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 coverage of\nlegal and regulatory issues\xe2\x80\x94and organized to permit instructors to tailor the materials to their particular\napproach. This book engages students by relating law to everyday events with which they are already\nfamiliar (or with which they are familiarizing themselves in other business courses) and by its clear,\nconcise, and readable style. (An earlier business law text by authors Lieberman and Siedel was hailed \xe2\x80\x9cthe\nbest 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 which\nmanagers and business executives must grapple. The text provides the vocabulary and legal acumen\nnecessary for businesspeople to talk in an educated way to their customers, employees, suppliers,\ngovernment officials\xe2\x80\x94and to their own lawyers.\nTraditional publishers often create confusion among customers in the text selection process by offering a\nhuge array of publications. Once a text is selected, customers might still have to customize the text to meet\ntheir needs. For example, publishers usually offer books that include either case summaries or excerpted\ncases, but some instructors prefer to combine case summaries with a few excerpted cases so that students\ncan experience reading original material. Likewise, the manner in which most conventional texts\nincorporate video is cumbersome because the videos are contained in a separate library, which makes\naccess more complicating for instructors and students.\nThis model eliminates the need for \xe2\x80\x9cfamilies\xe2\x80\x9d of books (such as the ten Miller texts mentioned below) and\ngreatly simplifies text selection. Instructors have only to select between our Business Law and Legal\nEnvironment volumes of the text and then click on the features they want (as opposed to trying to\ncompare the large number of texts and packages offered by other publishers). In addition to the features\ninherent in any publication, this book offers these unique features:\n\xe2\x80\xa2 Cases are available in excerpted and summarized format, thus enabling instructors to easily \xe2\x80\x9cmix and\nmatch\xe2\x80\x9d excerpted cases with case summaries.\n\xe2\x80\xa2 Links to forms and uniform laws are embedded in the text. For example, the chapters on contract law\nincorporate discussion of various sections of the Uniform Commercial Code, which is available\nat http://www.law.cornell.edu/ucc/ucc.table.html.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n2\n\n\x0c\xe2\x80\xa2 Likewise, many sample legal forms are readily available online. For example, the chapter on\nemployment law refers to the type of terms commonly found in a standard employment agreement,\nexamples of which can be found athttp://smallbusiness.findlaw.com/employmentemployer/employment-employer-hiring/employment-employer-hiring-contract-samples.html.\n\xe2\x80\xa2 Every chapter contains overviews that include the organization and coverage, a list of key terms, chapter\nsummaries, and self-test questions in multiple-choice format (along with answers) that are followed by\nadditional problems with answers available in the Instructors\xe2\x80\x99 Manual.\n\xe2\x80\xa2 In addition to standard supplementary materials offered by other texts, students have access to\nelectronic flash cards, proactive quizzes, and audio study guides.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n3\n\n\x0cChapter 1\n\nIntroduction to Law and Legal Systems\nL EA R N IN G O B JEC T IV ES\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\nsystems.\n\nLaw has different meanings as well as different functions. Philosophers have considered issues of justice\nand law for centuries, and several different approaches, or schools of legal thought, have emerged. In this\nchapter, we will look at those different meanings and approaches and will consider how social and\npolitical dynamics interact with the ideas that animate the various schools of legal thought. We will also\nlook at typical sources of \xe2\x80\x9cpositive law\xe2\x80\x9d in the United States and how some of those sources have priority\nover others, and we will set out some basic differences between the US legal system and other legal\nsystems.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n4\n\n\x0c1.1 What Is Law?\nLaw is a word that means different things at different times. Black\xe2\x80\x99s Law Dictionary says that law is \xe2\x80\x9ca\nbody of rules of action or conduct prescribed by controlling authority, and having binding legal force. That\nwhich must be obeyed and followed by citizens subject to sanctions or legal consequence is a law.\xe2\x80\x9d\n\n[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 individual\nrights, (4) protect minorities against majorities, (5) promote social justice, and (6) provide for orderly\nsocial change. Some legal systems serve these purposes better than others. Although a nation ruled by an\nauthoritarian government may keep the peace and maintain the status quo, it may also oppress minorities\nor political opponents (e.g., Burma, Zimbabwe, or Iraq under Saddam Hussein). Under colonialism,\nEuropean nations often imposed peace in countries whose borders were somewhat arbitrarily created by\nthose same European nations. Over several centuries prior to the twentieth century, empires were built by\nSpain, Portugal, Britain, Holland, France, Germany, Belgium, and Italy. With regard to the functions of\nthe law, the 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.\n\nIn nations that were former colonies of European nations, various ethnic and tribal factions have\nfrequently made it difficult for a single, united government to rule effectively. In Rwanda, for example,\npower struggles between Hutus and Tutsis resulted in genocide of the Tutsi minority. (Genocide is the\ndeliberate and systematic killing or displacement of one group of people by another group. In 1948, the\ninternational community formally condemned the crime of genocide.) In nations of the former Soviet\nUnion, the withdrawal of a central power created power vacuums that were exploited by ethnic leaders.\nWhen Yugoslavia broke up, the different ethnic groups\xe2\x80\x94Croats, Bosnians, and Serbians\xe2\x80\x94fought bitterly\nfor home turf rather than share power. In Iraq and Afghanistan, the effective blending of different groups\nof families, tribes, sects, and ethnic groups into a national governing body that shares power remains to be\nseen.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n5\n\n\x0cLaw and Politics\nIn the United States, legislators, judges, administrative agencies, governors, and presidents make law,\nwith substantial input from corporations, lobbyists, and a diverse group of nongovernment organizations\n(NGOs) such as the American Petroleum Institute, the Sierra Club, and the National Rifle Association. In\nthe fifty states, judges are often appointed by governors or elected by the people. The process of electing\nstate judges has become more and more politicized in the past fifteen years, with growing campaign\ncontributions from those who would seek to seat judges with similar political leanings.\n\nIn the federal system, judges are appointed by an elected official (the president) and confirmed by other\nelected officials (the Senate). If the president is from one party and the other party holds a majority of\nSenate seats, political conflicts may come up during the judges\xe2\x80\x99 confirmation processes. Such a division\nhas been fairly frequent over the past fifty years.\n\nIn most nation-states (as countries are called in international law), knowing who has power to make\nand enforce the laws is a matter of knowing who has political power; in many places, the people or groups\nthat have military power can also command political power to make and enforce the laws. Revolutions are\ndifficult and contentious, but each year there are revolts against existing political-legal authority; an\naspiration for democratic rule, or greater \xe2\x80\x9crights\xe2\x80\x9d for citizens, is a recurring theme in politics and law.\n\nK E Y TA K EA WAY\nLaw is the result of political action, and the political landscape is vastly different from\nnation to nation. Unstable or authoritarian governments often fail to serve the principal\nfunctions of law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n6\n\n\x0cE XE R C IS ES\n1. Consider Burma (named Myanmar by its military rulers). What political rights do you\nhave that the average Burmese citizen does not?\n2. What is a nongovernment organization, and what does it have to do with government?\nDo you contribute to (or are you active in) a nongovernment organization? What kind of\nrights do they espouse, what kind of laws do they support, and what kind of laws do they\noppose?\n[1] Black\xe2\x80\x99s Law Dictionary, 6th ed., s.v. \xe2\x80\x9claw.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n7\n\n\x0c1.2 Schools of Legal Thought\nLEARN ING OB JECTIVES\n1. Distinguish different philosophies of law\xe2\x80\x94schools of legal thought\xe2\x80\x94and explain\ntheir relevance.\n2. Explain why natural law relates to the rights that the founders of the US politicallegal system found important.\n3. Describe legal positivism and explain how it differs from natural law.\n4. Differentiate critical legal studies and ecofeminist legal perspectives from both\nnatural law and legal positivist perspectives.\n\nThere are different schools (or philosophies) concerning what law is all about. Philosophy of law is also\ncalled jurisprudence, and the two main schools are legal positivism and natural law. Although\nthere are others (see Section 1.2.3 "Other Schools of Legal Thought"), these two are the most influential in\nhow people think about the law.\n\nLegal Positivism: Law as Sovereign Command\nAs legal philosopher John Austin concisely put it, \xe2\x80\x9cLaw is the command of a sovereign.\xe2\x80\x9d Law is only law,\nin other words, if it comes from a recognized authority and can be enforced by that authority,\nor sovereign\xe2\x80\x94such as a king, a president, or a dictator\xe2\x80\x94who has power within a defined area or\nterritory. Positivism is a philosophical movement that claims that science provides the only knowledge\nprecise enough to be worthwhile. But what are we to make of the social phenomena of laws?\n\nWe could examine existing statutes\xe2\x80\x94executive orders, regulations, or judicial decisions\xe2\x80\x94in a fairly\nprecise way to find out what the law says. For example, we could look at the posted speed limits on most\nUS highways and conclude that the \xe2\x80\x9ccorrect\xe2\x80\x9d or \xe2\x80\x9cright\xe2\x80\x9d speed is no more than fifty-five miles per hour. Or\nwe could look a little deeper and find out how the written law is usually applied. Doing so, we might\nconclude that sixty-one miles per hour is generally allowed by most state troopers, but that occasionally\nsomeone gets ticketed for doing fifty-seven miles per hour in a fifty-five miles per hour zone. Either\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n8\n\n\x0capproach is empirical, even if not rigorously scientific. The first approach, examining in a precise way\nwhat the rule itself says, is sometimes known as the \xe2\x80\x9cpositivist\xe2\x80\x9d school of legal thought. The second\napproach\xe2\x80\x94which relies on social context and the actual behavior of the principal actors who enforce the\nlaw\xe2\x80\x94is akin to the \xe2\x80\x9clegal realist\xe2\x80\x9d school of thought (see Section 1.2.3 "Other Schools of Legal Thought").\n\nPositivism has its limits and its critics. New Testament readers may recall that King Herod, fearing the\nbirth of a Messiah, issued a decree that all male children below a certain age be killed. Because it was the\ncommand of a sovereign, the decree was carried out (or, in legal jargon, the decree was \xe2\x80\x9cexecuted\xe2\x80\x9d).\nSuppose a group seizes power in a particular place and commands that women cannot attend school and\ncan only be treated medically by women, even if their condition is life-threatening and women doctors are\nfew and far between. Suppose also that this command is carried out, just because it is the law and is\nenforced with a vengeance. People who live there will undoubtedly question the wisdom, justice, or\ngoodness of such a law, but it is law nonetheless and is generally carried out. To avoid the law\xe2\x80\x99s impact, a\ncitizen would have to flee the country entirely. During the Taliban rule in Afghanistan, from which this\nexample is drawn, many did flee.\n\nThe positive-law school of legal thought would recognize the lawmaker\xe2\x80\x99s command as legitimate;\nquestions about the law\xe2\x80\x99s morality or immorality would not be important. In contrast, the natural-law\nschool of legal thought would refuse to recognize the legitimacy of laws that did not conform to natural,\nuniversal, or divine law. If a lawmaker issued a command that was in violation of natural law, a citizen\nwould be morally justified in demonstrating civil disobedience. For example, in refusing to give up her\nseat to a white person, Rosa Parks believed that 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 order.\nNatural law was \xe2\x80\x9cdiscovered\xe2\x80\x9d by humans through the use of reason and by choosing between that which is\ngood and that which is evil. Here is the definition of natural law according to the Cambridge Dictionary of\nPhilosophy: \xe2\x80\x9cNatural law, also called the law of nature in moral and political philosophy, is an objective\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n9\n\n\x0cnorm or set of objective norms governing human behavior, similar to the positive laws of a human ruler,\nbut binding on all people alike and usually understood as involving a superhuman legislator.\xe2\x80\x9d\n\n[1]\n\nBoth the US Constitution and the United Nations (UN) Charter have an affinity for the natural-law\noutlook, as it emphasizes certain objective norms and rights of individuals and nations. The US\nDeclaration of Independence embodies a natural-law philosophy. The following short extract should\nprovide some sense of the deep beliefs in natural law held by those who signed the document.\n\nThe Unanimous Declaration of the Thirteen United States of America\nJuly 4, 1776\n\nWhen in the Course of human events, it becomes necessary for one people to dissolve the political bands\nwhich have connected them with another, and to assume among the powers of the earth, the separate and\nequal station to which the Laws of Nature and of Nature\xe2\x80\x99s God entitle them, a decent respect to the\nopinions of mankind requires that they should declare the causes which impel them to the separation.\n\nWe hold these truths to be self-evident, that all men are created equal, that they are endowed by their\nCreator with certain unalienable Rights, that among these are Life, Liberty and the Pursuit of Happiness.\nThat to secure these rights, Governments are instituted among Men, deriving their just powers from the\nconsent of the governed.\xe2\x80\xa6\n\nThe natural-law school has been very influential in American legal thinking. The idea that certain rights,\nfor example, are \xe2\x80\x9cunalienable\xe2\x80\x9d (as expressed in the Declaration of Independence and in the writings of\nJohn Locke) is consistent with this view of the law. Individuals may have \xe2\x80\x9cGod-given\xe2\x80\x9d or \xe2\x80\x9cnatural\xe2\x80\x9d rights\nthat government cannot legitimately take away. Government only by consent of the governed is a natural\noutgrowth of this view.\n\nCivil disobedience\xe2\x80\x94in the tradition of Henry Thoreau, Mahatma Gandhi, or Martin Luther King Jr.\xe2\x80\x94\nbecomes a matter of morality over \xe2\x80\x9cunnatural\xe2\x80\x9d law. For example, in his \xe2\x80\x9cLetter from Birmingham Jail,\xe2\x80\x9d\nMartin Luther King Jr. claims that obeying an unjust law is not moral and that deliberately disobeying an\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n10\n\n\x0cunjust law is in fact a moral act that expresses \xe2\x80\x9cthe highest respect for law\xe2\x80\x9d: \xe2\x80\x9cAn individual who breaks a\nlaw that conscience tells him is unjust, and who willingly accepts the penalty of imprisonment in order to\narouse the conscience of the community over its injustice, is in reality expressing the highest respect for\nlaw.\xe2\x80\xa6One who breaks an unjust law must do so openly, lovingly, and with a willingness to accept the\npenalty.\xe2\x80\x9d\n\n[2]\n\nLegal positivists, on the other hand, would say that we cannot know with real confidence what \xe2\x80\x9cnatural\xe2\x80\x9d\nlaw or \xe2\x80\x9cuniversal\xe2\x80\x9d law is. In studying law, we can most effectively learn by just looking at what the written\nlaw says, or by examining how it has been applied. In response, natural-law thinkers would argue that if\nwe care about justice, every law and every legal system must be held accountable to some higher standard,\nhowever hard that may be to define.\n\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 example,\nhave specific statutes, rules, and decisions about racial discrimination. There are always difficult issues of\ninterpretation and decision, which is why courts will resolve differing views. But how can we know the\nmore fundamental \xe2\x80\x9cought\xe2\x80\x9d or \xe2\x80\x9cshould\xe2\x80\x9d of human equality? For example, how do we know that \xe2\x80\x9call men\nare created equal\xe2\x80\x9d (from the Declaration of Independence)? Setting aside for the moment questions about\nthe equality of women, or that of slaves, who were not counted as men with equal rights at the time of the\ndeclaration\xe2\x80\x94can the statement be empirically proven, or is it simply a matter of a priori knowledge? (A\npriori means \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 dialogue\nbetween natural-law theorists and more empirically oriented theories of \xe2\x80\x9cwhat law is\xe2\x80\x9d will raise similar\nquestions. In this book, we will focus mostly on the law as it is, but not without also raising questions\nabout 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 examples\nof the past. Precedent would be more important than moral arguments.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n11\n\n\x0cThe legal realist school flourished in the 1920s and 1930s as a reaction to the historical school. Legal\nrealists pointed out that because life and society are constantly changing, certain laws and doctrines have\nto be altered or modernized in order to remain current. The social context of law was more important to\nlegal realists than the formal application of precedent to current or future legal disputes. Rather than\nsuppose that judges inevitably acted objectively in applying an existing rule to a set of facts, legal realists\nobserved that judges had their own beliefs, operated in a social context, and would give legal decisions\nbased on their beliefs and their own social context.\n\nThe legal realist view influenced the emergence of the critical legal studies (CLS) school of thought. The\n\xe2\x80\x9cCrits\xe2\x80\x9d believe that the social order (and the law) is dominated by those with power, wealth, and influence.\nSome Crits are clearly influenced by the economist Karl Marx and also by distributive justice theory\n(see Chapter 2 "Corporate Social Responsibility and Business Ethics"). The CLS school believes the\nwealthy have historically oppressed or exploited those with less wealth and have maintained social control\nthrough law. In so doing, the wealthy have perpetuated an unjust distribution of both rights and goods in\nsociety. Law is politics and is thus not neutral or value-free. The CLS movement would use the law to\noverturn the hierarchical structures of domination in the modern society.\n\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 the rest of\nthe natural world. Ecofeminists would say that the same social mentality that leads to exploitation of\nwomen is at the root of man\xe2\x80\x99s exploitation and degradation of the natural environment. They would say\nthat male ownership of land has led to a \xe2\x80\x9cdominator culture,\xe2\x80\x9d in which man is not so much a steward of\nthe existing environment or those \xe2\x80\x9csubordinate\xe2\x80\x9d to him but is charged with making all that he controls\neconomically \xe2\x80\x9cproductive.\xe2\x80\x9d Wives, children, land, and animals are valued as economic resources, and legal\nsystems (until the nineteenth century) largely conferred rights only to men with land. Ecofeminists would\nsay that even with increasing civil and political rights for women (such as the right to vote) and with some\nnations\xe2\x80\x99 recognizing 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 and\nwomen.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n12\n\n\x0cK E Y TA K EA WAY\nEach of the various schools of legal thought has a particular view of what a legal system\nis or what 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\ncommand of a sovereign, the political power that those governed will obey. Recent\nwritings in the various legal schools of thought emphasize long-standing patterns of\ndomination of the wealthy over others (the CLS school) and of men over women\n(ecofeminist legal theory).\n\nE XE R C IS ES\n1. Vandana Shiva draws a picture of a stream in a forest. She says that in our society the\nstream is seen as unproductive if it is simply there, fulfilling the need for water of\nwomen\xe2\x80\x99s families and communities, until engineers come along and tinker with it,\nperhaps damming it and using it for generating hydropower. The same is true of a forest,\nunless it is replaced with a monoculture plantation of a commercial species. A forest may\nvery well be productive\xe2\x80\x94protecting groundwater; creating oxygen; providing fruit, fuel,\nand craft materials for nearby inhabitants; and creating a habitat for animals that are\nalso a valuable resource. She criticizes the view that if there is no monetary amount that\ncan contribute to gross domestic product, neither the forest nor the river can be seen as\na productive resource. Which school of legal thought does her criticism reflect?\n2. Anatole France said, \xe2\x80\x9cThe law, in its majesty, forbids rich and poor alike from sleeping\nunder bridges.\xe2\x80\x9d Which school of legal thought is represented by this quote?\n3. 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\nfor incarceration\xe2\x80\x94and eventual extermination\xe2\x80\x94at labor camps like Auschwitz and\nBuchenwald. After an Israeli \xe2\x80\x9cextraction team\xe2\x80\x9d took him from Argentina to Israel, he was\nput on trial for \xe2\x80\x9ccrimes against humanity.\xe2\x80\x9d His defense was that he was \xe2\x80\x9cjust following\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n13\n\n\x0corders.\xe2\x80\x9d Explain why Eichmann was not an adherent of the natural-law school of legal\nthought.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n14\n\n\x0c1.3 Basic Concepts and Categories of US Positive Law\nL EA R N IN G O B JEC T IV ES\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.\n\nMost of what we discuss in this book is positive law\xe2\x80\x94US positive law in particular. We will also consider\nthe laws and legal systems of other nations. But first, it will be useful to cover some basic concepts and\ndistinctions.\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, it aims to\ncurb the worst kind of wrongs, the kinds of wrongs that violate what might be called the \xe2\x80\x9cmoral\nminimums\xe2\x80\x9d that a community demands of its members. These include not only violations of criminal law\n(see Chapter 6 "Criminal Law") but also torts (see Chapter 7 "Introduction to Tort Law") and broken\npromises (see (Reference mayer_1.0-ch08 not found in Book)). Thus it may be wrong to refuse to return a\nphone call from a friend, but that wrong will not result in a viable lawsuit against you. But if a phone (or\nthe Internet) is used to libel or slander someone, a tort has been committed, and the law may allow the\ndefamed person to be compensated.\n\nThere is a strong association between what we generally think of as ethical behavior and what the laws\nrequire and provide. For example, contract law upholds society\xe2\x80\x99s sense that promises\xe2\x80\x94in general\xe2\x80\x94should\nbe kept. Promise-breaking is seen as unethical. The law provides remedies for broken promises (in breach\nof contract cases) but not for all broken promises; some excuses are accepted when it would be reasonable\nto do so. For tort law, harming others is considered unethical. If people are not restrained by law from\nharming one another, orderly society would be undone, leading to anarchy. Tort law provides for\ncompensation when serious injuries or harms occur. As for property law issues, we generally believe that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n15\n\n\x0cprivate ownership of property is socially useful and generally desirable, and it is generally protected (with\nsome exceptions) by laws. You can\xe2\x80\x99t throw a party at my house without my permission, but my right to do\nwhatever I want 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 throughout\nthe neighborhood.\n\nThe Common Law: Property, Torts, and Contracts\nEven before legislatures met to make rules for society, disputes happened and judges decided them. In\nEngland, judges began writing down the facts of a case and the reasons for their decision. They often\nresorted to deciding cases on the basis of prior written decisions. In relying on those prior decisions, the\njudge would reason that since a current case was pretty much like a prior case, it ought to be decided the\nsame way. This is essentially reasoning by analogy. Thus the use of precedent in common-law cases\ncame into being, and a doctrine of stare decisis (pronounced STAR-ay-de-SIGH-sus) became accepted\nin English courts. Stare decisis means, in Latin, \xe2\x80\x9clet the decision stand.\xe2\x80\x9d\n\nMost judicial decisions that don\xe2\x80\x99t apply legislative acts (known as statutes) will involve one of three areas\nof law\xe2\x80\x94property, contract, or tort. Property law deals with the rights and duties of those who can legally\nown land (real property), how that ownership can be legally confirmed and protected, how property can\nbe bought and sold, what the rights of tenants (renters) are, and what the various kinds of \xe2\x80\x9cestates\xe2\x80\x9d in\nland are (e.g., fee simple, life estate, future interest, easements, or rights of way). Contract law deals with\nwhat kinds of promises courts should enforce. For example, should courts enforce a contract where one of\nthe parties was intoxicated, underage, or insane? Should courts enforce a contract where one of the\nparties seemed to have an unfair advantage? What kind of contracts would have to be in writing to be\nenforced by courts? 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 competitor\nlies about your product, your remedy would be in tort, not contract.\n\nThe thirteen original colonies had been using English common law for many years, and they continued to\ndo so after independence from England. Early cases from the first states are full of references to alreadySaylor URL: http://www.saylor.org/books\n\nSaylor.org\n16\n\n\x0cdecided English cases. As years went by, many precedents were established by US state courts, so that\ntoday a judicial opinion that refers to a seventeenth- or eighteenth-century English common-law case is\nquite rare.\n\nCourts in one state may look to common-law decisions from the courts of other states where the reasoning\nin a similar case is persuasive. This will happen in \xe2\x80\x9ccases of first impression,\xe2\x80\x9d a fact pattern or situation\nthat the courts in one state have never seen before. But if the supreme court in a particular state has\nalready ruled on a certain kind of case, lower courts in that state will always follow the rule set forth by\ntheir 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. States had\njurisdiction (the power to make and enforce laws) over the most important aspects of business life. The\npower of state law has historically included governing the following kinds of issues and claims:\n\xe2\x80\xa2 Contracts, including sales, commercial paper, letters of credit, and secured transactions\n\xe2\x80\xa2 Torts\n\xe2\x80\xa2 Property, including real property, bailments of personal property (such as when you check your coat at a\ntheater or leave your clothes with a dry cleaner), trademarks, copyrights, and the estates of decedents\n(dead people)\n\xe2\x80\xa2 Corporations\n\xe2\x80\xa2 Partnerships\n\xe2\x80\xa2 Domestic matters, including marriage, divorce, custody, adoption, and visitation\n\xe2\x80\xa2 Securities law\n\xe2\x80\xa2 Environmental law\n\xe2\x80\xa2 Agency law, governing the relationship between principals and their agents.\n\xe2\x80\xa2 Banking\n\xe2\x80\xa2 Insurance\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n17\n\n\x0cOver the past eighty years, however, federal law has become increasingly important in many of these\nareas, 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 interest to\nbusiness, especially as companies may break criminal laws. A criminal case involves a governmental\ndecision\xe2\x80\x94whether state or federal\xe2\x80\x94to prosecute someone (named as a defendant) for violating society\xe2\x80\x99s\nlaws. The law establishes a moral minimum and does so especially in the area of criminal laws; if you\nbreak a criminal law, you can lose your freedom (in jail) or your life (if you are convicted of a capital\noffense). In a civil action, you would not be sent to prison; in the worst case, you can lose property\n(usually money or other assets), such as when Ford Motor Company lost a personal injury case and the\njudge awarded $295 million to the plaintiffs or when Pennzoil won a $10.54 billion verdict against Texaco\n(see Chapter 7 "Introduction to Tort Law").\n\nSome of the basic differences between civil law and criminal lawcases are illustrated in Table 1.1\n"Differences between Civil and Criminal Cases".\n\nTable 1.1 Differences between Civil and Criminal Cases\n\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 Money damages (legal remedy)\n\nFines, jail, and forfeitures\n\nInjunctions (equitable remedy)\nSpecific performance (equity)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n18\n\n\x0cRegarding plaintiffs and prosecutors, you can often tell a civil case from a criminal case by looking at the\ncaption of a case going to trial. If the government appears first in the caption of the case (e.g., U.S. v.\nLieberman, it is likely that the United States is prosecuting on behalf of the people. The same is true of\ncases prosecuted by state district attorneys (e.g., State v. Seidel). But this is not a foolproof formula.\nGovernments will also bring civil actions to collect debts from or settle disputes with individuals,\ncorporations, or other governments. Thus U.S. v. Mayer might be a collection action for unpaid taxes,\nor U.S. v. Canada might be a boundary dispute in the International Court of Justice. Governments can be\nsued, as well; people occasionally sue their state or federal government, but they can only get a trial if the\ngovernment waives its sovereign immunity and allows such suits. Warner v. U.S., for example, could be a\nclaim for a tax refund wrongfully withheld or for damage caused to the Warner residence by a sonic boom\nfrom a US Air Force jet flying overhead.\n\nSubstance versus Procedure\nMany rules and regulations in law are substantive, and others are procedural. We are used to seeing laws\nas substantive; that is, there is some rule of conduct or behavior that is called for or some action that is\nproscribed (prohibited). The substantive rules tell us how to act with one another and with the\ngovernment. For example, all of the following are substantive rules of law and provide a kind of command\nor direction to citizens:\n\xe2\x80\xa2 Drive not more than fifty-five miles per hour where that speed limit is posted.\n\xe2\x80\xa2 Do not conspire to fix prices with competitors in the US market.\n\xe2\x80\xa2 Do not falsely represent the curative effects of your over-the-counter herbal remedy.\n\xe2\x80\xa2 Do not drive your motor vehicle through an intersection while a red traffic signal faces the direction you\nare coming from.\n\xe2\x80\xa2 Do not discriminate against job applicants or employees on the basis of their race, sex, religion, or\nnational origin.\n\xe2\x80\xa2 Do not discharge certain pollutants into the river without first getting a discharge permit.\n\nIn contrast, procedural laws are the rules of courts and administrative agencies. They tell us how to\nproceed if there is a substantive-law problem. For example, if you drive fifty-three miles per hour in a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n19\n\n\x0cforty mile-per-hour zone on Main Street on a Saturday night and get a ticket, you have broken a\nsubstantive rule of law (the posted speed limit). Just how and what gets decided in court is a matter of\nprocedural law. Is the police officer\xe2\x80\x99s word final, or do you get your say before a judge? If so, who goes\nfirst, you or the officer? Do you have the right to be represented by legal counsel? Does the hearing or trial\nhave to take place within a certain time period? A week? A month? How long can the state take to bring its\ncase? What kinds of evidence will be relevant? Radar? (Does it matter what kind of training the officer has\nhad on the radar device? Whether the radar device had been tested adequately?) The officer\xe2\x80\x99s personal\nobservation? (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 hundred\nmiles an hour on Main Street five years ago at half past three on a Tuesday morning? (If the prosecutor\nknows of this and the \xe2\x80\x9cfriend\xe2\x80\x9d is willing to testify, is it relevant to the charge of fifty-three in a forty-mileper-hour zone?)