\x0ca.\n\nA written security agreement must be authenticated by the debtor.\n\nb. There must be a financing statement filed by or for the creditor.\nc. The secured party received consideration.\nd. The debtor must have rights in the collateral.\nTo perfect a security interest, one may\na.\n\nfile a financing statement\n\nb. pledge collateral\nc. take a purchase-money security interest in consumer goods\nd. do any of the above\nPerfection benefits the secured party by\na.\n\nkeeping the collateral out of the debtor\xe2\x80\x99s reach\n\nb. preventing another creditor from getting a secured interest in the collateral\nc. obviating the need to file a financing statement\nd. establishing who gets priority if the debtor defaults\nCreditor filed a security interest in inventory on June 1, 2012. Creditor\xe2\x80\x99s\ninterest takes priority over which of the following?\na.\n\na purchaser in the ordinary course of business who bought on June 5\n\nb. mechanic\xe2\x80\x99s lien filed on May 10\nc. purchase-money security interest in after-acquired property who filed on May 15\nd. judgment lien creditor who filed the judgment on June 10\n\nSELF-TEST ANSWERS\n\n1. c\n2. d\n3. d\n4. d\n5. d\n\nChapter 17\nMortgages and Nonconsensual Liens\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n609\n\n\x0cAfter reading this chapter, you should understand the following:\n1. The basic concepts of mortgages\n2. How the mortgage is created\n3. Priorities with mortgages as security devices\n4. Termination of the mortgage\n5. Other methods of using real estate as security\n6. Nonconsensual liens\n\n17.1 Uses, History, and Creation of Mortgages\nLEARNING OBJECTIVES\n\n1. Understand the terminology used in mortgage transactions, and how mortgages are used as\nsecurity devices.\n2. Know a bit about the history of mortgages.\n3. Understand how the mortgage is created.\nHaving discussed in Chapter 16 "Secured Transactions and Suretyship" security interests in\npersonal property and suretyship\xe2\x80\x94two of the three common types of consensual security\narrangements\xe2\x80\x94we turn now to the third type of consensual security arrangement, the mortgage.\nWe also discuss briefly various forms of nonconsensual liens (see Figure 17.1 "Security\nArrangements").\n\nFigure 17.1 Security Arrangements\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n610\n\n\x0cDefinitions\nA mortgage is a means of securing a debt with real estate. A long time ago, the mortgage was\nconsidered an actual transfer of title, to become void if the debt was paid off. The modern view,\nheld in most states, is that the mortgage is but a lien, giving the holder, in the event of default,\nthe right to sell the property and repay the debt from the proceeds. The person giving the\nmortgage is the mortgagor, or borrower. In the typical home purchase, that\xe2\x80\x99s the buyer. The\nbuyer needs to borrow to finance the purchase; in exchange for the money with which to pay the\nseller, the buyer \xe2\x80\x9ctakes out a mortgage\xe2\x80\x9d with, say, a bank. The lender is the mortgagee, the\nperson or institution holding the mortgage, with the right to foreclose on the property if the debt\nis not timely paid. Although the law of real estate mortgages is different from the set of rules in\nArticle 9 of the Uniform Commercial Code (UCC) that we examined in Chapter 16 "Secured\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n611\n\n\x0cTransactions and Suretyship", the circumstances are the same, except that the security is real\nestate rather than personal property (secured transactions) or the promise of another\n(suretyship).\n\nThe Uses of Mortgages\nMost frequently, we think of a mortgage as a device to fund a real estate purchase: for a\nhomeowner to buy her house, or for a commercial entity to buy real estate (e.g., an office\nbuilding), or for a person to purchase farmland. But the value in real estate can be mortgaged for\nalmost any purpose (a home equity loan): a person can take out a mortgage on land to fund a\nvacation. Indeed, during the period leading up to the recession in 2007\xe2\x80\x9308, a lot of people\nborrowed money on their houses to buy things: boats, new cars, furniture, and so on.\nUnfortunately, it turned out that some of the real estate used as collateral was overvalued: when\nthe economy weakened and people lost income or their jobs, they couldn\xe2\x80\x99t make the mortgage\npayments. And, to make things worse, the value of the real estate sometimes sank too, so that\nthe debtors owed more on the property than it was worth (that\xe2\x80\x99s called being underwater). They\ncouldn\xe2\x80\x99t sell without taking a loss, and they couldn\xe2\x80\x99t make the payments. Some debtors just\nwalked away, leaving the banks with a large number of houses, commercial buildings, and even\nshopping centers on their hands.\n\nShort History of Mortgage Law\nThe mortgage has ancient roots, but the form we know evolved from the English land law in the\nMiddle Ages. Understanding that law helps to understand modern mortgage law. In the\nfourteenth century, the mortgage was a deed that actually transferred title to the mortgagee. If\ndesired, the mortgagee could move into the house, occupy the property, or rent it out. But\nbecause the mortgage obligated him to apply to the mortgage debt whatever rents he collected,\nhe seldom ousted the mortgagor. Moreover, the mortgage set a specific date (the \xe2\x80\x9claw day\xe2\x80\x9d) on\nwhich the debt was to be repaid. If the mortgagor did so, the mortgage became void and the\nmortgagor was entitled to recover the property. If the mortgagor failed to pay the debt, the\nproperty automatically vested in the mortgagee. No further proceedings were necessary.\nThis law was severe. A day\xe2\x80\x99s delay in paying the debt, for any reason, forfeited the land, and the\ncourts strictly enforced the mortgage. The only possible relief was a petition to the king, who\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n612\n\n\x0cover time referred these and other kinds of petitions to the courts of equity. At first fitfully, and\nthen as a matter of course (by the seventeenth century), the equity courts would order the\nmortgagee to return the land when the mortgagor stood ready to pay the debt plus interest. Thus\na new right developed: the equitable right of redemption, known for short as the equity of\nredemption. In time, the courts held that this equity of redemption was a form of property right;\nit could be sold and inherited. This was a powerful right: no matter how many years later, the\nmortgagor could always recover his land by proffering a sum of money.\nUnderstandably, mortgagees did not warm to this interpretation of the law, because their\nproperty rights were rendered insecure. They tried to defeat the equity of redemption by having\nmortgagors waive and surrender it to the mortgagees, but the courts voided waiver clauses as a\nviolation of public policy. Hence a mortgage, once a transfer of title, became a security for debt.\nA mortgage as such can never be converted into a deed of title.\nThe law did not rest there. Mortgagees won a measure of relief in the development of\nthe foreclosure. On default, the mortgagee would seek a court order giving the mortgagor a fixed\ntime\xe2\x80\x94perhaps six months or a year\xe2\x80\x94within which to pay off the debt; under the court decree,\nfailure meant that the mortgagor was forever foreclosed from asserting his right of redemption.\nThis strict foreclosure gave the mortgagee outright title at the end of the time period.\nIn the United States today, most jurisdictions follow a somewhat different approach: the\nmortgagee forecloses by forcing a public sale at auction. Proceeds up to the amount of the debt\nare the mortgagee\xe2\x80\x99s to keep; surplus is paid over to the mortgagor.Foreclosure by sale is the\nusual procedure in the United States. At bottom, its theory is that a mortgage is a lien on land.\n(Foreclosure issues are further discussed in Section 17.2 "Priority, Termination of the Mortgage,\nand Other Methods of Using Real Estate as Security".)\nUnder statutes enacted in many states, the mortgagor has one last chance to recover his\nproperty, even after foreclosure. This statutory right of redemption extends the period to repay,\noften by one year.\n\nCreation of the Mortgage\nStatutory Regulation\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n613\n\n\x0cThe decision whether to lend money and take a mortgage is affected by several federal and state\nregulations.\n\nConsumer Credit Statutes Apply\nStatutes dealing with consumer credit transactions have a bearing on the mortgage, including\nstate usury statutes, and the federal Truth in Lending Act and Equal Credit Opportunity Act.\n\nReal Estate Settlement Procedures Act\nOther federal statutes are directed more specifically at mortgage lending. One, enacted in 1974,\nis the Real Estate Settlement Procedures Act (RESPA), aimed at abuses in the settlement\nprocess\xe2\x80\x94the process of obtaining the mortgage and purchasing a residence. The act covers all\nfederally related first mortgage loans secured by residential properties for one to four families. It\nrequires the lender to disclose information about settlement costs in advance of the closing day:\nit prohibits the lender from \xe2\x80\x9cspringing\xe2\x80\x9d unexpected or hidden costs onto the borrower. The\nRESPA is a US Department of Housing and Urban Development (HUD) consumer protection\nstatute designed to help home buyers be better shoppers in the home-buying process, and it is\nenforced by HUD. It also outlaws what had been a common practice of giving and accepting\nkickbacks and referral fees. The act prohibits lenders from requiring mortgagors to use a\nparticular company to obtain insurance, and it limits add-on fees the lender can demand to\ncover future insurance and tax charges.\nRedlining. Several statutes are directed to the practice of redlining\xe2\x80\x94the refusal of lenders to\nmake loans on property in low-income neighborhoods or impose stricter mortgage terms when\nthey do make loans there. (The term derives from the supposition that lenders draw red lines on\nmaps around ostensibly marginal neighborhoods.) The most important of these is the\nCommunity Reinvestment Act (CRA) of 1977. [1] The act requires the appropriate federal\nfinancial supervisory agencies to encourage regulated financial institutions to meet the credit\nneeds of the local communities in which they are chartered, consistent with safe and sound\noperation. To enforce the statute, federal regulatory agencies examine banking institutions for\nCRA compliance and take this information into consideration when approving applications for\nnew bank branches or for mergers or acquisitions. The information is compiled under the\nauthority of the Home Mortgage Disclosure Act of 1975, which requires financial institutions\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n614\n\n\x0cwithin its purview to report annually by transmitting information from their loan application\nregisters to a federal agency.\n\nThe Note and the Mortgage Documents\nThe note and the mortgage documents are the contracts that set up the deal: the mortgagor gets\ncredit, and the mortgagee gets the right to repossess the property in case of default.\n\nThe Note\nIf the lender decides to grant a mortgage, the mortgagor signs two critical documents at the\nclosing: the note and the mortgage. It is enough here to recall that in a note (really a type of\nIOU), the mortgagor promises to pay a specified principal sum, plus interest, by a certain date or\ndates. The note is the underlying obligation for which the mortgage serves as security. Without\nthe note, the mortgagee would have an empty document, since the mortgage would secure\nnothing. Without a mortgage, a note is still quite valid, evidencing the debtor\xe2\x80\x99s personal\nobligation.\nOne particular provision that usually appears in both mortgages and the underlying notes is\nthe acceleration clause. This provides that if a debtor should default on any particular payment,\nthe entire principal and interest will become due immediately at the lender\xe2\x80\x99s option. Why an\nacceleration clause? Without it, the lender would be powerless to foreclose the entire mortgage\nwhen the mortgagor defaulted but would have to wait until the expiration of the note\xe2\x80\x99s term.\nAlthough the acceleration clause is routine, it will not be enforced unless the mortgagee acts in\nan equitable and fair manner. The problem arises where the mortgagor\xe2\x80\x99s default was the result\nof some unconscionable conduct of the mortgagee, such as representing to the mortgagee that\nshe might take a sixty-day \xe2\x80\x9choliday\xe2\x80\x9d from having to make payments. In Paul H. Cherry v. Chase\nManhattan Mortgage Group (Section 17.4 "Cases"), the equitable powers of the court were\ninvoked to prevent acceleration.\n\nThe Mortgage\nUnder the statute of frauds, the mortgage itself must be evidenced by some writing to be\nenforceable. The mortgagor will usually make certain promises and warranties to the mortgagee\nand state the amount and terms of the debt and the mortgagor\xe2\x80\x99s duties concerning taxes,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n615\n\n\x0cinsurance, and repairs. A sample mortgage form is presented inFigure 17.2 "Sample Mortgage\nForm".\n\nFigure 17.2 Sample Mortgage Form\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n616\n\n\x0cKEY TAKEAWAY\nAs a mechanism of security, a mortgage is a promise by the debtor (mortgagor) to repay the\ncreditor (mortgagee) for the amount borrowed or credit extended, with real estate put up as\nsecurity. If the mortgagor doesn\xe2\x80\x99t pay as promised, the mortgagee may repossess the real\nestate. Mortgage law has ancient roots and brings with it various permutations on the theme\nthat even if the mortgagor defaults, she may nevertheless have the right to get the property\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n617\n\n\x0cback or at least be reimbursed for any value above that necessary to pay the debt and the\nexpenses of foreclosure. Mortgage law is regulated by state and federal statute.\n\nEXERCISES\n\n1. What role did the right of redemption play in courts of equity changing the substance of a\nmortgage from an actual transfer of title to the mortgagee to a mere lien on the property?\n2. What abuses did the federal RESPA address?\n3. What are the two documents most commonly associated with mortgage transactions?\n[1] 12 United States Code, Section 2901.\n\n17.2 Priority, Termination of the Mortgage, and Other\nMethods of Using Real Estate as Security\nLEARNING OBJECTIVES\n\n1. Understand why it is important that the mortgagee (creditor) record her interest in the\ndebtor\xe2\x80\x99s real estate.\n2. Know the basic rule of priority\xe2\x80\x94who gets an interest in the property first in case of default\xe2\x80\x94\nand the exceptions to the rule.\n3. Recognize the three ways mortgages can be terminated: payment, assumption, and\nforeclosure.\n4. Be familiar with other methods (besides mortgages) by which real property can be used as\nsecurity for a creditor.\n\nPriorities in Real Property Security\nYou may recall from Chapter 16 "Secured Transactions and Suretyship" how important it is for a\ncreditor to perfect its secured interest in the goods put up as collateral. Absent perfection, the\ncreditor stands a chance of losing out to another creditor who took its interest in the goods\nsubsequent to the first creditor. The same problem is presented in real property security: the\nmortgagee wants to make sure it has first claim on the property in case the mortgagor (debtor)\ndefaults.\n\nThe General Rule of Priorities\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n618\n\n\x0cThe general rule of priority is the same for real property security as for personal property\nsecurity: the first in time to give notice of the secured interest is first in right. For real property,\nthe notice is by recording the mortgage. Recording is the act of giving public notice of changes in\ninterests in real estate. Recording was created by statute; it did not exist at common law. The\ntypical recording statute calls for a transfer of title or mortgage to be placed in a particular\ncounty office, usually the auditor, recorder, or register of deeds.\nA mortgage is valid between the parties whether or not it is recorded, but a mortgagee might\nlose to a third party\xe2\x80\x94another mortgagee or a good-faith purchaser of the property\xe2\x80\x94unless the\nmortgage is recorded.\n\nExceptions to the General Rule\nThere are exceptions to the general rule; two are taken up here.\n\nFixture Filing\nThe fixture-filing provision in Article 9 of the UCC is one exception to the general rule. As noted\nin Chapter 16 "Secured Transactions and Suretyship", the UCC gives priority to purchase-money\nsecurity interests in fixtures if certain requirements are met.\n\nFuture Advances\nA bank might make advances to the debtor after accepting the mortgage. If the future advances\nare obligatory, then the first-in-time rule applies. For example: Bank accepts Debtor\xe2\x80\x99s mortgage\n(and records it) and extends a line of credit on which Debtor draws, up to a certain limit. (Or, as\nin the construction industry, Bank might make periodic advances to the contractors as work\nprogresses, backed by the mortgage.) Second Creditor loans Debtor money\xe2\x80\x94secured by the\nsame property\xe2\x80\x94before Debtor began to draw against the first line of credit. Bank has priority: by\nsearching the mortgage records, Second Creditor should have been on notice that the first\nmortgage was intended as security for the entire line of credit, although the line was doled out\nover time.\nHowever, if the future advances are not obligatory, then priority is determined by notice. For\nexample, a bank might take a mortgage as security for an original loan and for any future loans\nthat the bank chooses to make. A later creditor can achieve priority by notifying the bank with\nthe first mortgage that it is making an advance. Suppose Jimmy mortgages his property to a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n619\n\n\x0cwealthy dowager, Mrs. Calabash, in return for an immediate loan of $20,000 and they agree\nthat the mortgage will serve as security for future loans to be arranged. The mortgage is\nrecorded. A month later, before Mrs. Calabash loans him any more money, Jimmy gives a\nsecond mortgage to Louella in return for a loan of $10,000. Louella notifies Mrs. Calabash that\nshe is loaning Jimmy the money. A month later, Mrs. Calabash loans Jimmy another $20,000.\nJimmy then defaults, and the property turns out to be worth only $40,000. Whose claims will\nbe honored and in what order? Mrs. Calabash will collect her original $20,000, because it was\nrecited in the mortgage and the mortgage was recorded. Louella will collect her $10,000 next,\nbecause she notified the first mortgage holder of the advance. That leaves Mrs. Calabash in third\nposition to collect what she can of her second advance. Mrs. Calabash could have protected\nherself by refusing the second loan.\n\nTermination of the Mortgage\nThe mortgagor\xe2\x80\x99s liability can terminate in three ways: payment, assumption (with a novation),\nor foreclosure.\n\nPayment\nUnless they live in the home for twenty-five or thirty years, the mortgagors usually pay off the\nmortgage when the property is sold. Occasionally, mortgages are paid off in order to refinance. If\nthe mortgage was taken out at a time of high interest rates and rates later drop, the homeowner\nmight want to obtain a new mortgage at the lower rates. In many mortgages, however, this\nentails extra closing costs and penalties for prepaying the original mortgage. Whatever the\nreason, when a mortgage is paid off, the discharge should be recorded. This is accomplished by\ngiving the mortgagor a copy of, and filing a copy of, a Satisfaction of Mortgage document. In\nthe Paul H. Cherry v. Chase Manhattan Mortgage Group case (Section 17.4 "Cases"), the\nbank mistakenlyfiled the Satisfaction of Mortgage document, later discovered its mistake,\nretracted the satisfaction, accelerated the loan because the mortgagor stopped making payments\n(the bank, seeing no record of an outstanding mortgage, refused to accept payments), and then\ntried to foreclose on the mortgage, meanwhile having lost the note and mortgage besides.\n\nAssumption\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n620\n\n\x0cThe property can be sold without paying off the mortgage if the mortgage is assumed by the new\nbuyer, who agrees to pay the seller\xe2\x80\x99s (the original mortgagor\xe2\x80\x99s) debt. This is a novation if, in\napproving the assumption, the bank releases the old mortgagor and substitutes the buyer as the\nnew debtor.\nThe buyer need not assume the mortgage. If the buyer purchases the property without agreeing\nto be personally liable, this is a sale \xe2\x80\x9csubject to\xe2\x80\x9d the mortgage (see Figure 17.3 "\xe2\x80\x9cSubject to\xe2\x80\x9d Sales\nversus Assumption"). In the event of the seller\xe2\x80\x99s subsequent default, the bank can foreclose the\nmortgage and sell the property that the buyer has purchased, but the buyer is not liable for any\ndeficiency.\n\nFigure 17.3 \xe2\x80\x9cSubject to\xe2\x80\x9d Sales versus Assumption\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n621\n\n\x0cWhat if mortgage rates are high? Can buyers assume an existing low-rate mortgage from the\nseller rather than be forced to obtain a new mortgage at substantially higher rates? Banks, of\ncourse, would prefer not to allow that when interest rates are rising, so they often include in the\nmortgage a due-on-sale clause, by which the entire principal and interest become due when the\nproperty is sold, thus forcing the purchaser to get financing at the higher rates. The clause is a\ndevice for preventing subsequent purchasers from assuming loans with lower-than-market\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n622\n\n\x0cinterest rates. Although many state courts at one time refused to enforce the due-on-sale clause,\nCongress reversed this trend when it enacted the Garn\xe2\x80\x93St. Germain Depository Institutions Act\nin 1982. [1] The act preempts state laws and upholds the validity of due-on-sale clauses. When\ninterest rates are low, banks have no interest in enforcing such clauses, and there are ways to\nwork around the due-on-sale clause.\n\nForeclosure\nThe third method of terminating the mortgage is by foreclosure when a mortgagor defaults.\nEven after default, the mortgagor has the right to exercise his equity of redemption\xe2\x80\x94that is, to\nredeem the property by paying the principal and interest in full. If he does not, the mortgagee\nmay foreclose the equity of redemption. Although strict foreclosure is used occasionally, in most\ncases the mortgagee forecloses by one of two types of sale (see Figure 17.4 "Foreclosure").\nThe first type is judicial sale. The mortgagee seeks a court order authorizing the sale to be\nconducted by a public official, usually the sheriff. The mortgagor is entitled to be notified of the\nproceeding and to a hearing. The second type of sale is that conducted under a clause called\na power of sale, which many lenders insist be contained in the mortgage. This clause permits the\nmortgagee to sell the property at public auction without first going to court\xe2\x80\x94although by custom\nor law, the sale must be advertised, and typically a sheriff or other public official conducts the\npublic sale or auction.\nFigure 17.4 Foreclosure\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n623\n\n\x0cOnce the property has been sold, it is deeded to the new purchaser. In about half the states, the\nmortgagor still has the right to redeem the property by paying up within six months or a year\xe2\x80\x94\nthe statutory redemption period. Thereafter, the mortgagor has no further right to redeem. If\nthe sale proceeds exceed the debt, the mortgagor is entitled to the excess unless he has given\nsecond and third mortgages, in which case the junior mortgagees are entitled to recover their\nclaims before the mortgagor. If the proceeds are less than the debt, the mortgagee is entitled to\nrecover the deficiency from the mortgagor. However, some states have statutorily abolished\ndeficiency judgments.\n\nOther Methods of Using Real Estate as Security\nBesides the mortgage, there are other ways to use real estate as security. Here we take up two:\nthe deed of trust and the installment or land contract.\n\nDeed of Trust\nThe deed of trust is a device for securing a debt with real property; unlike the mortgage, it\nrequires three parties: the borrower, the trustee, and the lender. Otherwise, it is at base identical\nto a mortgage. The borrower conveys the land to a third party, the trustee, to hold in trust for the\nlender until the borrower pays the debt. (The trustee\xe2\x80\x99s interest is really a kind of legal fiction:\nthat person is expected to have no interest in the property.) The primary benefit to the deed of\ntrust is that it simplifies the foreclosure process by containing a provision empowering the\ntrustee to sell the property on default, thus doing away with the need for any court filings. The\ndisinterested third party making sure things are done properly becomes the trustee, not a judge.\nIn thirty states and the District of Columbia\xe2\x80\x94more than half of US jurisdictions\xe2\x80\x94the deed of\ntrust is usually used in lieu of mortgages. [2]\nBut the deed of trust may have certain disadvantages as well. For example, when the debt has\nbeen fully paid, the trustee will not release the deed of trust until she sees that all notes secured\nby it have been marked canceled. Should the borrower have misplaced the canceled notes or\nfailed to keep good records, he will need to procure a surety bond to protect the trustee in case of\na mistake. This can be an expensive procedure. In many jurisdictions, the mortgage holder is\nprohibited from seeking a deficiency judgment if the holder chooses to sell the property through\nnonjudicial means.\nAlpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, Section 17.4 "Cases",\ndiscusses several issues involving deeds of trust.