\n\nIn the United States, all state procedural laws must be fair, since the due process clause of the Fourteenth\nAmendment directs that no state shall deprive any citizen of \xe2\x80\x9clife, liberty, or property,\xe2\x80\x9d without due\nprocess of law. (The $200 fine plus court costs is designed to deprive you of property, that is, money, if\nyou violate the speed limit.) Federal laws must also be fair, because the Fifth Amendment to the US\nConstitution has the exact same due process language as the Fourteenth Amendment. This suggests that\nsome laws are more powerful or important than others, which is true. The next section looks at various\ntypes of positive law and their relative importance.\n\nK E Y TA K EA WAY\nIn most legal systems, like that in the United States, there is a fairly firm distinction\nbetween criminal law (for actions that are offenses against the entire society) and civil\nlaw (usually for disputes between individuals or corporations). Basic ethical norms for\npromise-keeping and not harming others are reflected in the civil law of contracts and\ntorts. In the United States, both the states and the federal government have roles to\nplay, and sometimes these roles will overlap, as in environmental standards set by both\nstates and the federal government.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n20\n\n\x0cE XE R C IS ES\n1. Jenna gets a ticket for careless driving after the police come to investigate a car accident\nshe had with you on Hanover Boulevard. Your car is badly damaged through no fault of\nyour own. Is 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\nher. The thirty days conforms to a state law that sets this time limit. Is the thirty-day\nlimit procedural law or substantive law?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n21\n\n\x0c1.4 Sources of Law and Their Priority\nL EA R N IN G O B JEC T IV ES\n1. Describe the different sources of law in the US legal system and the principal\ninstitutions that create 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\nmajority, whether 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) constitutions\xe2\x80\x94both\nstate and federal, (2) statutes and agency regulations, and (3) judicial decisions. In addition, chief\nexecutives (the president and the various governors) can issue executive orders that have the effect of law.\n\nIn international legal systems, sources of law include treaties(agreements between states or countries)\nand what is known as customary international law (usually consisting of judicial decisions from national\ncourt systems where parties from two or more nations are in a dispute).\n\nAs you might expect, these laws sometimes conflict: a state law may conflict with a federal law, or a\nfederal law might be contrary to an international obligation. One nation\xe2\x80\x99s law may provide one\nsubstantive rule, while another nation\xe2\x80\x99s law may provide a different, somewhat contrary rule to apply. Not\nall laws, in other words, are created equal. To understand which laws have priority, it is essential to\nunderstand the relationships between the various kinds of law.\n\nConstitutions\nConstitutions are the foundation for a state or nation\xe2\x80\x99s other laws, providing the country\xe2\x80\x99s legislative,\nexecutive, and judicial framework. Among the nations of the world, the United States has the oldest\nconstitution still in use. It is difficult to amend, which is why there have only been seventeen amendments\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n22\n\n\x0cfollowing the first ten in 1789; two-thirds of the House and Senate must pass amendments, and threefourths of the states must approve them.\n\nThe nation\xe2\x80\x99s states also have constitutions. Along with providing for legislative, executive, and judicial\nfunctions, state constitutions prescribe various rights of citizens. These rights may be different from, and\nin addition to, rights granted by the US Constitution. Like statutes and judicial decisions, a constitution\xe2\x80\x99s\nspecific provisions can provide people with a \xe2\x80\x9ccause of action\xe2\x80\x9d on which to base a lawsuit (see Section\n1.4.3 "Causes of Action, Precedent, and " on \xe2\x80\x9ccauses of action\xe2\x80\x9d). For example, California\xe2\x80\x99s constitution\nprovides that the citizens of that state have a right of privacy. This has been used to assert claims against\nbusinesses that invade an employee\xe2\x80\x99s right of privacy. In the case of Virginia Rulon-Miller, her employer,\nInternational Business 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 in\ndamages. As the California court noted, \xe2\x80\x9cWhile an employee sacrifices some privacy rights when he enters\nthe workplace, the employee\xe2\x80\x99s privacy expectations must be balanced against the employer\xe2\x80\x99s\ninterests.\xe2\x80\xa6[T]he point here is that privacy, like the other unalienable rights listed first in our\nConstitution\xe2\x80\xa6is unquestionably a fundamental interest of our society.\xe2\x80\x9d\n\n[1]\n\nStatutes and Treaties in Congress\nIn Washington, DC, the federal legislature is known as Congress and has both a House of Representatives\nand a Senate. The House is composed of representatives elected every two years from various districts in\neach state. These districts are established by Congress according to population as determined every ten\nyears by the census, a process required by the Constitution. Each state has at least one district; the most\npopulous state (California) has fifty-two districts. In the Senate, there are two senators from each state,\nregardless of the state\xe2\x80\x99s population. Thus Delaware has two senators and California has two senators, even\nthough California has far more people. Effectively, less than 20 percent of the nation\xe2\x80\x99s population can\nsend fifty senators to Washington.\n\nMany consider this to be antidemocratic. The House of Representatives, on the other hand, is directly\nproportioned by population, though no state can have less than one representative.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n23\n\n\x0cEach Congressional legislative body has committees for various purposes. In these committees, proposed\nbills are discussed, hearings are sometimes held, and bills are either reported out (brought to the floor for\na vote) or killed in committee. If a bill is reported out, it may be passed by majority vote. Because of the\nprocedural differences between the House and the Senate, bills that have the same language when\nproposed in both houses are apt to be different after approval by each body. A conference committee will\nthen be held to try to match the two versions. If the two versions differ widely enough, reconciliation of\nthe two differing versions into one acceptable to both chambers (House and Senate) is more difficult.\n\nIf the House and Senate can agree on identical language, the reconciled bill will be sent to the president\nfor signature or veto. The Constitution prescribes that the president will have veto power over any\nlegislation. But the two bodies can override a presidential veto with a two-thirds vote in each chamber.\n\nIn the case of treaties, the Constitution specifies that only the Senate must ratify them. When the Senate\nratifies a treaty, it becomes part of federal law, with the same weight and effect as a statute passed by the\nentire Congress. The statutes of Congress are collected in codified form in the US Code. The code is\navailable 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 laws\n(see Chapter 5 "Administrative Law"). The Constitution does not expressly provide for administrative\nagencies, but the US Supreme Court has upheld the delegation of power to create federal agencies.\n\nExamples of administrative agencies would include the Occupational Safety and Health Administration\n(OSHA), the Environmental Protection Agency (EPA), and the Federal Trade Commission (FTC).\n\nIt is important to note that Congress does not have unlimited authority to delegate its lawmaking powers\nto an agency. It must delegate its authority with some guidelines for the agency and cannot altogether\navoid its constitutional responsibilities (see Chapter 5 "Administrative Law").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n24\n\n\x0cAgencies propose rules in the Federal Register, published each working day of the year. Rules that are\nformally adopted are published in theCode of Federal Regulations, or CFR, available online\nathttp://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 representatives.\nLike the federal government, state legislatures will agree on the provisions of a bill, which is then sent to\nthe governor (acting like the president for that state) for signature. Like the president, governors often\nhave a veto power. The process of creating and amending, or changing, laws is filled with political\nnegotiation and compromise.\n\nOn a more local level, counties and municipal corporations or townships may be authorized under a\nstate\xe2\x80\x99s constitution to create or adopt ordinances. Examples of ordinances include local building codes,\nzoning laws, and misdemeanors or infractions such as skateboarding or jaywalking. Most of the more\nunusual laws that are in the news from time to time are local ordinances. For example, in Logan County,\nColorado, it is illegal to kiss a sleeping woman; in Indianapolis, Indiana, and Eureka, Nebraska, it is a\ncrime to kiss if you have a mustache. But reportedly, some states still have odd laws here and there.\nKentucky law proclaims that every person in the state must take a bath at least once a year, and failure to\ndo so is illegal.\n\nJudicial Decisions: The Common Law\nCommon law consists of decisions by courts (judicial decisions) that do not involve interpretation of\nstatutes, regulations, treaties, or the Constitution. Courts make such interpretations, but many cases are\ndecided where there is no statutory or other codified law or regulation to be interpreted. For example, a\nstate court deciding what kinds of witnesses are required for a valid will in the absence of a rule (from a\nstatute) is making common law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n25\n\n\x0cUnited States law comes primarily from the tradition of English common law. By the time England\xe2\x80\x99s\nAmerican colonies revolted in 1776, English common-law traditions were well established in the colonial\ncourts. English common law was a system that gave written judicial decisions the force of law throughout\nthe country. Thus if an English court delivered an opinion as to what constituted the common-law crime\nof burglary, other courts would stick to that decision, so that a common body of law developed throughout\nthe country. Common law is essentially shorthand for the notion that a common body of law, based on\npast written decisions, is desirable and necessary.\n\nIn England and in the laws of the original thirteen states, common-law decisions defined crimes such as\narson, burglary, homicide, and robbery. As time went on, US state legislatures either adopted or modified\ncommon-law definitions of most crimes by putting them in the form of codes or statutes. This legislative\nability\xe2\x80\x94to modify or change common law into judicial law\xe2\x80\x94points to an important phenomenon: the\npriority of statutory law over common law. As we will see in the next section, constitutional law will have\npriority 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 inconsistent. For\nexample, if Michigan were to decide legislatively that students cannot speak ill of professors in statesponsored universities, that law would be void, since it is inconsistent with the state\xe2\x80\x99s obligation under the\nFirst Amendment to protect free speech. Or if the Michigan courts were to allow a professor to bring a\nlawsuit against a student who had said something about him that was derogatory but not defamatory, the\nstate\xe2\x80\x99s judicial system would not be acting according to the First Amendment. (As we will see in Chapter 7\n"Introduction to Tort Law", free speech has its limits; defamation was a cause of action at the time the\nFirst Amendment was added to the Constitution, and it has been understood that the free speech rights in\nthe First Amendment did not negate existing common law.)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n26\n\n\x0cStatutes and Cases\nStatutes generally have priority, or take precedence, over case law (judicial decisions). Under commonlaw judicial decisions, employers could hire young children for difficult work, offer any wage they wanted,\nand not pay overtime work at a higher rate. But various statutes changed that. For example, the federal\nFair Labor Standards Act (1938) forbid the use of oppressive child labor and established a minimum pay\nwage 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 the North\nAmerican Free Trade Agreement (NAFTA), any judicial decisions or previous statutes that were\ninconsistent\xe2\x80\x94such as quotas or limitations on imports from Mexico that were opposite to NAFTA\ncommitments\xe2\x80\x94would no longer be valid. Similarly, US treaty obligations under the General Agreement\non Tariffs and Trade (GATT) and obligations made later through the World Trade Organization (WTO)\nwould override previous federal or state statutes.\n\nOne example of treaty obligations overriding, or taking priority over, federal statutes was the tunadolphin dispute between the United States and Mexico. The Marine Mammal Protection Act amendments\nin 1988 spelled out certain protections for dolphins in the Eastern Tropical Pacific, and the United States\nbegan refusing to allow the importation of tuna that were caught using \xe2\x80\x9cdolphin-unfriendly\xe2\x80\x9d methods\n(such as purse seining). This was challenged at a GATT dispute panel in Switzerland, and the United\nStates lost. The discussion continued at the WTO under its dispute resolution process. In short, US\nenvironmental statutes can be ruled contrary to US treaty obligations.\n\nUnder most treaties, the United States can withdraw, or take back, any voluntary limitation on its\nsovereignty; participation in treaties is entirely elective. That is, the United States may \xe2\x80\x9cunbind\xe2\x80\x9d itself\nwhenever it chooses. But for practical purposes, some limitations on sovereignty may be good for the\nnation. The argument goes something like this: if free trade in general helps the United States, then it\nmakes some sense to be part of a system that promotes free trade; and despite some temporary setbacks,\nthe WTO decision process will (it is hoped) provide far more benefits than losses in the long run. This\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n27\n\n\x0cargument invokes utilitarian theory (that the best policy does the greatest good overall for society) and\nDavid Ricardo\xe2\x80\x99s theory of comparative advantage.\n\nUltimately, whether the United States remains a supporter of free trade and continues to participate as a\nleader in the WTO will depend upon citizens electing leaders who support the process. Had Ross Perot\nbeen elected in 1992, for example, NAFTA would have been politically (and legally) dead during his term\nof 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 court are\nthose that can be tied to one or more causes of action. Positive law is full of cases, treaties, statutes,\nregulations, and constitutional provisions that can be made into a cause of action. If you have an\nagreement with Harold Hill that he will purchase seventy-six trombones from you and he fails to pay for\nthem after you deliver, you will probably feel wronged, but a court will only act favorably on your\ncomplaint if you can show that his behavior gives you a cause of action based on some part of your state\xe2\x80\x99s\ncontract law. This case would give you a cause of action under the law of most states; unless Harold Hill\nhad some legal excuse recognized by the applicable state\xe2\x80\x99s contract law\xe2\x80\x94such as his legal incompetence,\nhis being less than eighteen years of age, his being drunk at the time the agreement was made, or his claim\nthat the instruments were trumpets rather than trombones or that they were delivered too late to be of use\nto him\xe2\x80\x94you could expect to recover some compensation for his breaching of your agreement with him.\n\nAn old saying in the law is that the law does not deal in trifles, or unimportant issues (in Latin, de minimis\nnon curat lex). Not every wrong you may suffer in life will be a cause to bring a court action. If you are\nstood up for a Saturday night date and feel embarrassed or humiliated, you cannot recover anything in a\ncourt of law in the United States, as there is no cause of action (no basis in the positive law) that you can\nuse in your complaint. If you are engaged to be married and your spouse-to-be bolts from the wedding\nceremony, there are some states that do provide a legal basis on which to bring a lawsuit. \xe2\x80\x9cBreach of\npromise to marry\xe2\x80\x9d is recognized in several states, but most states have abolished this cause of action,\neither by judicial decision or by legislation. Whether a runaway bride or groom gives rise to a valid cause\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n28\n\n\x0cof action in the courts depends on whether the state courts still recognize and enforce this nowdisappearing cause of action.\n\nYour cause of action is thus based on existing laws, including decided cases. How closely your case \xe2\x80\x9cfits\xe2\x80\x9d\nwith a prior decided case raises the question of precedent.\n\nAs noted earlier in this chapter, the English common-law tradition placed great emphasis on precedent\nand what is called stare decisis. A court considering one case would feel obliged to decide that case in a\nway similar to previously decided cases. Written decisions of the most important cases had been spread\nthroughout England (the common \xe2\x80\x9crealm\xe2\x80\x9d), and judges hoped to establish a somewhat predictable,\nconsistent group of decisions.\n\nThe English legislature (Parliament) was not in the practice of establishing detailed statutes on crimes,\ntorts, contracts, or property. Thus definitions and rules were left primarily to the courts. By their nature,\ncourts could only decide one case at a time, but in doing so they would articulate holdings, or general\nrules, that would apply to later cases.\n\nSuppose that one court had to decide whether an employer could fire an employee for no reason at all.\nSuppose that there were no statutes that applied to the facts: there was no contract between the employer\nand the employee, but the employee had worked for the employer for many years, and now a younger\nperson was replacing him. The court, with no past guidelines, would have to decide whether the employee\nhad stated a \xe2\x80\x9ccause of action\xe2\x80\x9d against the employer. If the court decided that the case was not legally\nactionable, it would dismiss the action. Future courts would then treat similar cases in a similar way. In\nthe process, the court might make a holding that employers could fire employees for any reason or for no\nreason. This rule could be applied in the future should similar cases come up.\n\nBut suppose that an employer fired an employee for not committing perjury (lying on the witness stand in\na court proceeding); the employer wanted the employee to cover up the company\'s criminal or unethical\nact. Suppose that, as in earlier cases, there were no applicable statutes and no contract of employment.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n29\n\n\x0cCourts relying on a holding or precedent that \xe2\x80\x9cemployers may fire employees for any reason or no reason\xe2\x80\x9d\nmight rule against an employee seeking compensation for being fired for telling the truth on the witness\nstand. Or it might make an exception to the general rule, such as, \xe2\x80\x9cEmployers may generally discharge\nemployees for any reason or for no reason without incurring legal liability; however, employers will incur\nlegal liability for firing an employee who refuses to lie on behalf of the employer in a court proceeding.\xe2\x80\x9d\n\nIn each case (the general rule and its exception), the common-law tradition calls for the court to explain\nthe reasons for its ruling. In the case of the general rule, \xe2\x80\x9cfreedom of choice\xe2\x80\x9d might be the major reason.\nIn the case of the perjury exception, the efficiency of the judicial system and the requirements of\ncitizenship might be used as reasons. Because the court\xe2\x80\x99s \xe2\x80\x9creasons\xe2\x80\x9d will be persuasive to some and not to\nothers, there is inevitably a degree of subjectivity to judicial opinions. That is, reasonable people will\ndisagree as to the persuasiveness of the reasoning a court may offer for its decision.\n\nWritten judicial opinions are thus a good playing field for developing critical thinking skills by identifying\nthe issue in a case and examining the reasons for the court\xe2\x80\x99s previous decision(s), or holding. What hasthe\ncourt actually decided, and why? Remember that a court, especially the US Supreme Court, is not only\ndeciding one particular case but also setting down guidelines (in its holdings) for federal and state courts\nthat encounter similar issues. Note that court cases often raise a variety of issues or questions to be\nresolved, and judges (and attorneys) will differ as to what the real issue in a case is. A holding is the\ncourt\xe2\x80\x99s complete answer to an issue that is critical to deciding the case and thus gives guidance to the\nmeaning of the case as a precedent for future cases.\n\nBeyond the decision of the court, it is in looking at the court\xe2\x80\x99s reasoningthat you are most likely to\nunderstand what facts have been most significant to the court and what theories (schools of legal thought)\neach trial or appellate judge believes in. Because judges do not always agree on first principles (i.e., they\nsubscribe to different schools of legal thought), there are many divided opinions in appellate opinions and\nin each US Supreme Court term.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n30\n\n\x0cK E Y TA K EA WAY\nThere are different sources of law in the US legal system. The US Constitution is\nfoundational; US statutory and common law cannot be inconsistent with its provisions.\nCongress creates statutory law (with the signature of the president), and courts will\ninterpret constitutional law and statutory law. Where there is neither constitutional law\nnor statutory law, the courts function in the realm of common law. The same is true of\nlaw within the fifty states, each of which also has a constitution, or foundational law.\nBoth the federal government and the states have created administrative agencies. An\nagency only has the power that the legislature gives it. Within the scope of that power,\nan agency will often create regulations (see Chapter 5 "Administrative Law"), which have\nthe same force and effect as statutes. Treaties are never negotiated and concluded by\nstates, as the federal government has exclusive authority over relations with other\nnation-states. A treaty, once ratified by the Senate, has the same force and effect as a\nstatute passed by Congress and signed into law by the president.\nConstitutions, statutes, regulations, treaties, and court decisions can provide a legal\nbasis in the positive law. You may believe you have been wronged, but for you to have a\nright that is enforceable in court, you must have something in the positive law that you\ncan point to that will support a cause of action against your chosen defendant.\n\nE XE R C IS ES\n1. Give one example of where common law was overridden by the passage of a federal\nstatute.\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\nhas spent all her time rushing that particular sorority, which chooses some of her friends\nbut not her. She is disappointed and angry and wants to sue the sorority. What are her\nprospects of recovery in the legal system? Explain.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n31\n\n\x0c4.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n32\n\n\x0cL EA R N IN G O B JEC T IV E\n1.\n\nDescribe how the common-law system differs from the civil-law system.\n\nOther legal and political systems are very different from the US system, which came from English\ncommon-law traditions and the framers of the US Constitution. Our legal and political traditions are\ndifferent both in what kinds of laws we make and honor and in how disputes are resolved in court.\n\nComparing Common-Law Systems with Other Legal Systems\nThe common-law tradition is unique to England, the United States, and former colonies of the British\nEmpire. Although there are differences among common-law systems (e.g., most nations do not permit\ntheir judiciaries to declare legislative acts unconstitutional; some nations use the jury less frequently), all\nof them recognize the use of precedent in judicial cases, and none of them relies on the comprehensive,\nlegislative 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 Roman\nand Napoleonic law. A civil-law or code-law system is one where all the legal rules are in one or more\ncomprehensive legislative enactments. During Napoleon\xe2\x80\x99s reign, a comprehensive book of laws\xe2\x80\x94a code\xe2\x80\x94\nwas developed for all of France. The code covered criminal law, criminal procedure, noncriminal law and\nprocedure, and commercial law. The rules of the code are still used today in France and in other\ncontinental European legal systems. The code is used to resolve particular cases, usually by judges without\na jury. Moreover, the judges are not required to follow the decisions of other courts in similar cases. As\nGeorge Cameron of the University of Michigan has noted, \xe2\x80\x9cThe law is in the code, not in the cases.\xe2\x80\x9d He\ngoes on to note, \xe2\x80\x9cWhere several cases all have interpreted a provision in a particular way, the French\ncourts may feel bound to reach the same result in future cases, under the doctrine of jurisprudence\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 nations in\nAsia and Africa have also adopted codes based on European civil law. Germany, Holland, Spain, France,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n33\n\n\x0cand Portugal all had colonies outside of Europe, and many of these colonies adopted the legal practices\nthat were imposed on them by colonial rule, much like the original thirteen states of the United States,\nwhich adopted English common-law practices.\n\nOne source of possible confusion at this point is that we have already referred to US civil law in contrast to\ncriminal law. But the European civil law covers both civil and criminal law.\n\nThere are also legal systems that differ significantly from the common-law and civil-law systems. The\ncommunist and socialist legal systems that remain (e.g., in Cuba and North Korea) operate on very\ndifferent assumptions than those of either English common law or European civil law. Islamic and other\nreligion-based systems of law bring different values and assumptions to social and commercial relations.\nFor the Islamic and Middle Eastern law, seehttp://www.soas.ac.uk/library/subjects/law/region/islamic.\n\nK E Y TA K EA WAY\nLegal systems vary widely in their aims and in the way they process civil and criminal\ncases. Common-law systems use juries, have one judge, and adhere to precedent. Civillaw systems decide cases without a jury, often use three judges, and often render\nshorter opinions without reference to previously decided cases.\n\nE XE R C IS E\n1. Use the Internet to identify some of the better-known nations with civil-law systems.\nWhich Asian nations came to adopt all or part of civil-law traditions, and why?\n\n1.6 A Sample Case\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n34\n\n\x0cPreliminary Note to Students\n\nTitle VII of the Civil Rights Act of 1964 is a federal statute that applies to all employers whose workforce\nexceeds fifteen people. The text of Title VII says that\n\n(a) it shall be an unlawful employment practice for an employer\xe2\x80\x94\n\n(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against any\nindividual with respect to his compensation, terms, conditions, or privileges of employment, because of\nsuch individual\xe2\x80\x99s race, color, religion, sex, or natural origin.\n\nAt common law\xe2\x80\x94where judges decide cases without reference to statutory guidance\xe2\x80\x94employers were\ngenerally free to hire and fire on any basis they might choose, and employees were generally free to work\nfor an employer or quit an employer on any basis they might choose (unless the employer and the\nemployee had a contract). This rule has been called \xe2\x80\x9cemployment at will.\xe2\x80\x9d State and federal statutes that\nprohibit discrimination on any basis (such as the prohibitions on discrimination because of race, color,\nreligion, sex, or national origin in Title VII) are essentially legislative exceptions to the common-law\nemployment-at-will rule.\n\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 employment\nor promotion (quid pro quo sexual harassment) or found themselves in a working environment that put\ntheir chances for continued employment or promotion at risk. This form of sexual discrimination came to\nbe called \xe2\x80\x9chostile working environment\xe2\x80\x9d sexual harassment.\n\nNotice that the statute itself says nothing about sexual harassment but speaks only in broad terms about\ndiscrimination \xe2\x80\x9cbecause of\xe2\x80\x9d sex (and four other factors). Having set the broad policy, Congress left it to\nemployees, employers, and the courts to fashion more specific rules through the process of civil litigation.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n35\n\n\x0cThis is a case from our federal court system, which has a trial or hearing in the federal district court, an\nappeal to the Sixth Circuit Court of Appeals, and a final appeal to the US Supreme Court. Teresa Harris,\nhaving lost at both the district court and the Sixth Circuit Court of Appeals, here has petitioned for a writ\nof certiorari (asking the court to issue an order to bring the case to the Supreme Court), a petition that is\ngranted less than one out of every fifty times. The Supreme Court, in other words, chooses its cases\ncarefully. Here, the court wanted to resolve a difference of opinion among the various circuit courts of\nappeal as to whether or not a plaintiff in a hostile-working-environment claim could recover damages\nwithout showing \xe2\x80\x9csevere psychological injury.\xe2\x80\x9d\n\nHarris v. Forklift Systems\n510 U.S. 17 (U.S. Supreme Court 1992)\n\nJUDGES: O\xe2\x80\x99CONNOR, J., delivered the opinion for a unanimous Court. SCALIA, J., and GINSBURG, J.,\nfiled concurring opinions.\n\nJUSTICE O\xe2\x80\x99CONNOR delivered the opinion of the Court.\n\nIn this case we consider the definition of a discriminatorily \xe2\x80\x9cabusive work environment\xe2\x80\x9d (also known as a\n\xe2\x80\x9chostile work environment\xe2\x80\x9d) under Title VII of the Civil Rights Act of 1964, 78 Stat. 253, as amended, 42\nU.S.C. \xc2\xa7 2000e et seq. (1988 ed., Supp. III).\n\nI\nTeresa Harris worked as a manager at Forklift Systems, Inc., an equipment rental company, from April\n1985 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 of her\ngender and often made her the target of unwanted sexual innuendoes. Hardy told Harris on several\noccasions, in the presence of other employees, \xe2\x80\x9cYou\xe2\x80\x99re a woman, what do you know\xe2\x80\x9d and \xe2\x80\x9cWe need a man\nas the rental manager\xe2\x80\x9d; at least once, he told her she was \xe2\x80\x9ca dumbass woman.\xe2\x80\x9d Again in front of others, he\nsuggested that the two of them \xe2\x80\x9cgo to the Holiday Inn to negotiate [Harris\xe2\x80\x99s] raise.\xe2\x80\x9d Hardy occasionally\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n36\n\n\x0casked Harris and other female employees to get coins from his front pants pocket. He threw objects on the\nground in front of Harris and other women, and asked them to pick the objects up. He made sexual\ninnuendoes about Harris\xe2\x80\x99 and other women\xe2\x80\x99s clothing.\n\nIn mid-August 1987, Harris complained to Hardy about his conduct. Hardy said he was surprised that\nHarris was offended, claimed he was only joking, and apologized. He also promised he would stop, and\nbased on this assurance Harris stayed on the job. But in early September, Hardy began anew: While\nHarris was arranging a deal with one of Forklift\xe2\x80\x99s customers, he asked her, again in front of other\nemployees, \xe2\x80\x9cWhat did you do, promise the guy\xe2\x80\xa6some [sex] Saturday night?\xe2\x80\x9d On October 1, Harris\ncollected her paycheck and quit.\n\nHarris then sued Forklift, claiming that Hardy\xe2\x80\x99s conduct had created an abusive work environment for her\nbecause of her gender. The United States District Court for the Middle District of Tennessee, adopting the\nreport and recommendation of the Magistrate, found this to be \xe2\x80\x9ca close case,\xe2\x80\x9d but held that Hardy\xe2\x80\x99s\nconduct did not create an abusive environment. The court found that some of Hardy\xe2\x80\x99s comments\n\xe2\x80\x9coffended [Harris], and would offend the reasonable woman,\xe2\x80\x9d but that they were not \xe2\x80\x9cso severe as to be\nexpected to seriously affect [Harris\xe2\x80\x99s] psychological well-being. A reasonable woman manager under like\ncircumstances would 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\n\xe2\x80\x9cNeither do I believe that [Harris] was subjectively so offended that she suffered injury.