\n\nInstallment or Land Contract\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n624\n\n\x0cUnder the installment contract or land contract, the purchaser takes possession and agrees to\npay the seller over a period of years. Until the final payment, title belongs to the seller. The\ncontract will specify the type of deed to be conveyed at closing, the terms of payment, the buyer\xe2\x80\x99s\nduty to pay taxes and insure the premises, and the seller\xe2\x80\x99s right to accelerate on default. The\nbuyer\xe2\x80\x99s particular concern in this type of sale is whether the seller in fact has title. The buyers\ncan protect themselves by requiring proof of title and title insurance when the contract is signed.\nMoreover, the buyer should record the installment contract to protect against the seller\xe2\x80\x99s\nattempt to convey title to an innocent third-party purchaser while the contract is in effect.\nThe benefit to the land contract is that the borrower need not bank-qualify, so the pool of\navailable buyers is larger, and buyers who have inadequate resources at the time of contracting\nbut who have the expectation of a rising income in the future are good candidates for the land\ncontract. Also, the seller gets all the interest paid by the buyer, instead of the bank getting it in\nthe usual mortgage. The obvious disadvantage from the seller\xe2\x80\x99s point is that she will not get a big\nlump sum immediately: the payments trickle in over years (unless she can sell the contract to a\nthird party, but that would be at a discount).\n\nKEY TAKEAWAY\n\nThe general rule on priority in real property security is that the first creditor to record its\ninterest prevails over subsequent creditors. There are some exceptions; the most familiar is\nthat the seller of a fixture on a purchase-money security interest has priority over a\npreviously recorded mortgagee. The mortgage will terminate by payment, assumption by a\nnew buyer (with a novation releasing the old buyer), and foreclosure. In a judicial-sale\nforeclosure, a court authorizes the property\xe2\x80\x99s sale; in a power-of-sale foreclosure, no court\napproval is required. In most states, the mortgagor whose property was foreclosed is given\nsome period of time\xe2\x80\x94six months or a year\xe2\x80\x94to redeem the property; otherwise, the sale is\ndone, but the debtor may be liable for the deficiency, if any. The deed of trust avoids any\njudicial involvement by having the borrower convey the land to a disinterested trustee for\nthe benefit of the lender; the trustee sells it upon default, with the proceeds (after expenses)\ngoing to the lender. Another method of real property security is a land contract: title shifts to\nthe buyer only at the end of the term of payments.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n625\n\n\x0c1. A debtor borrowed $350,000 to finance the purchase of a house, and the bank recorded its\ninterest on July 1. On July 15, the debtor bought $10,000 worth of replacement windows\nfrom Window Co.; Window Co. recorded its purchase-money security interest that day, and\nthe windows were installed. Four years later, the debtor, in hard financial times, declared\nbankruptcy. As between the bank and Windows Co., who will get paid first?\n2. Under what interest rate circumstances would banks insist on a due-on-sale clause? Under\nwhat interest rate circumstance would banks not object to a new person assuming the\nmortgage?\n3. What is the primary advantage of the deed of trust? What is the primary advantage of the\nland contract?\n4. A debtor defaulted on her house payments. Under what circumstances might a\ncourt not allow the bank\xe2\x80\x99s foreclosure on the property?\n[1] 12 United States Code, Section 1701-j.\n[2] The states using the deed of trust system are as follows: Alabama, Alaska, Arkansas, Arizona,\nCalifornia, Colorado, District of Columbia, Georgia, Hawaii, Idaho, Iowa, Michigan, Minnesota,\nMississippi, Missouri, Montana, Nevada, New Hampshire, North Carolina, Oklahoma, Oregon, Rhode\nIsland, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, West Virginia, Wisconsin, and\nWyoming.\n\n17.3 Nonconsensual Lien\n\nLEARNING OBJECTIVES\n\n1. Understand the nonconsensual liens issued by courts\xe2\x80\x94attachment liens and judgment\nliens\xe2\x80\x94and how they are created.\n2. Recognize other types of nonconsensual liens: mechanic\xe2\x80\x99s lien, possessory lien, and tax lien.\nThe security arrangements discussed so far\xe2\x80\x94security interests, suretyship, mortgages\xe2\x80\x94are all\nobtained by the creditor with the debtor\xe2\x80\x99s consent. A creditor may obtain certain liens without\nthe debtor\xe2\x80\x99s consent.\n\nCourt-Decreed Liens\nSome nonconsensual liens are issued by courts.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n626\n\n\x0cAttachment Lien\nAn attachment lien is ordered against a person\xe2\x80\x99s property\xe2\x80\x94real or personal\xe2\x80\x94to prevent him\nfrom disposing of it during a lawsuit. To obtain an attachment lien, the plaintiff must show that\nthe defendant likely will dispose of or hide his property; if the court agrees with the plaintiff, she\nmust post a bond and the court will issue a writ of attachment to the sheriff, directing the sheriff\nto seize the property. Attachments of real property should be recorded. Should the plaintiff win\nher suit, the court issues a writ of execution, directing the sheriff to sell the property to satisfy\nthe judgment.\n\nJudgment Lien\nA judgment lien may be issued when a plaintiff wins a judgment in court if an attachment lien\nhas not already been issued. Like the attachment lien, it provides a method by which the\ndefendant\xe2\x80\x99s property may be seized and sold.\n\nMechanic\xe2\x80\x99s Lien\nOverview\nThe most common nonconsensual lien on real estate is the mechanic\xe2\x80\x99s lien. A mechanic\xe2\x80\x99s lien\ncan be obtained by one who furnishes labor, services, or materials to improve real estate: this is\nstatutory, and the statute must be carefully followed. The \xe2\x80\x9cmechanic\xe2\x80\x9d here is one who works\nwith his or her hands, not specifically one who works on machines. An automobile mechanic\ncould not obtain a mechanic\xe2\x80\x99s lien on a customer\xe2\x80\x99s house to secure payment of work he did on\nher car. (The lien to which the automobile mechanic is entitled is a \xe2\x80\x9cpossessory lien\xe2\x80\x9d or\n\xe2\x80\x9cartisan\xe2\x80\x99s lien,\xe2\x80\x9d considered inSection 17.3.3 "Possessory Lien") To qualify for a mechanic\xe2\x80\x99s lien,\nthe claimant must file a sworn statement describing the work done, the contract made, or the\nmaterials furnished that permanently improved the real estate.\nA particularly difficult problem crops up when the owner has paid the contractor, who in turn\nfails to pay his subcontractors. In many states, the subcontractors can file a lien on the owner\xe2\x80\x99s\nproperty, thus forcing the owner to pay them (see Figure 17.5 "Subcontractors\xe2\x80\x99 Lien")\xe2\x80\x94and\nmaybe twice. To protect themselves, owners can demand a sworn statement from general\ncontractors listing the subcontractors used on the job, and from them, owners can obtain a\nwaiver of lien rights before paying the general contractor.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n627\n\n\x0cFigure 17.5Subcontractors\xe2\x80\x99\n\nLien\n\nProcedure for Obtaining a Mechanic\xe2\x80\x99s Lien\nAnyone claiming a lien against real estate must record a lien statement stating the amount due\nand the nature of the improvement. The lienor has a specified period of time (e.g., ninety days)\nto file from the time the work is finished. Recording as such does not give the lienor an\nautomatic right to the property if the debt remains unpaid. All states specify a limited period of\ntime, usually one year, within which the claimant must file suit to enforce the lien. Only if the\ncourt decides the lien is valid may the property be sold to satisfy the debt. Difficult questions\nsometimes arise when a lien is filed against a landlord\xe2\x80\x99s property as a result of improvements\nand services provided to a tenant, as discussed in F & D Elec. Contractors, Inc. v. Powder\nCoaters, Inc.,Section 17.4 "Cases".\n\nMechanic\xe2\x80\x99s Liens Priorities\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n628\n\n\x0cA mechanic\xe2\x80\x99s lien represents a special risk to the purchaser of real estate or to lenders who wish\nto take a mortgage. In most states, the mechanic\xe2\x80\x99s lien is given priority not from the date when\nthe lien is recorded but from an earlier date\xe2\x80\x94either the date the contractor was hired or the date\nconstruction began. Thus a purchaser or lender might lose priority to a creditor with a\nmechanic\xe2\x80\x99s lien who filed after the sale or mortgage. A practical solution to this problem is to\nhold back part of the funds (purchase price or loan) or place them in escrow until the period for\nrecording liens has expired.\n\nPossessory Lien\nThe most common nonconsensual lien on personal property (not real estate) is\nthepossessory lien. This is the right to continue to keep the goods on which work has been\nperformed or for which materials have been supplied until the owner pays for the labor or\nmaterials. The possessory lien arises both under common law and under a variety of statutes.\nBecause it is nonconsensual, the possessory lien is not covered by Article 9 of the UCC, which is\nrestricted to consensual security interests. Nor is it governed by the law of mechanic\xe2\x80\x99s liens,\nwhich are nonpossessory and relate only to work done to improve real property.\nThe common-law rule is that anyone who, under an express or implied contract, adds value to\nanother\xe2\x80\x99s chattel (personal property) by labor, skill, or materials has a possessory lien for the\nvalue of the services. Moreover, the lienholder may keep the chattel until her services are paid.\nFor example, the dry cleaner shop is not going to release the wool jacket that you took in for\ncleaning unless you make satisfactory arrangements to pay for it, and the chain saw store won\xe2\x80\x99t\nlet you take the chain saw that you brought in for a tune-up until you pay for the labor and\nmaterials for the tune-up.\n\nTax Lien\nAn important statutory lien is the federal tax lien. Once the government assesses a tax, the\namount due constitutes a lien on the owner\xe2\x80\x99s property, whether real or personal. Until it is filed\nin the appropriate state office, others take priority, including purchasers, mechanics\xe2\x80\x99 lienors,\njudgment lien creditors, and holders of security interests. But once filed, the tax lien takes\npriority over all subsequently arising liens. Federal law exempts some property from the tax\nlien; for example, unemployment benefits, books and tools of a trade, workers\xe2\x80\x99 compensation,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n629\n\n\x0cjudgments for support of minor children, minimum amounts of wages and salary, personal\neffects, furniture, fuel, and provisions are exempt.\nLocal governments also can assess liens against real estate for failure to pay real estate taxes.\nAfter some period of time, the real estate may be sold to satisfy the tax amounts owing.\n\nKEY TAKEAWAY\n\nThere are four types of nonconsensual liens: (1) court-decreed liens are attachment liens,\nwhich prevent a person from disposing of assets pending a lawsuit, and judgment liens,\nwhich allow the prevailing party in a lawsuit to take property belonging to the debtor to\nsatisfy the judgment; (2) mechanics\xe2\x80\x99 liens are authorized by statute, giving a person who has\nprovided labor or material to a landowner the right to sell the property to get paid; (3)\npossessory liens on personal property allow one in possession of goods to keep them to\nsatisfy a claim for work done or storage of them; and (4) tax liens are enforced by the\ngovernment to satisfy outstanding tax liabilities and may be assessed against real or personal\nproperty.\n\nEXERCISES\n\n1. The mortgagor\xe2\x80\x99s interests are protected in a judicial foreclosure by a court\xe2\x80\x99s oversight of the\nprocess; how is the mortgagor\xe2\x80\x99s interest protected when a deed of trust is used?\n2. Why is the deed of trust becoming increasingly popular?\n3. What is the rationale for the common-law possessory lien?\n4. Mike Mechanic repaired Alice Ace\xe2\x80\x99s automobile in his shop, but Alice didn\xe2\x80\x99t have enough\nmoney to pay for the repairs. May Mike have a mechanic\xe2\x80\x99s lien on the car? A possessory lien?\n5. Why does federal law exempt unemployment benefits, books and tools of a trade, workers\xe2\x80\x99\ncompensation, minimum amounts of wages and salary, personal effects, furniture, fuel, and\nother such items from the sweep of a tax lien?\n\n17.4 Cases\nDenial of Mortgagee\xe2\x80\x99s Right to Foreclose; Erroneous Filings; Lost Instruments\nPaul H. Cherry v. Chase Manhattan Mortgage Group\n190 F.Supp.2d 1330 (Fed. Dist. Ct. FL 2002)\nBackground\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n630\n\n\x0c[Paul Cherry filed a complaint suing Chase for Fair Debt Collection Practices Act violations and\nslander of credit.]\xe2\x80\xa6Chase counter-claimed for foreclosure and reestablishment of the lost\nnote.\xe2\x80\xa6\n\xe2\x80\xa6Chase held a mortgage on Cherry\xe2\x80\x99s home to which Cherry made timely payments until August\n2000. Cherry stopped making payments on the mortgage after he received a letter from Chase\nacknowledging his satisfaction of the mortgage. Cherry notified Chase of the error through a\ncustomer service representative. Cherry, however, received a check dated August 15, 2000, as an\nescrow refund on the mortgage. Chase subsequently recorded a Satisfaction of Mortgage into the\nPinellas County public records on October 19, 2000. On November 14, 2000, Chase sent Cherry\na \xe2\x80\x9cLoan Reactivation\xe2\x80\x9d letter with a new loan number upon which to make the payments. During\nthis time, Cherry was placing his mortgage payments into a bank account, which subsequently\nwere put into an escrow account maintained by his attorney. These payments were not, and have\nnot, been tendered to Chase. As a result of the failure to tender, Chase sent Cherry an\nacceleration warning on November 17, 2000, and again on March 16, 2001. Chase notified the\ncredit bureaus as to Cherry\xe2\x80\x99s default status and moved for foreclosure. In a letter addressed to\nCherry\xe2\x80\x99s attorney, dated April 24, 2001, Chase\xe2\x80\x99s attorney advised Cherry to make the mortgage\npayments to Chase. Chase recorded a \xe2\x80\x9cvacatur, revocation, and cancellation of satisfaction of\nmortgage\xe2\x80\x9d (vacatur) [vacatur: an announcement filed in court that something is cancelled or set\naside; an annulment] in the Pinellas County public records on May 3, 2001. Chase signed the\nvacatur on March 21, 2001, and had it notarized on March 27, 2001. Chase has also been unable\nto locate the original note, dated October 15, 1997, and deems it to be lost.\xe2\x80\xa6\nForeclosure\nChase accelerated Cherry\xe2\x80\x99s mortgage debt after determining he was in a default status under the\nmortgage provisions. Chase claims that the right to foreclose under the note and mortgage is\n\xe2\x80\x9cabsolute,\xe2\x80\x9d [Citation], and that this Court should enforce the security interest in the mortgage\nthough Chase made an administrative error in entering a Satisfaction of Mortgage into the\npublic records.\xe2\x80\xa6\nMortgage\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n631\n\n\x0c\xe2\x80\xa6Chase relies on the Florida Supreme Court decision in United Service Corp. v. Vi-An Const.\nCorp., [Citation] (Fla.1955), which held that a Satisfaction of Mortgage \xe2\x80\x9cmade through a mistake\nmay be canceled\xe2\x80\x9d and a mortgage reestablished as long as no other innocent third parties have\n\xe2\x80\x9cacquired an interest in the property.\xe2\x80\x9d Generally the court looks to the rights of any innocent\nthird parties, and if none exist, equity will grant relief to a mortgagee who has mistakenly\nsatisfied a mortgage before fully paid. [Citation]. Both parties agree that the mortgage was\nreleased before the debt was fully paid. Neither party has presented any facts to this Court that\nimplies the possibility nor existence of a third party interest. Although Cherry argues\nunder Biggs v. Smith, 184 So. 106, 107 (1938), that a recorded satisfaction of mortgage is \xe2\x80\x9cprima\nfacie evidence of extinguishment of a mortgage lien,\xe2\x80\x9d Biggs does not apply this standard to\nmortgage rights affected by a mistake in the satisfaction.\nTherefore, on these facts, this Court acknowledges that a vacatur is a proper remedy for Chase to\ncorrect its unilateral mistake since \xe2\x80\x9cequity will grant relief to those who have through mistake\nreleased a mortgage.\xe2\x80\x9d [Citation.] Accordingly, this Court holds that an equity action is required\nto make a vacatur enforceable unless the parties consent to the vacatur or a similar remedy\nduring the mortgage negotiation.\xe2\x80\xa6\nTender\nCherry has not made a mortgage payment to Chase since August 2000, but claims to have made\nthese payments into an escrow account, which he claims were paid to the escrow account\nbecause Chase recorded a satisfaction of his mortgage and, therefore, no mortgage existed.\nCherry also claims that representatives of Chase rejected his initial attempts to make payments\nbecause of a lack of a valid loan number. Chase, however, correctly argues that payments made\nto an escrow account are not a proper tender of payment. Matthews v. Lindsay, [Citation]\n(1884) (requiring tender to be made to the court). Nor did Cherry make the required mortgage\npayments to the court as provided by [relevant court rules], allowing for a \xe2\x80\x9cdeposit with the\ncourt all or any part of such sum or thing, whether that party claims all or any part of the sum or\nthing.\xe2\x80\x9d Further, Chase also correctly argues that Cherry\xe2\x80\x99s failure to tender the payments from\nthe escrow account or make deposits with the court is more than just a \xe2\x80\x9ctechnical breach\xe2\x80\x9d of the\nmortgage and note. [Citation.]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n632\n\n\x0cChase may, therefore, recover the entire amount of the mortgage indebtedness, unless the court\nfinds a \xe2\x80\x9climited circumstance\xe2\x80\x9d upon which the request may be denied. [Citation.] Although not\npresented by Chase in its discussion of this case, the Court may refuse foreclosure,\nnotwithstanding that the defendant established a foreclosure action, if the acceleration was\nunconscionable and the \xe2\x80\x9cresult would be inequitable and unjust.\xe2\x80\x9d This Court will analyze the\ninequitable result test and the limited circumstances by which the court may deny foreclosure.\nFirst, this Court does not find the mortgage acceleration unconscionable by assuming arguendo\n[for the purposes of argument] that the mortgage was valid during the period that the\nSatisfaction of Mortgage was entered into the public records. Chase did not send the first\nacceleration warning until November 14, 2000, the fourth month of non-payment, followed by\nthe second acceleration letter on March 16, 2001, the eighth month of non-payment. Although\nCherry could have argued that a foreclosure action was an \xe2\x80\x9cinequitable\xe2\x80\x9d and \xe2\x80\x9cunjust\xe2\x80\x9d result after\nthe Satisfaction of Mortgage was entered on his behalf, the result does not rise to an\nunconscionable level since Cherry could have properly tendered the mortgage payments to the\ncourt.\nSecond, the following \xe2\x80\x9climited circumstances\xe2\x80\x9d will justify a court\xe2\x80\x99s denial of foreclosure: 1)\nwaiver of right to accelerate; 2) mortgagee estopped from asserting foreclosure because\nmortgagor reasonably assumed the mortgagee would not foreclose; 3) mortgagee failed to\nperform a condition precedent for acceleration; 4) payment made after default but prior to\nreceiving intent to foreclose; or, 5) where there was intent to make to make timely payment, and\nit was attempted, or steps taken to accomplish it, but nevertheless the payment was not made\ndue to a misunderstanding or excusable neglect, coupled with some conduct of the mortgagee\nwhich in a measure contributed to the failure to pay when due or within the grace period.\n[Citations.]\nChase fails to address this fifth circumstance in its motion, an apparent obfuscation of the case\nlaw before the court. This Court acknowledges that Cherry\xe2\x80\x99s facts do not satisfy the first four\nlimited circumstances. Chase at no time advised Cherry that the acceleration right was being\nwaived; nor is Chase estopped from asserting foreclosure on the mortgage because of the\nadministrative error, and Cherry has not relied on this error to his detriment; and since Chase\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n633\n\n\x0csent the acceleration letter to Cherry and a request for payment to his attorney, there can be no\nargument that Cherry believed Chase would not foreclose. Chase has performed all conditions\nprecedent required by the mortgage provisions prior to notice of the acceleration; sending\nacceleration warnings on November 17, 2000, and March 16, 2001. Cherry also has no argument\nfor lack of notice of intent to accelerate after default since he has not tendered a payment since\nJuly 2000, thus placing him in default of the mortgage provisions, and he admits receiving the\nacceleration notices.\nThis Court finds, however, that this claim fails squarely into the final limited circumstance\nregarding intent to make timely payments. Significant factual issues exist as to the intent of\nCherry to make or attempt to make timely mortgage payments to Chase. Cherry claims that he\nattempted to make the payments, but was told by a representative of Chase that there was no\nmortgage loan number upon which to apply the payments. As a result, the mortgage payments\nwere placed into an account and later into his counsel\xe2\x80\x99s trust account as a mortgage escrow.\nAlthough these payments should have, at a minimum, been placed with the court to ensure\ntender during the resolution of the mortgage dispute, Cherry did take steps to accomplish timely\nmortgage payments. Although Cherry, through excusable neglect or a misunderstanding as to\nwhat his rights were after the Satisfaction of Mortgage was entered, failed to tender the\npayments, Chase is also not without fault; its conduct in entering a Satisfaction of Mortgage into\nthe Pinellas County public records directly contributed to Cherry\xe2\x80\x99s failure to tender timely\npayments. Cherry\xe2\x80\x99s attempt at making the mortgage payments, coupled with Chase\xe2\x80\x99s improper\nsatisfaction of mortgage fits squarely within the limited circumstance created to justify a court\xe2\x80\x99s\ndenial of a foreclosure. Equity here requires a balancing between Chase\xe2\x80\x99s right to the security\ninterest encumbered by the mortgage and Cherry\xe2\x80\x99s attempts to make timely payments. As such,\nthese limited circumstances exist to ensure that a foreclosure remains an action in equity. In\napplying this analysis, this Court finds that equity requires that Chase\xe2\x80\x99s request for foreclosure\nbe denied at this juncture.\xe2\x80\xa6\nReestablishment of the Lost Note and Mortgage\nChase also requests, as part of the foreclosure counterclaim, the reestablishment of the note\ninitially associated with the mortgage, as it is unable to produce the original note and provide by\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n634\n\n\x0caffidavit evidence of its loss. Chase has complied with the [necessary statutory]\nrequirements[.]\xe2\x80\xa6This Court holds the note to be reestablished and that Chase has the lawful\nright to enforce the note upon the issuance of this order.\nThis Court also agrees that Chase may reestablish the mortgage through a vacatur, revocation,\nand cancellation of satisfaction of mortgage. [Citation] (allowing the Equity Court to reestablish\na mortgage that was improperly canceled due to a mistake). However, this Court will deem the\nvacatur effective as of the date of this order. This Court leaves the status of the vacatur during\nthe disputed period, and specifically since May 3, 2001, to be resolved in subsequent\nproceedings.\xe2\x80\xa6Accordingly, it is:\nORDERED that [Chase cannot foreclose and] the request to reestablish the note and mortgage is\nhereby granted and effective as of the date of this order. Cherry will tender all previously\nescrowed mortgage payments to the Court, unless the parties agree otherwise, within ten days of\nthis order and shall henceforth, tender future monthly payments to Chase as set out in the\nreestablished note and mortgage.\n\nCASE QUESTIONS\n\n1. When Chase figured out that it had issued a Satisfaction of Mortgage erroneously, what did it\nfile to rectify the error?\n2. Cherry had not made any mortgage payments between the time Chase sent the erroneous\nSatisfaction of Mortgage notice to him and the time of the court\xe2\x80\x99s decision in this case. The\ncourt listed five circumstances in which a mortgagee (Chase here) might be denied the right\nto foreclose on a delinquent account: which one applied here? The court said Chase had\nengaged in \xe2\x80\x9can apparent obfuscation of the case law before the court\xe2\x80\x9d? What obfuscation\ndid it engage in?\n3. What did Cherry do with the mortgage payments after Chase erroneously told him the\nmortgage was satisfied? What did the court say he should have done with the payments?\n\nMechanic\xe2\x80\x99s Lien Filed against Landlord for Payment of Tenant\xe2\x80\x99s Improvements\nF & D Elec. Contractors, Inc. v. Powder Coaters, Inc.\n567 S.E.2d 842 (S.C. 2002)\nFactual/ Procedural Background\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n635\n\n\x0cBG Holding f/k/a Colite Industries, Inc. (\xe2\x80\x9cBG Holding\xe2\x80\x9d) is a one-third owner of about thirty\nacres of real estate in West Columbia, South Carolina. A warehouse facility is located on the\nproperty. In September 1996, Powder Coaters, Inc. (\xe2\x80\x9cPowder Coaters\xe2\x80\x9d) agreed to lease a portion\nof the warehouse to operate its business. Powder Coaters was engaged in the business of\nelectrostatically painting machinery parts and equipment and then placing them in an oven to\ncure. A signed lease was executed between Powder Coaters and BG Holding. Prior to signing the\nlease, Powder Coaters negotiated the terms with Mark Taylor, (\xe2\x80\x9cTaylor\xe2\x80\x9d) who was the property\nmanager for the warehouse facility and an agent of BG Holding.\nThe warehouse facility did not have a sufficient power supply to support Powder Coaters\xe2\x80\x99\nmachinery. Therefore, Powder Coaters contracted with F & D Electrical (\xe2\x80\x9cF & D\xe2\x80\x9d) to perform\nelectrical work which included installing two eight foot strip light fixtures and a two hundred\namp load center. Powder Coaters never paid F & D for the services. Powder Coaters was also\nunable to pay rent to BG Holding and was evicted in February 1997. Powder Coaters is no longer\na viable company.\nIn January 1997, F & D filed a Notice and Certificate of Mechanic\xe2\x80\x99s Lien and Affidavit of\nMechanic\xe2\x80\x99s Lien. In February 1997, F & D filed this action against BG Holding foreclosing on its\nmechanic\xe2\x80\x99s lien pursuant to S.C. [statute].\xe2\x80\xa6\nA jury trial was held on September 2nd and 3rd, 1998. At the close of F & D\xe2\x80\x99s evidence, and at\nthe close of all evidence, BG Holding made motions for directed verdicts, which were denied.\nThe jury returned a verdict for F & D in the amount of $8,264.00. The court also awarded F & D\nattorneys\xe2\x80\x99 fees and cost in the amount of $8,264.00, for a total award of $16,528.00.\nBG Holding appealed. The Court of Appeals, in a two to one decision, reversed the trial court,\nholding a directed verdict should have been granted to BG Holding on the grounds BG Holding\ndid not consent to the electrical upgrade, as is required by the Mechanic\xe2\x80\x99s Lien Statute. This\nCourt granted F & D\xe2\x80\x99s petition for certiorari, and the issue before this Court is:\nDid the trial court err in denying BG Holding\xe2\x80\x99s motion for directed verdict because the record\nwas devoid of any evidence of owner\xe2\x80\x99s consent to materialman\xe2\x80\x99s performance of work on its\nproperty as required by [the S.C. statute]?\n\nLaw/Analysis\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n636\n\n\x0cF & D argues the majority of the Court of Appeals erred in holding the facts of the case failed to\nestablish that BG Holding consented to the work performed by F & D, as is required by the\n[South Carolina] Mechanic\xe2\x80\x99s Lien Statute. We agree.\xe2\x80\xa6\nSouth Carolina\xe2\x80\x99s Mechanic\xe2\x80\x99s Lien Statute provides:\nA person to whom a debt is due for labor performed or furnished or for materials furnished and\nactually used in the erection, alteration, or repair of a building\xe2\x80\xa6by virtue of an agreement with,\nor by consent of, the owner of the building or structure, or a person having authority from, or\nrightfully acting for, the owner in procuring or furnishing the labor or materials shall have a\nlien upon the building or structure and upon the interest of the owner of the building or\nstructure \xe2\x80\xa6to secure the payment of the debt due. [emphasis added.]\nBoth parties in this case concede there was no express \xe2\x80\x9cagreement\xe2\x80\x9d between F & D and BG\nHolding. Therefore, the issue in this appeal turns on the meaning of the word \xe2\x80\x9cconsent\xe2\x80\x9d in the\nstatute, as applied in the landlord-tenant context. This is a novel issue in South Carolina.\nThis Court must decide who must give the consent, who must receive consent, and what type of\nconsent (general, specific, oral, written) must be given in order to satisfy the statute. Finally, the\nCourt must decide whether the evidence in this case shows BG Holding gave the requisite\nconsent.\n\nA. Who Must Receive the Consent.\nThe Court of Appeals\xe2\x80\x99 opinion in this case contemplates the consent must be between the\nmaterialman (lien claimant) and the landlord (owner). \xe2\x80\x9cIt is only logical\xe2\x80\xa6that consent under\n[the relevant section] must\xe2\x80\xa6be between the owner and the entity seeking the lien\xe2\x80\xa6\xe2\x80\x9d [Citation\nfrom Court of Appeals]. As stated previously, applying the Mechanic\xe2\x80\x99s Lien Statute in the\nlandlord-tenant context presents a novel issue. We find the consent required by the statute does\nnot have to be between the landlord/owner and the materialman, as the Court of Appeals\xe2\x80\x99\nopinion indicates. A determination that the required consent must come from the owner to the\nmaterialman means the materialman can only succeed if he can prove an agreement with the\nowner. Such an interpretation would render meaningless the language of the statute that\nprovides: \xe2\x80\x9c\xe2\x80\xa6by virtue of an agreement with, or by consent of the owner.\xe2\x80\xa6"\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n637\n\n\x0cTherefore, it is sufficient for the landlord/owner or his agent to give consent to his tenant. The\nlandlord/owner should be able to delegate to his tenant the responsibility for making the\nrequested improvements. The landlord/owner may not want to have direct involvement with the\nmaterialman or sub-contractors, but instead may wish to allow the tenant to handle any\nimprovements or upgrades himself. In addition, the landlord/owner may be located far away\nand may own many properties, making it impractical for him to have direct involvement with\nthe materialman. We find the landlord/owner or his agent is free to enter into a lease or\nagreement with a tenant which allows the tenant to direct the modifications to the property\nwhich have been specifically consented to by the landlord/owner or his agent.\nWe hold a landlord/owner or his agent can give his consent to the lessee/tenant, as well as\ndirectly to the lien claimant, to make modifications to the leased premises.\n\nB. What Kind of Consent Is Necessary.\nThis Court has already clearly held the consent required by [the relevant section] is \xe2\x80\x9csomething\nmore than a mere acquiescence in a state of things already in existence. It implies an agreement\nto that which, but for the consent, could not exist, and which the party consenting has a right to\nforbid.\xe2\x80\x9d [Citations.] However, our Mechanics Lien Statute has never been applied in the\nlandlord-tenant context where a third party is involved.\nOther jurisdictions have addressed this issue. The Court of Appeals cited [a Connecticut case,\n1987] in support of its holding. We agree with the Court of Appeals that the Connecticut court\xe2\x80\x99s\nreasoning is persuasive, especially since Connecticut has a similar mechanics lien statute.\xe2\x80\xa6\nThe Connecticut courts have stated \xe2\x80\x9cthe consent required from the owner or one acting under\nthe owner\xe2\x80\x99s authority is more than the mere granting of permission for work to be conducted on\none\xe2\x80\x99s property; or the mere knowledge that work was being performed on one\xe2\x80\x99s land.\xe2\x80\x9d\nFurthermore, although the Connecticut courts have stated the statute does not require an\nexpress contract, the courts have required \xe2\x80\x9cconsent that indicates an agreement that the owner\nof\xe2\x80\xa6the land shall be, or may be, liable for the materials or labor.\xe2\x80\x9d\xe2\x80\xa6\nThe reasoning of [Connecticut and other states that have decided this issue] is persuasive. F &\nD\xe2\x80\x99s brief appears to argue that mere knowledge by the landowner that the work needed to be\ndone, coupled with the landlord\xe2\x80\x99s general \xe2\x80\x9cpermission\xe2\x80\x9d to perform the work, is enough to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n638\n\n\x0cestablish consent under the statute. Under this interpretation, a landlord who knew a tenant\nneeded to improve, upgrade, or add to the leased premises would be liable to any contractor\nand/or subcontractor who performed work on his land. Under F & D\xe2\x80\x99s interpretation the\nlandlord would not be required to know the scope, cost, etc. of the work, but would only need to\ngive the tenant general permission to perform upgrades or improvements.\nClearly, if the landlord/owner or his agent gives consent directly to the materialman, a lien can\nbe established. Consent can also be given to the tenant, but the consent needs to be specific. The\nlandlord/owner or his agent must know the scope of the project (for instance, as the lease\nprovided in the instant case, the landlord could approve written plans submitted by the tenant).\nThe consent needs to be more than \xe2\x80\x9cmere knowledge\xe2\x80\x9d that the tenant will perform work on the\nproperty. There must be some kind of express or implied agreement that the landlord may be\nheld liable for the work or material. The landlord/owner or his agent may delegate the project or\nwork to his tenant, but there must be an express or implied agreement about the specific work to\nbe done. A general provision in a lease which allows tenant to make repairs or improvements is\nnot enough.\n\nC. Evidence There Was No Consent\n\xe2\x80\xa2\n\nThe record is clear that no contract, express or implied, existed between BG Holding and F & G.\nBG Holding had no knowledge F & G would be performing the work.\n\n\xe2\x80\xa2\n\nF & G\xe2\x80\x99s supervisor, David Weatherington, and Ray Dutton, the owner of F & D, both testified\nthey never had a conversation with anyone from BG Holding. In fact, until Powder Coaters failed\nto pay under the contract, F & D did not know BG Holding was the owner of the building.\n\n\xe2\x80\xa2\n\nMark Taylor, BG Holding\xe2\x80\x99s agent, testified he never authorized any work by F & D, nor did he\nsee any work being performed by them on the site.\n\n\xe2\x80\xa2\n\nThe lease specifically provided that all work on the property was to be approved in writing by BG\nHolding.\n\n\xe2\x80\xa2\n\nDavid Weatherington of F & D testified he was looking to Powder Coaters, not BG Holding, for\npayment.\n\n\xe2\x80\xa2\n\nPowder Coaters acknowledged it was not authorized to bind BG Holding to pay for the\nmodifications.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n639\n\n\x0c\xe2\x80\xa2\n\nThe lease states, \xe2\x80\x9c[i]f the Lessee should make any [alterations, modification, additions, or\ninstallations], the Lessee hereby agrees to indemnify, defend, and save harmless the Lessor from\nany liability\xe2\x80\xa6\xe2\x80\x9d\n\nD. Evidence There Was Consent\n\xe2\x80\xa2\n\nBruce Houston, owner of Powder Coaters testified that during the lease negotiations, he\ninformed Mark Taylor, BG Holding\xe2\x80\x99s property manager and agent, that electrical and gas\nupgrading would be necessary for Powder Coaters to perform their work.\n\n\xe2\x80\xa2\n\nHouston testified Mark Taylor was present at the warehouse while F & D performed their work.\n[However, Taylor testified he did not see F & D performing any work on the premises.]\n\n\xe2\x80\xa2\n\nHouston testified he would not have entered into the lease if he was not authorized to upgrade\nthe electrical since the existing power source was insufficient to run the machinery needed for\nPowder Coaters to operate.\n\n\xe2\x80\xa2\n\nHouston testified Mark Taylor, BG Holding\xe2\x80\x99s agent, showed him the power source for the\nbuilding so Taylor could understand the extent of the work that was going to be required.\n\n\xe2\x80\xa2\n\nHouston testified Paragraph 5 of the addendum to the lease was specifically negotiated. He\ntestified the following language granted him the authority to perform the electrical upfit, so that\nhe was not required to submit the plans to BG Holding as required by a provision in the lease:\n\xe2\x80\x9cLessor shall allow Lessee to put Office Trailer in Building. All Utilities necessary to handle\nLessee\xe2\x80\x99s equipment shall be paid for by the Lessee including, but not limited to electricity, water,\nsewer, and gas.\xe2\x80\x9d (We note that BG Holding denies this interpretation, but insists it just requires\nthe Lessee to pay for all utility bills.)\n\n\xe2\x80\xa2\n\nPowder Coaters no longer occupies the property, and BG Holding possibly benefits from the\nwork done.\nIn the instant case, there is some evidence of consent. However, it does not rise to the level\nrequired under the statute.\xe2\x80\xa6\nViewing the evidence in the light most favorable to F & D, whether BG Holding gave their\nconsent is a close question. However, we agree with the Court of Appeals, that F & D has not\npresented enough evidence to show: (1) BG Holding gave anything more than general consent to\nmake improvements (as the lease could be interpreted to allow); or (2) BG Holding had anything\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n640\n\n\x0cmore that \xe2\x80\x9cmere knowledge\xe2\x80\x9d that the work was to be done. Powder Coaters asserted the lease\xe2\x80\x99s\naddendum evidenced BG Holding\xe2\x80\x99s consent to perform the modifications; however, there is no\nevidence BG Holding expressly or implicitly agreed that it might be liable for the work. In fact,\nthe lease between Powder Coaters and BG Holding expressly provided Powder Coaters was\nresponsible for any alterations made to the property. Even Powder Coaters acknowledged it was\nnot authorized to bind BG Holding.\xe2\x80\xa6Therefore, it is impossible to see how the very general\nprovision requiring Powder Coaters to pay for water, sewer, and gas can be interpreted to\nauthorize Powder Coaters to perform an electrical upgrade. Furthermore, we agree with the\nCourt of Appeals that the mere presence of BG Holding\xe2\x80\x99s agent at the work site is not enough to\nestablish consent.\n\nConclusion\nWe hold consent, as required by the Mechanic\xe2\x80\x99s Lien Statute, is something more than mere\nknowledge work will be or could be done on the property. The landlord/owner must do more\nthan grant the tenant general permission to make repairs or improvements to the leased\npremises. The landlord/owner or his agent must give either his tenant or the materialman\nexpress or implied consent acknowledging he may be held liable for the work.\nThe Court of Appeals\xe2\x80\x99 opinion is affirmed as modified.\n\nCASE QUESTIONS\n\n1. Why did the lienor want to go after the landlord instead of the tenant?\n2. Did the landlord here know that there were electrical upgrades needed by the tenant?\n3. What kind of knowledge or acceptance did the court determine the landlord-owner needed\nto have or give before a material man could have a lien on the real estate?\n4. What remedy has F & D (the material man) now?\n\nDeeds of Trust; Duties of Trustee\nAlpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, II (SFI).\n2005 WL 715940, (Wash. Ct. App. 2005)\nApplewick, J.\nAlpha Imperial LLC challenges the validity of a non-judicial foreclosure sale on multiple\ngrounds. Alpha was the holder of a third deed of trust on the building sold, and contests the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n641\n\n\x0clocation of the sale and the adequacy of the sale price. Alpha also claims that the trustee had a\nduty to re-open the sale, had a duty to the junior lienholder, chilled the bidding, and had a\nconflict of interest. We find that the location of the sale was proper, the price was adequate,\nbidding was not chilled, and that the trustee had no duty to re-open the sale, [and] no duty to\nthe junior lienholder.\xe2\x80\xa6We affirm.\n\nFacts\nMayur Sheth and another individual formed Alpha Imperial Building, LLC in 1998 for the\npurpose of investing in commercial real estate. In February 2000 Alpha sold the property at\n1406 Fourth Avenue in Seattle (the Property) to Pioneer Northwest, LLC (Pioneer). Pioneer\nfinanced this purchase with two loans from [defendant Schnitzer Family Investment, LLC, II\n(SFI)]. Pioneer also took a third loan from Alpha at the time of the sale for $1.3 million. This\nloan from Alpha was junior to the two [other] loans[.]\nPioneer defaulted and filed for bankruptcy in 2002.\xe2\x80\xa6In October 2002 defendant Blackstone\nCorporation, an entity created to act as a non-judicial foreclosure trustee, issued a Trustee\xe2\x80\x99s\nNotice of Sale. Blackstone is wholly owned by defendant Witherspoon, Kelley, Davenport &\nToole (Witherspoon). Defendant Michael Currin, a shareholder at Witherspoon, was to conduct\nthe sale on January 10, 2003. Currin and Witherspoon represented SFI and 4th Avenue LLC.\nSheth received a copy of the Notice of Sale through his attorney.\nOn January 10, 2003, Sheth and his son Abhi arrived at the Third Avenue entrance to the King\nCounty courthouse between 9:30 and 9:45 a.m. They waited for about ten minutes. They noticed\ntwo signs posted above the Third Avenue entrance. One sign said that construction work was\noccurring at the courthouse and \xe2\x80\x98all property auctions by the legal and banking communities will\nbe moved to the 4th Avenue entrance of the King County Administration Building.\xe2\x80\x99 The other\nsign indicated that the Third Avenue entrance would remain open during construction. Sheth\nand Abhi asked a courthouse employee about the sign, and were told that all sales were\nconducted at the Administration Building.\nSheth and Abhi then walked to the Administration Building, and asked around about the sale of\nthe Property. [He was told Michael Currin, one of the shareholders of Blackstone\xe2\x80\x94the trustee\xe2\x80\x94\nwas holding the sale, and was advised] to call Currin\xe2\x80\x99s office in Spokane. Sheth did so, and was\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n642\n\n\x0ctold that the sale was at the Third Avenue entrance. Sheth and Abhi went back to the Third\nAvenue entrance.\nIn the meantime, Currin had arrived at the Third Avenue entrance between 9:35 and 9:40 a.m.\nThe head of SFI, Danny Schnitzer (Schnitzer), and his son were also present. Currin was\nsurprised to notice that no other foreclosure sales were taking place, but did not ask at the\ninformation desk about it. Currin did not see the signs directing auctions to occur at the\nAdministration Building. Currin conducted the auction, Schnitzer made the only bid, for $2.1\nmillion, and the sale was complete. At this time, the debt owed on the first two deeds of trust\ntotaled approximately $4.1 million. Currin then left the courthouse, but when he received a call\nfrom his assistant telling him about Sheth, he arranged to meet Sheth back at the Third Avenue\nentrance. When they met, Sheth told Currin that the sales were conducted at the Administration\nBuilding. Currin responded that the sale had already been conducted, and he was not required\nto go to the Administration Building. Currin told Sheth that the notice indicated the sale was to\nbe at the Third Avenue entrance, and that the sale had been held at the correct location. Sheth\ndid not ask to re-open the bidding.\xe2\x80\xa6\nSheth filed the current lawsuit, with Alpha as the sole plaintiff, on February 14, 2003. The\nlawsuit asked for declaratory relief, restitution, and other damages. The trial court granted the\ndefendants\xe2\x80\x99 summary judgment motion on August 8, 2003. Alpha appeals.\nLocation of the Sale\nAlpha argues that the sale was improper because it was at the Third Avenue entrance, not the\nAdministration Building. Alpha points to a letter from a King County employee stating that\nauctions are held at the Administration Building. The letter also stated that personnel were\ninstructed to direct bidders and trustees to that location if asked. In addition, Alpha argues that\nthe Third Avenue entrance was not a \xe2\x80\x98public\xe2\x80\x99 place, as required by [the statute], since auction\nsales were forbidden there. We disagree. Alpha has not shown that the Third Avenue entrance\nwas an improper location. The evidence shows that the county had changed its policy as to\nwhere auctions would be held and had posted signs to that effect. However, the county did not\nexclude people from the Third Avenue entrance or prevent auctions from being held there.\nStreet, who frequented sales, stated that auctions were being held in both locations. The sale was\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n643\n\n\x0cheld where the Notice of Sale indicated it would be. In addition, Alpha has not introduced any\nevidence to show that the Third Avenue entrance was not a public place at the time of the sale.\nThe public was free to come and go at that location, and the area was \xe2\x80\x98open and available for all\nto use.\xe2\x80\x99 Alpha relies on Morton v. Resolution Trust(S.D. Miss. 1995) to support its contention\nthat the venue of the sale was improper. [But] Morton is not on point.\n\nDuty to Re-Open Sale\nAlpha argues that Currin should have re-opened the sale. However, it is undisputed that Sheth\ndid not request that Currin re-open it. The evidence indicates that Currin may have known\nabout Sheth\xe2\x80\x99s interest in bidding prior to the day of the sale, due to a conversation with Sheth\xe2\x80\x99s\nattorney about Sheth\xe2\x80\x99s desire to protect his interest in the Property. But, this knowledge did not\ncreate in Currin any affirmative duty to offer to re-open the sale.\nIn addition, Alpha cites no Washington authority to support the contention that Currin would\nhave been obligated to re-open the sale if Sheth had asked him to. The decision to continue a\nsale appears to be fully within the discretion of the trustee: \xe2\x80\x9c[t]he trustee may for any cause the\ntrustee deems advantageous, continue the sale.\xe2\x80\x9d [Citation.] Alpha\xe2\x80\x99s citation to Peterson v.\nKansas City Life Ins. Co., Missouri (1936) to support its contention that Currin should have reopened the sale is unavailing. In Peterson, the Notice of Sale indicated that the sale would be\nheld at the \xe2\x80\x98front\xe2\x80\x99 door of the courthouse. But, the courthouse had four doors, and the customary\ndoor for sales was the east door. The sheriff, acting as the trustee, conducted the sale at the east\ndoor, and then re-opened the sale at the south door, as there had been some sales at the south\ndoor. Alpha contends this shows that Currin should have re-opened the sale when learning of\nthe Administration Building location, akin to what the sheriff did in Peterson. However,\nPeterson does not indicate that the sheriff had an affirmative duty to re-sell the property at the\nsouth door. This case is not on point.\n\nChilled Bidding\nAlpha contends that Currin chilled the bidding on the Property by telling bidders that he\nexpected a full credit sale price and by holding the sale at the courthouse. Chilled bidding can be\ngrounds for setting aside a sale. Country Express Stores, Inc. v. Sims,[Washington Court of\nAppeals] (1997). The Country Express court explained the two types of chilled bidding:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n644\n\n\x0cThe first is intentional, occurring where there is collusion for the purpose of holding down the\nbids. The second consists of inadvertent and unintentional acts by the trustee that have the\neffect of suppressing the bidding. To establish chilled bidding, the challenger must establish the\nbidding was actually suppressed, which can sometimes be shown by an inadequate sale price.\nWe hold that there was no chilling. Alpha has not shown that Currin engaged in intentional\nchilling. There is no evidence that Currin knew about the signs indicating auctions were\noccurring at the Administration Building when he prepared the Notice of Sale, such that he\nintentionally held the sale at a location from which he knew bidders would be absent.\nAdditionally, Currin\xe2\x80\x99s statement to [an interested person who might bid on the property] that a\nfull credit sale price was expected and that the opening bid would be $4.1 million did not\nconstitute intentional chilling. SFI was owed $4.1 million on the Property. SFI could thus bid up\nto that amount at no cost to itself, as the proceeds would go back to SFI. Currin confirmed that\nSFI was prepared to make a full-credit bid. [It is common for trustees to] disclose the full-credit\nbid amount to potential third party bidders, and for investors to lose interest when they learn of\nthe amount of indebtedness on property. It was therefore not a misrepresentation for Currin to\nstate $4.1 million as the opening bid, due to the indebtedness on the Property. Currin\xe2\x80\x99s\nstatements had no chilling effect\xe2\x80\x94they merely informed [interested persons] of the minimum\namount necessary to prevail against SFI. Thus, Currin did not intentionally chill the bidding by\ngiving Street that information.\nAlpha also argues that the chilled bidding could have been unintended by Currin.\xe2\x80\xa6 [But the\nevidence is that] Currin\xe2\x80\x99s actions did not intentionally or unintentionally chill the bidding, and\nthe sale will not be set aside.\n\nAdequacy of the Sale Price\nAlpha claims that the sale price was \xe2\x80\x98greatly inadequate\xe2\x80\x99 and that the sale should thus be set\naside. Alpha submitted evidence that the property had an \xe2\x80\x98as is\xe2\x80\x99 value of $4.35 million in\nDecember 2002, and an estimated 2004 value of $5.2 million. The debt owed to SFI on the\nproperty was $4.1 million. SFI bought the property for $2.1 million. These facts do not suggest\nthat the sale must be set aside.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n645\n\n\x0cWashington case law suggests that the price the property is sold for must be \xe2\x80\x98grossly inadequate\xe2\x80\x99\nfor a trustee\xe2\x80\x99s sale to be set aside on those grounds alone. In Cox [Citation, 1985], the property\nwas worth between $200,000 and $300,000, and was sold to the beneficiary for $11,873. The\nCourt held that amount to be grossly inadequate InSteward [Citation, 1988] the property had\nbeen purchased for approximately $64,000, and then was sold to a third party at a foreclosure\nsale for $4,870. This court held that $4,870 was not grossly inadequate. In Miebach [Citation]\n(1984), the Court noted that a sale for less than two percent of the property\xe2\x80\x99s fair market value\nwas grossly inadequate. The Court in Miebach also noted prior cases where the sale had been\nvoided due to grossly inadequate purchase price; the properties in those cases had been sold for\nless than four percent of the value and less than three percent of the value. In addition, the\nRestatement indicates that gross inadequacy only exists when the sale price is less than 20\npercent of the fair market value\xe2\x80\x94without other defects, sale prices over 20 percent will not be\nset aside. [Citation.] The Property was sold for between 40 and 48 percent of its value. These\nfacts do not support a grossly inadequate purchase price.\nAlpha cites Miebach for the proposition that \xe2\x80\x98where the inadequacy of price is great the sale will\nbe set aside with slight indications of fraud or unfairness,\xe2\x80\x99 arguing that such indications existed\nhere. However, the cases cited by the Court in Miebach to support this proposition involved\nproperties sold for less than three and four percent of their value. Alpha has not demonstrated\nthe slightest indication of fraud, nor shown that a property that sold for 40 to 48 percent of its\nvalue sold for a greatly inadequate price.