\xe2\x80\xa6Although Hardy\nmay at times have genuinely offended [Harris], I do not believe that he created a working environment so\npoisoned 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 precedent.\nSee Rabidue v. Osceola Refining Co., 805 F.2d 611, 620 (CA6 1986), cert. denied, 481 U.S. 1041, 95 L. Ed.\n2d 823, 107 S. Ct. 1983 (1987). The United States Court of Appeals for the Sixth Circuit affirmed in a brief\nunpublished decision\xe2\x80\xa6reported at 976 F.2d 733 (1992).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n37\n\n\x0cWe granted certiorari, 507 U.S. 959 (1993), to resolve a conflict among the Circuits on whether conduct,\nto be actionable as \xe2\x80\x9cabusive work environment\xe2\x80\x9d harassment (no quid pro quo harassment issue is present\nhere), must \xe2\x80\x9cseriously affect [an employee\xe2\x80\x99s] psychological well-being\xe2\x80\x9d or lead the plaintiff to \xe2\x80\x9csuffer\ninjury.\xe2\x80\x9d Compare Rabidue (requiring serious effect on psychological well-being); Vance v. Southern Bell\nTelephone & Telegraph Co., 863 F.2d 1503, 1510 (CA11 1989) (same); and Downes v. FAA, 775 F.2d 288,\n292 (CA Fed. 1985) (same), with Ellison v. Brady, 924 F.2d 872, 877\xe2\x80\x93878 (CA9 1991) (rejecting such a\nrequirement).\n\nII\nTitle VII of the Civil Rights Act of 1964 makes it \xe2\x80\x9can unlawful employment practice for an employer\xe2\x80\xa6to\ndiscriminate against any individual with respect to his compensation, terms, conditions, or privileges of\nemployment, because of such individual\xe2\x80\x99s race, color, religion, sex, or national origin.\xe2\x80\x9d 42 U.S.C. \xc2\xa7 2000e2(a)(1). As we made clear in Meritor Savings Bank, FSB v. Vinson, 477 U.S. 57 (1986), this language \xe2\x80\x9cis\nnot limited to \xe2\x80\x98economic\xe2\x80\x99 or \xe2\x80\x98tangible\xe2\x80\x99 discrimination. The phrase \xe2\x80\x98terms, conditions, or privileges of\nemployment\xe2\x80\x99 evinces a congressional intent \xe2\x80\x98to strike at the entire spectrum of disparate treatment of men\nand women\xe2\x80\x99 in employment,\xe2\x80\x9d which includes requiring people to work in a discriminatorily hostile or\nabusive environment. Id., at 64, quoting Los Angeles Dept. of Water and Power v. Manhart, 435 U.S. 702,\n707, n.13, 55 L. Ed. 2d 657, 98 S. Ct. 1370 (1978). When the workplace is permeated with \xe2\x80\x9cdiscriminatory\nintimidation, ridicule, and insult,\xe2\x80\x9d 477 U.S. at 65, that is \xe2\x80\x9csufficiently severe or pervasive to alter the\nconditions of the victim\xe2\x80\x99s employment and create an abusive working environment,\xe2\x80\x9d Title VII is violated.\n\nThis standard, which we reaffirm today, takes a middle path between making actionable any conduct that\nis merely offensive and requiring the conduct to cause a tangible psychological injury. As we pointed out\nin Meritor, \xe2\x80\x9cmere utterance of an\xe2\x80\xa6epithet which engenders offensive feelings in an employee,\xe2\x80\x9d does not\nsufficiently affect the conditions of employment to implicate Title VII. Conduct that is not severe or\npervasive enough to create an objectively hostile or abusive work environment\xe2\x80\x94an environment that a\nreasonable person would find hostile or abusive\xe2\x80\x94is beyond Title VII\xe2\x80\x99s purview. Likewise, if the victim\ndoes not subjectively perceive the environment to be abusive, the conduct has not actually altered the\nconditions of the victim\xe2\x80\x99s employment, and there is no Title VII violation.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n38\n\n\x0cBut 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, discourage\nemployees from remaining on the job, or keep them from advancing in their careers. Moreover, even\nwithout regard to these tangible effects, the very fact that the discriminatory conduct was so severe or\npervasive that it created a work environment abusive to employees because of their race, gender, religion,\nor national origin offends Title VII\xe2\x80\x99s broad rule of workplace equality. The appalling conduct alleged in\nMeritor, and the reference in that case to environments \xe2\x80\x9c\xe2\x80\x98so heavily polluted with discrimination as to\ndestroy completely the emotional and psychological stability of minority group workers,\xe2\x80\x99\xe2\x80\x9d Id., at 66,\nquoting Rogers v. EEOC, 454 F.2d 234, 238 (CA5 1971), cert. denied, 406 U.S. 957,32 L. Ed. 2d 343, 92 S.\nCt. 2058 (1972), merely present some especially egregious examples of harassment. They do not mark the\nboundary of what is actionable.\n\nWe therefore believe the District Court erred in relying on whether the conduct \xe2\x80\x9cseriously affected\nplaintiff\xe2\x80\x99s psychological well-being\xe2\x80\x9d or led her to \xe2\x80\x9csuffer injury.\xe2\x80\x9d Such an inquiry may needlessly focus the\nfact finder\xe2\x80\x99s attention on concrete psychological harm, an element Title VII does not require. Certainly\nTitle VII bars conduct that would seriously affect a reasonable person\xe2\x80\x99s psychological well-being, but the\nstatute is not limited to such conduct. So long as the environment would reasonably be perceived, and is\nperceived, as hostile or abusive, Meritor, supra, at 67, there is no need for it also to be psychologically\ninjurious.\n\nThis is not, and by its nature cannot be, a mathematically precise test. We need not answer today all the\npotential questions it raises, nor specifically address the Equal Employment Opportunity Commission\xe2\x80\x99s\nnew regulations on this subject, see 58 Fed. Reg. 51266 (1993) (proposed 29 CFR \xc2\xa7\xc2\xa7 1609.1, 1609.2); see\nalso 29 CFR \xc2\xa7 1604.11 (1993). But we can say that whether an environment is \xe2\x80\x9chostile\xe2\x80\x9d or \xe2\x80\x9cabusive\xe2\x80\x9d can be\ndetermined only by looking at all the circumstances. These may include the frequency of the\ndiscriminatory conduct; its severity; whether it is physically threatening or humiliating, or a mere\noffensive utterance; and whether it unreasonably interferes with an employee\xe2\x80\x99s work performance. The\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n39\n\n\x0ceffect on the employee\xe2\x80\x99s psychological well-being is, of course, relevant to determining whether the\nplaintiff actually found the environment abusive. But while psychological harm, like any other relevant\nfactor, may be taken into account, no single factor is required.\n\nIII\nForklift, while conceding that a requirement that the conduct seriously affect psychological well-being is\nunfounded, argues that the District Court nonetheless correctly applied the Meritor standard. We\ndisagree. Though the District Court did conclude that the work environment was not \xe2\x80\x9cintimidating or\nabusive to [Harris],\xe2\x80\x9d it did so only after finding that the conduct was not \xe2\x80\x9cso severe as to be expected to\nseriously affect plaintiff\xe2\x80\x99s psychological well-being,\xe2\x80\x9d and that Harris was not \xe2\x80\x9csubjectively so offended that\nshe suffered injury,\xe2\x80\x9d ibid. The District Court\xe2\x80\x99s application of these incorrect standards may well have\ninfluenced its ultimate conclusion, especially given that the court found this to be a \xe2\x80\x9cclose case.\xe2\x80\x9d\n\nWe therefore reverse the judgment of the Court of Appeals, and remand the case for further proceedings\nconsistent with this opinion.\n\nSo ordered.\n\nNote to Students\nThis was only the second time that the Supreme Court had decided a sexual harassment\ncase. Many feminist legal studies scholars feared that the court would raise the bar and\nmake hostile-working-environment claims under Title VII more difficult to win. That\ndid not happen. When the question to be decided is combined with the court\xe2\x80\x99s decision,\nwe get the holding of the case. Here, the question that the court poses, plus its answer,\nyields a holding that \xe2\x80\x9cAn employee need not prove severe psychological injury in order\nto win a Title VII sexual harassment claim.\xe2\x80\x9d This holding will be true until such time as\nthe court revisits a similar question and answers it differently. This does happen, but\nhappens rarely.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n40\n\n\x0cC A SE QU ES TIO NS\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?\n3. 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\nhave any rights to equal treatment in the workplace? Why shouldn\xe2\x80\x99t that judge dismiss\nthe case even before trial? Or should the judge dismiss the case after giving the female\nplaintiff her day in court?\n5. What was the employer\xe2\x80\x99s argument in this case? Do you agree or disagree with it? What\nif those who legislated Title VII gave no thought to the question of seriousness of injury\nat all?\n\n1.7 Summary and Exercises\nSummary\nThere are differing conceptions of what law is and of what law should be. Laws and legal systems differ\nworldwide. The legal system in the United States is founded on the US Constitution, which is itself\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n41\n\n\x0cinspired by natural-law theory and the idea that people have rights that cannot be taken by government\nbut only protected by government. The various functions of the law are done well or poorly depending on\nwhich nation-state you look at. Some do very well in terms of keeping order, while others do a better job\nof allowing civil and political freedoms. Social and political movements within each nation greatly affect\nthe nature and quality of the legal system within that nation.\nThis chapter has familiarized you with a few of the basic schools of legal thought, such as natural law,\npositive law, legal realism, and critical legal studies. It has also given you a brief background in common\nlaw, including contracts, torts, and criminal law. The differences between civil and criminal cases,\nsubstance and procedure, and the various sources of law have also been reviewed. Each source has a\ndifferent level of authority, starting with constitutions, which are primary and will negate any lower-court\nlaws that are not consistent with its principles and provisions. The basic differences between the common\nlaw and civil law (continental, or European) systems of law are also discussed.\n\nE XE R C IS ES\n1. What is the common law? Where do the courts get the authority to interpret it and\nto change it?\n2. After World War II ended in 1945, there was an international tribunal at Nuremberg\nthat prosecuted various officials in Germany\xe2\x80\x99s Third Reich who had committed\n\xe2\x80\x9ccrimes against humanity.\xe2\x80\x9d Many of them claim that they were simply \xe2\x80\x9cfollowing\norders\xe2\x80\x9d of Adolf Hitler and his chief lieutenants. What law, if any, have they\nviolated?\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. The state statute conflicts with the common law of that state.\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\nS EL F -T E ST QU EST IO N S\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n42\n\n\x0c1. The source of law that is foundational in the US legal system is\na. the common law\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 thought?\na. civil law\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. torts and contracts\nb. bankruptcy\nc. maritime law\nd. international law\nWhere was natural law discovered?\na. in nature\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 ofRiddick v. Clouse, which\ninvolves 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n43\n\n\x0ca. deductive reasoning\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, also a\ncontract dispute, there is no Colorado Supreme Court or court of appeals decision\nthat sets forth a rule that could be applied. However, the California case of Zhu v.\nPatel Enterprises, Inc. is \xe2\x80\x9cvery close\xe2\x80\x9d on the facts and sets forth a rule of law that\ncould be applied to the Cassidy case. What process must Moore follow in\nconsidering whether to use the Zhu case as precedent?\na. Moore is free to decide the case any way he wants, but he may not look\nat decisions and reasons in similar cases from other states.\nb. Moore must wait for the Colorado legislature and the governor to pass a\nlaw that addresses 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\nS EL F -T E ST A NSW E R S\n1. c\n2. e\n3. a\n4. c\n5. d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n44\n\n\x0c6. d\n\nChapter 2\n\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n45\n\n\x0cL EA R N IN G O B JEC T IV ES\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\nbusiness organizations.\n2. Understand the principal philosophies of ethics, including utilitarianism, duty-based\nethics, and virtue ethics.\n3. Distinguish between the ethical merits of various choices by using an ethical\ndecision model.\n4. Explain the difference between shareholder and stakeholder models of ethical\ncorporate governance.\n5. Explain why it is difficult to establish and maintain an ethical corporate culture in a\nbusiness organization.\n\nFew subjects are more contentious or important as the role of business in society, particularly, whether\ncorporations have social responsibilities that are distinct from maximizing shareholder value. While the\nphrase \xe2\x80\x9cbusiness ethics\xe2\x80\x9d is not oxymoronic (i.e., a contradiction in terms), there is plenty of evidence that\nbusinesspeople and firms seek to look out primarily for themselves. However, business organizations\nignore the ethical and social expectations of consumers, employees, the media, nongovernment\norganizations (NGOs), government officials, and socially responsible investors at their peril. Legal\ncompliance alone no longer serves the long-term interests of many companies, who find that sustainable\nprofitability requires thinking about people and the planet as well as profits.\nThis chapter has a fairly modest aim: to introduce potential businesspeople to the differences between\nlegal compliance and ethical excellence by reviewing some of the philosophical perspectives that apply to\nbusiness, businesspeople, and the role of business organizations in society.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n46\n\n\x0c2.1 What Is Ethics?\nL EA R N IN G O B JEC T IV ES\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\nimportant than legal compliance.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n47\n\n\x0cMost of those who write about ethics do not make a clear distinction between ethics and morality. The\nquestion 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 desirable\xe2\x80\x9d in any\nsituation is variously phrased, but all of the words and phrases are after the same thing: what act is\n\xe2\x80\x9cbetter\xe2\x80\x9d in a moral or ethical sense than some other act? People sometimes speak of morality as\nsomething personal but view ethics as having wider social implications. Others see morality as the subject\nof a field of study, that field being ethics. Ethics would be morality as applied to any number of subjects,\nincluding journalistic ethics, business ethics, or the ethics of professionals such as doctors, attorneys, and\naccountants. We will venture a definition of ethics, but for our purposes, ethics and morality will be used\nas equivalent terms.\n\nPeople often speak about the ethics or morality of individuals and also about the morality or ethics of\ncorporations and nations. There are clearly differences in the kind of moral responsibility that we can\nfairly ascribe to corporations and nations; we tend to see individuals as having a soul, or at least a\nconscience, but there is no general agreement that nations or corporations have either. Still, our ordinary\nuse of language does point to something significant: if we say that some nations are \xe2\x80\x9cevil\xe2\x80\x9d and others are\n\xe2\x80\x9ccorrupt,\xe2\x80\x9d then we make moral judgments about the quality of actions undertaken by the governments or\npeople of that nation. For example, if North Korea is characterized by the US president as part of an \xe2\x80\x9caxis\nof evil,\xe2\x80\x9d or if we conclude that WorldCom or Enron acted \xe2\x80\x9cunethically\xe2\x80\x9d in certain respects, then we are\nmaking judgments that their collective actions are morally deficient.\n\nIn talking about morality, we often use the word good; but that word can be confusing. If we say that\nMicrosoft is a \xe2\x80\x9cgood company,\xe2\x80\x9d we may be making a statement about the investment potential of\nMicrosoft stock, or their preeminence in the market, or their ability to win lawsuits or appeals or to\ninfluence administrative agencies. Less likely, though possibly, we may be making a statement about the\ncivic virtue and corporate social responsibility of Microsoft. In the first set of judgments, we use the\nword good but mean something other than ethical or moral; only in the second instance are we using the\nword good in its ethical or moral sense.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n48\n\n\x0cA word such as good can embrace ethical or moral values but also nonethical values. If I like Daniel and\ntry to convince you what a \xe2\x80\x9cgood guy\xe2\x80\x9d he is, you may ask all sorts of questions: Is he good-looking? Welloff? Fun to be with? Humorous? Athletic? Smart? I could answer all of those questions with a yes, yet you\nwould still not know any of his moral qualities. But if I said that he was honest, caring, forthright, and\ndiligent, volunteered in local soup kitchens, or tithed to the church, many people would see Daniel as\nhaving certain ethical or moral qualities. If I said that he keeps the Golden Rule as well as anyone I know,\nyou could conclude that he is an ethical person. But if I said that he is \xe2\x80\x9calways in control\xe2\x80\x9d or \xe2\x80\x9calways at the\ntop of his game,\xe2\x80\x9d you would probably not make inferences or assumptions about his character or ethics.\n\nThere are three key points here:\n1. Although morals and ethics are not precisely measurable, people generally have similar reactions about\nwhat 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 person or\ncompany is ethical.\n\nHere is a cautionary note: for individuals, it is far from easy to recognize an ethical problem, have a clear\nand usable decision-making process to deal it, and then have the moral courage to do what\xe2\x80\x99s right. All of\nthat is even more difficult within a business organization, where corporate employees vary in their\nmotivations, loyalties, commitments, and character. There is no universally accepted way for developing\nan organization where employees feel valued, respected, and free to openly disagree; where the actions of\ntop management are crystal clear; and where all 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 morality\xe2\x80\x94\xe2\x80\x9cright\xe2\x80\x9d\nand \xe2\x80\x9cwrong\xe2\x80\x9d\xe2\x80\x94in the context of everyday life, organizational behaviors, and even how society operates and\nis governed.\n\nHow Do Law and Ethics Differ?\nThere is a difference between legal compliance and moral excellence. Few would choose a professional\nservice, health care or otherwise, because the provider had a record of perfect legal compliance, or always\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n49\n\n\x0cfollowing the letter of the law. There are many professional ethics codes, primarily because people realize\nthat law prescribes only a minimum of morality and does not provide purpose or goals that can mean\nexcellent service to customers, clients, or patients.\n\nBusiness ethicists have talked for years about the intersection of law and ethics. Simply put, what is legal\nis not necessarily ethical. Conversely, what is ethical is not necessarily legal. There are lots of legal\nmaneuvers that are not all that ethical; the well-used phrase \xe2\x80\x9clegal loophole\xe2\x80\x9d suggests as much.\n\nHere are two propositions about business and ethics. Consider whether they strike you as true or whether\nyou would need to know more in order to make a judgment.\n\n\xe2\x80\xa2 Individuals and organizations have reputations. (For an individual, moral reputation is most often tied\nto others\xe2\x80\x99 perceptions of his or her character: is the individual honest, diligent, reliable, fair, and caring?\nThe reputation of an organization is built on the goodwill that suppliers, customers, the community, and\nemployees feel toward it. Although an organization is not a person in the usual sense, the goodwill that\npeople feel about the organization is based on their perception of its better qualities by a variety of\nstakeholders: customers or clients, suppliers, investors, employees, government officials).\n\xe2\x80\xa2 The goodwill of an organization is to a great extent based on the actions it takes and on whether the\nactions are favorably viewed. (This goodwill is usually specifically counted in the sale of a business as an\nasset that the buyer pays for. While it is difficult to place a monetary value on goodwill, a firm\xe2\x80\x99s good\nreputation will generally call for a higher evaluation in the final accounting before the sale. Legal\ntroubles or a reputation for having legal troubles will only lessen the price for a business and will even\nlessen the value of the company\xe2\x80\x99s stock as bad legal news comes to the public\xe2\x80\x99s attention.)\n\nAnother reason to think about ethics in connection with law is that the laws themselves are meant to\nexpress some moral view. If there are legal prohibitions against cheating the Medicare program, it is\nbecause people (legislators or their agents) have collectively decided that cheating Medicare is wrong. If\nthere are legal prohibitions against assisting someone to commit suicide, it is because there has been a\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n50\n\n\x0cgroup decision that doing so is immoral. Thus the law provides some important cues as to what society\nregards as right or wrong.\n\nFinally, important policy issues that face society are often resolved through law, but it is important to\nunderstand the moral perspectives that underlie public debate\xe2\x80\x94as, for example, in the continuing\ncontroversies over stem-cell research, medical use of marijuana, and abortion. Some ethical perspectives\nfocus on rights, some on social utility, some on virtue or character, and some on social justice. People\nconsciously (or, more often, unconsciously) adopt one or more of these perspectives, and even if they\ncompletely agree on the facts with an opponent, they will not change their views. Fundamentally, the\ndifference comes down to incompatible moral perspectives, a clash of basic values. These are hot-button\nissues because society is divided, not so much over facts, but over basic values. Understanding the varied\nmoral perspectives and values in public policy debates is a clarifying benefit in following or participating\nin 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 attention to\nethics as well as law do better; they are viewed more favorably by customers. But this is a difficult claim to\nmeasure scientifically, because \xe2\x80\x9cthe long run\xe2\x80\x9d is an indistinct period of time and because there are as yet\nno generally accepted criteria by which ethical excellence can be measured. In addition, life is still lived in\nthe short run, and there are many occasions when something short of perfect conduct is a lot more\nprofitable.\nSome years ago, Royal Dutch/Shell (one of the world\xe2\x80\x99s largest companies) found that it was in deep\ntrouble with the public for its apparent carelessness with the environment and human rights. Consumers\nwere boycotting and investors were getting frightened, so the company took a long, hard look at its ethic\nof short-term profit maximization. Since then, changes have been made. The CEO told one group of\nbusiness ethicists that the uproar had taken them by surprise; they thought they had done everything\nright, but it seemed there was a \xe2\x80\x9cghost in the machine.\xe2\x80\x9d That ghost was consumers, NGOs, and the media,\nall of whom objected to the company\xe2\x80\x99s seeming lack of moral sensitivity.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n51\n\n\x0cThe market does respond to unethical behavior. In Section 2.4 "Corporations and Corporate Governance",\nyou will read about the Sears Auto Centers case. The loss of goodwill toward Sears Auto Centers was real,\neven though the total amount of money lost cannot be clearly accounted for. Years later, there are people\nwho will not go near a Sears Auto Center; the customers who lost trust in the company will never return,\nand many of their children may avoid Sears Auto Centers as well.\n\nThe Arthur Andersen story is even more dramatic. A major accounting firm, Andersen worked closely\nwith Enron in hiding its various losses through creative accounting measures. Suspiciously, Andersen\xe2\x80\x99s\nHouston office also did some shredding around the clock, appearing to cover up what it was doing for\nEnron. A criminal case based on this shredding resulted in a conviction, later overturned by the Supreme\nCourt. But it was too late. Even before the conviction, many clients had found other accounting firms that\nwere not under suspicion, and the Supreme Court\xe2\x80\x99s reversal came too late to save the company. Even\nwithout the conviction, Andersen would have lost significant market share.\n\nThe irony of Andersen as a poster child for overly aggressive accounting practices is that the man who\nfounded the firm built it on integrity and straightforward practices. \xe2\x80\x9cThink straight, talk straight\xe2\x80\x9d was the\ncompany\xe2\x80\x99s motto. Andersen established the company\xe2\x80\x99s reputation for integrity over a hundred years ago\nby refusing to play numbers games for a potentially lucrative client.\n\nMaximizing profits while being legally compliant is not a very inspiring goal for a business. People in an\norganization need some quality or excellence to strive for. By focusing on pushing the edge of what is\nlegal, by looking for loopholes in the law that would help create short-term financial gain, companies have\noften learned that in the long term they are not actually satisfying the market, the shareholders, the\nsuppliers, or the community generally.\n\nK E Y TA K EA WAY\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n52\n\n\x0cE XE R C IS ES\n1. Think of a person who did something morally wrong, at least to your way of thinking.\nWhat was it? Explain to a friend of yours\xe2\x80\x94or a classmate\xe2\x80\x94why you think it was wrong.\nDoes your friend agree? Why or why not? What is the basic principle that forms the basis\nfor your judgment that it was wrong?\n2. Think of a person who did something morally right, at least to your way of thinking. (This\nis not a matter of finding something they did well, like efficiently changing a tire, but\nsomething good.) What was it? Explain to a friend of yours\xe2\x80\x94or a classmate\xe2\x80\x94why you\nthink it was right. Does your friend agree? Why or why not? What is the basic principle\nthat forms the basis for your judgment that it was right?\n3. Think of an action by a business organization (sole proprietor, partnership, or\ncorporation) that was legal but still strikes you as wrong. What was it? Why do you think\nit was wrong?\n4. Think of an act by an individual or a corporation that is ethical but not legal. Compare\nyour answer with those of your classmates: were you more likely to find an example\nfrom individual action or corporate action? Do you have any thoughts as to why?\n\n2.2 Major Ethical Perspectives\nL EA R N IN G O B JEC T IV ES\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\nlife and business.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n53\n\n\x0cThere are several well-respected ways of looking at ethical issues. Some of them have been around for\ncenturies. It is important to know that many who think a lot about business and ethics have deeply held\nbeliefs about which perspective is best. Others would recommend considering ethical problems from a\nvariety of different perspectives. Here, we take a brief look at (1) utilitarianism, (2) deontology, (3) social\njustice and social contract theory, and (4) virtue theory. We are leaving out some important perspectives,\nsuch as general theories of justice and \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 the\nfree-market outlook that has come to dominate much current thinking about business, management, and\neconomics. Jeremy Bentham is often considered the founder of utilitarianism, though John Stuart Mill\n(who wrote On Liberty and Utilitarianism) and others promoted it as a guide to what is good.\nUtilitarianism emphasizes not rules but results. An action (or set of actions) is generally deemed good or\nright if it maximizes happiness or pleasure throughout society. Originally intended as a guide for\nlegislators charged with seeking the greatest good for society, the utilitarian outlook may also be practiced\nindividually and by corporations.\n\nBentham believed that the most promising way to obtain agreement on the best policies for a society\nwould be to look at the various policies a legislature could pass and compare the good and bad\nconsequences of each. The right course of action from an ethical point of view would be to choose the\npolicy that would produce the greatest amount of utility, or usefulness. In brief, the utilitarian principle\nholds that an action is right if and only if the sum of utilities produced by that action is greater than the\nsum of utilities from any other possible act.\n\nThis statement describes \xe2\x80\x9cact utilitarianism\xe2\x80\x9d\xe2\x80\x94which action among various options will deliver the\ngreatest good to society? \xe2\x80\x9cRule utilitarianism\xe2\x80\x9d is a slightly different version; it asks, what rule or principle,\nif followed regularly, will create the greatest good?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n54\n\n\x0cNotice that the emphasis is on finding the best possible results and that the assumption is that we can\nmeasure the utilities involved. (This turns out to be more difficult that you might think.) Notice also that\n\xe2\x80\x9cthe sum total of utilities\xe2\x80\x9d clearly implies that in doing utilitarian analysis, we cannot be satisfied if an act\nor set of acts provides the greatest utility to us as individuals or to a particular corporation; the test is,\ninstead, whether it provides the greatest utility to society as a whole. Notice that the theory does not tell us\nwhat kinds of utilities may be better than others or how much better a good today is compared with a\ngood a year from today.\n\nWhatever its difficulties, utilitarian thinking is alive and well in US law and business. It is found in such\ndiverse places as cost-benefit analysis in administrative and regulatory rules and calculations,\nenvironmental impact studies, the majority vote, product comparisons for consumer information,\nmarketing studies, tax laws, and strategic planning. In management, people will often employ a form of\nutility reasoning by projecting costs and benefits for plan X versus plan Y. But the issue in most of these\ncost-benefit analyses is usually (1) put exclusively in terms of money and (2) directed to the benefit of the\nperson or organization doing the analysis and not to the benefit of society as a whole.\n\nAn individual or a company that consistently uses the test \xe2\x80\x9cWhat\xe2\x80\x99s the greatest good for me or the\ncompany?\xe2\x80\x9d is not following the utilitarian test of the greatest good overall. Another common failing is to\nsee only one or two options that seem reasonable. The following are some frequent mistakes that people\nmake in applying what they think are utilitarian principles in justifying their chosen course of action:\n\n1. Failing to come up with lots of options that seem reasonable and then choosing the one that has the\ngreatest benefit for the greatest number. Often, a decision maker seizes on one or two alternatives\nwithout thinking carefully about other courses of action. If the alternative does more good than harm,\nthe 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 is,\nlooking 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 Pinto\ncase demonstrates how Ford Motor Company executives drastically underestimated the legal costs of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n55\n\n\x0cnot correcting a feature on their Pinto models that they knew could cause death or injury. General\nMotors was often taken to task by juries that came to understand that the company would not recall or\nrepair known and dangerous defects because it seemed more profitable not to. In 2010, Toyota learned\nthe same lesson.\n4. Underestimating the cost or harm of a certain decision to someone else or some other group of people.\n5. Favoring short-term benefits, even though the long-term costs are greater.\n6. Assuming that all values can be reduced to money. In comparing the risks to human health or safety\nagainst, say, the risks of job or profit losses, cost-benefit analyses will often try to compare apples to\noranges 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 Immanuel\nKant purports that having a moral intent and following the right rules is a better path to ethical conduct\nthan achieving the right results. A deontologist like Kant is likely to believe that ethical action arises from\ndoing one\xe2\x80\x99s duty and that duties are defined by rational thought. Duties, according to Kant, are not\nspecific to particular kinds of human beings but are owed universally to all human beings. Kant therefore\nuses \xe2\x80\x9cuniversalizing\xe2\x80\x9c as a form of rational thought that assumes the inherent equality of all human beings.