\n\nDuty to a Junior Lienholder\nAlpha claims that Currin owed a duty to Alpha, the junior lienholder. Alpha cites no case law for\nthis proposition, and, indeed, there is none\xe2\x80\x94Division Two specifically declined to decide this\nissue in Country Express [Citation]. Alpha acknowledges the lack of language in RCW 61.24 (the\ndeed of trust statute) regarding fiduciary duties of trustees to junior lienholders. But Alpha\nargues that since RCW 61.24 requires that the trustee follow certain procedures in conducting\nthe sale, and allows for sales to be restrained by anyone with an interest, a substantive duty from\nthe trustee to a junior lienholder can be inferred.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n646\n\n\x0cAlpha\xe2\x80\x99s arguments are unavailing. The procedural requirements in RCW 61.24 do not create\nimplied substantive duties. The structure of the deed of trust sale illustrates that no duty is owed\nto the junior lienholder. The trustee and the junior lienholder have no relationship with each\nother. The sale is pursuant to a contract between the grantor, the beneficiary and the trustee.\nThe junior lienholder is not a party to that contract. The case law indicates only that the trustee\nowes a fiduciary duty to the debtor and beneficiary: \xe2\x80\x9ca trustee of a deed of trust is a fiduciary for\nboth the mortgagee and mortgagor and must act impartially between them.\xe2\x80\x9d Cox [Citation]. The\nfact that a sale in accordance with that contract can extinguish the junior lienholder\xe2\x80\x99s interest\nfurther shows that the grantor\xe2\x80\x99s and beneficiary\xe2\x80\x99s interest in the deed of trust being foreclosed is\nadverse to the junior lienholder. We conclude the trustee, while having duties as fiduciary for\nthe grantor and beneficiary, does not have duties to another whose interest is adverse to the\ngrantor or beneficiary. Thus, Alpha\xe2\x80\x99s claim of a special duty to a junior lienholder fails.\xe2\x80\xa6\n\nAttorney Fees\n\xe2\x80\xa6Defendants claim they are entitled to attorney fees for opposing a frivolous claim, pursuant to\n[the Washington statute]. An appeal is frivolous \xe2\x80\x98if there are no debatable issues upon which\nreasonable minds might differ and it is so totally devoid of merit that there was no reasonable\npossibility of reversal.\xe2\x80\x99 [Citation] Alpha has presented several issues not so clearly resolved by\ncase law as to be frivolous, although Alpha\xe2\x80\x99s arguments ultimately fail. Thus, Respondents\xe2\x80\x99\nrequest for attorney fees under [state law] is denied.\nAffirmed.\n\nCASE QUESTIONS\n\n1. Why did the plaintiff (Alpha) think the sale should have been set aside because of the\nlocation problems?\n2. Why did the court decide the trustee had no duty to reopen bidding?\n3. What is meant by \xe2\x80\x9cchilling bidding\xe2\x80\x9d? What argument did the plaintiff make to support its\ncontention that bidding was chilled?\n4. The court notes precedent to the effect that a \xe2\x80\x9cgrossly inadequate\xe2\x80\x9d bid price has some\ndefinition. What is the definition? What percentage of the real estate\xe2\x80\x99s value in this case was\nthe winning bid?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n647\n\n\x0c5. A trustee is one who owes a fiduciary duty of the utmost loyalty and good faith to another,\nthe beneficiary. Who was the beneficiary here? What duty is owed to the junior lienholder\n(Alpha here)\xe2\x80\x94any duty?\n6. Why did the defendants not get the attorneys\xe2\x80\x99 fee award they wanted?\n\n17.5 Summary and Exercises\nSummary\n\nA mortgage is a means of securing a debt with real estate. The mortgagor, or borrower, gives the\nmortgage. The lender is the mortgagee, who holds the mortgage. On default, the mortgagee may\nforeclose the mortgage, convening the security interest into title. In many states, the mortgagor\nhas a statutory right of redemption after foreclosure.\nVarious statutes regulate the mortgage business, including the Truth in Lending Act, the Equal\nCredit Opportunity Act, the Real Estate Settlement Procedures Act, and the Home Mortgage\nDisclosure Act, which together prescribe a code of fair practices and require various disclosures\nto be made before the mortgage is created.\nThe mortgagor signs both a note and the mortgage at the closing. Without the note, the\nmortgage would secure nothing. Most notes and mortgages contain an acceleration clause,\nwhich calls for the entire principal and interest to be due, at the mortgagee\xe2\x80\x99s option, if the debtor\ndefaults on any payment.\nIn most states, mortgages must be recorded for the mortgagee to be entitled to priority over\nthird parties who might also claim an interest in the land. The general rule is \xe2\x80\x9cFirst in time, first\nin right,\xe2\x80\x9d although there are exceptions for fixture filings and nonobligatory future advances.\nMortgages are terminated by repayment, novation, or foreclosure, either through judicial sale or\nunder a power-of-sale clause.\nReal estate may also be used as security under a deed of trust, which permits a trustee to sell the\nland automatically on default, without recourse to a court of law.\nNonconsensual liens are security interests created by law. These include court-decreed liens,\nsuch as attachment liens and judgment liens. Other liens are mechanic\xe2\x80\x99s liens (for labor,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n648\n\n\x0cservices, or materials furnished in connection with someone\xe2\x80\x99s real property), possessory liens\n(for artisans working with someone else\xe2\x80\x99s personal properly), and tax liens.\n\nEXERCISES\n\n1. Able bought a duplex from Carr, who had borrowed from First Bank for its purchase.\nAble took title subject to Carr\xe2\x80\x99s mortgage. Able did not make mortgage payments\nto First Bank; the bank foreclosed and sold the property, leaving a deficiency.\nWhich is correct?\na.\n\nCarr alone is liable for the deficiency.\n\nb. Able alone is liable for the deficiency because he assumed the mortgage.\nc. First Bank may pursue either Able or Carr.\nd. Only if Carr fails to pay will Able be liable.\nHarry borrowed $175,000 from Judith, giving her a note for that amount and a mortgage\non his condo. Judith did not record the mortgage. After Harry defaulted on his payments,\nJudith began foreclosure proceedings. Harry argued that the mortgage was invalid because\nJudith had failed to record it. Judith counterargues that because a mortgage is not an interest\nin real estate, recording is not necessary. Who is correct? Explain.\nAssume in Exercise 2 that the documents did not contain an acceleration clause and that\nHarry missed three consecutive payments. Could Judith foreclose? Explain.\nRupert, an automobile mechanic, does carpentry work on weekends. He built a detached\ngarage for Clyde for $20,000. While he was constructing the garage, he agreed to tune up\nClyde\xe2\x80\x99s car for an additional $200. When the work was completed, Clyde failed to pay him\nthe $20,200, and Rupert claimed a mechanic\xe2\x80\x99s lien on the garage and car. What problems, if\nany, might Rupert encounter in enforcing his lien? Explain.\nIn Exercise 4, assume that Clyde had borrowed $50,000 from First Bank and had given the\nbank a mortgage on the property two weeks after Rupert commenced work on the garage\nbut several weeks before he filed the lien. Assuming that the bank immediately recorded its\nmortgage and that Rupert\xe2\x80\x99s lien is valid, does the mortgage take priority over the lien? Why?\nDefendant purchased a house from Seller and assumed the mortgage indebtedness to\nPlaintiff. All monthly payments were made on time until March 25, 1948, when no more\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n649\n\n\x0cwere made. On October 8, 1948, Plaintiff sued to foreclose and accelerate the note. In\nFebruary of 1948, Plaintiff asked to obtain a loan elsewhere and pay him off; he offered a\ndiscount if she would do so, three times, increasing the amount offered each time. Plaintiff\nunderstood that Defendant was getting a loan from the Federal Housing Administration\n(FHA), but she was confronted with a number of requirements, including significant property\nimprovements, which\xe2\x80\x94because they were neighbors\xe2\x80\x94Plaintiff knew were ongoing. While\nthe improvements were being made, in June or July, he said to her, \xe2\x80\x9cJust let the payments go\nand we\xe2\x80\x99ll settle everything up at the same time,\xe2\x80\x9d meaning she need not make monthly\npayments until the FHA was consummated, and he\xe2\x80\x99d be paid from the proceeds. But then\n\xe2\x80\x9che changed his tune\xe2\x80\x9d and sought foreclosure. Should the court order it?\n\nSELF-TEST QUESTIONS\n\n1. The person or institution holding a mortgage is called\na.\n\nthe mortgagor\nb. the mortgagee\nc. the debtor\nd. none of the above\nMortgages are regulated by\n\na.\n\nthe Truth in Lending Act\nb. the Equal Credit Opportunity Act\nc. the Real Estate Settlement Procedures Act\nd. all of the above\nAt the closing, a mortgagor signs\na.\n\nonly a mortgage\n\nb. only a note\nc. either a note or the mortgage\nd. both a note and the mortgage\nMortgages are terminated by\na.\n\nrepayment\n\nb. novation\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n650\n\n\x0cc. foreclosure\nd. any of the above\nA lien ordered against a person\xe2\x80\x99s property to prevent its disposal during a\nlawsuit is called\na.\n\na judgment lien\n\nb. an attachment lien\nc. a possessory lien\nd. none of the above\n\nSELF-TEST ANSWERS\n\n1. b\n2. d\n3. d\n4. d\n5. b\n\nChapter 18\nBailments and the Storage, Shipment, and Leasing\nof Goods\nLEARNING OBJECTIVES\n\nAfter reading this chapter, you should understand the following:\n1. What the elements of a bailment are\n2. What the bailee\xe2\x80\x99s liability is\n3. What the bailor\xe2\x80\x99s liability is\n4. What other rights and duties\xe2\x80\x94compensation, bailee\xe2\x80\x99s liens, casualty to goods\xe2\x80\x94arise\n5. What special types of bailments are recognized: innkeepers, warehousing\n6. What rules govern the shipment of goods\n7. How commodity paper is negotiated and transferred\n\n18.1 Introduction to Bailment Law\n\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n651\n\n\x0c1. Understand what a bailment is, and why the law of bailment is important.\n2. Recognize how bailments compare with sales.\n3. Point out the elements required to create a bailment.\nFinally, we turn to the legal relationships that buyers and sellers have with warehousers and\ncarriers\xe2\x80\x94the parties responsible for physically transferring goods from seller to buyer. This\ntopic introduces a new branch of law\xe2\x80\x94that of bailments; we\xe2\x80\x99ll examine it before turning directly\nto warehousers and carriers.\n\nOverview of Bailments\nA bailment is the relationship established when someone entrusts his property temporarily to\nsomeone else without intending to give up title. Although bailment has often been said to arise\nonly through a contract, the modern definition does not require that there be an agreement. One\nwidely quoted definition holds that a bailment is \xe2\x80\x9cthe rightful possession of goods by one who is\nnot the owner. It is the element of lawful possession, however created, and the duty to account\nfor the thing as the property of another, that creates the bailment, regardless of whether such\npossession is based upon contract in the ordinary sense or not.\xe2\x80\x9d [1]\nThe word bailment derives from a Latin verb, bajulare, meaning \xe2\x80\x9cto bear a burden,\xe2\x80\x9d and then\nfrom French, bailler, which means \xe2\x80\x9cto deliver\xe2\x80\x9d (i.e., into the hands or possession of someone).\nThe one who bails out a boat, filling a bucket and emptying it overboard, is a water-bearer. The\none who bails someone out of jail takes on the burden of ensuring that the one sprung appears\nin court to stand trial; he also takes on the risk of loss of bond money if the jailed party does not\nappear in court. The one who is abailee takes on the burden of being responsible to return the\ngoods to their owner.\nThe law of bailments is important to virtually everyone in modern society: anyone who has ever\ndelivered a car to a parking lot attendant, checked a coat in a restaurant, deposited property in a\nsafe-deposit box, rented tools, or taken items clothes or appliance in to a shop for repair. In\ncommercial transactions, bailment law governs the responsibilities of warehousers and the\ncarriers, such as UPS and FedEx, that are critical links in the movement of goods from\nmanufacturer to the consumer. Bailment law is an admixture of common law (property and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n652\n\n\x0ctort), state statutory law (in the Uniform Commercial Code; UCC), federal statutory law, and\xe2\x80\x94\nfor international issues\xe2\x80\x94treaty. [2]\n\nBailments Compared with Sales\nBailment versus Sales\nIn a sale, the buyer acquires title and must pay for the goods. In a bailment, the bailee acquires\npossession and must return the identical object. In most cases the distinction is clear, but\ndifficult borderline cases can arise. Consider the sad case of the leased cows: Carpenter v.\nGriffen (N.Y. 1841). Carpenter leased a farm for five years to Spencer. The lease included thirty\ncows. At the end of the term, Spencer was to give Carpenter, the owner, \xe2\x80\x9ccows of equal age and\nquality.\xe2\x80\x9d Unfortunately, Spencer fell into hard times and had to borrow money from one Griffin.\nWhen the time came to pay the debt, Spencer had no money, so Griffin went to court to levy\nagainst the cows (i.e., he sought a court order giving him the cows in lieu of the money owed).\nNeedless to say, this threatened transfer of the cows upset Carpenter, who went to court to stop\nGriffin from taking the cows. The question was whether Spencer was a bailee, in which case the\ncows would still belong to Carpenter (and Griffin could not levy against them), or a purchaser, in\nwhich case Spencer would own the cows and Griffin could levy against them. The court ruled\nthat title had passed to Spencer\xe2\x80\x94the cows were his. Why? The court reasoned that Spencer was\nnot obligated to return the identical cows to Carpenter, hence Spencer was not a\nbailee. [3] Section 2-304(1) of the UCC confirms this position, declaring that whenever the price\nof a sale is payable in goods, each party is a seller of the goods that he is to transfer.\nNote the implications that flow from calling this transaction a sale. Creditors of the purchaser\ncan seize the goods. The risk of loss is on the purchaser. The seller cannot recover the goods (to\nmake up for the buyer\xe2\x80\x99s failure to pay him) or sell them to a third party.\n\nFungible Goods\nFungible goods (goods that are identical, like grain in a silo) present an especially troublesome\nproblem. In many instances the goods of several owners are mingled, and the identical items are\nnot intended to be returned. For example, the operator of a grain elevator agrees to return an\nequal quantity of like-quality grain but not the actual kernels deposited there. Following the rule\nin Carpenter\xe2\x80\x99s cow case, this might seem to be a sale, but it is not. Under the UCC, Section 2Saylor URL: http://www.saylor.org/books\n\nSaylor.org\n653\n\n\x0c207, the depositors of fungible goods are \xe2\x80\x9ctenants in common\xe2\x80\x9d of the goods; in other words, the\ngoods are owned by all. This distinction between a sale and a bailment is important. When there\nis a loss through natural causes\xe2\x80\x94for example, if the grain elevator burns\xe2\x80\x94the depositors must\nshare the loss on a pro rata basis (meaning that no single depositor is entitled to take all his\ngrain out; if 20 percent of the grain was destroyed, then each depositor can take out no more\nthan 80 percent of what he deposited).\n\nElements of a Bailment\nAs noted, bailment is defined as \xe2\x80\x9cthe rightful possession of goods by one who is not the owner.\xe2\x80\x9d\nFor the most part, this definition is clear (and note that it does not dictate that a bailment be\ncreated by contract). Bailment law applies to the delivery of goods\xe2\x80\x94that is, to the delivery\npersonal property. Personal property is usually defined as anything that can be owned other\nthan real estate. As we have just seen in comparing bailments to sales, the definition implies a\nduty to return the identical goods when the bailment ends.\nBut one word in the definition is both critical and troublesome: possession. Possession requires\nboth a physical and a mental element. We examine these in turn.\n\nPossession: Physical Control\nIn most cases, physical control is proven easily enough. A car delivered to a parking garage is\nobviously within the physical control of the garage. But in some instances, physical control is\ndifficult to conceptualize. For example, you can rent a safe-deposit box in a bank to store\nvaluable papers, stock certificates, jewelry, and the like. The box is usually housed in the bank\xe2\x80\x99s\nvault. To gain access, you sign a register and insert your key after a bank employee inserts the\nbank\xe2\x80\x99s key. You may then inspect, add to, or remove contents of the box in the privacy of a small\nroom maintained in the vault for the purpose. Because the bank cannot gain access to the box\nwithout your key and does not know what is in the box, it might be said to have no physical\ncontrol. Nevertheless, the rental of a safe-deposit box is a bailment. In so holding, a New York\ncourt pointed out that if the bank was not in possession of the box renter\xe2\x80\x99s property \xe2\x80\x9cit is\ndifficult to know who was. Certainly [the renter] was not, because she could not obtain access to\nthe property without the consent and active participation of the defendant. She could not go into\nher safe unless the defendant used its key first, and then allowed her to open the box with her\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n654\n\n\x0cown key; thus absolutely controlling [her] access to that which she had deposited within the\nsafe. The vault was the [company\xe2\x80\x99s] and was in its custody, and its contents were under the same\nconditions.\xe2\x80\x9d [4] Statutes in some states, however, provide that the relationship is not a bailment\nbut that of a landlord and tenant, and many of these statutes limit the bank\xe2\x80\x99s liability for losses.\n\nPossession: Intent to Possess\nIn addition to physical control, the bailee must have had an intent to possess the goods; that is,\nto exercise control over them. This mental condition is difficult to prove; it almost always turns\non the specific circumstances and, as a fact question, is left to the jury to determine. To illustrate\nthe difficulty, suppose that one crisp fall day, Mimi goes to Sally Jane\xe2\x80\x99s Boutique to try on a\njacket. The sales clerk hands Mimi a jacket and watches while Mimi takes off her coat and places\nit on a nearby table. A few minutes later, when Mimi is finished inspecting herself in the mirror,\nshe goes to retrieve her coat, only to discover it is missing. Who is responsible for the loss? The\nanswer depends on whether the store is a bailee. In some sense the boutique had physical\ncontrol, but did it intend to exercise that control? In a leading case, the court held that it did,\neven though no one said anything about guarding the coat, because a store invites its patrons to\ncome in. Implicit in the act of trying on a garment is the removal of the garment being worn.\nWhen the customer places it in a logical place, with the knowledge of and without objection from\nthe salesperson, the store must exercise some care in its safekeeping. [5]\nNow suppose that when Mimi walked in, the salesperson told her to look around, to try on some\nclothes, and to put her coat on the table. When the salesperson was finished with her present\ncustomer, she said, she would be glad to help Mimi. So Mimi tried on a jacket and minutes later\ndiscovered her coat gone. Is this a bailment? Many courts, including the New York courts, would\nsay no. The difference? The salesperson was helping another customer. Therefore, Mimi had a\nbetter opportunity to watch over her own coat and knew that the salesperson would not be\nlooking out for it. This is a subtle distinction, but it has been sufficient in many cases to change\nthe ruling. [6]\nQuestions of intent and control frequently arise in parking lot cases. As someone once said, \xe2\x80\x9cThe\nkey to the problem is the key itself.\xe2\x80\x9d The key is symbolic of possession and intent to possess. If\nyou give the attendant your key, you are a bailor and he (or the company he works for) is the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n655\n\n\x0cbailee. If you do not give him the key, no bailment arises. Many parking lot cases do not fall\nneatly within this rule, however. Especially common are cases involving self-service airport\nparking lots. The customer drives through a gate, takes a ticket dispensed by a machine, parks\nhis car, locks it, and takes his key. When he leaves, he retrieves the car himself and pays at an\nexit gate. As a general rule, no bailment is created under these circumstances. The lot operator\ndoes not accept the vehicle nor intend to watch over it as bailee. In effect, the operator is simply\nrenting out space. [7] But a slight change of facts can alter this legal conclusion. Suppose, for\ninstance, that the lot had an attendant at the single point of entrance and exit, that the attendant\njotted down the license number on the ticket, one portion of which he retained, and that the car\nowner must surrender the ticket when leaving or prove that he owns the car. These facts have\nbeen held to add up to an intention to exercise custody and control over the cars in the lot, and\nhence to have created a bailment. [8]\nFor a bailment to exist, the bailee must know or have reason to know that the property exists.\nWhen property is hidden within the main object entrusted to the bailee, lack of notice can defeat\nthe bailment in the hidden property. For instance, a parking lot is not responsible for the\ndisappearance of valuable golf clubs stored in the trunk of a car, nor is a dance hall cloak room\nresponsible for the disappearance of a fur wrap inside a coat, if they did not know of their\nexistence. [9] This result is usually justified by observing that when a person is unaware that\ngoods exist or does not know their value, it is inequitable to hold him responsible for their loss\nsince he cannot take steps to prevent it. This rule has been criticized: trunks are meant to hold\nthings, and if the car was within the garage\xe2\x80\x99s control, surely its contents were too. Some courts\nsoften the impact of the rule by holding that a bailee is responsible for goods that he might\nreasonably expect to be present, like gloves in a coat checked at a restaurant or ordinary baggage\nin a car checked at a hotel.\n\nKEY TAKEAWAY\n\nA bailment arises when one person (a bailee) rightfully holds property belonging to another\n(a bailor). The law of bailments addresses the critical links in the movement of goods from\nthe manufacturer to the end user in a consumer society: to the storage and transportation of\ngoods. Bailments only apply to personal property; a bailment requires that the bailor deliver\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n656\n\n\x0cphysical control of the goods to the bailee, who has an intention to possess the goods and a\nduty to return them.\n\nEXERCISES\n\n1. Dennis takes his Mercedes to have the GPS system repaired. In the trunk of his car is a\nbriefcase containing $5,000 in cash. Is the cash bailed goods?\n2. Marilyn wraps up ten family-heirloom crystal goblets, packages them carefully in a cardboard\nbox, and drops the box off at the local UPS store. Are the goblets bailed goods?\n3. Bob agrees to help his friend Roger build a deck at Roger\xe2\x80\x99s house. Bob leaves some of his\ntools\xe2\x80\x94without Bob\xe2\x80\x99s noticing\xe2\x80\x94around the corner of the garage at the foot of a\nrhododendron bush. The tools are partly hidden. Are they bailed goods?\n[1] Zuppa v. Hertz, 268 A.2d 364 (N.J. 1970).\n[2] Here is a link to a history of bailment law: Globusz Publishing, \xe2\x80\x9cLecture v. the Bailee at Common\nLaw,\xe2\x80\x9d accessed March 1, 2011,http://www.globusz.com/ebooks/CommonLaw/00000015.htm.\n[3] Carpenter v. Spencer & Griffin, 37 Am. Dec. 396 (N.Y. 1841).\n[4] Lockwood v. Manhattan Storage & Warehouse Co., 50 N.Y.S. 974 (N.Y. 1898).\n[5] Bunnell v. Stern, 25 N.E. 910 (N.Y. 1890).\n[6] Wamser v. Browning, King & Co., 79 N.E. 861 (N.Y. 1907).\n[7] Wall v. Airport Parking Co. of Chicago, 244 N.E.2d 190 (Ill. 1969).\n[8] Continental Insurance Co. v. Meyers Bros. Operations, Inc., 288 N.Y.S.2d 756 (Civ. Ct. N.Y. 1968).\n[9] Samples v. Geary, 292 S.W. 1066 (Mo. App. 1927).\n\n18.2 Liability of the Parties to a Bailment\nLEARNING OBJECTIVES\n\n1. Understand how the bailee\xe2\x80\x99s liability arises and operates.\n2. Recognize the cases in which the bailee can disclaim liability, and what limits are put on such\ndisclaimers.\n3. Understand what duty and liability the bailor has.\n4. Know other rights and duties that arise in a bailment.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n657\n\n\x0c5. Understand the extent to which innkeepers\xe2\x80\x94hotel and motels\xe2\x80\x94are liable for their guests\xe2\x80\x99\nproperty.\n\nLiability of the Bailee\nDuty of Care\nThe basic rule is that the bailee is expected to return to its owner the bailed goods when the\nbailee\xe2\x80\x99s time for possession of them is over, and he is presumed liable if the goods are not\nreturned. But that a bailee has accepted delivery of goods does not mean that he is responsible\nfor their safekeeping no matter what. The law of bailments does not apply a standard of absolute\nliability: the bailee is not an insurer of the goods\xe2\x80\x99 safety; her liability depends on the\ncircumstances.\n\nThe Ordinary Care Rule\nSome courts say that the bailee\xe2\x80\x99s liability is the straightforward standard of \xe2\x80\x9cordinary care under\nthe circumstances.\xe2\x80\x9d The question becomes whether the bailee exercised such care. If she did, she\nis not liable for the loss.\n\nThe Benefit-of-the-Bargain Rule\nMost courts use a complex (some say annoying) tripartite division of responsibility. If the\nbailment is for the sole benefit of the owner (the bailor), the bailee is answerable only for gross\nneglect or fraud: the duty of care is slight. For example, imagine that your car breaks down on a\ndark night and you beg a passing motorist to tow it to a gas station; or you ask your neighbor if\nyou can store your utility trailer in her garage.\nOn the other hand, if the goods are entrusted to the bailee for his sole benefit, then he owes the\nbailor extraordinary care. For example, imagine that your neighbor asks you to let him borrow\nyour car to go to the grocery store downtown because his car is in the shop; or a friend asks if\nshe can borrow your party canopy.\nIf the bailment is for the mutual benefit of bailee and bailor, then the ordinary negligence\nstandard of care will govern. For example, imagine you park your car in a commercial parking\nlot, or you take your suit jacket to a dry cleaner (see Figure 18.1 "Duty of Care").\nFigure 18.1 Duty of Care\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n658\n\n\x0cOne problem with using the majority approach is the inherent ambiguity in the standards of\ncare. What constitutes \xe2\x80\x9cgross\xe2\x80\x9d negligence as opposed to \xe2\x80\x9cordinary\xe2\x80\x9d negligence? The degree-ofcare approach is further complicated by the tendency of the courts to take into account the value\nof the goods; the lesser the value of the goods, the lesser the obligation of the bailee to watch out\nfor them. To some degree, this approach makes sense, because it obviously behooves a person\nguarding diamonds to take greater precautions against theft than one holding three paperback\nbooks. But the value of the goods ought not to be the whole story: some goods obviously have\ngreat value to the owner, regardless of any lack of intrinsic value.\nAnother problem in using the majority approach to the standard of care is determining whether\nor not a benefit has been conferred on the bailee when the bailor did not expressly agree to pay\ncompensation. For example, a bank gives its customers free access to safe-deposit boxes. Is the\nbank a \xe2\x80\x9cgratuitous bailee\xe2\x80\x9d that owes its bailor only a slight degree of care, or has it made the\nboxes available as a commercial matter to hold onto its customers? Some courts cling to one\ntheory, some to the other, suggesting the difficulty with the tripartite division of the standard of\ncare. However, in many cases, whatever the formal theory, the courts look to the actual benefits\nto be derived. Thus when a customer comes to an automobile showroom and leaves her car in\nthe lot while she test-drives the new car, most courts would hold that two bailments for mutual\nbenefit have been created: (1) the bailment to hold the old car in the lot, with the customer as\nthe bailor; and (2) the bailment to try out the new car, with the customer as the bailee.\n\nBurden of Proof\nIn a bailment case, the plaintiff bailor has the burden of proving that a loss was caused by the\ndefendant bailee\xe2\x80\x99s failure to exercise due care. However, the bailor establishes a prima facie (\xe2\x80\x9cat\nfirst sight\xe2\x80\x9d\xe2\x80\x94on first appearance, but subject to further investigation) case by showing that he\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n659\n\n\x0cdelivered the goods into the bailee\xe2\x80\x99s hands and that the bailee did not return them or returned\nthem damaged. At that point, a presumption of negligence arises, and to avoid liability the\ndefendant must rebut that presumption by showing affirmatively that he was not negligent. The\nreason for this rule is that the bailee usually has a much better opportunity to explain why the\ngoods were not returned or were returned damaged. To put this burden on the bailor might\nmake it impossible for him to win a meritorious case.\n\nLiability of the Bailor\nAs might be expected, most bailment cases involve the legal liability of bailees. However, a body\nof law on the liability of bailors has emerged.\n\nNegligence of Bailor\nA bailor may be held liable for negligence. If the bailor receives a benefit from the bailment, then\nhe has a duty to inform the bailee of known defects and to make a reasonable inspection for\nother defects. Suppose the Tranquil Chemical Manufacturing Company produces an insecticide\nthat it wants the Plattsville Chemical Storage Company to keep in tanks until it is sold. One of\nthe batches is defectively acidic and oozes out of the tanks. This acidity could have been\ndiscovered through a routine inspection, but Tranquil neglects to inspect the batch. The tanks\nleak and the chemical builds up on the floor until it explodes. Since Tranquil, the bailor, received\na benefit from the storage, it had a duty to warn Plattsville, and its failure to do so makes it liable\nfor all damages caused by the explosion.\nIf the bailor does not receive any benefit, however, then his only duty is to inform the bailee of\nknown defects. Your neighbor asks to borrow your car. You have a duty to tell her that the\nbrakes are weak, but you do not need to inspect the car beforehand for unknown defects.\n\nOther Types of Liability\nThe theory of products liability extends to bailors. Both warranty and strict liability theories\napply. The rationale for extending liability in the absence of sale is that in modern commerce,\ndamage can be done equally by sellers or lessors of equipment. A rented car can inflict\nsubstantial injury no less than a purchased one.\nIn several states, when an automobile owner (bailor) lends a vehicle to a friend (bailee) who\ncauses an accident, the owner is liable to third persons injured in the accident.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n660\n\n\x0cDisclaimers of Liability\nBailee\xe2\x80\x99s Disclaimer\nBailees frequently attempt to disclaim their liability for loss or damage. But courts often refuse\nto honor the disclaimers, usually looking to one of two justifications for invalidating them.\n\nLack of Notice\nThe disclaimer must be brought to the attention of the bailor and must be unambiguous. Thus\nposted notices and receipts disclaiming or limiting liability must set forth clearly and legibly the\nlegal effects intended. Most American courts follow the rule that the defendant bailee must show\nthat the bailor in fact knew about the disclaimer. Language printed on the back side of a receipt\nwill not do.\n\nPublic Policy Exception\nEven if the bailor reads the disclaimer, some courts will nevertheless hold the bailee liable on\npublic policy grounds, especially when the bailee is a \xe2\x80\x9cbusiness bailee,\xe2\x80\x9d such as a warehouse or\ncarrier. Indeed, to the extent that a business bailee attempts to totally disclaim liability, he will\nprobably fail in every American jurisdiction. But the Restatement (Second) of Contracts, Section\n195(2)(b), does not go quite this far for most nonbusiness bailees. They may disclaim liability as\nlong as the disclaimer is read and does not relieve the bailee from wanton carelessness.\n\nBailor\xe2\x80\x99s Disclaimer\nBailors most frequently attempt to disclaim liability in rental situations. For example,\nin Zimmer v. Mitchell and Ness, the plaintiff went to the defendant\xe2\x80\x99s rental shop at the\nCamelback ski area to rent skis, boots, and poles. [1] He signed a rental agreement before\naccepting the ski equipment. He was a lessee and a bailee. Later, while descending the\nbeginners\xe2\x80\x99 slope, he fell. The bindings on his skis did not release, thereby causing him to sustain\nnumerous injuries. The plaintiff sued the defendant and Camelback Ski Corporation, alleging\nnegligence, violation of Section 402A of the Restatement (Second) of Torts, and breach of\nwarranty. The defendant filed an answer and claimed that the plaintiff signed a rental\nagreement that fully released the defendant from liability. In his reply, the plaintiff admitted\nsigning the agreement but generally denied that it released the defendant from liability. The\ndefendant won on summary judgment.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n661\n\n\x0cOn appeal, the Pennsylvania Supreme Court held for the defendant and set out the law: \xe2\x80\x9cThe\ntest for determining the validity of exculpatory clauses, admittedly not favored in the law, is set\nout in [Citation]. The contract must not contravene any policy of the law. It must be a contract\nbetween individuals relating to their private affairs. Each party must be a free bargaining agent,\nnot simply one drawn into an adhesion contract, with no recourse but to reject the entire\ntransaction.\xe2\x80\xa6We must construe the agreement strictly and against the party asserting it [and],\nthe agreement must spell out the intent of the parties with the utmost particularity.\xe2\x80\x9d The court\nhere was satisfied with the disclaimer.\n\nOther Rights and Duties\nCompensation\nIf the bailor hires the bailee to perform services for the bailed property, then the bailee is\nentitled to compensation. Remember, however, that not every bailment is necessarily for\ncompensation. The difficult question is whether the bailee is entitled to compensation when\nnothing explicit has been said about incidental expenses he has incurred to care for the bailed\nproperty\xe2\x80\x94as, for example, if he were to repair a piece of machinery to keep it running. No firm\nrule can be given. Perhaps the best generalization that can be made is that, in the absence of an\nexpress agreement, ordinary repairs fall to the bailee to pay, but extraordinary repairs are the\nbailor\xe2\x80\x99s responsibility. An express agreement between the parties detailing the responsibilities\nwould solve the problem, of course.\n\nBailee\xe2\x80\x99s Lien\nLien is from the French, originally meaning \xe2\x80\x9cline,\xe2\x80\x9d \xe2\x80\x9cstring,\xe2\x80\x9d or \xe2\x80\x9ctie.\xe2\x80\x9d In law a lien is the hold that\nsomeone has over the property of another. It is akin, in effect, to a security interest. A common\ntype is the mechanic\xe2\x80\x99s lien (\xe2\x80\x9cmechanic\xe2\x80\x9d here means one who works with his hands). For\nexample, a carpenter builds a room on your house and you fail to pay him; he can secure a lien\non your house, meaning that he has a property interest in the house and can start foreclosure\nproceedings if you still fail to pay. Similarly, a bailee is said to have a lien on the bailed property\nin his possession and need not redeliver it to the bailor until he has been paid. Try to take your\ncar out of a parking lot without paying and see what happens. The attendant\xe2\x80\x99s refusal to give you\nthe car is entirely lawful under a common-law rule now more than a century and a half old. As\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n662\n\n\x0cthe rule is usually stated, the common law confers the lien on the bailee if he has added value to\nthe property through his labor, skill, or materials. But that statement of the rule is somewhat\ndeceptive, since the person who has simply housed the goods is entitled to a lien, as is a person\nwho has altered or repaired the goods without measurably adding value to them. Perhaps a\nbetter way of stating the rule is this: a lien is created when the bailee performs some special\nbenefit to the goods (e.g., preserving them or repairing them).\nMany states have enacted statutes governing various types of liens. In many instances, these\nhave broadened the bailee\xe2\x80\x99s common-law rights. This book discusses two types of liens in great\ndetail: the liens of warehousemen and those of common carriers. Recall that a lease creates a\ntype of bailment: the lessor is the bailor and the lessee is the bailee. This book references the\nUCC\xe2\x80\x99s take on leasing in its discussion of the sale of goods. [2]\n\nRights When Goods Are Taken or Damaged by a Third Party\nThe general rule is that the bailee can recover damages in full if the bailed property is damaged\nor taken by a third party, but he must account in turn to the bailor. A delivery service is carrying\nparcels\xe2\x80\x94bailed goods entrusted to the trucker for delivery\xe2\x80\x94when the truck is struck from\nbehind and blows up. The carrier may sue the third person who caused the accident and recover\nfor the total loss, including the value of the packages. The bailor may also recover for damages to\nthe parcels, but not if the bailee has already recovered a judgment. Suppose the bailee has sued\nand lost. Does the bailor have a right to sue independently on the same grounds? Ordinarily, the\nprinciple of res judicata would prevent a second suit, but if the bailor did not know of and\ncooperate in the bailee\xe2\x80\x99s suit, he probably has the right to proceed on his own suit.\n\nInnkeepers\xe2\x80\x99 Liability\nThe liability of an innkeeper\xe2\x80\x94a type of bailor\xe2\x80\x94is thought to have derived from the warlike\nconditions that prevailed in medieval England, where brigands and bandits roamed the\ncountryside and the innkeeper himself might not have been above stealing from his guests. The\ninnkeeper\xe2\x80\x99s liability extended not merely to loss of goods through negligence. His was an\ninsurer\xe2\x80\x99s liability, extending to any loss, no matter how occasioned, and even to losses that\noccurred in the guest\xe2\x80\x99s room, a place where the guest had the primary right of possession. The\nonly exception was for losses due to the guest\xe2\x80\x99s own negligence.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n663\n\n\x0cMost states have enacted statutes providing exceptions to this extraordinarily broad commonlaw duty. Typically, the statutes exempt the hotel keeper from insurer\xe2\x80\x99s liability if the hotelier\nfurnishes a safe in which the guests can leave their jewels, money, and other valuables and if a\nnotice is posted a notice advising the guests of the safe\xe2\x80\x99s availability. The hotelier might face\nliability for valuables lost or stolen from the safe but not from the rooms.\n\nKEY TAKEAWAY\n\nIf the bailee fails to redeliver the goods to the bailor, a presumption of negligence arises, but\nthe bailee can rebut the presumption by showing that she exercised appropriate care. What\nis \xe2\x80\x9cappropriate care\xe2\x80\x9d depends on the test used in the jurisdiction: some courts use the\n\xe2\x80\x9cordinary care under the circumstances,\xe2\x80\x9d and some determine how much care the bailee\nshould have exercised based on the extent to which she was benefited from the transaction\ncompared to the bailor. The bailor can be liable too for negligently delivering goods likely to\ncause damage to the bailee. In either case reasonable disclaimers of liability are allowed. If\nthe bailed goods need repair while in the bailee\xe2\x80\x99s possession, the usual rule is that ordinary\nrepairs are the bailee\xe2\x80\x99s responsibility, extraordinary ones the bailor\xe2\x80\x99s. Bailees are entitled to\nliens to enforce payment owing to them. In common law, innkeepers were insurers of their\nguests\xe2\x80\x99 property, but hotels and motels today are governed mostly by statute: they are to\nprovide a safe for their guests\xe2\x80\x99 valuables and are not liable for losses from the room.\n\nEXERCISES\n\n1. What is the \xe2\x80\x9cordinary care under the circumstances\xe2\x80\x9d test for a bailee\xe2\x80\x99s liability when the\nbailed goods are not returned?\n2. What is the tripartite test?\n3. What liability does a bailor have for delivering defective goods to a bailee?\n4. Under what circumstances are disclaimers of liability by the bailee or bailor acceptable?\n5. Jason takes his Ford Mustang to a repair shop but fails to pay for the repairs. On what theory\ncan the shop keep and eventually sell the car to secure payment?\n[1] Zimmer v. Mitchell and Ness, 385 A.2d 437 (Penn. 1978).\n[2] Uniform Commercial Code, Section 2A.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n664\n\n\x0c18.3 The Storage and Shipping of Goods\nLEARNING OBJECTIVES\n\n1. Understand a warehouser\xe2\x80\x99s liability for losing goods, what types of losses a warehouser is\nliable for, and what rights the warehouser has concerning the goods.\n2. Know the duties, liabilities, and exceptions to liability a carrier of freight has, and what rights\nthe carrier has.\n3. Understand the liability that is imposed on entities whose business it is to carry passengers.\n\nStorage of Goods\nWarehousing has been called the \xe2\x80\x9csecond oldest profession,\xe2\x80\x9d stemming from the biblical story of\nJoseph, who stored grain during the seven good years against the famine of the seven bad years.\nWhatever its origins, warehousing is today a big business, taking in billions of dollars to\nstockpile foods and other goods. As noted previously, the source of law governing warehousing\nis Article 7 of the UCC, but noncode law also can apply. Section 7-103 of the Uniform\nCommercial Code (UCC) specifically provides that any federal statute or treaty and any state\nregulation or tariff supersedes the provisions of Article 7. A federal example is the United States\nWarehouse Act, which governs receipts for stored agricultural products. Here we take up, after\nsome definitions, the warehouser\xe2\x80\x99s liabilities and rights. A warehouser is a special type of bailee.\n\nDefinitions\nA warehouser is defined in UCC, Section 7-102(h), as \xe2\x80\x9ca person engaged in the business of\nstoring goods for hire,\xe2\x80\x9d and under Section 1-201(45) awarehouse receipt is any receipt issued by\na warehouser. The warehouse receipt is an important document because it can be used to\ntransfer title to the goods, even while they remain in storage: it is worth money. No form is\nprescribed for the warehouse receipt, but unless it lists in its terms the following nine items, the\nwarehouser is liable to anyone who is injured by the omission of any of them:\n1. Location of the warehouse\n2. Date receipt was issued\n3. Consecutive number of the receipt\n4. Statement whether the goods will be delivered to bearer, to a specified person, or \xe2\x80\x9cto a specified\nperson or his order\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n665\n\n\x0c5. The rate of storage and handling charges\n6. Description of the goods or the packages containing them\n7. Signature of the warehouser, which his or her authorized agent may make\n8. The warehouser\xe2\x80\x99s ownership of the goods, if he or she has a sole or part ownership in them\n9. The amount (if known, otherwise the fact) of advances made and liabilities incurred for which\nthe warehouser claims a lien or security interest\n\nGeneral Duty of Care\nThe warehouser\xe2\x80\x99s general duty of care is embodied in the tort standard for measuring\nnegligence: he is liable for any losses or injury to the goods caused by his failure to exercise\n\xe2\x80\x9csuch care in regard to them as a reasonably careful man would exercise under like\ncircumstances.\xe2\x80\x9d [1] However, subsection 4 declares that this section does not repeal or dilute any\nother state statute that imposes a higher responsibility on a warehouser. Nor does the section\ninvalidate contractual limitations otherwise permissible under Article 7. The warehouser\xe2\x80\x99s duty\nof care under this section is considerably weaker than the carrier\xe2\x80\x99s duty. Determining when a\nwarehouser becomes a carrier, if the warehouser is to act as shipper, can become an important\nissue.\n\nLimitation of Liability\nThe warehouser may limit the amount of damages she will pay by so stating in the warehouse\nreceipt, but she must strictly observe that section\xe2\x80\x99s requirements, under which the limitation\nmust be stated \xe2\x80\x9cper article or item, or value per unit of weight.\xe2\x80\x9d [2]Moreover, the warehouser\ncannot force the bailor to accept this limitation: the bailor may demand in writing increased\nliability, in which event the warehouser may charge more for the storage. If the warehouser\nconverts the goods to her own UCC, the limitation of liability does not apply.\n\nSpecific Types of Liability and Duties\nSeveral problems recur in warehousing, and the law addresses them.\n\nNonreceipt or Misdescription\nUnder UCC Section 7-203, a warehouser is responsible for goods listed in a warehouse receipt\nthat were not in fact delivered to the warehouse (or were misdescribed) and must pay damages\nto a good-faith purchaser of or party to a document of title. To avoid this liability, the issuer\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n666\n\n\x0cmust conspicuously note on the document that he does not know whether the goods were\ndelivered or are correctly described. One simple way is to mark on the receipt that \xe2\x80\x9ccontents,\ncondition, and quality are unknown.\xe2\x80\x9d\n\nDelivery to the Wrong Party\nThe bailee is obligated to deliver the goods to any person with documents that entitle him to\npossession, as long as the claimant pays any outstanding liens and surrenders the document so\nthat it can be marked \xe2\x80\x9ccancelled\xe2\x80\x9d (or can be partially cancelled in the case of partial delivery).\nThe bailee can avoid liability for no delivery by showing that he delivered the goods to someone\nwith a claim to possession superior to that of the claimant, that the goods were lost or destroyed\nthrough no fault of the bailee, or that certain other lawful excuses apply. [3] Suppose a thief\ndeposits goods he has stolen with a warehouse. Discovering the theft, the warehouser turns the\ngoods over to the rightful owner. A day later the thief arrives with a receipt and demands\ndelivery. Because the rightful owner had the superior claim, the warehouser is not liable in\ndamages to the thief.\nNow suppose you are moving and have placed your goods with a local storage company. A few\nweeks later, you accidentally drop your wallet, which contains the receipt for the goods and all\nyour identification. A thief picks up the wallet and immediately heads for the warehouse,\npretending to be you. Having no suspicion that anything is amiss\xe2\x80\x94it\xe2\x80\x99s a large place and no one\ncan be expected to remember what you look like\xe2\x80\x94the warehouse releases the goods to the thief.\nThis time you are probably out of luck. Section 7-404 says that \xe2\x80\x9ca bailee who in good faith\nincluding observance of reasonable commercial standards has received goods and\ndelivered\xe2\x80\xa6them according to the terms of the document of title\xe2\x80\xa6is not liable.\xe2\x80\x9d This rule is true\neven though the person to whom he made delivery had no authority to receive them, as in the\ncase of the thief. However, if the warehouser had a suspicion and failed to take precautions, then\nhe might be liable to the true owner.\n\nDuty to Keep Goods Separate\nExcept for fungible goods, like grain, the warehouse must keep separate goods covered by each\nwarehouse receipt. The purpose of this rule, which may be negated by explicit language in the\nreceipt, is to permit the bailor to identify and take delivery of his goods at any time.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n667\n\n\x0cRights of the Warehouser\nThe warehouser has certain rights concerning the bailed goods.\n\nTermination\nA warehouser is not obligated to store goods indefinitely. Many warehouse receipts will specify\nthe period of storage. At the termination of the period, the warehouser may notify the bailor to\npay and to recover her goods. If no period is fixed in the receipt or other document of title, the\nwarehouser may give notice to pay and remove within no less than thirty days. The bailor\xe2\x80\x99s\nfailure to pay and remove permits the warehouser to sell the goods for her fee. Suppose the\ngoods begin to deteriorate. Sections 7-207(2) and 7-207(3) of the UCC permit the warehouser to\nsell the goods early if necessary to recover the full amount of her lien or if the goods present a\nhazard. But if the rightful owner demands delivery before such a sale, the warehouser is\nobligated to do so.\n\nLiens\nSection 7-209(1) of the UCC provides that a warehouser has a lien on goods covered by a\nwarehouse receipt to recover the following charges and expenses: charges for storage or\ntransportation, insurance, labor, and expenses necessary to preserve the goods. The lien is not\ndischarged if the bailor transfers his property interest in the goods by negotiating a warehouse\nreceipt to a purchaser in good faith, although the warehouser is limited then to an amount or a\nrate fixed in the receipt or to a reasonable amount or rate if none was stated. The lien attaches\nautomatically and need not be spelled out in the warehouse receipt.\nThe warehouser may enforce the lien by selling the goods at a public or private sale, as long as\nshe does so in a commercially reasonable manner, as defined in Section 7-210. All parties known\nto be claiming an interest in the goods must be notified of the sale and told the amount due, the\nnature of the sale, and its time and place. Any person who in good faith purchases the goods\ntakes them free of any claim by the bailor, even if the warehouser failed to comply with the\nrequirements of Section 7-210. However, her failure to comply subjects her to damages, and if\nshe has willfully violated the provisions of this section she is liable to the bailor for conversion.\n\nShipment of Goods\nIntroduction and Terminology\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n668\n\n\x0cThe shipment of goods throughout the United States and abroad is a very big business, and\nmany specialized companies have been established to undertake it, including railways, air cargo\noperations, trucking companies, and ocean carriers. Article 7 of the UCC applies to carriage of\ngoods as it does to warehousing, but federal law is more important. The Federal Bill of Lading\nAct (FBLA) covers bills of lading issued by common carriers for transportation of goods in\ninterstate or foreign commerce (i.e., from one state to another; in federal territory; or to foreign\ncountries). The Carmack Amendment was enacted in 1906 as an amendment to the Interstate\nCommerce Act of 1887, and it is now part of the Interstate Commerce Commission Termination\nAct of 1995; it covers liability of interstate carriers for loss, destruction, and damage to goods.\nThe shipper is the entity hiring the one who transports the goods: if you send your sister crystal\ngoblets for her birthday, you are the shipper.\nTwo terms are particularly important in discussing shipment of goods. One is common carrier;\nthe common carrier is \xe2\x80\x9cone who undertakes for hire or reward to transport the goods of such as\nchooses to employ him, from place to place.