\nIt considers all humans as equal, not in the physical, social, or economic sense, but equal before God,\nwhether they are male, female, Pygmy, Eskimoan, Islamic, Christian, gay, straight, healthy, sick, young, or\nold.\nFor Kantian thinkers, this basic principle of equality means that we should be able to universalize any\nparticular law or action to determine whether it is ethical. For example, if you were to consider\nmisrepresenting yourself on a resume for a particular job you really wanted and you were convinced that\ndoing so would get you that job, you might be very tempted to do so. (What harm would it be? you might\nask yourself. When I have the job, I can prove that I was perfect for it, and no one is hurt, while both the\nemployer and I are clearly better off as a result!) Kantian ethicists would answer that your chosen course\nof action should be a universal one\xe2\x80\x94a course of action that would be good for all persons at all times.\nThere are two requirements for a rule of action to be universal: consistency and reversibility. Consider\nreversibility: if you make a decision as though you didn\xe2\x80\x99t know what role or position you would have after\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n56\n\n\x0cthe decision, you would more likely make an impartial one\xe2\x80\x94you would more likely choose a course of\naction that would be most fair to all concerned, not just you. Again, deontology requires that we put\nduty first, act rationally, and give moral weight to the inherent equality of all human beings.\n\nIn considering whether to lie on your resume, reversibility requires you to actively imagine both that you\nwere the employer in this situation and that you were another well-qualified applicant who lost the job\nbecause someone else padded his resume with false accomplishments. If the consequences of such an\nexercise of the imagination are not appealing to you, your action is probably not ethical.\n\nThe second requirement for an action to be universal is the search for consistency. This is more abstract.\nA deontologist would say that since you know you are telling a lie, you must be willing to say that lying, as\na general, universal phenomenon, is acceptable. But if everyone lied, then there would be no point to\nlying, since no one would believe anyone. It is only because honesty works well for society as a whole and\nis generally practiced that lying even becomes possible! That is, lying cannot be universalized, for it\ndepends on the preexistence of honesty.\n\nSimilar demonstrations can be made for actions such as polluting, breaking promises, and committing\nmost crimes, including rape, murder, and theft. But these are the easy cases for Kantian thinkers. In the\ngray areas of life as it is lived, the consistency test is often difficult to apply. If breaking a promise would\nsave a life, then Kantian thought becomes difficult to apply. If some amount of pollution can allow\nemployment and the harm is minimal or distant, Kantian thinking is not all that helpful. Finally, we\nshould note that the well-known Golden Rule, \xe2\x80\x9cDo unto others as you would have them do unto you,\xe2\x80\x9d\nemphasizes the easier of the two universalizing requirements: practicing reversibility (\xe2\x80\x9cHow would I like it\nif someone did this to me?\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 distribute goods\namong a group of people? Marxist thought emphasizes that members of society should be given goods to\naccording to their needs. But this redistribution would require a governing power to decide who gets what\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n57\n\n\x0cand when. Capitalist thought takes a different approach, rejecting any giving that is not voluntary. Certain\neconomists, such as the late Milton Friedman (see the sidebar in Section 2.4 "Corporations and Corporate\nGovernance") also reject the notion that a corporation has a duty to give to unmet needs in society,\nbelieving that the government should play that role. Even the most dedicated free-market capitalist will\noften admit 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 defense,\neducation, highways, parks, and support of key industries affecting national security).\n\nPeople who do not see the need for public goods (including laws, court systems, and the government\ngoods and services just cited) often question why there needs to be a government at all. One response\nmight be, \xe2\x80\x9cWithout government, there would be no corporations.\xe2\x80\x9d Thomas Hobbes believed that people in\na \xe2\x80\x9cstate of nature\xe2\x80\x9d would rationally choose to have some form of government. He called this the\nsocial contract, where people give up certain rights to government in exchange for security and\ncommon benefits. In your own lives and in this course, you will see an ongoing balancing act between\nhuman desires for freedom and human desires for order; it is an ancient tension. Some commentators\nalso see a kind of social contract between corporations and society; in exchange for perpetual duration\nand limited liability, the corporation has some corresponding duties toward society. Also, if a corporation\nis legally a \xe2\x80\x9cperson,\xe2\x80\x9d as the Supreme Court reaffirmed in 2010, then some would argue that if this\ncorporate person commits three felonies, 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 Bind, 1999),\nobserve that various communities, not just nations, make rules for the common good. Your college or\nschool is a community, and there are communities within the school (fraternities, sororities, the folks\nbehind the counter at the circulation desk, the people who work together at the university radio station,\nthe sports teams, the faculty, the students generally, the gay and lesbian alliance) that have rules, norms,\nor standards that people can buy into or not. If not, they can exit from that community, just as we are free\n(though not without cost) to reject US citizenship and take up residence in another country.\n\nDonaldson and Dunfee\xe2\x80\x99s integrative social contracts theory stresses the importance of studying the rules\nof smaller communities along with the larger social contracts made in states (such as Colorado or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n58\n\n\x0cCalifornia) and nation-states (such as the United States or Germany). Our Constitution can be seen as a\nfundamental social contract.\n\nIt is important to realize that a social contract can be changed by the participants in a community, just as\nthe US Constitution can be amended. Social contract theory is thus dynamic\xe2\x80\x94it allows for structural and\norganic changes. Ideally, the social contract struck by citizens and the government allows for certain\nfundamental rights such as those we enjoy in the United States, but it need not. People can give up\nfreedom-oriented rights (such as the right of free speech or the right to be free of unreasonable searches\nand seizures) to secure order (freedom from fear, freedom from terrorism). For example, many citizens in\nRussia now miss the 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.\n\nThus the rights that people have\xe2\x80\x94in positive law\xe2\x80\x94come from whatever social contract exists in the\nsociety. This view differs from that of the deontologists and that of the natural-law thinkers such as\nGandhi, Jesus, or Martin Luther King Jr., who believed that rights come from God or, in less religious\nterms, from some transcendent moral order.\n\nAnother important movement in ethics and society is the communitarian outlook. Communitarians\nemphasize that rights carry with them corresponding duties; that is, there cannot be a right without a\nduty. Interested students may wish to explore the work of Amitai Etzioni. Etzioni was a founder of the\nCommunitarian Network, which is a group of individuals who have come together to bolster the moral,\nsocial, and political environment. It claims to be nonsectarian, nonpartisan, and international in scope.\n\nThe relationship between rights and duties\xe2\x80\x94in both law and ethics\xe2\x80\x94calls for some explanations:\n\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 president, but\nyou can\xe2\x80\x99t get away with threatening the president\xe2\x80\x99s life. Even if your criticisms are strong and insistent,\nyou have the right (and our government has the duty to protect your right) to speak freely. In Singapore\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n59\n\n\x0cduring the 1990s, even indirect criticisms\xe2\x80\x94mere hints\xe2\x80\x94of the political leadership were enough to land\nyou 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 individuals.\nYour right to be free from physical assault is protected by the law in most states, and when someone\nwalks up to you and punches you in the nose, your rights\xe2\x80\x94as set forth in the positive law of your state\xe2\x80\x94\nhave been violated. Thus other people have a duty to respect your rights and to not punch you in the\nnose.\n3. Your right in legal terms is only as good as your society\xe2\x80\x99s willingness to provide legal remedies through\nthe courts and political institutions of society.\n\nA distinction between basic rights and nonbasic rights may also be important. Basic rights may include\nsuch fundamental elements as food, water, shelter, and physical safety. Another distinction is between\npositive rights (the right to bear arms, the right to vote, the right of privacy) and negative rights (the right\nto be free from unreasonable searches and seizures, the right to be free of cruel or unusual punishments).\nYet another is between economic or social rights (adequate food, work, and environment) and political or\ncivic rights (the right to vote, the right 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, particularly\nin contrast to utilitarian and deontological approaches to ethics. Virtue theory emphasizes the value of\nvirtuous qualities rather than formal rules or useful results. Aristotle is often recognized as the first\nphilosopher to advocate the ethical value of certain qualities, or virtues, in a person\xe2\x80\x99s character. As LaRue\nHosmer has noted, Aristotle saw the goal of human existence as the active, rational search for excellence,\nand excellence requires the personal virtues of honesty, truthfulness, courage, temperance, generosity,\nand high-mindedness. This pursuit is also termed \xe2\x80\x9cknowledge of the good\xe2\x80\x9d in Greek philosophy.\n\nSaylor URL: http://www.saylor.org/books\n\n[1]\n\nSaylor.org\n60\n\n\x0cAristotle believed that all activity was aimed at some goal or perceived good and that there must be some\nranking that we do among those goals or goods. Happiness may be our ultimate goal, but what does that\nmean, exactly? Aristotle rejected wealth, pleasure, and fame and embraced reason as the distinguishing\nfeature of humans, as opposed to other species. And since a human is a reasoning animal, happiness must\nbe associated with reason. Thus happiness is living according to the active (rather than passive) use of\nreason. The use of reason leads to excellence, and so happiness can be defined as the active, rational\npursuit of personal excellence, or virtue.\n\nAristotle named fourteen virtues: (1) courage, particularly in battle; (2) temperance, or moderation in\neating and drinking; (3) liberality, or spending money well; (4) magnificence, or living well; (5) pride, or\ntaking pleasure in accomplishments and stature; (6) high-mindedness, or concern with the noble rather\nthan the petty; (7) unnamed virtue, which is halfway between ambition and total lack of effort; (8)\ngentleness, or concern for others; (9) truthfulness; (10) wit, or pleasure in group discussions; (11)\nfriendliness, or pleasure in personal conduct; (12) modesty, or pleasure in personal conduct; (13)\nrighteous indignation, or getting angry at the right things and in the right amounts; and (14) justice.\n\nFrom a modern perspective, some of these virtues seem old-fashioned or even odd. Magnificence, for\nexample, is not something we commonly speak of. Three issues emerge: (1) How do we know what a virtue\nis these days? (2) How useful is a list of agreed-upon virtues anyway? (3) What do virtues have to do with\ncompanies, particularly large ones where various groups and individuals may have little or no contact\nwith other parts of the organization?\n\nAs to the third question, whether corporations can \xe2\x80\x9chave\xe2\x80\x9d virtues or values is a matter of lively debate. A\ncorporation is obviously not the same as an individual. But there seems to be growing agreement that\norganizations do differ in their practices and that these practices are value driven. If all a company cares\nabout is the bottom line, other values will diminish or disappear. Quite a few books have been written in\nthe past twenty years that emphasize the need for businesses to define their values in order to be\ncompetitive in today\xe2\x80\x99s global economy.\n\nSaylor URL: http://www.saylor.org/books\n\n[2]\n\nSaylor.org\n61\n\n\x0cAs to the first two questions regarding virtues, a look at Michael Josephson\xe2\x80\x99s core values may prove\nhelpful.\n\nJosephson\xe2\x80\x99s Core Values Analysis and Decision Process\nMichael Josephson, a noted American ethicist, believes that a current set of core values has been\nidentified and that the values can be meaningfully applied to a variety of personal and corporate\ndecisions.\n\nTo simplify, let\xe2\x80\x99s say that there are ethical and nonethical qualities among people in the United States.\nWhen you ask people what kinds of qualities they admire in others or in themselves, they may say wealth,\npower, fitness, sense of humor, good looks, intelligence, musical ability, or some other quality. They may\nalso value honesty, caring, fairness, courage, perseverance, diligence, trustworthiness, or integrity. The\nqualities on the second list have something in common\xe2\x80\x94they are distinctively ethical characteristics. That\nis, they are commonly seen as moral or ethical qualities, unlike the qualities on the first list. You can be,\nlike the Athenian Alcibiades, brilliant but unprincipled, or, like some political leaders today, powerful but\ndishonest, or wealthy but uncaring. You can, in short, have a number of admirable qualities (brilliance,\npower, wealth) that are not per se virtuous. Just because Harold is rich or good-looking or has a good\nsense of humor 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 in\nMarina del Rey, California, have identified six core values in our society, values that almost everyone\nagrees are important to them. When asked what values people hold dear, what values they wish to be\nknown by, and what values they wish others would exhibit in their actions, six values consistently turn up:\n(1) trustworthiness, (2) respect, (3) responsibility, (4) fairness, (5) caring, and (6) citizenship.\n\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 virtuous in our\ncharacter and habits. But being more trustworthy (by being honest and by keeping promises) does make\nus more virtuous, as does staying true to the other five core values.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n62\n\n\x0cNotice also that these six core values share something in common with other ethical values that are less\nuniversally agreed upon. Many values taught in the family or in places of worship are not generally agreed\non, practiced, or admired by all. Some families and individuals believe strongly in the virtue of saving\nmoney or in abstaining from alcohol or sex prior to marriage. Others clearly do not, or at least don\xe2\x80\x99t act on\ntheir beliefs. Moreover, it is possible to have and practice core ethical values even if you take on heavy\ndebt, knock down several drinks a night, or have frequent premarital sex. Some would dispute this, saying\nthat you can\xe2\x80\x99t really lead a virtuous life if you get into debt, drink heavily, or engage in premarital sex. But\nthe point here is that since people do disagree in these areas, the ethical traits of thrift, temperance, and\nsexual abstinence do not have the unanimity of approval that the six core values do.\n\nThe importance of an individual\xe2\x80\x99s having these consistent qualities of character is well known. Often we\nremember the last bad thing a person did far more than any or all previous good acts. For example, Eliot\nSpitzer and Bill Clinton are more readily remembered by people for their last, worst acts than for any good\nthey accomplished as public servants. As for a company, its good reputation also has an incalculable value\nthat when lost takes a great deal of time and work to recover. Shell, Nike, and other companies have\ndiscovered that there is a market for morality, however difficult to measure, and that not paying attention\nto business ethics often comes at a serious price. In the past fifteen years, the career of ethics and\ncompliance officer has emerged, partly as a result of criminal proceedings against companies but also\nbecause major companies have found that reputations cannot be recovered retroactively but must be\npursued proactively. For individuals, Aristotle emphasized the practice of virtue to the point where virtue\nbecomes a habit. Companies are gradually learning the same lesson.\n\nK E Y TA K EA WAY\nThroughout history, people have pondered what it means \xe2\x80\x9cto do what is right.\xe2\x80\x9d Some of\nthe main answers have come from the differing perspectives of utilitarian thought; dutybased, or deontological, thought; social contract theory; and virtue ethics.\n\nE XE R C IS ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n63\n\n\x0cXYZ Motor Corporation begins to get customer complaints about two models of its\nautomobiles. Customers have had near-death experiences from sudden acceleration;\nthey would be driving along a highway at normal speed when suddenly the car would\nbegin to accelerate, and efforts to stop the acceleration by braking fail to work. Drivers\ncould turn off the ignition and come to a safe stop, but XYZ does not instruct buyers of\nits cars to do so, nor is this a common reaction among drivers who experience sudden\nacceleration.\nInternal investigations of half a dozen accidents in US locations come to the conclusion\nthat the accidents are not being caused by drivers who mistake the gas pedal for the\nbrake pedal. In fact, there appears to be a possible flaw in both models, perhaps in a\nsemiconductor chip, that makes sudden acceleration happen. Interference by floor mats\nand poorly designed gas pedals 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\nare more complaints. Recalling the two models so that local dealers and their mechanics\ncould examine them is also an option, but it would be extremely costly. Company\nexecutives are aware that quarterly and annual profit-and-loss statements, on which\ntheir bonuses depend, could be decisively worse with a recall. They decide that on a\ncost-benefit basis, it makes more sense to wait until there are more accidents and more\ndata. After a hundred or more accidents and nearly fifteen fatalities, the company\ninstitutes a selective recall, still not notifying NHTSA, which has its own experts and the\nauthority to order XYZ to do a full recall of 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\ncompany does not wish to take that advice, as it would be\xe2\x80\x94as one top executive put it\xe2\x80\x94\n\xe2\x80\x9ctoo time-consuming and expensive.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n64\n\n\x0c1. Can XYZ\xe2\x80\x99s approach to this problem be justified under utilitarian theory? If so, how?\nIf not, why 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[1] LaRue Tone Hosmer, Moral Leadership in Business (Chicago: Irwin Professional Publishing,\n1994), 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\nL EA R N IN G O B JEC T IV E\n1. Understand one model for ethical decision making: a process to arrive at the most\nethical option for an individual or a business organization, using a virtue ethics\napproach combined with some elements of stakeholder analysis and utilitarianism.\n\nJosephson\xe2\x80\x99s Core Values Model\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n65\n\n\x0cOnce you recognize that there is a decision that involves ethical judgment, Michael Josephson would first\nhave you ask as many questions as are necessary to get a full background on the relevant facts. Then,\nassuming you have all the needed information, the decision process is as follows:\n1. Identify the stakeholders. That is, who are the potential gainers and losers in the various decisions that\nmight be made here?\n2. Identify several likely or reasonable decisions that could be made.\n3. 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 decision\ndelivers the greatest good to the various stakeholders.\n\nIt is often helpful to identify who (or what group) is the most important stakeholder, and why. In Milton\nFriedman\xe2\x80\x99s view, it will always be the shareholders. In the view of John Mackey, the CEO of Whole Foods\nMarket, the long-term viability and profitability of the organization may require that customers come\nfirst, or, at times, some other stakeholder group (see \xe2\x80\x9cConscious Capitalism\xe2\x80\x9d in Section 2.4 "Corporations\nand Corporate Governance").\n\nThe Core Values\nHere are the core values and their subcomponents as developed by the Josephson Institute of Ethics.\n\nTrustworthiness: Be honest\xe2\x80\x94tell the truth, the whole truth, and nothing but the truth; be sincere,\nforthright; don\xe2\x80\x99t deceive, mislead, or be tricky with the truth; don\xe2\x80\x99t cheat or steal, and don\xe2\x80\x99t betray a\ntrust. Demonstrate integrity\xe2\x80\x94stand up for what you believe, walk the walk as well as talking the talk; be\nwhat you seem to be; show commitment and courage. Be loyal\xe2\x80\x94stand by your family, friends, co-workers,\ncommunity, and nation; be discreet with information that comes into your hands; don\xe2\x80\x99t spread rumors or\nengage in harmful gossip; don\xe2\x80\x99t violate your principles just to win friendship or approval; don\xe2\x80\x99t ask a\nfriend to do something that is wrong. Keep promises\xe2\x80\x94keep your word, honor your commitments, and pay\nyour debts; return what you borrow.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n66\n\n\x0cRespect: Judge people on their merits, not their appearance; be courteous, polite, appreciative, and\naccepting of differences; respect others\xe2\x80\x99 right to make decisions about their own lives; don\xe2\x80\x99t abuse,\ndemean, mistreat anyone; don\xe2\x80\x99t use, manipulate, exploit, or take advantage of others.\n\nResponsibility: Be accountable\xe2\x80\x94think about the consequences on yourself and others likely to be\naffected before you act; be reliable; perform your duties; take responsibility for the consequences of your\nchoices; set a good example and don\xe2\x80\x99t make excuses or take credit for other people\xe2\x80\x99s work. Pursue\nexcellence: Do your best, don\xe2\x80\x99t quit easily, persevere, be diligent, make all you do worthy of pride.\nExercise self-restraint\xe2\x80\x94be disciplined, know the difference between what you have a right to do and what\nis right to do.\n\nFairness: Treat all people fairly, be open-minded; listen; consider opposing viewpoints; be consistent;\nuse only appropriate considerations; don\xe2\x80\x99t let personal feelings improperly interfere with decisions; don\xe2\x80\x99t\ntake unfair advantage of mistakes; don\xe2\x80\x99t take more than your fair share.\n\nCaring: Show you care about others through kindness, caring, sharing, compassion, and empathy; treat\nothers the way you want to be treated; don\xe2\x80\x99t be selfish, mean, cruel, or insensitive to others\xe2\x80\x99 feelings.\n\nCitizenship: Play by the rules, obey laws; do your share, respect authority, stay informed, vote, protect\nyour neighbors, pay your taxes; be charitable, help your community; protect the environment, conserve\nresources.\n\nWhen individuals and organizations confront ethical problems, the core values decision model offered by\nJosephson generally works well (1) to clarify the gains and losses of the various stakeholders, which then\nraises ethical awareness on the part of the decision maker and (2) to provide a fairly reliable guide as to\nwhat the most ethical decision would be. In nine out of ten cases, step 5 in the decision process is not\nneeded.\nThat said, it does not follow that students (or managers) would necessarily act in accord with the results of\nthe core values decision process. There are many psychological pressures and organizational constraints\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n67\n\n\x0cthat place limits on people both individually and in organizations. These pressures and constraints tend to\ncompromise ideal or the most ethical solutions for individuals and for organizations. For a business, one\nessential problem is that ethics can cost the organization money or resources, at least in the short term.\nDoing the most ethical thing will often appear to be something that fails to maximize profits in the short\nterm or that may seem pointless because if you or your organization acts ethically, others will not, and\nsociety will be no better off, anyway.\n\nK E Y TA K EA WAY\nHaving a step-by-step process to analyze difficult moral dilemmas is useful. One such\nprocess is offered here, based on the core values of trustworthiness, caring, respect,\nfairness, responsibility, and citizenship.\n\nE XE R C IS E\n\n1. 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\noptions when they first notice that two of their models are causing sudden acceleration\nincidents that put their customers at risk? Who are the stakeholders? What options\nmost clearly meet the criteria for each of the core values?\n\n2.4 Corporations and Corporate Governance\nL EA R N IN G O B JEC T IV ES\n1. Explain the basic structure of the typical corporation and how the shareholders own\nthe company and elect directors to run it.\n2. Understand how the shareholder profit-maximization model is different from\nstakeholder theory.\n3. Discern and describe the ethical challenges for corporate cultures.\n4. Explain what conscious capitalism is and how it differs from stakeholder theory.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n68\n\n\x0cLegal Organization of the Corporation\nFigure 2.1 Corporate Legal Structure\n\nFigure 2.1 "Corporate Legal Structure", though somewhat oversimplified, shows the basic legal structure\nof a corporation under Delaware law and the laws of most other states in the United States. Shareholders\nelect directors, who then hire officers to manage the company. From this structure, some very basic\nrealities follow. Because the directors of a corporation do not meet that often, it\xe2\x80\x99s possible for the officers\nhired (top management, or the \xe2\x80\x9cC-suite\xe2\x80\x9d) to be selective of what the board knows about, and directors are\nnot always ready and able to provide the oversight that the shareholders would like. Nor does the law\nrequire officers to be shareholders, so that officers\xe2\x80\x99 motivations may not align with the best interests of the\ncompany. This is the \xe2\x80\x9cagency problem\xe2\x80\x9d often discussed in corporate governance: how to get officers and\nother top management 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 members are\nsusceptible to misalignment of interets; for example, board members might resist hostile takeover bids\nbecause they would likely lose their perks (short for perquisites) as directors, even though the tender offer\nwould benefit stockholders. Among other attempted realignments, the use of stock options was an\nattempt to make managers more attentive to the value of company stock, but the law of unintended\nconsequences was in full force; managers tweaked and managed earnings in the bubble of the 1990s bull\nmarket, and \xe2\x80\x9cmanaging by numbers\xe2\x80\x9d became an epidemic in corporations organized under US corporate\nlaw. The rights of shareholders can be bolstered by changes in state and federal law, and there have been\nsome attempts to do that since the late 1990s. But as owners, shareholders have the ultimate power to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n69\n\n\x0creplace nonperforming or underperforming directors, which usually results in changes at the C-suite level\nas 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 profits\xe2\x80\x94is\nthe prevailing view among business managers and in business schools. This view largely follows the idea\nof Milton Friedman that the duty of a manager is to maximize return on investment to the owners. In\nessence, managers\xe2\x80\x99 legally prescribed duties are those that make their employment possible. In terms of\nthe legal organization of the corporation, the shareholders elect directors who hire managers, who have\nlegally prescribed duties toward both directors and shareholders. Those legally prescribed duties are a\nreflection of the fact that managers are managing other people\xe2\x80\x99s money and have a moral duty to act as a\nresponsible agent for the owners. In law, this is called the manager\xe2\x80\x99s fiduciary duty. Directors have the\nsame duties 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 corporation has is to\nmake the most possible money, or to maximize profits, for its stockholders. Friedman\xe2\x80\x99s beliefs are noted\nat length (see sidebar on Friedman\xe2\x80\x99s article from the New York Times), but he asserted in a now-famous\n1970 article that in a free society, \xe2\x80\x9cthere is one and only one social responsibility of business: to use its\nresources and engage in activities designed to increase its profits as long as it stays within the rules of the\ngame, which is to say, engages in open and free competition without deception and fraud.\xe2\x80\x9d What follows is\na major portion of what 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 responsibilities. A\ncorporation is an artificial person and in this sense may have artificial responsibilities, but \xe2\x80\x9cbusiness\xe2\x80\x9d as a\nwhole cannot be said to have responsibilities, even in this vague sense.\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n70\n\n\x0cPresumably, 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 executive\nis an employee of the owners of the business. He has direct responsibility to his employers. That\nresponsibility is to conduct the business in accordance with their desires, which generally will be to make\nas much money as possible while conforming to the basic rules of the society, both those embodied in law\nand those embodied in ethical custom.\xe2\x80\xa6\n\n\xe2\x80\xa6[T]he manager is that agent of the individuals who own the corporation or establish the eleemosynary\ninstitution, and his primary responsibility is to them\xe2\x80\xa6\n\nOf course, the corporate executive is also a person in his own right. As a person, he may have other\nresponsibilities that he recognizes or assumes voluntarily\xe2\x80\x94to his family, his conscience, his feeling of\ncharity, his church, his clubs, his city, his country. He may feel impelled by these responsibilities to devote\npart of his income to causes he regards as worthy, to refuse to work for particular corporations, even to\nleave his job\xe2\x80\xa6But in these respects he is acting as a principal, not an agent; he is spending his own money\nor time or energy, not the money of his employers or the time or energy he has contracted to devote to\ntheir purposes. If these are \xe2\x80\x9csocial responsibilities,\xe2\x80\x9d they are the social responsibilities of individuals, not\nof business.\n\nWhat does it mean to say that the corporate executive has a \xe2\x80\x9csocial responsibility\xe2\x80\x9d in his capacity as\nbusinessman? If this statement is not pure rhetoric, it must mean that he has to act in some way that is\nnot in the interest of his employers. For example, that he is to refrain from increasing the price of the\nproduct in order to contribute to the social objective of preventing inflation, even though a price increase\nwould be in the best interests of the corporation. Or that he is to make expenditures on reducing pollution\nbeyond the amount that is in the best interests of the corporation or that is required by law in order to\ncontribute to the social objective of improving the environment. Or that, at the expense of corporate\nprofits, he is to hire \xe2\x80\x9chardcore\xe2\x80\x9d unemployed instead of better qualified available workmen to contribute to\nthe social objective of reducing poverty.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n71\n\n\x0cIn each of these cases, the corporate executive would be spending someone else\xe2\x80\x99s money for a general\nsocial interest. Insofar as his actions\xe2\x80\xa6reduce returns to stockholders, he is spending their money. Insofar\nas his actions raise the price to customers, he is spending the customers\xe2\x80\x99 money. Insofar as his actions\nlower 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 political\nprinciple, the imposition of taxes and the expenditure of tax proceeds are governmental functions. We\nhave established elaborate constitutional, parliamentary, and judicial provisions to control these\nfunctions, to assure that taxes are imposed so far as possible in accordance with the preferences and\ndesires of the public.\xe2\x80\xa6\n\nOthers have challenged the notion that corporate managers have no real duties except toward the owners\n(shareholders). By changing two letters in shareholder, stakeholder theorists widened the range of people\nand institutions that a corporation should pay moral consideration to. Thus they contend that a\ncorporation, through its management, has a set of responsibilities toward nonshareholder interests.