\xe2\x80\x9d [4] This definition contains three elements: (1) the\ncarrier must hold itself out for all in common for hire\xe2\x80\x94the business is not restricted to\nparticular customers but is open to all who apply for its services; (2) it must charge for his\nservices\xe2\x80\x94it is for hire; (3) the service in question must be carriage. Included within this\ntripartite definition are numerous types of carriers: household moving companies, taxicabs,\ntowing companies, and even oil and gas pipelines. Note that to be a common carrier it is not\nnecessary to be in the business of carrying every type of good to every possible point; common\ncarriers may limit the types of goods or the places to which they will transport them.\nA bill of lading is any document that evidences \xe2\x80\x9cthe receipt of goods for shipment issued by a\nperson engaged in the business of transporting or forwarding goods.\xe2\x80\x9d [5]This is a comprehensive\ndefinition and includes documents used by contract carriers\xe2\x80\x94that is, carriers who are not\ncommon carriers. An example of a bill of lading is depicted in Figure 18.2 "A Bill of Lading\nForm".\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n669\n\n\x0cFigure 18.2 A Bill of Lading Form\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n670\n\n\x0cDuties and Liabilities\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n671\n\n\x0cThe transportation of goods has been an important part of all evolved economic systems for a\nlong time, and certainly it is critical to the development and operation of any capitalistic system.\nThe law regarding it is well developed.\n\nAbsolute Liability\nDamage, destruction, and loss are major hazards of transportation for which the carrier will be\nliable. Who will assert the claim against the carrier depends on who bears the risk of loss. The\nrules governing risk of loss determine whether the buyer or seller will be the plaintiff. But\nwhoever is the plaintiff, the common carrier defendant faces absolute liability. With five\nexceptions explored two paragraphs on, the common carrier is an insurer of goods, and\nregardless of the cause of damage or loss\xe2\x80\x94that is, whether or not the carrier was negligent\xe2\x80\x94it\nmust make the owner whole. This ancient common-law rule is codified in state law, in the\nfederal Carmack Amendment, and in the UCC, Section 7-309(1), all of which hold the common\ncarrier to absolute liability to the extent that the common law of the state had previously done\nso.\nAbsolute liability was imposed in the early cases because the judges believed such a rule was\nnecessary to prevent carriers from conspiring with thieves. Since it is difficult for the owner, who\nwas not on the scene, to prove exactly what happened, the judges reasoned that putting the\nburden of loss on the carrier would prompt him to take extraordinary precautions against loss\n(and would certainly preclude him from colluding with thieves). Note that the rules in this\nsection govern only common carriers; contract carriers that do not hold themselves out for\ntransport for hire are liable as ordinary bailees.\n\nExceptions to Absolute Liability\nIn general, the burden or proof rests on the carrier in favor of the shipper. The shipper (or\nconsignee of the shipper) can make out a prima facie case by showing that it delivered the goods\nto the carrier in good condition and that the goods either did not arrive or arrived damaged in a\nspecified amount. Thereafter the carrier has the burden of proving that it was not negligent and\nthat the loss or damage was caused by one of the five following recognized exceptions to the rule\nof absolute liability.\n\nAct of God\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n672\n\n\x0cNo one has ever succeeded in defining precisely what constitutes an act of God, but the courts\nseem generally agreed that it encompasses acts that are of sudden and extraordinary natural, as\nopposed to human, origin. Examples of acts of God are earthquakes, hurricanes, and fires\ncaused by lightning against which the carrier could not have protected itself. Rapid River\nCarriers contracts to transport a refrigerated cargo of beef down the Mississippi River on the\nSS Rapid. When the ship is en route, it is hit by a tornado and sinks. This is an act of God. But a\ncontributing act of negligence by a carrier overcomes the act of God exception. If it could be\nshown that the captain was negligent to set sail when the weather warned of imminent tornados,\nthe carrier might be liable.\n\nAct of Public Enemy\nThis is a narrow exception that applies only to acts committed by pirates at high sea or by the\narmed forces of enemies of the state to which the carrier owes allegiance. American ships at sea\nthat are sunk during wartime by enemy torpedoes would not be liable for losses to the owners of\ncargo. Moreover, public enemies do not include lawless mobs or criminals listed on the FBI\xe2\x80\x99s\nTen Most Wanted list, even if federal troops are required, as in the Pullman Strike of 1894, to\nput down the violence. After the Pullman Strike, carriers were held liable for property destroyed\nby violent strikers.\n\nAct of Public Authority\nWhen a public authority\xe2\x80\x94a sheriff or federal marshal, for example\xe2\x80\x94through lawful process\nseizes goods in the carrier\xe2\x80\x99s possession, the carrier is excused from liability. Imagine that federal\nagents board the SS Rapid in New Orleans and, as she is about to sail, show the captain a search\nwarrant and seize several boxes of cargo marked \xe2\x80\x9cbeef\xe2\x80\x9d that turn out to hold cocaine. The owner\nor consignee of this illegal cargo will not prevail in a suit against the carrier to recover damages.\nLikewise, if the rightful owner of the goods obtains a lawful court order permitting him to attach\nthem, the carrier is obligated to permit the goods to be taken. It is not the carrier\xe2\x80\x99s responsibility\nto contest a judicial writ or to face the consequences of resisting a court order. The courts\ngenerally agree that the carrier must notify the owner whenever goods are seized.\n\nAct of Shipper\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n673\n\n\x0cWhen goods are lost or damaged because of the shipper\xe2\x80\x99s negligence, the shipper is liable, not\nthe carrier. The usual situation under this exception arises from defective packing. The shipper\nwho packs the goods defectively is responsible for breakage unless the defect is apparent and the\ncarrier accepts the goods anyway. For example, if you ship your sister crystal goblets packed\nloosely in the box, they will inevitably be broken when driven in trucks along the highways. The\ntrucker who knowingly accepts boxes in this condition is liable for the damage. Likewise, the\ncarrier\xe2\x80\x99s negligence will overcome the exception and make him absolutely liable. A paper\nsupplier ships several bales of fine stationery in thin cardboard boxes susceptible to moisture.\nKnowing their content, SS Rapid accepts the bales and exposes them to the elements on the\nupper deck. A rainstorm curdles the stationery. The carrier is liable.\n\nInherent Nature of the Goods\nThe fifth exception to the rule of absolute liability is rooted in the nature of the goods\nthemselves. If they are inherently subject to deterioration or their inherent characteristics are\nsuch that they might be destroyed, then the loss must lie on the owner. Common examples are\nchemicals that can explode spontaneously and perishable fruits and vegetables. Of course, the\ncarrier is responsible for seeing that foodstuffs are properly stored and cared for, but if they\ndeteriorate naturally and not through the carrier\xe2\x80\x99s negligence, he is not liable.\n\nWhich Carrier Is Liable?\nThe transportation system is complex, and few goods travel from portal to portal under the care\nof one carrier only. In the nineteenth century, the shipper whose goods were lost had a difficult\ntime recovering their value. Initial carriers blamed the loss on subsequent carriers, and even if\nthe shipper could determine which carrier actually had possession of the goods when the\ndamage or loss occurred, diverse state laws made proof burdensome. The Carmack Amendment\nended the considerable confusion by placing the burden on the initial carrier; connecting\ncarriers are deemed agents of the initial carrier. So the plaintiff, whether seller or buyer, need\nsue only the initial carrier, no matter where the loss occurred. Likewise, Section 7-302 of the\nUCC fastens liability on an initial carrier for damages or loss caused by connecting carriers.\n\nWhen Does Carrier Liability Begin and End?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n674\n\n\x0cWhen a carrier\xe2\x80\x99s liability begins and ends is an important issue because the same company can\nact both to store the goods and to carry them. The carrier\xe2\x80\x99s liability is more stringent than the\nwarehouser\xe2\x80\x99s. So the question is, when does a warehouser become a carrier and vice versa?\nThe basic test for the beginning of carrier liability is whether the shipper must take further\naction or give further instructions to the carrier before its duty to transport arises. Suppose that\nCotton Picking Associates delivers fifty bales of cotton to Rapid River Carriers for transport on\nthe SS Rapid. The SS Rapid is not due back to port for two more days, so Rapid River Carrier\nstores the cotton in its warehouse, and on the following day the warehouse is struck by lightning\nand burns to the ground. Is Rapid River Carriers liable in its capacity as a carrier or warehouse?\nSince nothing was left for the owner to do, and Rapid River was storing the cotton for its own\nconvenience awaiting the ship\xe2\x80\x99s arrival, it was acting as a carrier and is liable for the loss. Now\nsuppose that when Cotton Picking Associates delivered the fifty bales it said that another fifty\nbales would be coming in a week and the entire lot was to be shipped together. Rapid River\nstores the first fifty bales and lightning strikes. Since more remained for Cotton Picking to do\nbefore Rapid River was obligated to ship, the carrier was acting in its warehousing capacity and\nis not liable.\nThe carrier\xe2\x80\x99s absolute liability ends when it has delivered the goods to the consignee\xe2\x80\x99s residence\nor place of business, unless the agreement states otherwise (as it often does). By custom, certain\ncarriers\xe2\x80\x94notably rail carriers and carriers by water\xe2\x80\x94are not required to deliver the goods to the\nconsignee (since rail lines and oceans do not take the carrier to the consignee\xe2\x80\x99s door). Instead,\nconsignees must take delivery at the dock or some other place mutually agreed on or established\nby custom.\nWhen the carrier must make personal delivery to the consignee, carrier liability continues until\nthe carrier has made reasonable efforts to deliver. An express trucking company cannot call on a\ncorporate customer on Sunday or late at night, for instance. If reasonable efforts to deliver fail, it\nmay store the goods in its own warehouse, in which case its liability reverts to that of a\nwarehouser.\nIf personal delivery is not required (e.g., as in shipment by rail), the states use different\napproaches for determining when the carrier\xe2\x80\x99s liability terminates. The most popular intrastate\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n675\n\n\x0capproach provides that the carrier continues to be absolutely responsible for the goods until the\nconsignee has been notified of their arrival and has had a reasonable opportunity to take\npossession of them.\nInterstate shipments are governed by the Carmack Amendment, which generally provides that\nliability will be determined by language in the bill of lading. The typical bill of lading (or \xe2\x80\x9cBOL\xe2\x80\x9d\nand \xe2\x80\x9cB/L\xe2\x80\x9d) provides that if the consignee does not take the goods within a stated period of time\nafter receiving notice of their arrival, the carrier will be liable as warehouser only.\n\nDisclaimers\nThe apparently draconian liability of the carrier\xe2\x80\x94as an insurer of the goods\xe2\x80\x94is in practice easily\nminimized. Under neither federal nor state law may the carrier disclaim its absolute liability, but\nat least as to commercial transactions it may limit the damages payable under certain\ncircumstances. Both the Carmack Amendment and Section 7-309 of the UCC permit the carrier\nto set alternate tariffs, one costing the shipper more and paying full value, the other costing less\nand limited to a dollar per pound or some other rate less than full value. The shipper must have\na choice; the carrier may not impose a lesser tariff unilaterally on the shipper, and the loss must\nnot be occasioned by the carrier\xe2\x80\x99s own negligence.\n\nSpecific Types of Liability\nThe rules just discussed relate to the general liability of the carrier for damages to the goods.\nThere are two specific types of liability worth noting.\n\nNonreceipt or Misdescription\nUnder the UCC, Section 7-301(1), the owner of the goods (e.g., a consignee) described in a bill of\nlading may recover damages from the issuer of the bill (the carrier) if the issuer did not actually\nreceive the goods from the shipper, if the goods were misdescribed, or if the bill was misdated.\nThe issuer may avoid liability by reciting in the bill of lading that she does not know whether the\ngoods were received or if they conform to the description; the issuer may avoid liability also by\nmarking the goods with such words as \xe2\x80\x9ccontents or condition of contents unknown.\xe2\x80\x9d Even this\nqualifying language may be ineffective. For instance, a common carrier may not hide behind\nlanguage indicating that the description was given by the shipper; the carrier must actually\ncount the packages of goods or ascertain the kind and quantity of bulk freight. Just because the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n676\n\n\x0ccarrier is liable to the consignee for errors in description does not mean that the shipper is free\nfrom blame. Section 7-301(5) requires the shipper to indemnify the carrier if the shipper has\ninaccurately described the goods in any way (including marks, labels, number, kind, quantity,\ncondition, and weight).\n\nDelivery to the Wrong Party\nThe rule just discussed for warehouser applies to carriers under both state and federal law:\ncarriers are absolutely liable for delivering the goods to the wrong party. In the classic case\nof Southern Express Co. v. C. L. Ruth & Son, a clever imposter posed as the representative of a\nreputable firm and tricked the carrier into delivering a diamond ring.[6] The court held the\ncarrier liable, even though the carrier was not negligent and there was no collusion. The UCC\ncontains certain exceptions; under Section 7-303(1), the carrier is immune from liability if the\nholder, the consignor, or (under certain circumstances) the consignee gives instructions to\ndeliver the goods to someone other than a person named in the bill of lading.\n\nCarrier\xe2\x80\x99s Right to Lien and Enforcement of Lien\nJust as the warehouser can have a lien, so too can the carrier. The lien can cover charges for\nstorage, transportation, and preservation of goods. When someone has purchased a negotiable\nbill of lading, the lien is limited to charges stated in the bill, allowed under applicable tariffs, or,\nif none are stated, to a reasonable charge. A carrier who voluntarily delivers or unjustifiably\nrefuses to deliver the goods loses its lien. The carrier has rights paralleling those of the\nwarehouser to enforce the lien.\n\nPassengers\nIn addition to shipping goods, common carriers also transport passengers and their baggage.\nThe carrier owes passengers a high degree of care; in 1880 the Supreme Court described the\nstandard as \xe2\x80\x9cthe utmost caution characteristic of very careful prudent men.\xe2\x80\x9d [7] This duty implies\nliability for a host of injuries, including mental distress occasioned by insults (\xe2\x80\x9clunatic,\xe2\x80\x9d\n\xe2\x80\x9cwhore,\xe2\x80\x9d \xe2\x80\x9ccheap, common scalawag\xe2\x80\x9d) and by profane or indecent language. In Werndli v.\nGreyhound, [8] Mrs. Werndli deboarded the bus at her destination at 2:30 a.m.; finding the bus\nstation closed, she walked some distance to find a bathroom. While doing so, she became the\nvictim of an assault. The court held Greyhound liable: it should have known the station was\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n677\n\n\x0cclosed at 2:30 a.m. and that it was located in a area that became dangerous after hours. The case\nillustrates the degree to which a carrier is responsible for its passengers\xe2\x80\x99 safety and comfort.\nThe baggage carrier is liable as an insurer unless the baggage is not in fact delivered to the\ncarrier. A passenger who retains control over his hand luggage by taking it with him to his seat\nhas not delivered the baggage to the carrier, and hence the carrier has no absolute liability for its\nloss or destruction. The carrier remains liable for negligence, however. When the passenger does\ndeliver his luggage to the carrier, the question often arises whether the property so delivered is\n\xe2\x80\x9cbaggage.\xe2\x80\x9d If it is not, the carrier does not have an insurer\xe2\x80\x99s liability toward it. Thus a person\nwho transports household goods in a suitcase would not have given the carrier \xe2\x80\x9cbaggage,\xe2\x80\x9d as that\nterm is usually defined (i.e., something transported for the passenger\xe2\x80\x99s personal use or\nconvenience). At most, the carrier would be responsible for the goods as a gratuitous bailee.\n\nKEY TAKEAWAY\n\nThe storage of goods is a special type of bailment. People who store goods can retrieve them\nor transfer ownership of them by transferring possession of the warehouse receipt: whoever\nhas rightful possession of the receipt can take the goods, and the warehouser is liable for\nmisdelivery or for mixing up goods. The warehouser has a right to a lien to secure his fee,\nenforceable by selling the goods in a commercially reasonable way. The shipping of goods is\nof course an important business. Common carriers (those firms that hire out their trucks,\nairplanes, ships, or trains to carry cargo) are strictly liable to ensure the proper arrival of the\ngoods to their destination, with five exceptions (act of God, public enemy, public authority,\nshipper; inherent nature of the goods); the first carrier to receive them is liable\xe2\x80\x94others who\nsubsequently carry are that carrier\xe2\x80\x99s agents. The carrier may also store goods: if it does so for\nits own convenience it is liable as a carrier; if it does so for the shipper\xe2\x80\x99s convenience, it is\nliable as a warehouser. As with warehousers, the carrier is liable for misdelivery and is\nentitled to a lien to enforce payment. Carriers also carry people, and the standard of care\nthey owe to passengers is very high. Carrying passengers\xe2\x80\x99 baggage, the carrier is liable as an\ninsurer\xe2\x80\x94it is strictly liable.\n\nEXERCISES\n\n1. How are warehousers any different from the more generic bailees?\n2. How do the duties and liabilities of warehousers differ from those of carriers?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n678\n\n\x0c3. What rights do warehousers and carriers have to ensure their payment?\n4. May a carrier limit its liability for losses not its fault?\n[1] Uniform Commercial Code, Section 7-204(1).\n[2] Uniform Commercial Code, Section 7-204(2).\n[3] Uniform Commercial Code, Section 7-403(1).\n[4] Ace High Dresses v. J. C. Trucking Co., 191 A. 536 (Conn. 1937).\n[5] Uniform Commercial Code, Section 1-206(6).\n[6] Southern Express Co. v. C. L. Ruth & Son, 59 So. 538 (Ala. Ct. App. 1912).\n[7] Pennsylvania Co. v. Roy, 102 US 451 (1880).\n[8] Werndli v. Greyhound Corp., 365 So.2d 177 (Fla. Ct. App., 1978)\n\n18.4 Negotiation and Transfer of Documents of Title (or\nCommodity Paper)\nLEARNING OBJECTIVES\n\n1. Understand how commodity paper operates in the sale of goods.\n2. Recognize when the transferee of a properly negotiated document of title gets better rights\nthan her transferor had and the exceptions to this principle.\n\nOverview of Negotiability\nWe have discussed in several places the concept of a document of title (also\ncalledcommodity paper). That is a written description, identification, or declaration of goods\nauthorizing the holder\xe2\x80\x94usually a bailee\xe2\x80\x94to receive, hold, and dispose of the document and the\ngoods it covers. Examples of documents of title are warehouse receipts, bills of lading, and\ndelivery orders. The document of title, properly negotiated (delivered), gives its holder\nownership of the goods it represents. It is much easier to pass around a piece of paper\nrepresenting the ownership interest in goods than it is to pass around the goods themselves.\nIt is a basic feature of our legal system that a person cannot transfer more rights to property\nthan he owns. It would follow here that no holder of a document of title has greater rights in the\ngoods than the holder\xe2\x80\x99s transferor\xe2\x80\x94the one from whom she got the document (and thus the\ngoods). But there are certain exceptions to this rule; for example, the power of a merchant in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n679\n\n\x0ccertain circumstances to transfer title to goods, even though the merchant himself did not have\ntitle to them. A critically important exception to the general rule arises when certain types of\npaper are sold; for example, commercial paper such as checks and notes. To conclude this\nchapter, we discuss the rule as it applies to documents of title, sometimes known as commodity\npaper.\n\nThe Elements and Effect of Negotiation\nIf a document of title is \xe2\x80\x9cnegotiable\xe2\x80\x9d and is \xe2\x80\x9cduly negotiated,\xe2\x80\x9d the purchaser can obtain rights\ngreater than those of the storer or shipper. In the following discussion, we refer only to the\nUniform Commercial Code (UCC), although federal law also distinguishes between negotiable\nand nonnegotiable documents of title (some of the technical details in the federal law may differ,\nbut these are beyond the scope of this book).\n\nNegotiable Defined\nAny document of title, including a warehouse receipt and a bill of lading, is negotiable or\nbecomes negotiable if by its terms the goods are to be delivered \xe2\x80\x9cto bearer or to the order of\xe2\x80\x9d a\nnamed person. [1] All other documents of title are nonnegotiable. Suppose a bill of lading says\nthat the goods are consigned to Tom Thumb but that they may not be delivered unless Tom\nsigns a written order that they be delivered. Under Section 7-104(2), that is not a negotiable\ndocument of title. A negotiable document of title must bear words such as \xe2\x80\x9cDeliver to the bearer\xe2\x80\x9d\nor \xe2\x80\x9cdeliver to the order of Tom Thumb.\xe2\x80\x9d These are the \xe2\x80\x9cmagic words\xe2\x80\x9d that create a negotiable\ndocument.\n\nDuly Negotiated\nTo transfer title effectively through negotiation of the document of title, it must be \xe2\x80\x9cduly\nnegotiated.\xe2\x80\x9d In general terms, under Section 7-501 of the UCC, a negotiable document of title\nis duly negotiated when the person named in it indorses (signs it over\xe2\x80\x94literally \xe2\x80\x9con the back of\xe2\x80\x9d)\nand delivers it to a holder who purchases it in good faith and for value, without any notice that\nsomeone else might have a claim against the goods, assuming the transaction is in the regular\ncourse of business or financing. Note that last part: assuming the transaction is in the regular\ncourse of business. If you gave your roommate a negotiable document of title in payment for a\ncar you bought from her, your roommate would have something of value, but it would not have\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n680\n\n\x0cbeen duly negotiated. Paper made out \xe2\x80\x9cto bearer\xe2\x80\x9d (bearer paper) is negotiated by delivery alone;\nno indorsement is needed. A holder is anyone who possesses a document of title that is drawn to\nhis order, indorsed to him, or made out \xe2\x80\x9cto bearer.\xe2\x80\x9d\n\nEffect\nAs a general rule, if these requirements are not met, the transferee acquires only those rights\nthat the transferor had and nothing more. And if a nonnegotiable document is sold, the buyer\xe2\x80\x99s\nrights may be defeated. For example, a creditor of the transferor might be entitled to treat the\nsale as void.\nUnder Section 7-502 of the UCC, however, if the document is duly negotiated, then the holder\nacquires (1) title to the document, (2) title to the goods, (3) certain rights to the goods delivered\nto the bailee after the document itself was issued, and (4) the right to have the issuer of the\ndocument of title hold the goods or deliver the goods free of any defense or claim by the issuer.\nTo contrast the difference between sale of goods and negotiation of the document of title,\nconsider the plight of Lucy, the owner of presidential campaign pins and other political\nmemorabilia. Lucy plans to hold them for ten years and then sell them for many times their\npresent value. She does not have the room in her cramped apartment to keep them, so she crates\nthem up and takes them to a friend for safekeeping. The friend gives her a receipt that says\nsimply: \xe2\x80\x9cReceived from Lucy, five cartons; to be stored for ten years at $25 per year.\xe2\x80\x9d Although a\ndocument of title, the receipt is not negotiable. Two years later, a browser happens on Lucy\xe2\x80\x99s\ncrates, discovers their contents, and offers the friend $1,000 for them. Figuring Lucy will forget\nall about them, the friend sells them. As it happens, Lucy comes by a week later to check on her\nmemorabilia, discovers what her former friend has done, and sues the browser for their return.\nLucy would prevail. Now suppose instead that the friend, who has authority from Lucy to store\nthe goods, takes the cartons to the Trusty Storage Company, receives a negotiable warehouse\nreceipt (\xe2\x80\x9cdeliver to bearer five cartons\xe2\x80\x9d), and then negotiates the receipt. This time Lucy would\nbe out of luck. The bona fide purchaser from her friend would cut off Lucy\xe2\x80\x99s right to recover the\ngoods, even though the friend never had good title to them.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n681\n\n\x0cA major purpose of the concept is to allow banks and other creditors to loan money with the\nright to the goods as represented on the paper as collateral. They can, in effect, accept the paper\nas collateral without fear that third parties will make some claim on the goods.