\n\nStakeholder Theory\nStakeholders 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 obligations\nthat extend beyond the bottom-line aim of maximizing profits. A stakeholder is anyone who most would\nagree is significantly affected (positively or negatively) by the decision of another moral agent.\n\nThere is one vital fact about corporations: the corporation is a creation of the law. Without law (and\ngovernment), corporations would not have existence. The key concept for corporations is the legal fact of\nlimited liability. The benefit of limited liability for shareholders of a corporation meant that larger pools of\ncapital could be aggregated for larger enterprises; shareholders could only lose their investments should\nthe venture fail in any way, and there would be no personal liability and thus no potential loss of personal\nassets other than the value of the corporate stock. Before New Jersey and Delaware competed to make\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n72\n\n\x0cincorporation as easy as possible and beneficial to the incorporators and founders, those who wanted the\nbenefits of incorporation had to go to legislatures\xe2\x80\x94usually among the states\xe2\x80\x94to show a public purpose\nthat the company would serve.\n\nIn the late 1800s, New Jersey and Delaware changed their laws to make incorporating relatively easy.\nThese two states allowed incorporation \xe2\x80\x9cfor any legal purpose,\xe2\x80\x9d rather than requiring some public\npurpose. Thus it is government (and its laws) that makes limited liability happen through the corporate\nform. That is, only through the consent of the state and armed with the charter granted by the state can a\ncorporation\xe2\x80\x99s shareholders have limited liability. This is a right granted by the state, a right granted for\ngood and practical reasons for encouraging capital and innovation. But with this right comes a related\nduty, not clearly stated at law, but assumed when a charter is granted by the state: that the corporate form\nof doing business is legal because the government feels that it socially useful to do so.\n\nImplicitly, then, there is a social contract between governments and corporations: as long as corporations\nare considered socially useful, they can exist. But do they have explicit social responsibilities? Milton\nFriedman\xe2\x80\x99s position suggests that having gone along with legal duties, the corporation can ignore any\nother social obligations. But there are others (such as advocates of stakeholder theory) who would say\nthat a corporation\xe2\x80\x99s social responsibilities go beyond just staying within the law and go beyond the\ncorporation\xe2\x80\x99s shareholders to include a number of other important stakeholders, those whose lives can be\naffected by corporate decisions.\n\nAccording to stakeholder theorists, corporations (and other business organizations) must pay attention\nnot only to the bottom line but also to their overall effect on the community. Public perception of a\ncompany\xe2\x80\x99s unfairness, uncaring, disrespect, or lack of trustworthiness often leads to long-term failure,\nwhatever the short-term successes or profits may be. A socially responsible corporation is likely to\nconsider the impact of its decisions on a wide range of stakeholders, not just shareholders. As Table 2.1\n"The Stakes of Various Stakeholders"indicates, stakeholders have very different kinds of interests\n(\xe2\x80\x9cstakes\xe2\x80\x9d) in the actions of a corporation.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n73\n\n\x0cTable 2.1 The Stakes of Various Stakeholders\nManagers\n\nOwnership\n\nThe value of the organization has a direct impact on the\nwealth of these stakeholders.\n\nDirectors who\nown stock\nShareholders\nSalaried\nmanagers\nCreditors\nSuppliers\n\nEconomic\nDependence\n\nEmployees\nStakeholders can be economically dependent without having\nLocal\nownership. Each of these stakeholders relies on the\ncorporation in some way for financial well-being.\ncommunities\nCommunities\n\nThese stakeholders are not directly linked to the organization Government\nbut have an interest in making sure the organization acts in a\nSocial Interests socially responsible manner.\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 legal system.\n(It is a legal or juridical person, not a natural person, according to our Supreme Court.) Moreover, many\ncorporations have distinct cultures and beliefs that are lived and breathed by its members. Often, the\nculture of a corporation is the best defense against individuals within that firm who may be tempted to\nbreak the law or commit serious ethical misdeeds.\n\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 rewarded. If the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n74\n\n\x0cCEO is firm about acting ethically, others in the organization will take their cues from him or her. People\nat the top tend to set the target, the climate, the beliefs, and the expectations 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 before\n\xe2\x80\x9cfunny numbers\xe2\x80\x9d or other earnings management tricks come to light.\n\n[1]\n\nAgain, we see that the manager is\n\noften an agent for himself or herself and will often act more in his or her self-interest than for the\ncorporate interest.\n\nKilling the Messenger\nWhere organizations no longer function, inevitably some employees are unhappy. If they call attention to\nproblems that are being covered up by coworkers or supervisors, they bring bad news. Managers like to\nhear good news and discourage bad news. Intentionally or not, those who told on others, or blew the\nwhistle, have rocked the boat and become unpopular with those whose defalcations they report on and\nwith the managers who don\xe2\x80\x99t really want to hear the bad news. In many organizations, \xe2\x80\x9ckilling the\nmessenger\xe2\x80\x9d solves the problem. Consider James Alexander at Enron Corporation, who was deliberately\nshut out after bringing problems to CEO Ken Lay\xe2\x80\x99s attention.\n\n[2]\n\nWhen Sherron Watkins sent Ken Lay a\n\nletter warning him about Enron\xe2\x80\x99s accounting practices, CFO Andrew Fastow tried to fire her.\n\n[3]\n\nEthics Codes\nWithout strong leadership and a willingness to listen to bad news as well as good news, managers do not\nhave the feedback necessary to keep the organization healthy. Ethics codes have been put in place\xe2\x80\x94partly\nin response to federal sentencing guidelines and partly to encourage feedback loops to top management.\nThe best ethics codes are aspirational, or having an ideal to be pursued, not legalistic or compliance\ndriven. The Johnson & Johnson ethics code predated the Tylenol scare and the company\xe2\x80\x99s oft-celebrated\n[4]\n\ncorporate response. The corporate response was consistent with that code, which was lived and modeled\nby the top of the organization.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n75\n\n\x0cIt\xe2\x80\x99s often noted that a code of ethics is only as important as top management is willing to make it. If the\ncode is just a document that goes into a drawer or onto a shelf, it will not effectively encourage good\nconduct within the corporation. The same is true of any kind of training that the company undertakes,\nwhether it be in racial sensitivity or sexual harassment. If the message is not continuously reinforced, or\n(worse yet) if the message is undermined by management\xe2\x80\x99s actions, the real message to employees is that\nviolations of the ethics code will not be taken seriously, or that efforts to stop racial discrimination or\nsexual harassment are merely token efforts, and that the important things are profits and performance.\nThe ethics code at Enron seems to have been one of those \xe2\x80\x9c3-P\xe2\x80\x9d codes that wind up sitting on shelves\xe2\x80\x94\n\xe2\x80\x9cPrint, Post, and Pray.\xe2\x80\x9d Worse, the Enron board twice suspended the code in 1999 to allow outside\npartnerships to be led by a top Enron executive who stood to gain financially from them.\n\n[5]\n\nEthics Hotlines and Federal Sentencing Guidelines\nThe federal sentencing guidelines were enacted in 1991. The original idea behind these guidelines was for\nCongress to correct the lenient treatment often given to white-collar, or corporate, criminals. The\nguidelines require judges to consider \xe2\x80\x9caggravating and mitigating\xe2\x80\x9d factors in determining sentences and\nfines. (While corporations cannot go to jail, its officers and managers certainly can, and the corporation\nitself can be fined. Many companies will claim that it is one bad apple that has caused the problem; the\nguidelines invite these companies to show that they are in fact tending their orchard well. They can show\nthis by providing evidence that they have (1) a viable, active code of ethics; (2) a way for employees to\nreport violations of law or the ethics code; and (3) an ethics ombudsman, or someone who oversees the\ncode.\n\nIn short, if a company can show that it has an ongoing process to root out wrongdoing at all levels of the\ncompany, the judge is allowed to consider this as a major mitigating factor in the fines the company will\npay. Most Fortune 500 companies have ethics hotlines and processes in place to find legal and ethical\nproblems within the company.\n\nManaging by the Numbers\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n76\n\n\x0cIf you manage by the numbers, there is a temptation to lie about those numbers, based on the need to get\nstock price ever higher. At Enron, \xe2\x80\x9c15 percent a year or better earnings growth\xe2\x80\x9d was the mantra. Jeffrey\nPfeffer, professor of organizational behavior at Stanford University, observes how the belief that \xe2\x80\x9cstock\nprice is all that matters\xe2\x80\x9d has been hardwired into the corporate psyche. It dictates not only how people\njudge the worth of their company but also how they feel about themselves and the work that they are\ndoing. And, over time, it has clouded judgments about what is acceptable corporate behavior.\n\n[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 win.\n\xe2\x80\x94Michael Josephson\nMost people want to be winners or associate with winners. As humans, our desire to associate with those\nwho have status provides plenty of incentive to glorify winners and ignore losers. But if an individual, a\nteam, or a company does whatever it takes to win, then all other values are thrown out in the goal to win\nat all costs. The desire of some people within Sears & Roebuck Company\xe2\x80\x99s auto repair division to win by\ngaining higher profits resulted in the situation portrayed here.\nSears Roebuck & Company has been a fixture in American retailing throughout the twentieth century. At\none time, people in rural America could order virtually anything (including a house) from Sears. Not\nwithout some accuracy, the company billed itself as \xe2\x80\x9cthe place where Americans shop.\xe2\x80\x9d But in 1992, Sears\nwas charged by California authorities with gross and deliberate fraud in many of its auto centers.\nThe authorities were alerted by a 50 percent increase in consumer complaints over a three-year period.\nNew Jersey\xe2\x80\x99s division of consumer affairs also investigated Sears Auto Centers and found that all six\nvisited by investigators had recommended unnecessary repairs. California\xe2\x80\x99s department of consumer\naffairs found that Sears had systematically overcharged by an average of $223 for repairs and routinely\nbilled for work that was not done. Sears Auto Centers were the largest providers of auto repair services in\nthe state.\nThe scam was a variant on the old bait-and-switch routine. Customers received coupons in the mail\ninviting them to take advantage of hefty discounts on brake jobs. When customers came in to redeem\ntheir coupons, sales staffers would convince them to authorize additional repairs. As a management tool,\nSears had also established quotas for each of their sales representatives to meet.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n77\n\n\x0cUltimately, California got Sears to settle a large number of lawsuits against it by threatening to revoke\nSears\xe2\x80\x99 auto repair license. Sears agreed to distribute $50 coupons to nearly a million customers\nnationwide who had obtained certain services between August 1, 1990, and January 31, 1992. Sears also\nagreed to pay $3.5 million to cover the costs of various government investigations and to contribute $1.5\nmillion annually to conduct auto mechanic training programs. It also agreed to abandon its repair service\nquotas. The entire settlement cost Sears $30 million. Sears Auto Center sales also dropped about 15 to 20\npercent after news of the scandal broke.\nNote that in boosting sales by performing unnecessary services, Sears suffered very bad publicity. Losses\nwere incalculable. The short-term gains were easy to measure; long-term consequences seldom are. The\ncase illustrates a number of important lessons:\n\xe2\x80\xa2 People generally choose short-term gains over potential long-term losses.\n\xe2\x80\xa2 People often justify the harm to others as being minimal or \xe2\x80\x9cnecessary\xe2\x80\x9d to achieve the desired sales\nquota or financial goal.\n\xe2\x80\xa2 In working as a group, we often form an \xe2\x80\x9cus versus them\xe2\x80\x9d mentality. In the Sears case, it is likely that\nSears \xe2\x80\x9cinsiders\xe2\x80\x9d looked at customers as \xe2\x80\x9coutsiders,\xe2\x80\x9d effectively treating them (in Kantian terms) as\nmeans rather than ends in themselves. In short, outsiders were used for the benefit of insiders.\n\xe2\x80\xa2 The long-term losses to Sears are difficult to quantify, while the short-term gains were easy to measure\nand (at least for a brief while) quite satisfying financially.\n\xe2\x80\xa2 Sears\xe2\x80\x99 ongoing rip-offs were possible only because individual consumers lacked the relevant information\nabout the service being offered. This lack of information is a market failure, since many consumers were\ndemanding more of Sears Auto Center services than they would have (and at a higher price) if relevant\ninformation had been available to them earlier. Sears, like other sellers of goods and services, took\nadvantage of a market system, which, in its ideal form, would not permit such information distortions.\n\xe2\x80\xa2 People in the organization probably thought that the actions they took were necessary.\n\nNoting this last point, we can assume that these key people were motivated by maximizing profits and had\nlost sight of other goals for the organization.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n78\n\n\x0cThe emphasis on doing whatever is necessary to win is entirely understandable, but it is not ethical. The\ntemptation will always exist\xe2\x80\x94for individuals, companies, and nations\xe2\x80\x94to dominate or to win and to write\nthe history of their actions in a way that justifies or overlooks the harm that has been done. In a way, this\nfits with the notion that \xe2\x80\x9cmight makes right,\xe2\x80\x9d or that power is the ultimate measure of right and wrong.\n\nConscious Capitalism\nOne effort to integrate the two viewpoints of stakeholder theory and shareholder primacy is the conscious\ncapitalism movement. Companies that practice conscious capitalism embrace the idea that profit and\nprosperity can and must go hand in hand with social justice and environmental stewardship. They operate\nwith a holistic or systems view. This means that they understand that all stakeholders are connected and\ninterdependent. They reject false trade-offs between stakeholder interests and strive for creative ways to\nachieve win-win-win outcomes for all.\n\n[7]\n\nThe \xe2\x80\x9cconscious business\xe2\x80\x9d has a purpose that goes beyond maximizing profits. It is designed to maximize\nprofits but is focused more on its higher purpose and does not fixate solely on the bottom line. To do so, it\nfocuses on delivering value to all its stakeholders, harmonizing as best it can the interests of consumers,\npartners, investors, the community, and the environment. This requires that company managers take a\n\xe2\x80\x9cservant leadership\xe2\x80\x9d role, serving as stewards to the company\xe2\x80\x99s deeper purpose and to the company\xe2\x80\x99s\nstakeholders.\n\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 personal gain\nand self-aggrandizement. Why is this refocusing needed? Within the standard profit-maximizing model,\ncorporations have long had to deal with the \xe2\x80\x9cagency problem.\xe2\x80\x9d Actions by top-level managers\xe2\x80\x94acting on\nbehalf of the company\xe2\x80\x94should align with the shareholders, but in a culture all about winning and money,\nmanagers sometimes act in ways that are self-aggrandizing and that do not serve the interests of\nshareholders. Laws exist to limit such self-aggrandizing, but the remedies are often too little and too late\nand often catch only the most egregious overreaching. Having a culture of servant leadership is a much\nbetter way to see that a company\xe2\x80\x99s top management works to ensure a harmony of interests.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n79\n\n\x0c[1] See Robert Jackall, Moral Mazes: The World of Corporate Managers (New York: Oxford\nUniversity Press, 1988).\n[2] John Schwartz, \xe2\x80\x9cAn Enron Unit Chief Warned, and Was Rebuffed,\xe2\x80\x9d New York Times, February\n20, 2002.\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:\nThe Johnson & Johnson Tylenol Crisis, accessed April 5,\n2011,http://www.ou.edu/deptcomm/dodjcc/groups/02C2/Johnson%20&20Johnson.htm.\n[5] FindLaw, Report of Investigation by the Special Investigative Committee of the Board of\nDirectors of Enron 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\nBusiness,\xe2\x80\x9d Reason.com, October 2005,http://reason.com/archives/2005/10/01/rethinking-thesocial-responsi.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n80\n\n\x0c2.5 Summary and Exercises\nSummary\nDoing good business requires attention to ethics as well as law. Understanding the long-standing\nperspectives on ethics\xe2\x80\x94utilitarianism, deontology, social contract, and virtue ethics\xe2\x80\x94is helpful in sorting\nout the ethical issues that face us as individuals and businesses. Each business needs to create or maintain\na culture of ethical excellence, where there is ongoing dialogue not only about the best technical practices\nbut also about the company\xe2\x80\x99s ethical challenges and practices. A firm that has purpose and passion\nbeyond profitability is best poised to meet the needs of diverse stakeholders and can best position itself\nfor long-term, sustainable success for shareholders and other stakeholders as well.\n\nE XE R C IS ES\n1. Consider again Milton Friedman\xe2\x80\x99s article.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n81\n\n\x0ca. What does Friedman mean by \xe2\x80\x9cethical custom\xe2\x80\x9d?\nb. If the laws of the society are limiting the company\xe2\x80\x99s profitability, would\nthe company be within its rights to disobey the law?\nc. What if the law is \xe2\x80\x9con the books,\xe2\x80\x9d but the company could count on a lack\nof enforcement from state officials who were overworked and\nunderpaid? Should the company limit its profits? Suppose that it could\nsave money by discharging a pollutant into a nearby river, adversely\naffecting fish and, potentially, drinking water supplies for downstream\nmunicipalities. In polluting against laws that aren\xe2\x80\x99t enforced, is it still\nacting \xe2\x80\x9cwithin the rules of the game\xe2\x80\x9d? What if almost all other\ncompanies in the industry were saving money by doing similar acts?\nConsider again the Harris v. Forklift case at the end ofChapter 1 "Introduction to\nLaw and Legal Systems". The Supreme Court ruled that Ms. Harris was entitled to\nbe heard again by the federal district court, which means that there would be a\ntrial on her claim that Mr. Hardy, owner of Forklift Systems, had created a \xe2\x80\x9chostile\nworking environment\xe2\x80\x9d for Ms. Harris. Apart from the legal aspects, did he really\ndo anything unethical? How can you tell?\na. Which of his actions, if any, were contrary to utilitarian thinking?\nb. If Kant were his second-in-command and advising him on ethical matters,\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\nare all true. In terms of core values, which of these behaviors are not consistent with the\ncore values Josephson points to? Be specific.\nAssume that Forklift Systems is a large public corporation and that the CEO engages\nin these kinds of behaviors. Assume also that the board of directors knows about it.\nWhat action should the board take, and why?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n82\n\n\x0cAssume that the year is 1963, prior to the passage of the Civil Rights Act of 1964\nand the Title VII provisions regarding equal employment opportunity that prohibit\ndiscrimination based on sex. So, Mr. Hardy\xe2\x80\x99s actions are not illegal, fraudulent, or\ndeceitful. Assume also that he heads a large public company and that there is a\nlarge amount of turnover and unhappiness among the women who work for the\ncompany. No one can sue him for being sexist or lecherous, but are his actions\nconsistent with maximizing shareholder returns? Should the board be concerned?\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\nS EL F -T E ST QU EST IO N S\n1. Milton Friedman would have been most likely to agree to which of the following\nstatements?\na. The purpose of the corporation is to find a path to sustainable corporate\nprofits by paying careful attention to key stakeholders.\nb. The business of business is business.\nc. The CEO and the board should have a single-minded focus on delivering\nmaximum value to shareholders of the business.\nd. All is fair in love, war, and business.\nMilton Friedman meant (using the material quoted in this chapter) that\ncompanies should\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n83\n\n\x0ca. Find a path to sustainable profits by looking at the interconnected needs\nand desires of all the stakeholders.\nb. Always remember that the business of business is business.\nc. Remind the CEO that he or she has one duty: to maximize shareholder\nwealth by any means possible.\nd. Maximize shareholder wealth by engaging in open competition without\nfraud or deceit.\nWhat are some key drawbacks to utilitarian thinking at the corporate level?\na. The corporation may do a cost-benefit analysis that puts the greatest\ngood of the firm above all other considerations.\nb. It is difficult to predict future consequences; decision makers in for-profit\norganizations will tend to overestimate the upside of certain decisions\nand underestimate the downside.\nc. Short-term interests will be favored over long-term consequences.\nd. all of the above\ne. a and b only\nWhich ethical perspective would allow that under certain circumstances, it\nmight be ethical to lie to a liar?\na. deontology\nb. virtue ethics\nc. utilitarianism\nd. all of the above\nUnder conscious capitalism,\na. Virtue ethics is ignored.\nb. Shareholders, whether they be traders or long-term investors, are always\nthe first and last consideration for the CEO and the board.\nc. Maximizing profits comes from a focus on higher purposes and\nharmonizing the interests of various stakeholders.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n84\n\n\x0cd. Kantian duties take precedence over cost-benefit analyses.\n\nS EL F -T E ST A NSW E R S\n1. c\n2. d\n3. d\n4. c\n5. c\n\nChapter 3\nCourts and the Legal Process\nL EA R N IN G O B JEC T IV ES\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\ncases can be filed in either court system.\n2. Explain the importance of subject matter jurisdiction and personal jurisdiction and\nknow the difference between the two.\n3. Describe the various stages of a civil action: from pleadings, to discovery, to trial,\nand to appeals.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n85\n\n\x0c4. Describe two alternatives to litigation: mediation and arbitration.\n\nIn the United States, law and government are interdependent. The Constitution establishes the basic\nframework of government and imposes certain limitations on the powers of government. In turn, the\nvarious branches of government are intimately involved in making, enforcing, and interpreting the law.\nToday, much of the law comes from Congress and the state legislatures. But it is in the courts that\nlegislation is interpreted and prior case law is interpreted and applied.\n\nAs we go through this chapter, consider the case of Harry and Kay Robinson. In which court should the\nRobinsons file their action? Can the Oklahoma court hear the case and make a judgment that will be\nenforceable against all of the defendants? Which law will the court use to come to a decision? Will it use\nNew York law, Oklahoma law, federal law, or German law?\n\nRobinson v. Audi\nHarry and Kay Robinson purchased a new Audi automobile from Seaway Volkswagen, Inc. (Seaway), in\nMassena, New York, in 1976. The following year the Robinson family, who resided in New York, left that\nstate for a new home in Arizona. As they passed through Oklahoma, another car struck their Audi in the\nrear, causing a fire that severely burned Kay Robinson and her two children. Later on, the Robinsons\nbrought a products-liability action in the District Court for Creek County, Oklahoma, claiming that their\ninjuries resulted from the defective design and placement of the Audi\xe2\x80\x99s gas tank and fuel system. They\nsued numerous defendants, including the automobile\xe2\x80\x99s manufacturer, Audi NSU Auto Union\nAktiengesellschaft (Audi); its importer, Volkswagen of America, Inc. (Volkswagen); its regional\ndistributor, World-Wide Volkswagen Corp. (World-Wide); and its retail dealer, Seaway.\n\nShould the Robinsons bring their action in state court or in federal court? Over which of the defendants\nwill the court have personal jurisdiction?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n86\n\n\x0c3.1 The Relationship between State and Federal Court\nSystems in the United States\n\nL EA R N IN G O B JEC T IV ES\n1. Understand the different but complementary roles of state and federal court\nsystems.\n2. Explain why it makes sense for some courts to hear and decide only certain kinds of\ncases.\n3. Describe the difference between a trial court and an appellate court.\n\nAlthough it is sometimes said that there are two separate court systems, the reality is more complex.\nThere are, in fact, fifty-two court systems: those of the fifty states, the local court system in the District of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n87\n\n\x0cColumbia, and the federal court system. At the same time, these are not entirely separate; they all have\nseveral points of contact.\n\nState and local courts must honor both federal law and the laws of the other states. First, state courts must\nhonor federal law where state laws are in conflict with federal laws (under the supremacy clause of the\nConstitution; see Chapter 4 "Constitutional Law and US Commerce"). Second, claims arising under\nfederal statutes can often be tried in the state courts, where the Constitution or Congress has not explicitly\nrequired that only federal courts can hear that kind of claim. Third, under the full faith and credit clause,\neach state court is obligated to respect the final judgments of courts in other states. Thus a contract\ndispute resolved by an Arkansas court cannot be relitigated in North Dakota when the plaintiff wants to\ncollect on the Arkansas judgment in North Dakota. Fourth, state courts often must consider the laws of\nother states in deciding cases involving issues where two states have an interest, such as when drivers\nfrom two different 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 another\nstate\xe2\x80\x99s laws to decide the case (see Table 3.1 "Sample Conflict-of-Law Principles").\n\nAs state courts are concerned with federal law, so federal courts are often concerned with state law and\nwith what happens in state courts. Federal courts will consider state-law-based claims when a case\ninvolves claims using both state and federal law. Claims based on federal laws will permit the federal court\nto take jurisdiction over the whole case, including any state issues raised. In those cases, the federal court\nis said to exercise \xe2\x80\x9cpendent jurisdiction\xe2\x80\x9d over the state claims. Also, the Supreme Court will occasionally\ntake appeals from a state supreme court where state law raises an important issue of federal law to be\ndecided. For example, a convict on death row may claim that the state\xe2\x80\x99s chosen method of execution using\nthe injection of drugs is unusually painful and involves \xe2\x80\x9ccruel and unusual punishment,\xe2\x80\x9d raising an Eighth\nAmendment issue.\n\nThere is also a broad category of cases heard in federal courts that concern only state legal issues\xe2\x80\x94\nnamely, cases that arise between citizens of different states. The federal courts are permitted to hear these\ncases under their so-called diversity of citizenship jurisdiction (or diversity jurisdiction). A citizen of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n88\n\n\x0cNew Jersey may sue a citizen of New York over a contract dispute in federal court, but if both were\ncitizens of New Jersey, the plaintiff would be limited to the state courts. The Constitution established\ndiversity jurisdiction because it was feared that local courts would be hostile toward people from other\nstates and that they would need separate courts. In 2009, nearly a third of all lawsuits filed in federal\ncourt were based on diversity of citizenship. In these cases, the federal courts were applying state law,\nrather than taking federal question jurisdiction, where federal law provided the basis for the lawsuit\nor where the United States was a party (as plaintiff or defendant).\n\nWhy are there so many diversity cases in federal courts? Defense lawyers believe that there is sometimes a\n\xe2\x80\x9chome-court advantage\xe2\x80\x9d for an in-state plaintiff who brings a lawsuit against a nonresident in his local\nstate court. The defense attorney is entitled to ask for removal to a federal court where there is diversity.\nThis fits with the original reason for diversity jurisdiction in the Constitution\xe2\x80\x94the concern that judges in\none state court would favor the in-state plaintiff rather than a nonresident defendant. Another reason\nthere are so many diversity cases is that plaintiffs\xe2\x80\x99 attorneys know that removal is common and that it will\nmove the case along faster by filing in federal court to begin with. Some plaintiffs\xe2\x80\x99 attorneys also find\nadvantages in pursuing a lawsuit in federal court. Federal court procedures are often more efficient than\nstate court procedures, 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 bench. In\nsome federal districts, judgments for plaintiffs may be higher, on average, than in the local state court. In\nshort, not only law but also legal strategy factor into the popularity of diversity 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 civil\nlawsuits are common to all state courts: trials and appeals. A court exercising a trial function has\noriginal jurisdiction\xe2\x80\x94that is, jurisdiction to determine the facts of the case and apply the law to them.\nA court that hears appeals from the trial court is said to have appellate jurisdiction\xe2\x80\x94it must accept the\nfacts as determined by the trial court and limit its review to the lower court\xe2\x80\x99s theory of the applicable law.\n\nLimited Jurisdiction Courts\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n89\n\n\x0cIn most large urban states and many smaller states, there are four and sometimes five levels of courts. The\nlowest level is that of the limited jurisdiction courts. These are usually county or municipal courts with\noriginal jurisdiction to hear minor criminal cases (petty assaults, traffic offenses, and breach of peace,\namong others) and civil cases involving monetary amounts up to a fixed ceiling (no more than $10,000 in\nmost states and far less in many states). Most disputes that wind up in court are handled in the 18,000plus limited jurisdiction courts, which are estimated to hear more than 80 percent of all cases.\n\nOne familiar limited jurisdiction court is the small claims court, with jurisdiction to hear civil cases\ninvolving claims for amounts ranging between $1,000 and $5,000 in about half the states and for\nconsiderably less in the other states ($500 to $1,000). The advantage of the small claims court is that its\nprocedures are informal, it is often located in a neighborhood outside the business district, it is usually\nopen after business hours, and it is speedy. Lawyers are not necessary to present the case and in some\nstates 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 jurisdiction.\nThese go by a variety of names: superior, circuit, district, or common pleas court (New York calls its\ngeneral trial court the supreme court). These are the courts in which people seek redress for incidents\nsuch as automobile accidents and injuries, or breaches of contract. These state courts also prosecute those\naccused of murder, rape, robbery, and other serious crimes. The fact finder in these general jurisdiction\ncourts is not a judge, as in the lower courts, but a jury of citizens.\n\nAlthough courts of general jurisdiction can hear all types of cases, in most states more than half involve\nfamily matters (divorce, child custody disputes, and the like). A third were commercial cases, and slightly\nover 10 percent were devoted to car accident cases and other torts (as discussed in Chapter 7\n"Introduction to Tort Law").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n90\n\n\x0cMost states have specialized courts that hear only a certain type of case, such as landlord-tenant disputes\nor probate of wills. Decisions by judges in specialized courts are usually final, although any party\ndissatisfied with the outcome may be able to get a new trial in a court of general jurisdiction. Because\nthere has been one trial already, this is known as a trial de novo. It is not an appeal, since the case\nessentially starts over.\n\nAppellate Courts\nThe losing party in a general jurisdiction court can almost always appeal to either one or two higher\ncourts. These intermediate appellate courts\xe2\x80\x94usually called courts of appeal\xe2\x80\x94have been established in\nforty states. They do not retry the evidence, but rather determine whether the trial was conducted in a\nprocedurally correct manner and whether the appropriate law was applied. For example, the appellant\n(the losing party who appeals) might complain that the judge wrongly instructed the jury on the meaning\nof the law, or improperly allowed testimony of a particular witness, or misconstrued the law in question.\nThe appellee (who won in the lower court) will ask that the appellant be denied\xe2\x80\x94usually this means that\nthe appellee wants the lower-court judgment affirmed. The appellate court has quite a few choices: it can\naffirm, modify, reverse, or reverse and remand the lower court (return the case to the lower court for\nretrial).\n\nThe last type of appeal within the state courts system is to the highest court, the state supreme court,\nwhich is composed of a single panel of between five and nine judges and is usually located in the state\ncapital. (The intermediate appellate courts are usually composed of panels of three judges and are situated\nin various locations around the state.) In a few states, the highest court goes by a different name: in New\nYork, it is known as the court of appeals. In certain cases, appellants to the highest court in a state have\nthe right to have their appeals heard, but more often the supreme court selects the cases it wishes to hear.\nFor most litigants, the ruling of the state supreme court is final. In a relatively small class of cases\xe2\x80\x94those\nin which federal constitutional claims are made\xe2\x80\x94appeal to the US Supreme Court to issue a\nwrit of certiorari remains a possibility.\n\nThe Federal Court System\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n91\n\n\x0cDistrict Courts\nThe federal judicial system is uniform throughout the United States and consists of three levels. At the\nfirst level are the federal district courts, which are the trial courts in the federal system. Every state has\none or more federal districts; the less populous states have one, and the more populous states (California,\nTexas, and New York) have four. The federal court with the heaviest commercial docket is the US District\nCourt for the Southern District of New York (Manhattan). There are forty-four district judges and fifteen\nmagistrates in this district. The district judges throughout the United States commonly preside over all\nfederal 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 are\nthirteen (Figure 3.1 "The Federal Judicial Circuits"). Each circuit oversees the work of the district courts in\nseveral states. For example, the US Court of Appeals for the Second Circuit hears appeals from district\ncourts in New York, Connecticut, and Vermont. The US Court of Appeals for the Ninth Circuit hears\nappeals from district courts in California, Oregon, Nevada, Montana, Washington, Idaho, Arizona, Alaska,\nHawaii, and Guam. The US Court of Appeals for the District of Columbia Circuit hears appeals from the\ndistrict court in Washington, DC, as well as from numerous federal administrative agencies (see Chapter 5\n"Administrative Law"). The US Court of Appeals for the Federal Circuit, also located in Washington, hears\nappeals in patent and customs cases. Appeals are usually heard by three-judge panels, but sometimes\nthere will be a rehearing at the court of appeals level, in which case all judges sit to hear the case \xe2\x80\x9cen\nbanc.\xe2\x80\x9d\n\nThere are also several specialized courts in the federal judicial system. These include the US Tax Court,\nthe 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 justices\xe2\x80\x94the\nchief justice and eight associate justices. (This number is not constitutionally required; Congress can\nestablish any number. It has been set at nine since after the Civil War.) The Supreme Court has selective\ncontrol over most of its docket. By law, the cases it hears represent only a tiny fraction of the cases that are\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n92\n\n\x0csubmitted. In 2008, the Supreme Court had numerous petitions (over 7,000, not including thousands of\npetitions from prisoners) but heard arguments in only 87 cases. The Supreme Court does not sit in panels.\nAll the justices hear and consider each case together, unless a justice has a conflict of interest and must\nwithdraw from hearing the case.\n\nFigure 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 term of years,\nfederal judges sit for life unless they voluntarily retire or are impeached.\n\nK E Y TA K EA WAY\nTrial courts and appellate courts have different functions. State trial courts sometimes\nhear cases with federal law issues, and federal courts sometimes hear cases with state\nlaw issues. Within both state and federal court systems, it is useful to know the different\nkinds of courts and what cases they can decide.\n\nE XE R C IS ES\n1. Why all of this complexity? Why don\xe2\x80\x99t state courts hear only claims based on state law,\nand federal courts only federal-law-based claims?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n93\n\n\x0c2. Why would a plaintiff in Iowa with a case against a New Jersey defendant prefer to have\nthe case heard in Iowa?\n3. James, a New Jersey resident, is sued by Jonah, an Iowa resident. After a trial in which\nJames appears and vigorously defends himself, the Iowa state court awards Jonah\n$136,750 dollars in damages for his tort claim. In trying to collect from James in New\nJersey, Jonah must have the New Jersey court certify the Iowa judgment. Why,\nordinarily, must the New Jersey court do so?\n\n3.2 The Problem of Jurisdiction\nL EA R N IN G O B JEC T IV ES\n1. Explain the concept of subject matter jurisdiction and distinguish it from\npersonal jurisdiction.\n2. Understand how and where the US Constitution provides a set of instructions\nas to what federal 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\ncase is eligible for diversity jurisdiction in the federal courts.\n\nJurisdiction is an essential concept in understanding courts and the legal system. Jurisdiction is a\ncombination of two Latin words: juris(law) and diction (to speak). Which court has the power \xe2\x80\x9cto speak\nthe law\xe2\x80\x9d is the basic question of jurisdiction.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n94\n\n\x0cThere are two questions about jurisdiction in each case that must be answered before a judge will hear a\ncase: the question of subject matter jurisdiction and the question of personal jurisdiction. We will\nconsider the question of subject matter jurisdiction first, because judges do; if they determine, on the\nbasis of the initial documents in the case (the \xe2\x80\x9cpleadings\xe2\x80\x9d), that they have no power to hear and decide\nthat 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 1789 was\nthat state courts coexisted with federal courts. Federalism was the system devised by the nation\xe2\x80\x99s\nfounders in which power is shared between states and the federal government. This sharing requires a\ndivision of labor between the states and the federal government. It is Article III of the US Constitution\nthat spells out the respective spheres of authority (jurisdiction) between state and federal courts.\nTake a close look at Article III of the Constitution. (You can find a printable copy of the Constitution\nat http://www.findlaw.com.) Article III makes clear that federal courts are courts of limited power or\njurisdiction. Notice that the only kinds of cases federal courts are authorized to deal with have strong\nfederal connections. For example, federal courts have jurisdiction when a federal law is being used by the\nplaintiff or prosecutor (a \xe2\x80\x9cfederal question\xe2\x80\x9d case) or the case arises \xe2\x80\x9cin admiralty\xe2\x80\x9d (meaning that the\nproblem arose not on land but on sea, beyond the territorial jurisdiction of any state, or in navigable\nwaters within the United States). Implied in this list is the clear notion that states would continue to have\ntheir own laws, interpreted by their own courts, and that federal courts were needed only where the issues\nraised by the parties had a clear federal connection. The exception to this is diversity jurisdiction,\ndiscussed later.\n\nThe Constitution was constructed with the idea that state courts would continue to deal with basic kinds\nof claims such as tort, contract, or property claims. Since states sanction marriages and divorce, state\ncourts would deal with \xe2\x80\x9cdomestic\xe2\x80\x9d (family) issues. Since states deal with birth and death records, it stands\nto reason that paternity suits, probate disputes, and the like usually wind up in state courts. You wouldn\xe2\x80\x99t\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n95\n\n\x0cgo to the federal building or courthouse to get a marriage license, ask for a divorce, or probate a will: these\nmatters have traditionally been dealt with by the states (and the thirteen original colonies before them).\nMatters that historically get raised and settled in state court under state law include not only domestic and\nprobate matters but also law relating to corporations, partnerships, agency, contracts, property, torts, and\ncommercial dealings generally. You cannot get married or divorced in federal court, because federal\ncourts have no jurisdiction over matters that are historically (and are still) exclusively within the domain\nof state law.\n\nIn terms of subject matter jurisdiction, then, state courts will typically deal with the kinds of disputes just\ncited. Thus if you are Michigan resident and have an auto accident in Toledo with an Ohio resident and\nyou each blame each other for the accident, the state courts would ordinarily resolve the matter if the\ndispute cannot otherwise be settled. Why state courts? Because when you blame one another and allege\nthat it\xe2\x80\x99s the other person\xe2\x80\x99s fault, you have the beginnings of a tort case, with negligence as a primary\nelement of the claim, and state courts have routinely dealt with this kind of claim, from British colonial\ntimes through Independence and to the present. (See also Chapter 7 "Introduction to Tort Law" of this\ntext.) People have had a need to resolve this kind of dispute long before our federal courts were created,\nand you can tell from 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 the kinds\nof cases specified in Article III. If the case before the federal court does not fall within one of those\ncategories, the federal court cannot constitutionally hear the case because it does not have subject matter\njurisdiction.\n\nAlways remember: a court must have subject matter jurisdiction to hear and decide a case. Without it, a\ncourt cannot address the merits of the controversy or even take the next jurisdictional step of figuring out\nwhich of the defendants can be sued in that court. The question of which defendants are appropriately\nbefore the court is a question of personal jurisdiction.\n\nBecause there are two court systems, it is important for a plaintiff to file in the right court to begin with.\nThe right court is the one that has subject matter jurisdiction over the case\xe2\x80\x94that is, the power to hear and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n96\n\n\x0cdecide the kind of case that is filed. Not only is it a waste of time to file in the wrong court system and be\ndismissed, but if the dismissal comes after the filing period imposed by the applicable\nstatute of limitations, it will be too late to refile in the correct court system. Such cases will be routinely\ndismissed, regardless of how deserving the plaintiff might be in his quest for justice. (The plaintiff\xe2\x80\x99s only\nremedy at that point would be to sue his lawyer for negligence for failing to mind the clock and get to the\nright 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 to file a\ncase in the state court system or the federal court system. Federal courts have exclusive jurisdiction over\ncertain kinds of cases. The reason for this comes directly from the Constitution. Article III of the US\nConstitution provides the following:\n\nThe judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution, the Laws\nof the United States, and Treaties made, or which shall be made, under their Authority; to all Cases\naffecting Ambassadors, other public Ministers and Consuls; to all Cases of admiralty and maritime\nJurisdiction; to Controversies to which the United States shall be a Party; to Controversies between two or\nmore States; between a State and Citizens of another State; between Citizens of different States; between\nCitizens of the same State claiming Lands under Grants of different States, and between a State, or the\nCitizens thereof, and foreign States, Citizens or Subjects.\n\nBy excluding diversity cases, we can assemble a list of the kinds of cases that can only be heard in federal\ncourts. The list looks like this:\n\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 foreign\nambassadors and other high-ranking public officials.\n3. Federal crimes. Crimes defined by or mentioned in the US Constitution or those defined or punished\nby federal statute. Such crimes include treason against the United States, piracy, counterfeiting, crimes\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n97\n\n\x0cagainst the law of nations, and crimes relating to the federal government\xe2\x80\x99s authority to regulate\ninterstate commerce. However, most crimes are state matters.\n4. Bankruptcy. The statutory procedure, usually triggered by insolvency, by which a person is relieved of\nmost debts and undergoes a judicially supervised reorganization or liquidation for the benefit of the\nperson\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(usually seventeen years), granted by the federal government to the inventor if the device\nor process is novel, useful, and nonobvious.\n\nb. Copyright. The body of law relating to a property right in an original work of authorship\n(such as a literary, musical, artistic, photographic, or film work) fixed in any tangible\nmedium of expression, giving the holder the exclusive right to reproduce, adapt,\ndistribute, perform, and display the work.\nc.\n\nTrademark. A word, phrase, logo, or other graphic symbol used by a manufacturer or\nseller to distinguish its product or products from those of others.\n\nAdmiralty. The system of laws that has grown out of the practice of admiralty courts: courts that\nexercise jurisdiction over all maritime contracts, torts, injuries, and offenses.\nAntitrust. Federal laws designed to protect trade and commerce from restraining monopolies, price\nfixing, and price discrimination.\nSecurities and banking regulation. The body of law protecting the public by regulating the\nregistration, 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 where Congress\ndeclares 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 of case\n(i.e., there is subject matter jurisdiction). If the plaintiff\xe2\x80\x99s main cause of action comes from a certain\nstate\xe2\x80\x99s constitution, statutes, or court decisions, the state courts have subject matter jurisdiction over the\ncase. If the plaintiff\xe2\x80\x99s main cause of action is based on federal law (e.g., Title VII of the Civil Rights Act of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n98\n\n\x0c1964), the federal courts have subject matter jurisdiction over the case. But federal courts will also have\nsubject matter jurisdiction over certain cases that have only a state-based cause of action; those cases are\nones in which the plaintiff(s) and the defendant(s) are from different states and the amount in\ncontroversy is more than $75,000. State courts can have subject matter jurisdiction over certain cases that\nhave only a federal-based cause of action. The Supreme Court has now made clear that state courts\nhave concurrent jurisdiction of any federal cause of action unless Congress has given exclusive jurisdiction\nto federal courts.\nIn short, a case with a federal question can be often be heard in either state or federal court, and a case\nthat has parties with a diversity of citizenship can be heard in state courts or in federal courts where the\ntests of complete diversity and amount in controversy are met. (SeeNote 3.18 "Summary of Rules on\nSubject Matter Jurisdiction".)\nWhether a case will be heard in a state court or moved to a federal court will depend on the parties. If a\nplaintiff files a case in state trial court where concurrent jurisdiction applies, a defendant may (or may\nnot) ask that the case be removed to federal district court.\n\nSummary of Rules on Subject Matter Jurisdiction\n1. 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 brought in a\nfederal court.\nSome cases can only be brought in federal court, such as bankruptcy cases, cases involving federal\ncrimes, patent cases, and Internal Revenue Service tax court claims. The list of cases for exclusive\nfederal jurisdiction is fairly short. That means that almost any state court will have subject matter\njurisdiction over almost any kind of case. If it\xe2\x80\x99s a case based on state law, a state court will always have\nsubject matter jurisdiction.\n3. A federal court will have subject matter jurisdiction over any case that is either based on a federal law\n(statute, case, or US Constitution)\n\nOR\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n99\n\n\x0cA federal court will have subject matter jurisdiction over any case based on state law where the parties are\n(1) from different states and (2) the amount in controversy is at least $75,000.\n\n(1) The different states requirement means that no plaintiff can have permanent residence in a state\nwhere any defendant has permanent residence\xe2\x80\x94there must be complete diversity of citizenship as\nbetween all plaintiffs and defendants.\n\n(2) The amount in controversy requirement means that a good-faith estimate of the amount the plaintiff\nmay 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.\n\n4. In diversity cases, the following rules apply.\n\n(1) Federal civil procedure rules apply to how the case is conducted before and during trial and any\nappeals, but\n\n(2) State law will be used as the basis for a determination of legal rights and responsibilities.\n\n(a) This \xe2\x80\x9cchoice of law\xe2\x80\x9d process is interesting but complicated. Basically, each state has its own set of\njudicial decisions that resolve conflict of laws. For example, just because A sues B in a Texas court, the\nTexas court will not necessarily apply Texas law. Anna and Bobby collide and suffer serious physical\ninjuries while driving their cars in Roswell, New Mexico. Both live in Austin, and Bobby files a lawsuit in\nAustin. The court there could hear it (having subject matter jurisdiction and personal jurisdiction over\nBobby) but would apply New Mexico law, which governs motor vehicle laws and accidents in New Mexico.\nWhy would the Texas judge do that?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n100\n\n\x0c(b) The Texas judge knows that which state\xe2\x80\x99s law is chosen to apply to the case can make a decisive\ndifference in the case, as different states have different substantive law standards. For example, in a\nbreach of contract case, one state\xe2\x80\x99s version of the Uniform Commercial Code may be different from\nanother\xe2\x80\x99s, and which one the court decides to apply is often exceedingly good for one side and dismal for\nthe other. In Anna v. Bobby, if Texas has one kind of comparative negligence statute and New Mexico has\na different kind of comparative negligence statute, who wins or loses, or how much is awarded, could well\ndepend on which law applies. Because both were under the jurisdiction of New Mexico\xe2\x80\x99s laws at the time,\nit makes sense to apply New Mexico law.\n\n(3) Why do some nonresident defendants prefer to be in federal court?\n\n(a) In the state court, the judge is elected, and the jury may be familiar with or sympathetic to the \xe2\x80\x9clocal\xe2\x80\x9d\nplaintiff.\n\n(b) The federal court provides a more neutral forum, with an appointed, life-tenured judge and a wider\npool of potential jurors (drawn from a wider geographical area).\n\n(4) If a defendant does not want to be in state court and there is diversity, what is to be done?\n\n(a) Make a motion for removal to the federal court.\n\n(b) The federal court will not want to add to its caseload, or docket, but must take the case unless there\nis not complete diversity of citizenship or the amount in controversy is less than$75,000.\n\nTo better understand subject matter jurisdiction in action, let\xe2\x80\x99s take an example. Wile E. Coyote wants a\nfederal judge to hear his products-liability action against Acme, Inc., even though the action is based on\nstate law. Mr. Coyote\xe2\x80\x99s attorney wants to \xe2\x80\x9cmake a federal case\xe2\x80\x9d out of it, thinking that the jurors in the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n101\n\n\x0cfederal district court\xe2\x80\x99s jury pool will understand the case better and be more likely to deliver a \xe2\x80\x9chigh value\xe2\x80\x9d\nverdict for Mr. Coyote. Mr. Coyote resides in Arizona, and Acme is incorporated in the state of Delaware\nand has its principal place of business in Chicago, Illinois. The federal court in Arizona can hear and\ndecide Mr. Coyote\xe2\x80\x99s case (i.e., it has subject matter jurisdiction over the case) because of diversity of\ncitizenship. If Mr. Coyote was injured by one of Acme\xe2\x80\x99s defective products while chasing a roadrunner in\nArizona, the 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.\n\nBut now change the facts only slightly: Acme is incorporated in Delaware but has its principal place of\nbusiness in Phoenix, Arizona. Unless Mr. Coyote has a federal law he is using as a basis for his claims\nagainst Acme, his attempt to get a federal court to hear and decide the case will fail. It will fail because\nthere is not complete diversity of citizenship between the plaintiff and the defendant.\n\nRobinson v. Audi\nNow consider Mr. and Mrs. Robinson and their products-liability claim against Seaway Volkswagen and\nthe other three defendants. There is no federal products-liability law that could be used as a cause of\naction. They are most likely suing the defendants using products-liability law based on common-law\nnegligence or common-law strict liability law, as found in state court cases. They were not yet Arizona\nresidents at the time of the accident, and their accident does not establish them as Oklahoma residents,\neither. They bought the vehicle in New York from a New York\xe2\x80\x93based retailer. None of the other\ndefendants is from Oklahoma.\nThey file in an Oklahoma state court, but how will they (their attorney or the court) know if the state court\nhas subject matter jurisdiction? Unless the case is required to be in a federal court (i.e., unless the federal\ncourts have exclusive jurisdiction over this kind of case), any state court system will have subject matter\njurisdiction, including Oklahoma\xe2\x80\x99s state court system. But if their claim is for a significant amount of\nmoney, they cannot file in small claims court, probate court, or any court in Oklahoma that does not have\nstatutory jurisdiction over their claim. They will need to file in a court of general jurisdiction. In short,\neven filing in the right court system (state versus federal), the plaintiff must be careful to find the court\nthat has subject matter jurisdiction.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n102\n\n\x0cIf they wish to go to federal court, can they? There is no federal question presented here (the claim is\nbased on state common law), and the United States is not a party, so the only basis for federal court\njurisdiction would be diversity jurisdiction. If enough time has elapsed since the accident and they have\nestablished themselves as Arizona residents, they could sue in federal court in Oklahoma (or elsewhere),\nbut only if none of the defendants\xe2\x80\x94the retailer, the regional Volkswagen company, Volkswagen of North\nAmerica, or Audi (in Germany) are incorporated in or have a principal place of business in Arizona. The\nfederal judge would decide the case using federal civil procedure but would have to make the appropriate\nchoice of state law. In this case, the choice of conflicting laws would most likely be Oklahoma, where the\naccident happened, or New York, where the defective product was sold.\n\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\nactivities\nNote: Choice-of-law clauses in a contract will ordinarily be honored by judges in state and\nfederal courts.\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 subject\nmatter jurisdiction and personal jurisdiction over at least one of the named defendants.\n\nThe courts are not the only institutions that can resolve disputes. InSection 3.8 "Alternative Means of\nResolving Disputes", we will discuss other dispute-resolution forums, such as arbitration and mediation.\nFor now, let us consider how courts make decisions in civil disputes. Judicial decision making in the\ncontext of litigation (civil lawsuits) is a distinctive form of dispute resolution.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n103\n\n\x0cFirst, to get the attention of a court, the plaintiff must make a claim based on existing laws. Second, courts\ndo not reach out for cases. Cases are brought to them, usually when an attorney files a case with the right\ncourt in the right way, following the various laws that govern all civil procedures in a state or in the federal\nsystem. (Most US states\xe2\x80\x99 procedural laws are similar to the federal procedural code.)\n\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), and the\narguments (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 the other\xe2\x80\x99s\ncase through proofs and cross-examination. Every person in the United States who wishes to take a case\nto court is entitled to hire a lawyer. The lawyer works for his client, not the court, and serves him as an\nadvocate, or supporter. The client\xe2\x80\x99s goal is to persuade the court of the accuracy and justness of his\nposition. The lawyer\xe2\x80\x99s duty is to shape the evidence and the argument\xe2\x80\x94the line of reasoning about the\nevidence\xe2\x80\x94to advance his client\xe2\x80\x99s cause and persuade the court of its rightness. The lawyer for the\nopposing party will be doing the same thing, of course, for her client. The judge (or, if one is sitting, the\njury) must sort out the facts and reach a decision from this cross-fire of evidence and argument.\n\nThe method of adjudication\xe2\x80\x94the act of making an order or judgment\xe2\x80\x94has several important features.\nFirst, it focuses the conflicting issues. Other, secondary concerns are minimized or excluded altogether.\nRelevance is a key concept in any trial. The judge is required to decide the questions presented at the trial,\nnot to talk about related matters. Second, adjudication requires that the judge\xe2\x80\x99s decision be reasoned, and\nthat is why judges write opinions explaining their decisions (an opinion may be omitted when the verdict\ncomes from a jury). Third, the judge\xe2\x80\x99s decision must not only be reasoned but also be responsive to the\ncase presented: the judge is not free to say that the case is unimportant and that he therefore will ignore it.\nUnlike other branches 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 people\npetition it to do so.) Fourth, the court must respond in a certain way. The judge must pay attention to the\nparties\xe2\x80\x99 arguments and his decision must result from their proofs and arguments. Evidence that is not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n104\n\n\x0cpresented and legal arguments that are not made cannot be the basis for what the judge decides. Also,\njudges are bound by standards of weighing evidence: the burden of proof in a civil case is generally a\n\xe2\x80\x9cpreponderance of the evidence.\xe2\x80\x9d\n\nIn all cases, the plaintiff\xe2\x80\x94the party making a claim and initiating the lawsuit (in a criminal case the\nplaintiff is the prosecution)\xe2\x80\x94has the burden of proving his case. If he fails to prove it, the defendant\xe2\x80\x94the\nparty being sued or prosecuted\xe2\x80\x94will win.\n\nCriminal prosecutions carry the most rigorous burden of proof: the government must prove its case\nagainst the defendant beyond a reasonable doubt. That is, even if it seems very likely that the defendant\ncommitted the crime, as long as there remains some reasonable doubt\xe2\x80\x94perhaps he was not clearly\nidentified as the culprit, perhaps he has an alibi that could be legitimate\xe2\x80\x94the jury must vote to acquit\nrather than convict.\n\nBy contrast, the burden of proof in ordinary civil cases\xe2\x80\x94those dealing with contracts, personal injuries,\nand most of the cases in this book\xe2\x80\x94is a preponderance of the evidence, which means that the plaintiff\xe2\x80\x99s\nevidence must outweigh whatever evidence the defendant can muster that casts doubts on the plaintiff\xe2\x80\x99s\nclaim. This is not merely a matter of counting the number of witnesses or of the length of time that they\ntalk: the judge in a trial without a jury (a bench trial), or the jury where one is impaneled, must apply the\npreponderance of evidence test by determining which side has the greater weight of credible, relevant\nevidence.\n\nAdjudication and the adversary system imply certain other characteristics of courts. Judges must be\nimpartial; those with a personal interest in a matter must refuse to hear it. The ruling of a court, after all\nappeals are exhausted, is final. This principle is known as res judicata (Latin for \xe2\x80\x9cthe thing is decided\xe2\x80\x9d),\nand it means that the same parties may not take up the same dispute in another court at another time.\nFinally, a court must proceed according to a public set of formal procedural rules; a judge cannot make up\nthe rules as he goes along. To these rules we now turn.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n105\n\n\x0cHow a Case Proceeds\nComplaint and Summons\nBeginning a lawsuit is simple and is spelled out in the rules of procedure by which each court system\noperates. In the federal system, the plaintiff begins a lawsuit by filing a complaint\xe2\x80\x94a document clearly\nexplaining the grounds for suit\xe2\x80\x94with the clerk of the court. The court\xe2\x80\x99s agent (usually a sheriff, for state\ntrial courts, or a US deputy marshal, in federal district courts) will then serve the defendant with the\ncomplaint and a summons. The summons is a court document stating the name of the plaintiff and his\nattorney and directing the defendant to respond to the complaint within a fixed time period.\nThe timing of the filing can be important. Almost every possible legal complaint is governed by a federal\nor state statute of limitations, which requires a lawsuit to be filed within a certain period of time. For\nexample, in many states a lawsuit for injuries resulting from an automobile accident must be filed within\ntwo years of the accident or the plaintiff forfeits his right to proceed. As noted earlier, making a correct\ninitial filing in a court that has subject matter jurisdiction is critical to avoiding statute of limitations\nproblems.\n\nJurisdiction and Venue\nThe place of filing is equally important, and there are two issues regarding location. The first is subject\nmatter jurisdiction, as already noted. A claim for breach of contract, in which the amount at stake is $1\nmillion, cannot be brought in a local county court with jurisdiction to hear cases involving sums of up to\nonly $1,000. Likewise, a claim for copyright violation cannot be brought in a state superior court, since\nfederal courts have exclusive jurisdiction over copyright cases.\n\nThe second consideration is venue\xe2\x80\x94the proper geographic location of the court. For example, every\ncounty in a state might have a superior court, but the plaintiff is not free to pick any county. Again, a\nstatute will spell out to which court the plaintiff must go (e.g., the county in which the plaintiff resides or\nthe county in which the defendant resides or maintains an office).\n\nService of Process and Personal Jurisdiction\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n106\n\n\x0cThe defendant must be \xe2\x80\x9cserved\xe2\x80\x9d\xe2\x80\x94that is, must receive notice that he has been sued. Service can be done\nby physically presenting the defendant with a copy of the summons and complaint. But sometimes the\ndefendant is difficult to find (or deliberately avoids the marshal or other process server). The rules spell\nout a variety of ways by which individuals and corporations can be served. These include using US Postal\nService certified mail or serving someone already designated to receive service of process. A corporation\nor partnership, for example, is often required by state law to designate a \xe2\x80\x9cregistered agent\xe2\x80\x9d for purposes of\ngetting public notices or receiving a summons and complaint.