\nBut even if the requirements of negotiability are met, the document of title still will confer no\nrights in certain cases. For example, when a thief forges the indorsement of the owner, who held\nnegotiable warehouse receipts, the bona fide purchaser from the thief does not obtain good title.\nOnly if the receipts were in bearer form would the purchaser prevail in a suit by the owner.\nLikewise, if the owner brought his goods to a repair shop that warehoused them without any\nauthority and then sold the negotiable receipts received for them, the owner would prevail over\nthe subsequent purchaser.\nAnother instance in which an apparent negotiation of a document of title will not give the bona\nfide purchaser superior rights occurs when a term in the document is altered without\nauthorization. But if blanks are filled in without authority, the rule states different consequences\nfor bills of lading and warehouse receipts. Under Section 7-306 of the UCC, any unauthorized\nfilling in of a blank in a bill of lading leaves the bill enforceable only as it was originally.\nHowever, under Section 7-208, an unauthorized filling in of a blank in a warehouse receipt\npermits the good-faith purchaser with no notice that authority was lacking to treat the insertion\nas authorized, thus giving him good title. This section makes it dangerous for a warehouser to\nissue a receipt with blanks in it, because he will be liable for any losses to the owner if a goodfaith purchaser takes the goods.\nFinally, note that a purchaser of a document of title who is unable to get his hands on the\ngoods\xe2\x80\x94perhaps the document was forged\xe2\x80\x94might have a breach of warranty action against the\nseller of the document. Under Section 7-507 of the UCC, a person who negotiates a document of\ntitle warrants to his immediate purchaser that the document is genuine, that he has no\nknowledge of any facts that would impair its validity, and that the negotiation is rightful and\neffective. Thus the purchaser of a forged warehouse receipt would not be entitled to recover the\ngoods but could sue his transferor for breach of the warranty.\n\nKEY TAKEAWAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n682\n\n\x0cIt is a lot easier to move pieces of paper around than goods in warehouses. Therefore\ncommercial paper, or commodity paper, was invented: the paper represents the goods, and\nthe paper is transferred from one person to another by negotiation. The holder signs on the\nback of the paper and indicates who its next holder should be (or foolishly leaves that blank);\nthat person then has rights to the goods and, indeed, better rights. On due negotiation the\ntransferee does not merely stand in the transferor\xe2\x80\x99s shoes: the transferee takes free of\ndefects and defenses that could have been available against the transferor. For a document\nof title to be a negotiable one, it must indicate that the intention of it is that it should be\npassed on through commerce, with the words \xe2\x80\x9cto bearer\xe2\x80\x9d or \xe2\x80\x9cto the order of [somebody],\xe2\x80\x9d\nand it must be duly negotiated: signed off on by its previous holder (or without any signature\nneeded if it was bearer paper).\n\nEXERCISES\n\n1. \xe2\x80\x9cGeorge Baker deposited five cardboard boxes in my barn\xe2\x80\x99s loft, and he can pick them up\nwhen he wants.\xe2\x80\x9d Is this statement a negotiable document of title?\n2. \xe2\x80\x9cGeorge Baker deposited five cardboard boxes in my barn\xe2\x80\x99s loft, and he or anybody to his\norder can pick them up.\xe2\x80\x9d Is this statement a negotiable document of title?\n3. Why is the concept of being a holder of duly negotiated documents of title important?\n[1] Uniform Commercial Code, Section 7-104(1)(a).\n\n18.5 Cases\nBailments and Disclaimers of Bailee\xe2\x80\x99s Liability\nCarr v. Hoosier Photo Supplies, Inc.\n441 N.E.2d 450 (Ind. 1982)\nGivan, J.\nLitigation in this cause began with the filing of a complaint in Marion Municipal Court by John\nR. Carr, Jr. (hereinafter \xe2\x80\x9cCarr\xe2\x80\x9d), seeking damages in the amount of $10,000 from defendants\nHoosier Photo Supplies, Inc. (hereinafter \xe2\x80\x9cHoosier\xe2\x80\x9d) and Eastman Kodak Company (hereinafter\n\xe2\x80\x9cKodak\xe2\x80\x9d). Carr was the beneficiary of a judgment in the amount of $1,013.60. Both sides\nappealed. The Court of Appeals affirmed the trial court in its entirety.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n683\n\n\x0cThe facts were established by stipulation agreement between the parties and thus are not in\ndispute. In the late spring or early summer of 1970, Carr purchased some Kodak film from a\nretailer not a party to this action, including four rolls of Kodak Ektachrome-X 135 slide film that\nare the subject matter of this dispute. During the month of August, 1970, Carr and his family\nvacationed in Europe. Using his own camera Carr took a great many photographs of the sites\nthey saw, using among others the four rolls of film referred to earlier. Upon their return to the\nUnited States, Carr took a total of eighteen [18] rolls of exposed film to Hoosier to be developed.\nOnly fourteen [14] of the rolls were returned to Carr after processing. All efforts to find the\nmissing rolls or the pictures developed from them were unsuccessful. Litigation commenced\nwhen the parties were unable to negotiate a settlement.\nThe film Carr purchased, manufactured by Kodak, is distributed in boxes on which there is\nprinted the following legend:\n\nREAD THIS NOTICE\n\nThis film will be replaced if defective in manufacture, labeling, or packaging, or if damaged or\nlost by us or any subsidiary company even though by negligence or other fault. Except for such\nreplacement, the sale, processing, or other handling of this film for any purpose is without other\nwarranty of liability.\nIn the stipulation of facts it was agreed though Carr never read this notice on the packages of\nfilm he bought, he knew there was printed on such packages \xe2\x80\x9ca limitation of liability similar or\nidentical to the Eastman Kodak limitation of liability.\xe2\x80\x9d The source of Carr\xe2\x80\x99s knowledge was\nagreed to be his years of experience as an attorney and as an amateur photographer.\nWhen Carr took all eighteen [18] rolls of exposed film to Hoosier for processing, he was given a\nreceipt for each roll. Each receipt contained the following language printed on the back side:\nAlthough film price does not include processing by Kodak, the return of any film or print to us\nfor processing or any other purpose, will constitute an agreement by you that if any such film or\nprint is damaged or lost by us or any subsidiary company, even though by negligence or other\nfault, it will be replaced with an equivalent amount of Kodak film and processing and, except for\nsuch replacement, the handling of such film or prints by us for any purpose is without other\nwarranty or liability.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n684\n\n\x0cAgain, it was agreed though Carr did not read this notice he was aware Hoosier \xe2\x80\x9c[gave] to their\ncustomers at the time of accepting film for processing, receipts on which there are printed\nlimitations of liability similar or identical to the limitation of liability printed on each receipt\nreceived by Carr from Hoosier Photo.\xe2\x80\x9d\nIt was stipulated upon receipt of the eighteen [18] rolls of exposed film only fourteen [14] were\nreturned to Hoosier by Kodak after processing. Finally, it was stipulated the four rolls of film\nwere lost by either Hoosier or Kodak.\xe2\x80\xa6\nThat either Kodak or Hoosier breached the bailment contract, by negligently losing the four rolls\nof film, was established in the stipulated agreement of facts. Therefore, the next issue raised is\nwhether either or both, Hoosier or Kodak, may limit their liability as reflected on the film\npackages and receipts.\xe2\x80\xa6\n[A] prerequisite to finding a limitation of liability clause in a contract unconscionable and\ntherefore void is a showing of disparity in bargaining power in favor of the party whose liability\nis thus limited.\xe2\x80\xa6In the case at bar the stipulated facts foreclose a finding of disparate bargaining\npower between the parties or lack of knowledge or understanding of the liability clause by Carr.\nThe facts show Carr is an experienced attorney who practices in the field of business law. He is\nhardly in a position comparable to that of the plaintiff in Weaver, supra. Moreover, it was\nstipulated he was aware of the limitation of liability on both the film packages and the receipts.\nWe believe these crucial facts belie a finding of disparate bargaining power working to Carr\xe2\x80\x99s\ndisadvantage.\nContrary to Carr\xe2\x80\x99s assertions, he was not in a \xe2\x80\x9ctake it or leave it position\xe2\x80\x9d in that he had no\nchoice but to accept the limitation of liability terms of the contract. As cross-appellants Hoosier\nand Kodak correctly point out, Carr and other photographers like him do have some choice in\nthe matter of film processing. They can, for one, undertake to develop their film themselves.\nThey can also go to independent film laboratories not a part of the Kodak Company. We do not\nsee the availability of processing as limited to Kodak.\xe2\x80\xa6\nWe hold the limitation of liability clauses operating in favor of Hoosier and Kodak were assented\nto by Carr; they were not unconscionable or void. Carr is, therefore, bound by such terms and is\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n685\n\n\x0climited in his remedy to recovery of the cost of four boxes of unexposed Kodak Ektachrome-X\n135 slide film.\nThe Court of Appeals\xe2\x80\x99 opinion in this case is hereby vacated. The cause is remanded to the trial\ncourt with instructions to enter a judgment in favor of appellant, John R. Carr, Jr., in the\namount of $13.60, plus interest. Each party is to bear its own costs.\nHunter and Pivarnik, JJ., concur. Prentice, J., concurs in result without opinion.\nDeBruler, J., dissenting.\n\xe2\x80\xa6As a general rule the law does not permit professional bailees to escape or diminish liability for\ntheir own negligence by posting signs or handing out receipts. [Citations] The statements on the\nfilm box and claim check used by Kodak and Hoosier Photo are in all respects like the printed\nforms of similar import which commonly appear on packages, signs, chits, tickets, tokens and\nreceipts with which we are all bombarded daily. No one does, or can reasonably be expected, to\ntake the time to carefully read the front, back, and sides of such things. We all know their gist\nanyway.\nThe distinguished trial judge below characterizes these statements before us as \xe2\x80\x9cmere notices\xe2\x80\x9d\nand concludes that plaintiff below did not \xe2\x80\x9cassent\xe2\x80\x9d to them so as to render them a binding part\nof the bailment contract. Implicit here is the recognition of the exception to the general rule\nregarding such notices, namely, that they may attain the dignity of a special contract limiting\nliability where the bailor overtly assents to their terms. [Citations] To assent to provisions of this\nsort requires more than simply placing the goods into the hands of the bailee and taking back a\nreceipt or claim check. Such acts are as probative of ignorance as they are of knowledge.\nHowever, according to the agreed statement of facts, plaintiff Carr \xe2\x80\x9cknew\xe2\x80\x9d by past experience\nthat the claim checks carried the limitation of liability statements, but he did not read them and\nwas unaware of the specific language in them. There is nothing in this agreed statement that\nCarr recalled this knowledge to present consciousness at the time of these transactions.\nObviously we all know many things which we do not recall or remember at any given time. The\nassent required by law is more than this; it is, I believe, to perform an act of understanding.\nThere is no evidence of that here.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n686\n\n\x0cThe evidence presented tending to support the award of damages included an actual\nuncontroverted amount of $13.60 thereby precluding mere nominal damages. There was further\nevidence that 150 exposures were lost. The actual award of $1,014.60 amounted to between\n$6.00 and $7.00 per picture. Carr provided evidence that the pictures were of exceptional value\nto him, having been taken in a once-in-a-lifetime European trip costing $6000 [about $33,000\nin 2110 dollars], including visits arranged there before hand with relatives. The award was fair\nand just compensation for the loss of value to the owner and does not include sentimental or\nfanciful value.\nThe trial court judgment should be affirmed.\n\nCASE QUESTIONS\n\n1. Four out of eighteen rolls of film were not returned to the bailor, Mr. Carr. The court here\naffirmed a judgment for about $6 per lost image. How could an image taken by an amateur\nphotographer be worth $6 a piece?\n2. The European trip cost him $6,000 in 1970; he asked for $10,000 (about $55,000 in 2010\ndollars). Upon what basis could such damages be arrived? What did he apparently want?\n3. What argument did the plaintiff make as to why the limitation of liability should not be\nenforced? What response did the court have to that?\n4. Would it have made a difference if the plaintiff were not himself a business attorney? Why or\nwhy not?\n5. Why did the dissent think the court of appeals\xe2\x80\x99 decision to award the plaintiff $1,000 was\ncorrect and the majority\xe2\x80\x99s opinion incorrect?\n\nBailed Goods of Sentimental Value\nMieske v. Bartell Drug Co.\n593 P.2d 1308 (Wash. 1979)\nBrachtenbach, J.\nThis case determines the measure of damages for personal property, developed movie film,\nwhich is destroyed, and which cannot be replaced or reproduced. It also decides the legal effect\nof a clause which purports to limit the responsibility of a film processor to replacement of film.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n687\n\n\x0cThe facts are that over a period of years the plaintiffs had taken movie films of their family\nactivities. The films started with the plaintiffs\xe2\x80\x99 wedding and honeymoon and continued through\nvacations in Mexico, Hawaii and other places, Christmas gatherings, birthdays, Little League\nparticipation by their son, family pets, building of their home and irreplaceable pictures of\nmembers of their family, such as the husband\xe2\x80\x99s brother, who are now deceased.\nPlaintiffs had 32 50-foot reels of such developed film which they wanted spliced together into\nfour reels for convenience of viewing. Plaintiff wife visited defendant Bartell\xe2\x80\x99s camera\ndepartment, with which she had dealt as a customer for at least 10 years. She was told that such\nservice could be performed.\nThe films were put in the order which plaintiffs desired them to be spliced and so marked. They\nwere then placed in four separate paper bags which in turn were placed in one large bag and\ndelivered to the manager of Bartell. The plaintiff wife explained the desired service and the\nmanner in which the films were assembled in the various bags. The manager placed a film\nprocessing packet on the bag and gave plaintiff wife a receipt which contained this language:\n\xe2\x80\x9cWe assume no responsibility beyond retail cost of film unless otherwise agreed to in writing.\xe2\x80\x9d\nThere was no discussion about the language on the receipt. Rather, plaintiff wife told the\nmanager, \xe2\x80\x9cDon\xe2\x80\x99t lose these. They are my life.\xe2\x80\x9d\nBartell sent the film package to defendant GAF Corporation, which intended to send them to\nanother processing lab for splicing. Plaintiffs assumed that Bartell did this service and were\nunaware of the involvement of two other firms.\nThe bag of films arrived at the processing lab of GAF. The manager of the GAF lab described the\nservice ordered and the packaging as very unusual. Yet it is undisputed that the film was in the\nGAF lab at the end of one day and gone the next morning. The manager immediately searched\nthe garbage disposal dumpster which already had been emptied. The best guess is that the\nplaintiffs\xe2\x80\x99 film went from GAF\xe2\x80\x99s lab to the garbage dumpster to a truck to a barge to an upSound landfill where it may yet repose.\nAfter several inquiries to Bartell, plaintiff wife was advised to call GAF. Not surprisingly, after\nbeing advised of the complete absence and apparent fatality of plaintiffs\xe2\x80\x99 films, this lawsuit\nensued.\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n688\n\n\x0cTwo main issues are raised: (1) the measure of damages and (2) the effect of the exclusionary\nclause appearing on the film receipt.\nOn damages, the defendants assign error to (a) the court\xe2\x80\x99s damages instruction and (b) the\ncourt\xe2\x80\x99s failure to give their proposed damages instruction.\nThe standard of recovery for destruction of personal property was summarized in [McCurdy].\nWe recognized in McCurdy that (1) personal property which is destroyed may have a market\nvalue, in which case that market value is the measure of damages; (2) if destroyed property has\nno market value but can be replaced or reproduced, then the measure is the cost of replacement\nor reproduction; (3) if the destroyed property has no market value and cannot be replaced or\nreproduced, then the value to the owner is to be the proper measure of damages. However, while\nnot stated in McCurdy, we have held that in the third McCurdy situation, damages are not\nrecoverable for the sentimental value which the owner places on the property. [Citations]\nThe defendants argue that plaintiffs\xe2\x80\x99 property comes within the second rule of McCurdy, i.e., the\nfilm could be replaced and that their liability is limited to the cost of replacement film. Their\nposition is not well taken. Defendants\xe2\x80\x99 proposal would award the plaintiffs the cost of acquiring\nfilm without pictures imposed thereon. That is not what plaintiffs lost. Plaintiffs lost not merely\nfilm able to capture images by exposure but rather film upon which was recorded a multitude of\nframes depicting many significant events in their lives. Awarding plaintiffs the funds to purchase\n32 rolls of blank film is hardly a replacement of the 32 rolls of images which they had recorded\nover the years. Therefore the third rule of McCurdy is the appropriate measure of damages, i.e.,\nthe property has no market value and cannot be replaced or reproduced.\nThe law, in those circumstances, decrees that the measure of damages is to be determined by the\nvalue to the owner, often referred to as the intrinsic value of the property. Restatement of Torts\ns. 911 (1939).\nNecessarily the measure of damages in these circumstances is the most imprecise of the three\ncategories. Yet difficulty of assessment is not cause to deny damages to a plaintiff whose\nproperty has no market value and cannot be replaced or reproduced. [Citations]\nThe fact that damages are difficult to ascertain and measure does not diminish the loss to the\nperson whose property has been destroyed. Indeed, the very statement of the rule suggests the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n689\n\n\x0copposite. If one\xe2\x80\x99s destroyed property has a market value, presumably its equivalent is available\non the market and the owner can acquire that equivalent property. However, if the owner cannot\nacquire the property in the market or by replacement or reproduction, then he simply cannot be\nmade whole.\nThe problem is to establish the value to the owner. Market and replacement values are relatively\nascertainable by appropriate proof. Recognizing that value to the owner encompasses a\nsubjective element, the rule has been established that compensation for sentimental or fanciful\nvalues will not be allowed. [Citations] That restriction was placed upon the jury in this case by\nthe court\xe2\x80\x99s damages instruction.\xe2\x80\xa6\nUnder these rules, the court\xe2\x80\x99s damages instruction was correct. In essence it allowed recovery\nfor the actual or intrinsic value to the plaintiffs but denied recovery for any unusual sentimental\nvalue of the film to the plaintiffs or a fanciful price which plaintiffs, for their own special\nreasons, might place thereon.\xe2\x80\xa6\nThe next issue is to determine the legal effect of the exclusionary clause which was on the film\nreceipt given plaintiff wife by Bartell. As noted above, it read: \xe2\x80\x9cWe assume no responsibility\nbeyond retail cost of film unless otherwise agreed to in writing.\xe2\x80\x9d\nIs the exclusionary clause valid? Defendants rely upon 2-719(3), a section of the Uniform\nCommercial Code, which authorizes a limitation or exclusion of consequential damages unless\nthe limitation is unconscionable.\nPlaintiffs, on the other hand, argue that the Uniform Commercial Code is not applicable to this\ntransaction.\xe2\x80\xa6It is now clearly established that the reach of Article 2 goes considerably beyond\nthe confines of that type transaction which the Code itself defines to be a \xe2\x80\x9csale\xe2\x80\x9d; namely, the\npassing of title from a party called the seller to one denominated a buyer for a price. Chief\nopportunity for this expansion is found in Section 2-102, which states that the article applies to\n\xe2\x80\x9ctransactions in goods.\xe2\x80\x9d \xe2\x80\x9cArticle 2 sections are finding their way into more and more decisions\ninvolving transactions which are not sales, but which are used as substitutes for a sale or which\nto a court appear to have attributes to which sales principles or at least some of them seem\nappropriate for application.\xe2\x80\xa6Most important of these is the application of the Article\xe2\x80\x99s warranty\nprovisions to leases, bailments, or construction contracts. Of growing importance is the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n690\n\n\x0ctendency of courts to find the Section on unconscionability, Section 2-302, appropriate to\nnonsales deals.\xe2\x80\x9d\nApplication of the Uniform Commercial Code to this transaction leads to defendants\xe2\x80\x99 next two\ncontentions. First, they urge that the code\xe2\x80\x99s recognition of course of dealings and trade usage\nvalidates the exclusionary clause. Second, defendants assign error to the grounds upon which\nthe court found the clause to be unconscionable and therefore invalid.\nDefendants contend that it is the uniform trade practice of film processors to impose an\nexclusionary clause similar to that contained in Bartell\xe2\x80\x99s film receipt. However, the existence of a\ntrade usage is to be established as a fact [Citation]. It was proved as a usage among film\nprocessors, but not as between commercial film processors and their retail\ncustomers.\xe2\x80\xa6Consequently, defendants\xe2\x80\x99 reliance on trade usage to uphold the exclusionary\nclause is not well founded.\nAs to course of dealings, the record is clear that Mrs. Mieske and the Bartell manager never\ndiscussed the exclusionary clause. Mrs. Mieske had never read it, she viewed the numbered slip\nas merely a receipt. The manager was not \xe2\x80\x9ctoo clear on what it said.\xe2\x80\x9d There was no showing what\nwas the language on any other receipt given in prior dealings between the parties. In summary,\ndefendants\xe2\x80\x99 proof fell short of that required by the express language of 1-205(3). Defendants\ncontend we should apply a course of dealing standard as a matter of law, but cite no authority\nfor such proposition. We decline the invitation.\nDefendants next assert that the trial court held the exclusionary clause to be unconscionable\nwithout considering the rules laid down in Schroeder v. Fageol Motors, Inc., 544 P.2d 20\n(1975). In Schroeder, we recognized that the term unconscionable is not defined in the Uniform\nCommercial Code. We acknowledge that the code mandates the court to determine\nunconscionability as a matter of law, 2-302(1). Schroeder held that numerous factors enter into\na determination of unconscionability. No one element is controlling. The court must examine all\nthe circumstances surrounding the transaction, including conspicuousness of the clause, prior\ncourse of dealings between the parties, negotiations about the clause, the commercial setting\nand usage of the trade. Not each element will be applicable factually to every transaction.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n691\n\n\x0cThe real question is whether the court considered the necessary elements of Schroeder. A review\nof the record convinces us that it did. The court had the facts, the Schroeder case was argued,\nthe criteria set forth therein were discussed by defendants\xe2\x80\x99 counsel both on objections and on\nexceptions. There was no error. Judgment affirmed.\n\nCASE QUESTIONS\n\n1. This case presents pretty much the same fact situation as the previous one, but it comes out\nthe other way. Why? What\xe2\x80\x99s the difference?\n2. The court said there could be \xe2\x80\x9crecovery for the actual or intrinsic value to the plaintiffs but\n[not for] for any unusual sentimental value of the film to the plaintiffs or a fanciful price\nwhich plaintiffs, for their own special reasons, might place thereon.\xe2\x80\x9d What actual value does\na role of film have if not sentimental value, and if the court were not concerned about the\nsentimental value, why did it mention all the irreplaceable memories recorded on the film\xe2\x80\x94\nwhat difference would it make what was on the film if it had an ascertainable \xe2\x80\x9cactual value\xe2\x80\x9d?\n3. Determining that this bailment was governed by the UCC opened up three lines of argument\nfor the defendant. What were they?\n4. Why did the court here say the disclaimer was unconscionable?\n\nLiability of Carrier; Limitations on Liability\nCalvin Klein Ltd. v. Trylon Trucking Corp.\n892 F.2d 191C.A.2 (N.Y. 1989)\nMiner, J.\nDefendant-appellant Trylon Trucking Corp. (\xe2\x80\x9cTrylon\xe2\x80\x9d) appeals from a judgment\xe2\x80\xa6in favor of\nplaintiff-appellee Calvin Klein Ltd. (\xe2\x80\x9cCalvin Klein\xe2\x80\x9d) for the full value of a lost shipment of\nclothing. The appeal presents a novel issue under New York law: whether a limitation of liability\nagreement between a shipper and a carrier is enforceable when the shipment is lost as a result of\nthe carrier\xe2\x80\x99s gross negligence.