\n\nOne of the most troublesome problems is service on an out-of-state defendant. The personal jurisdiction\nof a state court over persons is clear for those defendants found within the state. If the plaintiff claims that\nan out-of-state defendant injured him in some way, must the plaintiff go to the defendant\xe2\x80\x99s home state to\nserve him? Unless the defendant had some significant contact with the plaintiff\xe2\x80\x99s state, the plaintiff may\nindeed have to. For instance, suppose a traveler from Maine stopped at a roadside diner in Montana and\nordered a slice of homemade pie that was tainted and caused him to be sick. The traveler may not simply\nreturn home and mail the diner a notice that he is suing it in a Maine court. But if out-of-state defendants\nhave some contact with the plaintiff\xe2\x80\x99s state of residence, there might be grounds to bring them within the\njurisdiction of the plaintiff\xe2\x80\x99s state courts. InBurger King v. Rudzewicz, Section 3.9 "Cases", the federal\ncourt in Florida had to consider whether it was constitutionally permissible to exercise personal\njurisdiction over a Michigan franchisee.\n\nAgain, recall that even if a court has subject matter jurisdiction, it must also have personal jurisdiction\nover each defendant against whom an enforceable judgment can be made. Often this is not a problem; you\nmight be suing a person who lives in your state or regularly does business in your state. Or a nonresident\nmay answer your complaint without objecting to the court\xe2\x80\x99s \xe2\x80\x9cin personam\xe2\x80\x9d (personal) jurisdiction. But\nmany defendants who do not reside in the state where the lawsuit is filed would rather not be put to the\ninconvenience of contesting a lawsuit in a distant forum. Fairness\xe2\x80\x94and the due process clause of the\nFourteenth Amendment\xe2\x80\x94dictates that nonresidents should not be required to defend lawsuits far from\ntheir home base, especially where there is little or no contact or connection between the nonresident and\nthe state where a lawsuit is brought.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n107\n\n\x0cSummary of Rules on Personal Jurisdiction\n1. Once a court determines that it has subject matter jurisdiction, it must find at least one defendant over\nwhich it is \xe2\x80\x9cfair\xe2\x80\x9d (i.e., in accord with due process) to exercise personal jurisdiction.\n2. If a plaintiff sues five defendants and the court has personal jurisdiction over just one, the case can be\nheard, but the court cannot make a judgment against the other four.\n1.\n\nBut if the plaintiff loses against defendant 1, he can go elsewhere (to another state or\nstates) and sue defendants 2, 3, 4, or 5.\n\n2. The court\xe2\x80\x99s decision in the first lawsuit (against defendant 1) does not determine the\nliability of the nonparticipating defendants.\n\nThis involves the principle of res judicata, which means that you can\xe2\x80\x99t bring the same action against the\nsame person (or entity) twice. It\xe2\x80\x99s like the civil side of double jeopardy. Res means \xe2\x80\x9cthing,\xe2\x80\x9d\nand 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 not be judged\nagain. But, as to nonparticipating parties, it is not over. If you have a differentcase against the same\ndefendant\xe2\x80\x94one that arises out of a completely different situation\xe2\x80\x94that case is not barred by res judicata.\n\n3. Service of process is a necessary (but not sufficient) condition for getting personal jurisdiction over a\nparticular defendant (see rule 4).\n1.\n\nIn order to get a judgment in a civil action, the plaintiff must serve a copy of the\ncomplaint and a summons on the defendant.\n\n2. There are many ways to do this.\n\xe2\x80\xa2\n\nThe process server personally serves a complaint on the defendant.\n\n\xe2\x80\xa2\n\nThe process server leaves a copy of the summons and complaint at the residence\nof the defendant, in the hands of a competent person.\n\n\xe2\x80\xa2\n\nThe process server sends the summons and complaint by certified mail, return\nreceipt requested.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n108\n\n\x0c\xe2\x80\xa2\n\nThe process server, if all other means are not possible, notifies the defendant by\npublication in a newspaper having a minimum number of readers (as may be\nspecified by law).\n\n4. In addition to successfully serving the defendant with process, a plaintiff must convince the court that\nexercising personal jurisdiction over the defendant is consistent with due process and any statutes in\nthat state that prescribe the jurisdictional reach of that state (the so-called long-arm statutes). The\nSupreme Court has long recognized various bases for judging whether such process is fair.\n\n1.\n\nConsent. The defendant agrees to the court\xe2\x80\x99s jurisdiction by coming to court, answering\nthe complaint, and having the matter litigated there.\n\n2. 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\nfor the state 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.\n\nAgain, let\xe2\x80\x99s consider Mrs. Robinson and her children in the Audi accident. She could file a lawsuit\nanywhere in the country. She could file a lawsuit in Arizona after she establishes residency there. But\nwhile the Arizona court would have subject matter jurisdiction over any products-liability claim (or any\nclaim that was not required to be heard in a federal court), the Arizona court would face an issue of \xe2\x80\x9cin\npersonam jurisdiction,\xe2\x80\x9d or personal jurisdiction: under the due process clause of the Fourteenth\nAmendment, each state must extend due process to citizens of all of the other states. Because fairness is\nessential to due process, the court must consider whether it is fair to require an out-of-state defendant to\nappear and defend against a lawsuit that could result in a judgment against that defendant.\n\nAlmost every state in the United States has a statute regarding personal jurisdiction, instructing judges\nwhen it is permissible to assert personal jurisdiction over an out-of-state resident. These are called longarm statutes. But no state can reach out beyond the limits of what is constitutionally permissible under\nthe Fourteenth Amendment, which binds the states with its proviso to guarantee the due process rights of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n109\n\n\x0cthe citizens of every state in the union. The \xe2\x80\x9cminimum contacts\xe2\x80\x9d test in Burger King v.\nRudzewicz (Section 3.9 "Cases") tries to make the fairness mandate of the due process clause more\nspecific. So do other tests articulated in the case (such as \xe2\x80\x9cdoes not offend traditional notions of fair play\nand substantial justice\xe2\x80\x9d). These tests are posed by the Supreme Court and heeded by all lower courts in\norder to honor the provisions of the Fourteenth Amendment\xe2\x80\x99s due process guarantees. These tests are in\naddition to 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 parties in a\nlawsuit. Suppose the parties to a contract wind up in court arguing over the application of the contract\xe2\x80\x99s\nterms. If the parties are from two different states, the judge may have difficulty determining which law to\napply (see Table 3.1 "Sample Conflict-of-Law Principles"). But if the contract says that a particular state\xe2\x80\x99s\nlaw will be applied if there is a dispute, then ordinarily the judge will apply that state\xe2\x80\x99s law as a rule of\ndecision in the case. For example, Kumar Patel (a Missouri resident) opens a brokerage account with\nGoldman, Sachs and Co., and the contractual agreement calls for \xe2\x80\x9cany disputes arising under this\nagreement\xe2\x80\x9d to be 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, Sachs claims\nthat Kumar has failed to meet his margin call and owes $38,568.25 (plus interest and attorney\xe2\x80\x99s fees), the\njudge in Missouri will apply New York law based on the contract between Kumar and Goldman, Sachs.\n\nOrdinarily, a choice-of-law clause will be accompanied by a choice-of-forum clause. In a choice-of-forum\nclause, the parties in the contract specify which court they will go to in the event of a dispute arising under\nthe terms of contract. For example, Harold (a resident of Virginia) rents a car from Alamo at the Denver\nInternational Airport. He does not look at the fine print on the contract. He also waives all collision and\nother insurance that Alamo offers at the time of his rental. While driving back from Telluride Bluegrass\nFestival, he has an accident in Idaho Springs, Colorado. His rented Nissan Altima is badly damaged. On\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n110\n\n\x0creturning to Virginia, he would like to settle up with Alamo, but his insurance company and Alamo cannot\ncome to terms. He realizes, however, that he has agreed to hear the dispute with Alamo in a specific court\nin San Antonio, 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 San\nAntonio, Texas.\n\nK E Y TA K EA WAY\nThere are two court systems in the United States. It is important to know which\nsystem\xe2\x80\x94the state court system or the federal court system\xe2\x80\x94has the power to\nhear and decide a particular case. Once that is established, the Constitution\ncompels an inquiry to make sure that no court extends its reach unfairly to out-ofstate residents. The question of personal jurisdiction is a question of fairness and\ndue process to nonresidents.\n\nE XE R C IS ES\n1. The Constitution specifies that federal courts have exclusive jurisdiction over\nadmiralty claims. Mr. and Mrs. Shute have a claim against Carnival Cruise lines for\nthe negligence of the cruise line. Mrs. Shute sustained injuries as a result of the\ncompany\xe2\x80\x99s negligence. Mr. and Mrs. Shute live in the state of Washington. Can\nthey bring their claim in state court? Must they bring their claim in federal court?\n2. Congress passed Title VII of the Civil Rights Act of 1964. In Title VII, employers are\nrequired not to discriminate against employees on the basis of race, color, sex,\nreligion, or national origin. In passing Title VII, Congress did not require plaintiffs to\nfile only in federal courts. That is, Congress made no statement in Title VII that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n111\n\n\x0cfederal courts had \xe2\x80\x9cexclusive jurisdiction\xe2\x80\x9d over Title VII claims. Mrs. Harris wishes\nto sue Forklift Systems, Inc. of Nashville, Tennessee, for sexual harassment under\nTitle VII. She has gone through the Equal Employment Opportunity Commission\nprocess and has a right-to-sue letter, which is required before a Title VII action can\nbe brought to court. Can she file a complaint that will be heard by a state court?\n3. Mrs. Harris fails to go to the Equal Employment Opportunity Commission to get\nher right-to-sue letter against Forklift Systems, Inc. She therefore does not have a\nviable Title VII cause of action against Forklift. She does, however, have her rights\nunder Tennessee\xe2\x80\x99s equal employment statute and various court decisions from\nTennessee courts regarding sexual harassment. Forklift is incorporated in\nTennessee and has its principal place of business in Nashville. Mrs. Harris is also a\ncitizen of Tennessee. Explain why, if she brings her employment discrimination\nand sexual harassment lawsuit in a federal court, her lawsuit will be dismissed for\nlack of subject matter jurisdiction.\n4. Suppose Mr. and Mrs. Robinson find in the original paperwork with Seaway\nVolkswagen that there is a contractual agreement with a provision that says \xe2\x80\x9call\ndisputes arising between buyer and Seaway Volkswagen will be litigated, if at all,\nin the county courts of Westchester County, New York.\xe2\x80\x9d Will the Oklahoma court\ntake personal jurisdiction over Seaway Volkswagen, or will it require the Robinsons\nto litigate their claim in New York?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n112\n\n\x0c3.3 Motions and Discovery\nL EA R N IN G O B JEC T IV ES\n1. Explain how a lawsuit can be dismissed prior to any trial.\n2. Understand the basic principles and practices of discovery before a trial.\n\nThe early phases of a civil action are characterized by many different kinds of motions and a complex\nprocess of mutual fact-finding between the parties that is known as discovery. A lawsuit will start with the\npleadings (complaint and answer in every case, and in some cases a counterclaim by the defendant\nagainst the plaintiff and the plaintiff\xe2\x80\x99s reply to the defendant\xe2\x80\x99s counterclaim). After the pleadings, the\nparties may make various motions, which are requests to the judge. Motions in the early stages of a\nlawsuit usually aim to dismiss the lawsuit, to have it moved to another venue, or to compel the other party\nto act in certain ways during the discovery process.\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 and then\n(usually after thirty or more days) the answer or response from the defendant. The answer may be\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n113\n\n\x0ccoupled with a counterclaim against the plaintiff. (In effect, the defendant becomes the plaintiff for the\nclaims she has against the original plaintiff.) The plaintiff may reply to any counterclaim by the defendant.\n\nState and federal rules of civil procedure require that the complaint must state the nature of the plaintiff\xe2\x80\x99s\nclaim, the jurisdiction of the court, and the nature of the relief that is being asked for (usually an award of\nmoney, but sometimes an injunction, or a declaration of legal rights). In an answer, the defendant will\noften deny all the allegations of the complaint or will admit to certain of its allegations and deny others.\n\nA complaint and subsequent pleadings are usually quite general and give little detail. Cases can be decided\non the pleadings alone in the following situations: (1) If the defendant fails to answer the complaint, the\ncourt can enter a default judgment, awarding the plaintiff what he seeks. (2) The defendant can move to\ndismiss the complaint on the grounds that the plaintiff failed to \xe2\x80\x9cstate a claim on which relief can be\ngranted,\xe2\x80\x9d or on the basis that there is no subject matter jurisdiction for the court chosen by the plaintiff,\nor on the basis that there is no personal jurisdiction over the defendant. The defendant is saying, in effect,\nthat even if all the plaintiff\xe2\x80\x99s allegations are true, they do not amount to a legal claim that can be heard by\nthe court. For example, a claim that the defendant induced a woman to stop dating the plaintiff (a socalled alienation of affections cause of action) is no longer actionable in US state courts, and any court will\ndismiss the complaint without any further proceedings. (This type of dismissal is occasionally still called a\ndemurrer.)\n\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 promissory\nnote and, at deposition (an oral examination under oath), the defendant admits having made no payment\non the note and offers no excuse that would be recognizable as a reason not to pay. There is no reason to\nhave a trial, and the court should grant summary judgment.\n\nDiscovery\nIf there is a factual dispute, the case will usually involve some degree of discovery, where each party tries\nto get as much information out of the other party as the rules allow. Until the 1940s, when discovery\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n114\n\n\x0cbecame part of civil procedure rules, a lawsuit was frequently a game in which each party hid as much\ninformation as possible and tried to surprise the other party in court.\n\nBeginning with a change in the Federal Rules of Civil Procedure adopted by the Supreme Court in 1938\nand subsequently followed by many of the states, the parties are entitled to learn the facts of the case\nbefore trial. The basic idea is to help the parties determine what the evidence might be, who the potential\nwitnesses are, and what specific issues are relevant. Discovery can proceed by several methods. A party\nmay serve an interrogatory on his adversary\xe2\x80\x94a written request for answers to specific questions. Or a\nparty may depose the other party or a witness. A deposition is a live question-and-answer session at which\nthe witness answers questions put to him by one of the parties\xe2\x80\x99 lawyers. His answers are recorded\nverbatim and may be used at trial. Each party is also entitled to inspect books, documents, records, and\nother physical items in the possession of the other. This is a broad right, as it is not limited to just\nevidence that is admissible 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, engineering and\nquality-control reports, sales reports, and virtually any other document.\n\nThe lawyers, not the court, run the discovery process. For example, one party simply makes a written\ndemand, stating the time at which the deposition will take place or the type of documents it wishes to\ninspect and make copies of. A party unreasonably resisting discovery methods (whether depositions,\nwritten interrogatories, or requests for documents) can be challenged, however, and judges are often\nbrought into the process to push reluctant parties to make more disclosure or to protect a party from\nirrelevant or unreasonable discovery requests. For example, the party receiving the discovery request can\napply to the court for a protective order if it can show that the demand is for privileged material (e.g., a\nparty\xe2\x80\x99s lawyers\xe2\x80\x99 records are not open for inspection) or that the demand was made to harass the opponent.\nIn complex cases between companies, the discovery of documents can run into tens of millions of pages\nand can take years. Depositions can consume days or even weeks of an executive\xe2\x80\x99s time.\n\nK E Y TA K EA WAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n115\n\n\x0cMany cases never get to trial. They are disposed of by motions to dismiss or are settled\nafter extensive discovery makes clear to the parties the strengths and weaknesses of the\nparties to the dispute.\n\nE XE R C IS ES\n1. Mrs. Robinson (in the Volkswagen Audi case) never establishes residency in Arizona,\nreturns to New York, and files her case in federal district court in New York, alleging\ndiversity jurisdiction. Assume that the defendants do not want to have the case heard in\nfederal court. What motion will they make?\n2. Under contributory negligence, the negligence of any plaintiff that causes or contributes\nto the injuries a plaintiff complains of will be grounds for dismissal. Suppose that in\ndiscovery, Mr. Ferlito inFerlito v. Johnson & Johnson (Section 3.9 "Cases") admits that he\nbrought the cigarette lighter dangerously close to his costume, saying, \xe2\x80\x9cYes, you could\ndefinitely say I was being careless; I had a few drinks under my belt.\xe2\x80\x9d Also, Mrs. Ferlito\nadmits that she never reads product instructions from manufacturers. If the case is\nbrought in a state where contributory negligence is the law, on what basis can Johnson\n& Johnson have the case dismissed before trial?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n116\n\n\x0c3.4 The Pretrial and Trial Phase\nL EA R N IN G O B JEC T IV ES\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\nverdict\xe2\x80\x9d).\n\nAfter considerable discovery, one of the parties may believe that there is no triable issue of law or fact for\nthe court to consider and may file a motion with the court for summary judgment. Unless it is very clear,\nthe judge will deny a summary judgment motion, because that ends the case at the trial level; it is a \xe2\x80\x9cfinal\norder\xe2\x80\x9d in the case that tells the plaintiff \xe2\x80\x9cno\xe2\x80\x9d and leaves no room to bring another lawsuit against the\ndefendant for that particular set of facts (res judicata). If the plaintiff successfully appeals a summary\njudgment motion, the case will come back to the trial court.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n117\n\n\x0cPrior to the trial, the judge may also convene the parties in an effort to investigate the possibilities of\nsettlement. Usually, the judge will explore the strengths and weaknesses of each party\xe2\x80\x99s case with the\nattorneys. The parties may decide that it is more prudent or efficient to settle than to risk going to trial.\n\nPretrial Conference\nAt various times during the discovery process, depending on the nature and complexity of the case, the\ncourt may hold a pretrial conference to clarify the issues and establish a timetable. The court may also\nhold a settlement conference to see if the parties can work out their differences and avoid trial altogether.\nOnce discovery is complete, the case moves on to trial if it has not been settled. Most cases are settled\nbefore this stage; perhaps 85 percent of all civil cases end before trial, and more than 90 percent of\ncriminal 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 party can\nrequest one, based on the Sixth Amendment to the US Constitution.) The judge and sometimes the\nlawyers are permitted to question the jurors to be sure that they are unbiased. This questioning is known\nas the voir dire (pronounced vwahr-DEER). This is an important process, and a great deal of thought goes\ninto selecting the jury, especially in high-profile cases. A jury panel can be as few as six persons, or as\nmany as twelve, with alternates selected and sitting in court in case one of the jurors is unable to continue.\nIn a long trial, having alternates is essential; even in shorter trials, most courts will have at least two\nalternate jurors.\n\nIn both criminal and civil trials, each side has opportunities to challenge potential jurors for cause. For\nexample, in the Robinsons\xe2\x80\x99 case against Audi, the attorneys representing Audi will want to know if any\nprospective jurors have ever owned an Audi, what their experience has been, and if they had a similar\nproblem (or worse) with their Audi that was not resolved to their satisfaction. If so, the defense attorney\ncould well believe that such a juror has a potential for a bias against her client. In that case, she could use\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n118\n\n\x0ca challenge for cause, explaining to the judge the basis for her challenge. The judge, at her discretion,\ncould either accept the for-cause reason or reject it.\n\nEven if an attorney cannot articulate a for-cause reason acceptable to the judge, he may use one of several\nperemptory challenges that most states (and the federal system) allow. A trial attorney with many years of\nexperience may have a sixth sense about a potential juror and, in consultation with the client, may decide\nto use a peremptory challenge to avoid having that juror on the panel.\n\nAfter the jury is sworn and seated, the plaintiff\xe2\x80\x99s lawyer makes an opening statement, laying out the\nnature of the plaintiff\xe2\x80\x99s claim, the facts of the case as the plaintiff sees them, and the evidence that the\nlawyer will present. The defendant\xe2\x80\x99s lawyer may also make an opening statement or may reserve his right\nto do so at the end of the plaintiff\xe2\x80\x99s case.\n\nThe plaintiff\xe2\x80\x99s lawyer then calls witnesses and presents the physical evidence that is relevant to her proof.\nThe direct testimony at trial is usually far from a smooth narration. The rules of evidence (that govern the\nkinds of testimony and documents that may be introduced at trial) and the question-and-answer format\ntend to make the presentation of evidence choppy and difficult to follow.\n\nAnyone who has watched an actual televised trial or a television melodrama featuring a trial scene will\nappreciate the nature of the trial itself: witnesses are asked questions about a number of issues that may\nor may not be related, the opposing lawyer will frequently object to the question or the form in which it is\nasked, and the jury may be sent from the room while the lawyers argue at the bench before the judge.\n\nAfter direct testimony of each witness is over, the opposing lawyer may conduct cross-examination. This\nis a crucial constitutional right; in criminal cases it is preserved in the Constitution\xe2\x80\x99s Sixth Amendment\n(the right to confront one\xe2\x80\x99s accusers in open court). The formal rules of direct testimony are then relaxed,\nand the cross-examiner may probe the witness more informally, asking questions that may not seem\nimmediately relevant. This is when the opposing attorney may become harsh, casting doubt on a witness\xe2\x80\x99s\ncredibility, trying to trip her up and show that the answers she gave are false or not to be trusted. This use\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n119\n\n\x0cof cross-examination, along with the requirement that the witness must respond to questions that are at\nall relevant to the questions raised by the case, distinguishes common-law courts from those of\nauthoritarian regimes around the world.\n\nFollowing cross-examination, the plaintiff\xe2\x80\x99s lawyer may then question the witness again: this is called\nredirect examination and is used to demonstrate that the witness\xe2\x80\x99s original answers were accurate and to\nshow that any implications otherwise, suggested by the cross-examiner, were unwarranted. The crossexaminer may then engage the witness in re-cross-examination, and so on. The process usually stops after\ncross-examination or redirect.\n\nDuring the trial, the judge\xe2\x80\x99s chief responsibility is to see that the trial is fair to both sides. One big piece of\nthat responsibility is to rule on the admissibility of evidence. A judge may rule that a particular question is\nout of order\xe2\x80\x94that is, not relevant or appropriate\xe2\x80\x94or that a given document is irrelevant. Where the\nattorney is convinced that a particular witness, a particular question, or a particular document (or part\nthereof) is critical to her case, she may preserve an objection to the court\xe2\x80\x99s ruling by saying \xe2\x80\x9cexception,\xe2\x80\x9d in\nwhich case the court stenographer will note the exception; on appeal, the attorney may cite any number of\nexceptions as adding up to the lack of a fair trial for her client and may request a court of appeals to order\na retrial.\n\nFor the most part, courts of appeal will not reverse and remand for a new trial unless the trial court\njudge\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 entitled to a perfect\ntrial, but only to a fair trial, one in which the trial judge has made only \xe2\x80\x9charmless errors\xe2\x80\x9d and not\nprejudicial ones.\n\nAt the end of the plaintiff\xe2\x80\x99s case, the defendant presents his case, following the same procedure just\noutlined. The plaintiff is then entitled to present rebuttal witnesses, if necessary, to deny or argue with the\nevidence the defendant has introduced. The defendant in turn may present \xe2\x80\x9csurrebuttal\xe2\x80\x9d witnesses.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n120\n\n\x0cWhen all testimony has been introduced, either party may ask the judge for a directed verdict\xe2\x80\x94a\nverdict decided by the judge without advice from the jury. This motion may be granted if the plaintiff has\nfailed to introduce evidence that is legally sufficient to meet her burden of proof or if the defendant has\nfailed to do the same on issues on which she has the burden of proof. (For example, the plaintiff alleges\nthat the defendant owes him money and introduces a signed promissory note. The defendant cannot show\nthat the note is invalid. The defendant must lose the case unless he can show that the debt has been paid\nor otherwise discharged.)\n\nThe defendant can move for a directed verdict at the close of the plaintiff\xe2\x80\x99s case, but the judge will usually\nwait to hear the entire case until deciding whether to do so. Directed verdicts are not usually granted,\nsince it is the jury\xe2\x80\x99s job to determine the facts in dispute.\n\nIf the judge refuses to grant a directed verdict, each lawyer will then present a closing argument to the\njury (or, if there is no jury, to the judge alone). The closing argument is used to tie up the loose ends, as\nthe attorney tries to bring together various seemingly unrelated facts into a story that will make sense to\nthe jury.\n\nAfter closing arguments, the judge will instruct the jury. The purpose of jury instruction is to explain to\nthe jurors the meaning of the law as it relates to the issues they are considering and to tell the jurors what\nfacts they must determine if they are to give a verdict for one party or the other. Each lawyer will have\nprepared a set of written instructions that she hopes the judge will give to the jury. These will be tailored\nto advance her client\xe2\x80\x99s case. Many a verdict has been overturned on appeal because a trial judge has\nwrongly instructed the jury. The judge will carefully determine which instructions to give and often will\nuse a set of pattern instructions provided by the state bar association or the supreme court of the state.\nThese pattern jury instructions are often safer because they are patterned after language that appellate\ncourts have used previously, and appellate courts are less likely to find reversible error in the instructions.\n\nAfter all instructions are given, the jury will retire to a private room and discuss the case and the answers\nrequested by the judge for as long as it takes to reach a unanimous verdict. Some minor cases do not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n121\n\n\x0crequire a unanimous verdict. If the jury cannot reach a decision, this is called a hung jury, and the case\nwill have to be retried. When a jury does reach a verdict, it delivers it in court with both parties and their\nlawyers present. The jury is then discharged, and control over the case returns to the judge. (If there is no\njury, the judge will usually announce in a written opinion his findings of fact and how the law applies to\nthose facts. Juries just announce their verdicts 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 verdict\n(often called a judgment n.o.v., from the Latin non obstante veredicto). A judge who decides that a\ndirected verdict is appropriate will usually wait to see what the jury\xe2\x80\x99s verdict is. If it is favorable to the\nparty the judge thinks should win, she can rely on that verdict. If the verdict is for the other party, he can\ngrant the motion for judgment n.o.v. This is a safer way to proceed because if the judge is reversed on\nappeal, a new trial is not necessary. The jury\xe2\x80\x99s verdict always can be restored, whereas without a jury\nverdict (as happens when a directed verdict is granted before the case goes to the jury), the entire case\nmust be presented to a new jury. Ferlito v. Johnson & Johnson (Section 3.9 "Cases") illustrates the\njudgment n.o.v. process in a case where the judge allowed the case to go to a jury that was overly\nsympathetic to the plaintiffs.\n\nRule 50(b) of the Federal Rules of Civil Procedure provides the authorization for federal judges making a\njudgment contrary to the judgment of the jury. Most states have a similar rule.\n\nRule 50(b) says,\n\nWhenever a motion for a directed verdict made at the close of all the evidence is denied or for any reason\nis not granted, the court is deemed to have submitted the action to the jury subject to a later\ndetermination of the legal questions raised by the motion. Not later than 10 days after entry of judgment,\na party who has moved for a directed verdict may move to have the verdict and any judgment entered\nthereon set aside and to have judgment entered in accordance with the party\xe2\x80\x99s motion for a directed\nverdict.\xe2\x80\xa6[A] new trial may be prayed for in the alternative. If a verdict was returned the court may allow\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n122\n\n\x0cthe judgment to stand or may reopen the judgment and either order a new trial or direct the entry of\njudgment as if the requested verdict had been directed.\n\nK E Y TA K EA WAY\nThe purpose of a trial judge is to ensure justice to all parties to the lawsuit. The\njudge presides, instructs the jury, and may limit who testifies and what they testify\nabout what. In all of this, the judge will usually commit some errors; occasionally\nthese will be the kinds of errors that seriously compromise a fair trial for both\nparties. Errors that do seriously compromise a fair trial for both parties are\nprejudicial, as opposed to harmless. The appeals court must decide whether any\nerrors 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\none; if a judge grants judgment n.o.v., that will take away a jury verdict that one\nside has worked very hard to get. Thus a judge must be careful not to unduly favor\none side or the other, regardless of his or her sympathies.\n\nE XE R C IS ES\n1. What if there was not a doctrine of res judicata? What would the legal system\nbe like?\n2. Why do you think cross-examination is a \xe2\x80\x9cright,\xe2\x80\x9d as opposed to a \xe2\x80\x9cgood\nthing\xe2\x80\x9d? What kind of judicial system would not allow cross-examination of\nwitnesses as a matter of right?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n123\n\n\x0c3.5 Judgment, Appeal, and Execution\nL EA R N IN G O B JEC T IV ES\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 of a jury)\nand conclusions of law. The judge will also make a judgment as to what relief or remedy should be given.\nOften it is an award of money damages to one of the parties. The losing party may ask for a new trial at\nthis point or within a short period of time following. Once the trial judge denies any such request, the\njudgment\xe2\x80\x94in the form of the court\xe2\x80\x99s order\xe2\x80\x94is final.