\nThe district court held that the parties\xe2\x80\x99 customary limitation of liability agreement did not\nextend to the shipment at issue, due to the absence of assent and consideration. The court\nobserved that, had there been such an agreement, the liability of the carrier for its gross\nnegligence would be limited. For the reasons that follow, we reverse the judgment of the district\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n692\n\n\x0ccourt, find that the parties agreed to the limitation of liability, and determine that the agreement\nlimits Trylon\xe2\x80\x99s liability for its gross negligence.\xe2\x80\xa6\nTrylon is a New Jersey trucking firm which engaged in the business of transporting goods from\nNew York City\xe2\x80\x99s airports for delivery to its customers\xe2\x80\x99 facilities. Calvin Klein, a New York\nclothing company, had used the services of Trylon for at least three years, involving hundreds of\nshipments, prior to the lost shipment at issue. In past deliveries Calvin Klein, through its\ncustoms broker, would contact Trylon to pick up the shipment from the airport for delivery to\nCalvin Klein\xe2\x80\x99s facility. After completing the carriage, Trylon would forward to Calvin Klein an\ninvoice, which contained a limitation of liability provision as follows:\nIn consideration of the rate charged, the shipper agrees that the carrier shall not be liable for\nmore than $50.00 on any shipment accepted for delivery to one consignee unless a greater value\nis declared, in writing, upon receipt at time of shipment and charge for such greater value paid,\nor agreed to be paid, by the shipper.\nA shipment of 2,833 blouses from Hong Kong arrived at John F. Kennedy International Airport\nfor Calvin Klein on March 27, 1986. Calvin Klein arranged for Trylon to pick up the shipment\nand deliver it to Calvin Klein\xe2\x80\x99s New Jersey warehouse. On April 2, Trylon dispatched its driver,\nJamahl Jefferson, to pick up this shipment. Jefferson signed a receipt for the shipment from\nCalvin Klein\xe2\x80\x99s broker. By April 2, the parties discovered that Jefferson had stolen Trylon\xe2\x80\x99s truck\nand its shipment. The shipment never was recovered. Calvin Klein sent a claim letter to Trylon\nfor the full value of the lost blouses. In the absence of any response by Trylon, Calvin Klein filed\nthis action\xe2\x80\xa6to recover $150,000, allegedly the value of the lost shipment.\xe2\x80\xa6\nIn their stipulation in lieu of a jury trial, the parties agreed that Trylon is liable to Calvin Klein\nfor the loss of the shipment and that Trylon was grossly negligent in the hiring and supervision\nof Jefferson. They also agreed that \xe2\x80\x9c[t]he terms and conditions of [Trylon]\xe2\x80\x99s carriage [were] that\nliability for loss or damage to cargo is limited to $50 in accordance with the legend on Trylon\xe2\x80\x99s\ninvoice forms.\xe2\x80\x9d Calvin Klein conceded that it was aware of this limitation of liability, and that it\ndid not declare a value on the blouses at the time of shipment.\nThe parties left at issue whether the limitation of liability clause was valid and enforceable.\nCalvin Klein argued in the district court, as it does here, that the limitation clause was not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n693\n\n\x0cenforceable for two reasons: no agreement existed between Calvin Klein and Trylon as to the\nlimitation of liability; and, if such an agreement existed, public policy would prevent its\nenforcement because of Trylon\xe2\x80\x99s gross negligence.\nThe district court applied New York law, finding that the carriage was exempt from the\nInterstate Commerce Commission\xe2\x80\x99s jurisdiction, being entirely within the New York City\ncommercial zone.\xe2\x80\xa6\nA common carrier\xe2\x80\xa6under New York law is strictly liable for the loss of goods in its custody.\n\xe2\x80\x9cWhere the loss is not due to the excepted causes [that is, act of God or public enemy, inherent\nnature of goods, or shipper\xe2\x80\x99s fault], it is immaterial whether the carrier was negligent or not.\xe2\x80\xa6\xe2\x80\x9d\n[Citations] Even in the case of loss from theft by third parties, liability may be imposed up on a\nnegligent common carrier. [Citation]\nA shipper and a common carrier may contract to limit the carrier\xe2\x80\x99s liability in cases of loss to an\namount agreed to by the parties [Citations], so long as the language of the limitation is clear, the\nshipper is aware of the terms of the limitation, and the shipper can change the terms by\nindicating the true value of the goods being shipped. [Citations]\xe2\x80\xa6(similar scheme under\nInterstate Commerce Act). Such a limitation agreement is generally valid and enforceable\ndespite carrier negligence. The limitation of liability provision involved here clearly provides\nthat, at the time of delivery, the shipper may increase the limitation by written notice of the\nvalue of the goods to be delivered and by payment of a commensurately higher fee.\nThe parties stipulated to the fact that the $50 limitation of liability was a term and condition of\ncarriage and that Calvin Klein was aware of that limitation. This stipulated fact removes the first\nissue, namely whether an agreement existed as to a liability limitation between the parties, from\nthis case. Calvin Klein\xe2\x80\x99s argument that it never previously acknowledged this limitation by\naccepting only $50 in settlement of a larger loss does not alter this explicit stipulation. \xe2\x80\x9c[A]\nstipulation of fact that is fairly entered into is controlling on the parties and the court is bound\nto enforce it.\xe2\x80\x9d [Citations] Neither party here has argued that the stipulation was unfairly entered\ninto.\xe2\x80\xa6\nThe remaining issue concerns the enforceability of the limitation clause in light of Trylon\xe2\x80\x99s\nconceded gross negligence. The district court considered that, assuming an agreement between\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n694\n\n\x0cthe parties as to Trylon\xe2\x80\x99s liability, Trylon\xe2\x80\x99s gross negligence would not avoid the enforcement of\na limitation clause.\nThe district court found that New York law, as opposed to federal interstate commerce law,\napplies in this case. The parties do not seriously contest this choice of law. With the choice thus\nunchallenged, we must apply both established New York law as well as our belief of how the New\nYork Court of Appeals would rule if this case were before it.\xe2\x80\xa6\nAlthough the New York Court of Appeals has addressed a limitation of liability provision in the\ncontext of a contract between an airline and a passenger, [Citation] (refusing to enforce\nunilateral limitation provision for death of passenger due to defendant\xe2\x80\x99s negligence), that court\nhas never been called upon to enforce a limitation provision in the case of a grossly negligent\ncommon carrier of goods. The various departments of the Appellate Division of the New York\nState Supreme Court have addressed whether gross negligence bars enforcement of limitations\nof liability in the context of contracts for the installation, maintenance and monitoring of\nburglar alarm systems and are divided on the issue. Compare [Citation] (enforcing limitation\ndespite gross negligence) and [Citation] (even if gross negligence were established, plaintiff\xe2\x80\x99s\nrecovery would be limited by limitation clause) with [Citation] (limitation clause cannot limit\nliability for gross negligence) and [Citation] (finding \xe2\x80\x9cno significant distinction\xe2\x80\x9d between\ncomplete exculpation and limitation \xe2\x80\x9cto a nominal sum,\xe2\x80\x9d therefore limitation is ineffective). The\nFirst Department distinguished between exculpatory provisions and limitation provisions,\nindicating that the latter would be effective even if the former are unenforceable due to the\ncontracting party\xe2\x80\x99s gross negligence. [Citations].\xe2\x80\xa6The other departments which have considered\nthe question applied the holding of [Citation], that \xe2\x80\x9c[a]greements which purport to exempt a\nparty from liability for willful or grossly negligent acts are contrary to public policy and are\nvoid.\xe2\x80\x9d\xe2\x80\xa6\nAbsent a rule of decision formulated by the New York Court of Appeals, we are not bound by the\nopinions issued by the state\xe2\x80\x99s lower courts.\xe2\x80\xa6\nIn the absence of direct New York authority, we must make our best estimate as to how New\nYork\xe2\x80\x99s highest court would rule in this case. In making that determination, we are free to\nconsider all the resources the highest court of the state could use, including decisions reached in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n695\n\n\x0cother jurisdictions.\xe2\x80\xa6We believe that the New York Court of Appeals would not differentiate\nbetween gross negligence and ordinary negligence in recognizing the validity of the limitation of\nliability in this case.\nSince carriers are strictly liable for loss of shipments in their custody and are insurers of these\ngoods, the degree of carrier negligence is immaterial. [Citation] The common carrier must\nexercise reasonable care in relation to the shipment in its custody. U.C.C. \xc2\xa7 7-309(1). Carriers\ncan contract with their shipping customers on the amount of liability each party will bear for the\nloss of a shipment, regardless of the degree of carrier negligence. See U.C.C. \xc2\xa7 7-309(2)\n(allowing limitation of liability for losses from any cause save carrier conversion). Unlike the\nparachute school student, see [Citation], or the merchant acquiring a burglar alarm, the shipper\ncan calculate the specific amount of its potential damages in advance, declare the value of the\nshipment based on that calculation, and pay a commensurately higher rate to carry the goods, in\neffect buying additional insurance from the common carrier.\nIn this case, Calvin Klein and Trylon were business entities with an on-going commercial\nrelationship involving numerous carriages of Calvin Klein\xe2\x80\x99s goods by Trylon. Where such\nentities deal with each other in a commercial setting, and no special relationship exists between\nthe parties, clear limitations between them will be enforced. [Citation]. Here, each carriage was\nunder the same terms and conditions as the last, including a limitation of Trylon\xe2\x80\x99s liability. See\n[Citation] (court enforced limitation on shipper who possessed over five years of the carrier\xe2\x80\x99s\nmanifests which included the $50 limitation). This is not a case in which the shipper was dealing\nwith the common carrier for the first time or contracting under new or changed terms. Calvin\nKlein was aware of the terms and was free to adjust the limitation upon a written declaration of\nthe value of a given shipment, but failed to do so with the shipment at issue here. Since Calvin\nKlein failed to adjust the limitation, the limitation applies here, and no public policy that\ndictates otherwise can be identified.\nCalvin Klein now argues that the limitation is so low as to be void.\xe2\x80\xa6This amount is immaterial\nbecause Calvin Klein had the opportunity to negotiate the amount of coverage by declaring the\nvalue of the shipment.\xe2\x80\xa6Commercial entities can easily negotiate the degree of risk each party\nwill bear and which party will bear the cost of insurance. That this dispute actually involves who\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n696\n\n\x0cwill bear the cost of insurance is illustrated by the fact that this case has been litigated not by the\nprincipal parties, but by their insurers. Calvin Klein could have increased Trylon\xe2\x80\x99s coverage by\ndeclaring the value of its shipment, but did not do so. Calvin Klein had the opportunity to\ndeclare a higher value and we find all of its arguments relating to the unreasonableness of the\nlimitation to be without merit.\nWe reverse and remand to the district court with instructions to enter judgment against\ndefendant in the sum of $50.\n\nCASE QUESTIONS\n\n1. Why is the federal court here trying to figure out what the New York high court would do if it\nhad this case in front of it?\n2. Did the federal court find direct New York State law to apply?\n3. What is the legal issue here?\n4. What argument did Calvin Klein make as to why the $50 limitation should not be valid?\n5. The common-law rule was that carriers were strictly liable. Why didn\xe2\x80\x99t the court apply that\nrule?\n6. Would this case have come out differently if the shipper (a) were an unsophisticated in\nmatters of relevant business or (b) if it had never done business with Trylon before?\n\n18.6 Summary and Exercises\nSummary\n\nOwnership and sale of goods are not the only important legal relationships involving goods. In a\nmodern economy, possession of goods is often temporarily surrendered without surrendering\ntitle. This creates a bailment, which is defined as the lawful possession of goods by one who is\nnot the owner.\nTo create a bailment, the goods must be in the possession of the bailee. Possession requires\nphysical control and intent. Whether the owner or someone else must bear a loss often hinges on\nwhether the other person is or is not a bailee.\nThe bailee\xe2\x80\x99s liability for loss depends on the circumstances. Some courts use a straightforward\nstandard of ordinary care. Others use a tripartite test, depending on whether the bailment was\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n697\n\n\x0cfor the benefit of the owner (the standard then is gross negligence), for the bailee (extraordinary\ncare), or for both (ordinary care). Bailees may disclaim liability unless they have failed to give\nadequate notice or unless public policy prohibits disclaimers. A bailee who converts the property\nwill be held liable as an insurer.\nA bailor may have liability toward the bailee\xe2\x80\x94for example, for negligent failure to warn of\nhazards in the bailed property and for strict liability if the injury was caused by a dangerous\nobject in a defective condition.\nSpecial bailments arise in the cases of innkeepers (who have an insurer\xe2\x80\x99s liability toward their\nguests, although many state statutes provide exceptions to this general rule), warehouses,\ncarriers, and leases.\nA warehouser is defined as a person engaged in the business of storing goods for hire. The\ngeneral standard of care is the same as that of ordinary negligence. Many states have statutes\nimposing a higher standard.\nA common carrier\xe2\x80\x94one who holds himself out to all for hire to transport goods\xe2\x80\x94has an\ninsurer\xe2\x80\x99s liability toward the goods in his possession, with five exceptions: act of God, act of\npublic enemy, act of public authority, negligence of shipper, and inherent nature of the goods.\nBecause many carriers are involved in most commercial shipments of goods, the law places\nliability on the initial carrier. The carrier\xe2\x80\x99s liability begins once the shipper has given all\ninstructions and taken all action required of it. The carrier\xe2\x80\x99s absolute liability ends when it has\ndelivered the goods to the consignee\xe2\x80\x99s place of business or residence (unless the agreement\nstates otherwise) or, if no delivery is required, when the consignee has been notified of the\narrival of the goods and has had a reasonable opportunity to take possession.\nCommodity paper\xe2\x80\x94any document of title\xe2\x80\x94may be negotiated; that is, through proper\nindorsements on the paper, title may be transferred without physically touching the goods. A\nduly negotiated document gives the holder title to the document and to the goods, certain rights\nto the goods delivered to the bailee after the document was issued, and the right to take\npossession free of any defense or claim by the issuer of the document of title. Certain rules limit\nthe seemingly absolute right of the holder to take title better than that held by the transferor.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n698\n\n\x0c1. Joe Andrews delivered his quarter horse I\xe2\x80\x99ll Call Ya (worth about $319,000 in 2010 dollars) to\nHarold Stone for boarding and stabling. Later he asked Stone if Stone could arrange for the\nhorse\xe2\x80\x99s transportation some distance, and Stone engaged the services of the Allen brothers\nfor that purpose. Andrews did not know the Allens, but Stone had previously done business\nwith them. On the highway the trailer with I\xe2\x80\x99ll Call Ya in it became disengaged from the\nAllens\xe2\x80\x99 truck and rolled over. The mare, severely injured, \xe2\x80\x9capparently lingered for several\nhours on the side of the road before she died without veterinary treatment.\xe2\x80\x9d The evidence\nwas that the Allens had properly secured the horse\xe2\x80\x99s head at the front of the trailer and used\nall other equipment that a reasonably prudent person would use to secure and haul the\nhorse; that the ball was the proper size and in good condition; that the ball was used without\nincident to haul other trailers after the accident; that Ronny Allen was driving at a safe speed\nand in a safe manner immediately before the accident; that after the accident the sleeve of\nthe trailer hitch was still in the secured position; and that they made a reasonable effort to\nobtain veterinary treatment for the animal after the accident. The court determined this was\na mutual-benefit bailment. Are the Allens liable? [1]\n2. Fisher Corporation, a manufacturer of electronic equipment, delivered VCRs to Consolidated\nFreightways\xe2\x80\x99 warehouse in California for shipment to World Radio Inc., an electronics retailer\nin Council Bluffs, Iowa. World Radio rejected the shipments as duplicative, and they were\nreturned to Consolidated\xe2\x80\x99s terminal in Sarpy County, Nebraska, pending Fisher\xe2\x80\x99s instructions.\nThe VCRs were loaded onto a trailer; the doors of the trailer were sealed but not padlocked,\nand the trailer was parked at the south end of the terminal. Padlocks were not used on any\ntrailers so as not to call attention to a trailer containing expensive cargo. The doors of the\ntrailer faced away from the terminal toward a cyclone fence that encircled the yard. Two\nweeks later, on Sunday, July 15, a supervisor checked the grounds and found nothing amiss.\nOn Tuesday, July 17, Consolidated\xe2\x80\x99s employees discovered a 3 \xc3\x97 5 foot hole had been cut in\nthe fence near the trailer, and half the VCRs were gone; they were never recovered.\nConsolidated received Fisher\xe2\x80\x99s return authorization after the theft occurred. If Consolidated\nis considered a carrier, it would be strictly liable for the loss; if it is considered a bailee, it is\nnot liable unless negligent. Which is it?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n699\n\n\x0c3. Plaintiff purchased a Greyhound bus ticket in St. Petersburg, Florida, for a trip to Fort\nMeyers. The bus left at 11:30 p.m. and arrived at 4:15 a.m. When Plaintiff got off the bus, she\nnoticed that the station and restrooms were darkened, closed, and locked. She left the\nterminal to cross at a lighted service station to use the bathroom. As she walked away from\nthe terminal, she was attacked by an unknown person and injured. The terminal was located\nin a high-crime area of Fort Meyers. Is Greyhound liable?\n4. Mrs. Carter, Plaintiff, took her fur coat to Reichlin Furriers for cleaning, glazing, and storage\nuntil the next winter season. She was given a printed receipt form on the front of which\nFurrier\xe2\x80\x99s employee had written \xe2\x80\x9c$100\xe2\x80\x9d as the coat\xe2\x80\x99s value, though Mrs. Carter did not discuss\nits value with the employee, did not know that such a value had been noted, and didn\xe2\x80\x99t read\nthe receipt. A space for the customer\xe2\x80\x99s signature on the front of the receipt was blank; below\nthis in prominent type was this notice: \xe2\x80\x9csee reverse side for terms and conditions.\xe2\x80\x9d On the\nback was a statement that this was a storage contract and the customer would be bound by\nthe terms unless contrary notice was given within ten days. There were fifteen conditions,\none of which was the following: \xe2\x80\x9cStorage charges are based upon valuation herein declared\nby the depositor and amount recoverable for loss or damage shall not exceed\xe2\x80\xa6the\ndepositor\xe2\x80\x99s valuation appearing in this receipt.\xe2\x80\x9d Six months later, when Mrs. Carter sought to\nretrieve her coat, she was informed by Furrier that it was lost. Carter sued Furrier for $450\n(about $2,200 in 2010 dollars); Furrier claimed its liability was limited to $100. Who wins and\nwhy?\n5. Michael Capezzaro (Plaintiff) reported to the police that he had been robbed of $30,000 (in\n2010 dollars) at gunpoint by a woman. The next day police arrested a woman with $9,800 in\nher possession. Plaintiff identified her as the woman who had robbed him, and the money\nwas impounded as evidence. Two years later the case against her was dismissed because she\nwas determined to have been insane when she committed the crime, and the money in the\npolice property room was released to her. Plaintiff then sued the police department, which\nclaimed it was \xe2\x80\x9cobligated to return the money to [the woman] as bailor.\xe2\x80\x9d Who wins and\nwhy?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n700\n\n\x0c6. Harley Hightower delivered his Cadillac to Auto Auction, where it was damaged. Auto Auction\ndefended itself against Hightower\xe2\x80\x99s claim that it was a negligent bailee by asserting (1) that\nhe had not met the required burden of proof that a proximate cause of the injury was Auto\nAuction\xe2\x80\x99s negligence because it introduced evidence that negligence of a third party was a\nproximate cause of the damage to his car and (2) that it was entitled to judgment in the\nabsence of evidence of specific acts of negligence of the bailee. There was evidence that a\nMrs. Tune drove her automobile onto the lot to sell it and parked it where she was directed\nto; that the automobiles on said lot for sale were ordinarily lined up and numbered by Auto\nAuction; that Plaintiff\xe2\x80\x99s Cadillac was not so parked by the auction company but was parked so\nthat if Mrs. Tune\xe2\x80\x99s automobile continued forward it would strike Hightower\xe2\x80\x99s Cadillac\nbroadside; that when Mrs. Tune stopped her Buick and alighted, her car rolled down the\nincline on the lot toward Hightower\xe2\x80\x99s car; that she attempted to stop her car but it knocked\nher down and continued rolling toward appellee\xe2\x80\x99s Cadillac and, finally, struck and damaged\nit. Who wins and why?\n7. Several student radicals led by Richard Doctor, ranked number three on the FBI\xe2\x80\x99s Ten Most\nWanted list, destroyed a shipment of military cargo en route from Colorado to a military\nshipping facility in Washington State. Should the carrier be liable for the loss?\n8. Everlena Mitchell contracted in writing with All American Van & Storage to transport and\nstore her household goods and furnishings, and she was to pay all charges incurred on a\nmonthly basis. As security she granted All American a warehouser\xe2\x80\x99s lien giving it the right to\nsell the property if the charges remained unpaid for three months and if, in the opinion of\nthe company, such action would be necessary to protect accrued charges. Everlena fell eight\nmonths in arrears and on October 20 she received notice that the amount owed was to be\npaid by October 31, 1975. The notice also stated that if payment was not made, her goods\nand furnishings would be sold on November 7, 1975. Everlena had a pending claim with the\nSocial Security Administration, and advised All American that she would be receiving a\nsubstantial sum of money soon from the Social Services Administration; this was confirmed\nby two government agents. However, All American would not postpone the sale. Everlena\xe2\x80\x99s\nproperty was sold on November 7, 1975, for $925.50. Near the end of November 1975,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n701\n\n\x0cEverlena received approximately $5,500 (about $22,000 in 2010 dollars) from the United\nStates as a disability payment under the Social Security Act, and she sued All American for\nimproperly selling her goods. The trial court ruled for All American on summary judgment.\nWhat result should Everlena obtain on appeal?\n9. Roland delivered a shipment of desks to Security Warehousers and received from Security a\nnegotiable receipt. Peter broke into Roland\xe2\x80\x99s office, stole the document, and forged Roland\xe2\x80\x99s\nsignature as an indorsement, making Peter himself the holder. Peter then indorsed the\ndocument over to Billings, who knew nothing of the theft. Does Billings get good title to the\ndesks?\n10. Baker\xe2\x80\x99s Transfer & Storage Company, Defendant, hauled household goods and personal\neffects by trucks \xe2\x80\x9canywhere for hire.\xe2\x80\x9d Its trucks did not travel on regular routes or between\nestablished terminals; it hauled household goods and personal effects on private contracts\nwith the owners as and when the opportunity presented itself. Baker contracted to haul the\nKlein family\xe2\x80\x99s household goods from Bakersfield, California, to Hollywood. En route the goods\nwere destroyed by fire without Baker\xe2\x80\x99s negligence. Baker\xe2\x80\x99s contract provided it would\nredeliver the property \xe2\x80\x9cdamage by the elements excepted.\xe2\x80\x9d If Baker were a common carrier,\nits liability would be statutorily limited to less than the amount ordered by the trial court; if it\nwere a private carrier, its liability would be either based on ordinary negligence or as the\nparties\xe2\x80\x99 contract provided. Working with both points, what result obtains here?\n\nSELF-TEST QUESTIONS\n\n1. In a bailment, the bailee\na.\n\nmust return similar goods\nb. must return identical goods\nc. acquires title to the goods\nd. must pay for the goods\nIn a bailment for the benefit of a bailee, the bailee\xe2\x80\x99s duty of care is\n\na.\n\nslight\nb. extraordinary\nc. ordinary\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n702\n\n\x0cA disclaimer of liability by a bailee is\na.\n\nnever allowed\nb. sometimes allowed\nc. always allowed\nd. unheard of in business\nA bailor may be held liable to the bailee on\na.\n\na negligence theory\n\nb. a warranty theory\nc. a strict liability theory\nd. all of the above\nThe highest duty of care is imposed on which of the following?\na.\n\na common carrier\n\nb. a lessee\nc. a warehouser\nd. an innkeeper\n\nSELF-TEST ANSWERS\n\n1. b\n2. b\n3. b\n4. d\n5. a\n[1] Andrews v. Allen, 724 S.W.2d 893 (Tex. Ct. App., 1987).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n703\n\n\x0c'