\n\nAppeal\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n124\n\n\x0cIf the loser\xe2\x80\x99s motion for a new trial or a judgment n.o.v. is denied, the losing party may appeal but must\nordinarily post a bond sufficient to ensure that there are funds to pay the amount awarded to the winning\nparty. In an appeal, the appellant aims to show that there was some prejudicial error committed by the\ntrial judge. There will be errors, of course, but the errors must be significant (i.e., not harmless). The basic\nidea is for an appellate court to ensure that a reasonably fair trial was provided to both sides. Enforcement\nof the court\xe2\x80\x99s judgment\xe2\x80\x94an award of money, an injunction\xe2\x80\x94is usually stayed (postponed) until the\nappellate court has ruled. As noted earlier, the party making the appeal is called the appellant, and the\nparty defending the judgment is the appellee (or in some courts, the petitioner and the respondent).\n\nDuring the trial, the losing party may have objected to certain procedural decisions by the judge. In\ncompiling a record on appeal, the appellant needs to show the appellate court some examples of mistakes\nmade by the judge\xe2\x80\x94for example, having erroneously admitted evidence, having failed to admit proper\nevidence that should have been admitted, or having wrongly instructed the jury. The appellate court must\ndetermine if those mistakes were serious enough to amount to prejudicial error.\nAppellate and trial procedures are different. The appellate court does not hear witnesses or accept\nevidence. It reviews the record of the case\xe2\x80\x94the transcript of the witnesses\xe2\x80\x99 testimony and the documents\nreceived into evidence at trial\xe2\x80\x94to try to find a legal error on a specific request of one or both of the\nparties. The parties\xe2\x80\x99 lawyers prepare briefs (written statements containing the facts in the case), the\nprocedural steps taken, and the argument or discussion of the meaning of the law and how it applies to\nthe facts. After reading the briefs on appeal, the appellate court may dispose of the appeal without\nargument, issuing a written opinion that may be very short or many pages. Often, though, the appellate\ncourt will hear oral argument. (This can be months, or even more than a year after the briefs are filed.)\nEach lawyer is given a short period of time, usually no more than thirty minutes, to present his client\xe2\x80\x99s\ncase. The lawyer rarely gets a chance for an extended statement because he is usually interrupted by\nquestions from the judges. Through this exchange between judges and lawyers, specific legal positions can\nbe tested and their limits explored.\n\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 directed by the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n125\n\n\x0chigher court. The appellate court itself does not take specific action in the case; it sits only to rule on\ncontested issues of law. The lower court must issue the final judgment in the case. As we have already\nseen, there is the possibility of appealing from an intermediate appellate court to the state supreme court\nin twenty-nine states and to the US Supreme Court from a ruling from a federal circuit court of appeal. In\ncases raising constitutional issues, there is also the possibility of appeal to the Supreme Court from the\nstate courts.\n\nLike trial judges, appellate judges must follow previous decisions, or precedent. But not every previous\ncase is a precedent for every court. Lower courts must respect appellate court decisions, and courts in one\nstate are not bound by decisions of courts in other states. State courts are not bound by decisions of\nfederal courts, except on points of federal law that come from federal courts within the state or from a\nfederal circuit in which the state court sits. A state supreme court is not bound by case law in any other\nstate. But a supreme court in one state with a type of case it has not previously dealt with may find\npersuasive reasoning in decisions of other state supreme courts.\nFederal district courts are bound by the decisions of the court of appeals in their circuit, but decisions by\none circuit court are not precedents for courts in other circuits. Federal courts are also bound by decisions\nof the state supreme courts within their geographic territory in diversity jurisdiction cases. All courts are\nbound by decisions of the US Supreme Court, except the Supreme Court itself, which seldom reverses\nitself but on occasion has overturned its own precedents.\n\nNot everything a court says in an opinion is a precedent. Strictly speaking, only the exact holding is\nbinding on the lower courts. A holding is the theory of the law that applies to the particular circumstances\npresented in a case. The courts may sometimes declare what they believe to be the law with regard to\npoints that are not central to the case being decided. These declarations are called dicta (the\nsingular, dictum), and the lower courts do not have to give them the same weight as holdings.\n\nJudgment and Order\nWhen a party has no more possible appeals, it usually pays up voluntarily. If not voluntarily, then the\nlosing party\xe2\x80\x99s assets can be seized or its wages or other income garnished to satisfy the judgment. If the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n126\n\n\x0cfinal judgment is an injunction, failure to follow its dictates can lead to a contempt citation, with a fine or\njail time imposed.\n\nK E Y TA K EA WAY\nThe process of conducting a civil trial has many aspects, starting with pleadings\nand continuing with motions, discovery, more motions, pretrial conferences, and\nfinally the trial itself. At all stages, the rules of civil procedure attempt to give both\nsides plenty of notice, opportunity to be heard, discovery of relevant information,\ncross-examination, and the preservation of procedural objections for purposes of\nappeal. All of these rules and procedures are intended to provide each side with a\nfair trial.\n\nE XE R C IS ES\n1. Mrs. Robinson has a key witness on auto safety that the judge believes is not\nqualified as an expert. The judge examines the witness while the jury is in the\njury room and disqualifies him from testifying. The jury does not get to hear\nthis witness. Her attorney objects. She loses her case. What argument would\nyou 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\ntestimony under oath?\n3. A trial judge in Nevada is wondering whether to enforce a surrogate\nmotherhood contract. Penelope Barr, of Reno, Nevada, has contracted\nwith Reuben and Tina Goldberg to bear the in vitro fertilized egg of Mrs.\nGoldberg. After carrying the child for nine months, Penelope gives birth,\nbut she is reluctant to give up the child, even though she was paid $20,000\nat the start of the contract and will earn an additional $20,000 on handing\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n127\n\n\x0cover the baby to the Goldbergs. (Barr was an especially good candidate for\nsurrogate motherhood: she had borne two perfect children and at age 28\ndrinks no wine, does not smoke or use drugs of any kind, practices yoga,\nand maintains a largely vegetarian diet with just enough meat to meet the\nneeds of the fetus within.)\nThe Goldbergs have asked the judge for an order compelling Penelope to\ngive up the baby, who was five days old when the lawsuit was filed. The\nbaby is now a month old as the judge looks in vain for guidance from any\nNevada statute, federal statute, or any prior case in Nevada that addressed\nthe issue of surrogate motherhood. He does find several well-reasoned\ncases, one from New Jersey, one from Michigan, and one from Oregon. Are\nany of these \xe2\x80\x9cprecedent\xe2\x80\x9d that he must follow? May he adopt the reasoning\nof any of these courts, if he should find that reasoning persuasive?\n\n3.6 When Can Someone Bring a Lawsuit?\nL EA R N IN G O B JEC T IV ES\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\nfile a class action case.\n\nAlmost anyone can bring a lawsuit, assuming they have the filing fee and the help of an attorney. But the\ncourt may not hear it, for a number of reasons. There may be no case or controversy, there may be no law\nto support the plaintiff\xe2\x80\x99s claim, it may be in the wrong court, too much time might have lapsed (a statute\nof 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 Supreme\nCourt has decided that it has no power to adjudicate because there is no \xe2\x80\x9ccase or controversy.\xe2\x80\x9d For\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n128\n\n\x0cexample, perhaps the case has settled or the \xe2\x80\x9creal parties in interest\xe2\x80\x9d are not before the court. In such a\ncase, a court might dismiss the case on the grounds that the plaintiff does not have \xe2\x80\x9cstanding\xe2\x80\x9d to sue.\n\nFor example, suppose you see a sixteen-wheel moving van drive across your neighbor\xe2\x80\x99s flower bed,\ndestroying her beloved roses. You have enjoyed seeing her roses every summer, for years. She is forlorn\nand tells you that she is not going to raise roses there anymore. She also tells you that she has decided not\nto sue, because she has made the decision to never deal with lawyers if at all possible. Incensed, you\ndecide to sue on her behalf. But you will not have standing to sue because your person or property was not\ndirectly injured by the moving van. Standing means that only the person whose interests are directly\naffected has the legal right to sue.\n\nThe standing doctrine is easy to understand in straightforward cases such as this but is often a fairly\ncomplicated matter. For example, can fifteen or more state attorneys general bring a lawsuit for a\ndeclaratory judgment that the health care legislation passed in 2010 is unconstitutional? What particular\ninjury have they (or the states) suffered? Are they the best set of plaintiffs to raise this issue? Time\xe2\x80\x94and\nthe 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 other\norganization. But it can happen that someone injures more than one person at the same time. A driver\nwho runs a red light may hit another car carrying one person or many people. If several people are injured\nin the same accident, they each have the right to sue the driver for the damage that he caused them. Could\nthey sue as a group? Usually not, because the damages would probably not be the same for each person,\nand different facts would have to be proved at the trial. Plus, the driver of the car that was struck might\nhave been partially to blame, so the defendant\xe2\x80\x99s liability toward him might be different from his liability\ntoward the passengers.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n129\n\n\x0cIf, however, the potential plaintiffs were all injured in the same way and their injuries were identical, a\nsingle lawsuit might be a far more efficient way of determining liability and deciding financial\nresponsibility than many individual lawsuits.\n\nHow could such a suit be brought? All the injured parties could hire the same lawyer, and she could\npresent a common case. But with a group numbering more than a handful of people, it could become\noverwhelmingly complicated. So how could, say, a million stockholders who believed they were cheated by\na corporation ever get together to sue?\n\nBecause of these types of situations, there is a legal procedure that permits one person or a small group of\npeople to serve as representatives for all others. This is the class action. The class action is provided for in\nthe Federal Rules of Civil Procedure (Rule 23) and in the separate codes of civil procedure in the states.\nThese rules differ among themselves and are often complex, but in general anyone can file a class action in\nan appropriate case, subject to approval of the court. Once the class is \xe2\x80\x9ccertified,\xe2\x80\x9d or judged to be a legally\nadequate group with common injuries, the lawyers for the named plaintiffs become, in effect, lawyers for\nthe 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 be\nincluded in an eventual judgment or settlement. But a potential plaintiff who is included in the class\ncannot, after a final judgment is awarded, seek to relitigate the issue if she is dissatisfied with the\noutcome, even though she did not participate at all in the legal proceeding.\n\nK E Y TA K EA WAY\nAnyone can file a lawsuit, with or without the help of an attorney, but only those\nlawsuits where a plaintiff has standing will be heard by the courts. Standing has\nbecome a complicated question and is used by the courts to ensure that civil cases\nheard are being pursued by those with tangible and particular injuries. Class\nactions are a way of aggregating claims that are substantially similar and arise out\nof the same facts and circumstances.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n130\n\n\x0cE XE R C IS E\n1. Fuchs Funeral Home is carrying the body of Charles Emmenthaler to its\nresting place at Forest Lawn Cemetery. Charles\xe2\x80\x99s wife, Chloe, and their\ntwo children, Chucky and Clarice, are following the hearse when the coffin\nfalls on the street, opens, and the body of Charles Emmenthaler falls out.\nThe wife and children are shocked and aggrieved and later sue in civil\ncourt for damages. Assume that this is a viable cause of action based on\n\xe2\x80\x9cnegligent infliction of emotional distress\xe2\x80\x9d in the state of California and\nthat Charles\xe2\x80\x99s brother, sister-in-law, and multiple cousins also were in the\nfuneral procession and saw what happened. The brother of Charles,\nKingston Emmenthaler, also sees his brother\xe2\x80\x99s body on the street, but his\nwife, their 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\nwas studying abroad at the time of the funeral and could not make it back in\ntime. He is as emotionally distraught at his uncle\xe2\x80\x99s passing as anyone else in\nthe family and is especially grieved over the description of the incident and\nthe grainy video shot by one of the cousins on his cell phone. Who has\nstanding to sue Fuchs Funeral Home, and who does not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n131\n\n\x0c3.7 Relations with Lawyers\nL EA R N IN G O B JEC T IV ES\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\nregard to who pays attorneys\xe2\x80\x99 fees.\n\nLegal Fees\nLawyers charge for their services in one of three different ways: flat rate, hourly rate, and contingent fee.\nA flat rate is used usually when the work is relatively routine and the lawyer knows in advance\napproximately how long it will take her to do the job. Drawing a will or doing a real estate closing are\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n132\n\n\x0cexamples of legal work that is often paid a flat rate. The rate itself may be based on a percentage of the\nworth of the matter\xe2\x80\x94say, 1 percent of a home\xe2\x80\x99s selling price.\n\nLawyers generally charge by the hour for courtroom time and for ongoing representation in commercial\nmatters. Virtually every sizable law firm bills its clients by hourly rates, which in large cities can range\nfrom $300 for an associate\xe2\x80\x99s time to $500 and more for a senior partner\xe2\x80\x99s time.\n\nA contingent fee is one that is paid only if the lawyer wins\xe2\x80\x94that is, it is contingent, or depends upon, the\nsuccess of the case. This type of fee arrangement is used most often in personal injury cases (e.g.,\nautomobile accidents, products liability, and professional malpractice). Although used quite often, the\ncontingent fee is controversial. Trial lawyers justify it by pointing to the high cost of preparing for such\nlawsuits. A typical automobile accident case can cost at least ten thousand dollars to prepare, and a\ncomplicated products-liability case can cost tens of thousands of dollars. Few people have that kind of\nmoney or would be willing to spend it on the chance that they might win a lawsuit. Corporate and\nprofessional defendants complain that the contingent fee gives lawyers a license to go big game hunting,\nor to file suits against those with deep pockets in the hopes of forcing them to settle.\nTrial lawyers respond that the contingent fee arrangement forces them to screen cases and weed out cases\nthat are weak, because it is not worth their time to spend the hundreds of hours necessary on such cases if\ntheir chances of winning are slim or nonexistent.\n\nCosts\nIn England and in many other countries, the losing party must pay the legal expenses of the winning\nparty, including attorneys\xe2\x80\x99 fees. That is not the general rule in this country. Here, each party must pay\nmost of its own costs, including (and especially) the fees of lawyers. (Certain relatively minor costs, such\nas filing fees for various documents required in court, are chargeable to the losing side, if the judge\ndecides it.) This type of fee structure is known as the American rule (in contrast to the British rule).\nThere are two types of exceptions to the American rule. By statute, Congress and the state legislatures\nhave provided that the winning party in particular classes of cases may recover its full legal costs from the\nloser\xe2\x80\x94for example, the federal antitrust laws so provide and so does the federal Equal Access to Justice\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n133\n\n\x0cAct. The other exception applies to litigants who either initiate lawsuits in bad faith, with no expectation\nof winning, or who defend them in bad faith, in order to cause the plaintiff great expense. Under these\ncircumstances, a court has the discretion to award attorneys\xe2\x80\x99 fees to the winner. But this rule is not\ninfinitely flexible, and courts do not have complete freedom to award attorneys\xe2\x80\x99 fees in any amount, but\nonly "reasonable" attorney\'s fees.\n\nK E Y TA K EA WAY\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,\nthe loser pays attorneys\xe2\x80\x99 fees for both parties.\n\nE XE R C IS ES\n1. Mrs. Robinson\xe2\x80\x99s attorney estimates that they will recover a million dollars from\nVolkswagen in the Audi lawsuit. She has Mrs. Robinson sign a contract that gives\nher firm one-third of any recovery after the firm\xe2\x80\x99s expenses are deducted. The\njudge does in fact award a million dollars, and the defendant pays. The firm\xe2\x80\x99s\nexpenses are $100,000. How much does Mrs. Robinson get?\n2. Harry Potter brings a lawsuit against Draco Malfoy in Chestershire, England, for\nslander, a form of defamation. Potter alleges that Malfoy insists on calling him a\nmudblood. Ron Weasley testifies, as does Neville Chamberlain. But Harry loses,\nbecause the court has no conception of wizardry and cannot make sense of the\ncase at all. In dismissing the case, however, who (under English law) will bear the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n134\n\n\x0ccosts of the attorneys who have brought the case for Potter and defended the\nmatter for Malfoy?\n\n3.8 Alternative Means of Resolving Disputes\nL EA R N IN G O B JEC T IV ES\n1. Understand how arbitration and mediation are frequently used alternatives to\nlitigation.\n2. Describe the differences between arbitration and mediation.\n3. Explain why arbitration is final and binding.\n\nDisputes do not have to be settled in court. No law requires parties who have a legal dispute to seek\njudicial resolution if they can resolve their disagreement privately or through some other public forum. In\nfact, the threat of a lawsuit can frequently motivate parties toward private negotiation. Filing a lawsuit\nmay convince one party that the other party is serious. Or the parties may decide that they will come to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n135\n\n\x0cterms privately rather than wait the three or four years it can frequently take for a case to move up on the\ncourt calendar.\n\nArbitration\nBeginning around 1980, a movement toward alternative dispute resolution began to gain force throughout\nthe United States. Bar associations, other private groups, and the courts themselves wanted to find\nquicker and cheaper ways for litigants and potential litigants to settle certain types of quarrels than\nthrough the courts. As a result, neighborhood justice centers or dispute resolution centers have sprung up\nin communities. These are where people can come for help in settling disputes, of both civil and criminal\nnature, that should not consume the time and money of the parties or courts in lengthy proceedings.\n\nThese alternative forums use a variety of methods, including arbitration, mediation, and conciliation, to\nbring about agreement or at least closure of the dispute. These methods are not all alike, and their\ndifferences are worth noting.\n\nArbitration is a type of adjudication. The parties use a private decision maker, the arbitrator, and the\nrules of procedure are considerably more relaxed than those that apply in the courtroom. Arbitrators\nmight be retired judges, lawyers, or anyone with the kind of specialized knowledge and training that\nwould be useful in making a final, binding decision on the dispute. In a contractual relationship, the\nparties can decide even before a dispute arises to use arbitration when the time comes. Or parties can\ndecide after a dispute arises to use arbitration instead of litigation. In a predispute arbitration agreement\n(often part of a larger contract), the parties can spell out the rules of procedure to be used and the method\nfor choosing the arbitrator. For example, they may name the specific person or delegate the responsibility\nof choosing to some neutral person, or they may each designate a person and the two designees may\njointly pick a third arbitrator.\n\nMany arbitrations take place under the auspices of the American Arbitration Association, a private\norganization headquartered in New York, with regional offices in many other cities. The association uses\npublished sets of rules for various types of arbitration (e.g., labor arbitration or commercial arbitration);\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n136\n\n\x0cparties who provide in contracts for arbitration through the association are agreeing to be bound by the\nassociation\xe2\x80\x99s rules. Similarly, the National Association of Securities Dealers provides arbitration services\nfor disputes between clients and brokerage firms. International commercial arbitration often takes place\nthrough the auspices of the International Chamber of Commerce. A multilateral agreement known as the\nConvention on the Recognition and Enforcement of Arbitral Awards provides that agreements to\narbitrate\xe2\x80\x94and arbitral awards\xe2\x80\x94will be enforced across national boundaries.\n\nArbitration has two advantages over litigation. First, it is usually much quicker, because the arbitrator\ndoes not have a backlog of cases and because the procedures are simpler. Second, in complex cases, the\nquality of the decision may be higher, because the parties can select an arbitrator with specialized\nknowledge.\n\nUnder both federal and state law, arbitration is favored, and a decision rendered by an arbitrator is\nbinding by law and may be enforced by the courts. The arbitrator\xe2\x80\x99s decision is final and binding, with very\nfew exceptions (such as fraud or manifest disregard of the law by the arbitrator or panel of arbitrators).\nSaying that arbitration is favored means that if you have agreed to arbitration, you can\xe2\x80\x99t go to court if the\nother party wants you to arbitrate. Under the Federal Arbitration Act, the other party can go to court and\nget a stay against your litigation and also 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 mediator is a\ngo-between who attempts to help the parties negotiate a solution. The mediator will communicate the\nparties\xe2\x80\x99 positions to each other, will facilitate the finding of common ground, and will suggest outcomes.\nBut the parties have complete control: they may ignore the recommendations of the mediator entirely,\nsettle in their own way, find another mediator, agree to binding arbitration, go to court, or forget the\nwhole thing!\n\nK E Y TA K EA WAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n137\n\n\x0cLitigation is not the only way to resolve disputes. Informal negotiation between\nthe disputants usually comes first, but both mediation and arbitration are\navailable. Arbitration, though, is final and binding. Once you agree to arbitrate,\nyou will have a final, binding arbitral award that is enforceable through the courts,\nand courts will almost never allow you to litigate after you have agreed to\narbitrate.\n\nE XE R C IS ES\n1. When Mrs. Robinson buys her Audi from Seaway, there is a paragraph in the bill of\nsale, which both the dealer and Mrs. Robinson sign, that says, \xe2\x80\x9cIn the event of any\ncomplaint by customer/buyer against Seaway regarding the vehicle purchased\nherein, such complaint shall not be litigated, but may only be arbitrated under the\nrules of the American Arbitration Association and in accordance with New York\nlaw.\xe2\x80\x9d Mrs. Robinson did not see the provision, doesn\xe2\x80\x99t like it, and wants to bring a\nlawsuit in Oklahoma against Seaway. What result?\n2. Hendrik Koster (Netherlands) contracts with Automark, Inc. (a US company based\nin Illinois) to supply Automark with a large quantity of valve cap gauges. He does,\nand Automark fails to pay. Koster thinks he is owed $66,000. There is no\nagreement to arbitrate or mediate. Can Koster make Automark mediate or\narbitrate?\n3. Suppose that there is an agreement between Koster and Automark to arbitrate. It\nsays, \xe2\x80\x9cThe parties agree to arbitrate any dispute arising under this agreement in\naccordance with the laws of the Netherlands and under the auspices of the\nInternational Chamber of Commerce\xe2\x80\x99s arbitration facility.\xe2\x80\x9d The International\nChamber of Commerce has arbitration rules and will appoint an arbitrator or\narbitral panel in the event the parties cannot agree on an arbitrator. The\narbitration takes place in Geneva. Koster gets an arbitral award for $66,000 plus\ninterest. Automark does not participate in any way. Will a court in Illinois enforce\nthe arbitral award?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n138\n\n\x0c3.9 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 conducts\nrestaurant business through franchisees. The franchisees are licensed to use Burger King\xe2\x80\x99s trademarks\nand service marks in standardized restaurant facilities. Rudzewicz is a Michigan resident who, with a\npartner (MacShara) operated a Burger King franchise in Drayton Plains, Michigan. Negotiations for\nsetting up the franchise occurred in 1978 largely between Rudzewicz, his partner, and a regional office of\nBurger King in Birmingham, Michigan, although some deals and concessions were made by Burger King\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n139\n\n\x0cin Florida. A preliminary agreement was signed in February of 1979. Rudzewicz and MacShara assumed\noperation of an existing facility in Drayton Plains and MacShara attended prescribed management\ncourses in Miami during the four months following Feb. 1979.\n\nRudzewicz and MacShara bought $165,000 worth of restaurant equipment from Burger King\xe2\x80\x99s Davmor\nIndustries division in Miami. But before the final agreements were signed, the parties began to disagree\nover site-development fees, building design, computation of monthly rent, and whether Rudzewicz and\nMacShara could assign their liabilities to a corporation they had formed. Negotiations took place between\nRudzewicz, MacShara, and the Birmingham regional office; but Rudzewicz and MacShara learned that the\nregional office had limited decision-making power and turned directly to Miami headquarters for their\nconcerns. The final agreement was signed by June 1979 and provided that the franchise relationship was\ngoverned by Florida law, and called for payment of all required fees and forwarding of all relevant notices\nto Miami headquarters.\n\nThe Drayton Plains restaurant did fairly well at first, but a recession in late 1979 caused the franchisees to\nfall far behind in their monthly payments to Miami. Notice of default was sent from Miami to Rudzewicz,\nwho nevertheless continued to operate the restaurant as a Burger King franchise. Burger King sued in\nfederal district court for the southern district of Florida. Rudzewicz contested the court\xe2\x80\x99s personal\njurisdiction over him, since he had never been to Florida.\n\nThe federal court looked to Florida\xe2\x80\x99s long arm statute and held that it did have personal jurisdiction over\nthe non-resident franchisees, and awarded Burger King a quarter of a million dollars in contract damages\nand enjoined the franchisees from further operation of the Drayton Plains facility. Franchisees appealed\nto the 11th Circuit Court of Appeals and won a reversal based on lack of personal jurisdiction. Burger King\npetitioned the Supreme Ct. for a writ of certiorari.\n\nJustice Brennan delivered the opinion of the court.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n140\n\n\x0cThe Due Process Clause protects an individual\xe2\x80\x99s liberty interest in not being subject to the binding\njudgments of a forum with which he has established no meaningful \xe2\x80\x9ccontacts, ties, or relations.\xe2\x80\x9d\nInternational Shoe Co. v. Washington. By requiring that individuals have \xe2\x80\x9cfair warning that a particular\nactivity may subject [them] to the jurisdiction of a foreign sovereign,\xe2\x80\x9d the Due Process Clause \xe2\x80\x9cgives a\ndegree of predictability to the legal system that allows potential defendants to structure their primary\nconduct with some minimum assurance as to where that conduct will and will not render them liable to\nsuit.\xe2\x80\x9d\xe2\x80\xa6\n\nWhere a forum seeks to assert specific jurisdiction over an out-of-state defendant who has not consented\nto suit there, this \xe2\x80\x9cfair warning\xe2\x80\x9d requirement is satisfied if the defendant has \xe2\x80\x9cpurposefully directed\xe2\x80\x9d his\nactivities at residents of the forum, and the litigation results from alleged injuries that \xe2\x80\x9carise out of or\nrelate to\xe2\x80\x9d those activities, Thus \xe2\x80\x9c[t]he forum State does not exceed its powers under the Due Process\nClause if it asserts personal jurisdiction over a corporation that delivers its products into the stream of\ncommerce with the expectation that they will be purchased by consumers in the forum State\xe2\x80\x9d and those\nproducts subsequently injure forum consumers. Similarly, a publisher who distributes magazines in a\ndistant State may fairly be held accountable in that forum for damages resulting there from an allegedly\ndefamatory story.\xe2\x80\xa6\n\n\xe2\x80\xa6[T]he constitutional touchstone remains whether the defendant purposefully established \xe2\x80\x9cminimum\ncontacts\xe2\x80\x9d in the forum State.\xe2\x80\xa6In defining when it is that a potential defendant should \xe2\x80\x9creasonably\nanticipate\xe2\x80\x9d out-of-state litigation, the Court frequently has drawn from the reasoning of Hanson v.\nDenckla, 357 U.S. 235, 253 (1958):\n\nThe unilateral activity of those who claim some relationship with a nonresident defendant cannot satisfy\nthe requirement of contact with the forum State. The application of that rule will vary with the quality and\nnature of the defendant\xe2\x80\x99s activity, but it is essential in each case that there be some act by which the\ndefendant purposefully avails itself of the privilege of conducting activities within the forum State, thus\ninvoking the benefits and protections of its laws.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n141\n\n\x0cThis \xe2\x80\x9cpurposeful availment\xe2\x80\x9d requirement ensures that a defendant will not be haled into a jurisdiction\nsolely 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 \xe2\x80\x9cunilateral activity of\nanother party or a third person,\xe2\x80\x9d [Citations] Jurisdiction is proper, however, where the contacts\nproximately result from actions by the defendant himself that create a \xe2\x80\x9csubstantial connection\xe2\x80\x9d with the\nforum State. [Citations] Thus where the defendant \xe2\x80\x9cdeliberately\xe2\x80\x9d has engaged in significant activities\nwithin a State, or has created \xe2\x80\x9ccontinuing obligations\xe2\x80\x9d between himself and residents of the forum, he\nmanifestly has availed himself of the privilege of conducting business there, and because his activities are\nshielded by \xe2\x80\x9cthe benefits and protections\xe2\x80\x9d of the forum\xe2\x80\x99s laws it is presumptively not unreasonable to\nrequire him to submit to the burdens of litigation in that forum as well.\n\nJurisdiction in these circumstances may not be avoided merely because the defendant did not physically\nenter the forum State. Although territorial presence frequently will enhance a potential defendant\xe2\x80\x99s\naffiliation with a State and reinforce the reasonable foreseeability of suit there, it is an inescapable fact of\nmodern commercial life that a substantial amount of business is transacted solely by mail and wire\ncommunications across state lines, thus obviating the need for physical presence within a State in which\nbusiness is conducted. So long as a commercial actor\xe2\x80\x99s efforts are \xe2\x80\x9cpurposefully directed\xe2\x80\x9d toward residents\nof another State, we have consistently rejected the notion that an absence of physical contacts can defeat\npersonal jurisdiction there.\n\nOnce it has been decided that a defendant purposefully established minimum contacts within the forum\nState, these contacts may be considered in light of other factors to determine whether the assertion of\npersonal jurisdiction would comport with \xe2\x80\x9cfair play and substantial justice.\xe2\x80\x9d International Shoe Co. v.\nWashington, 326 U.S., at 320. Thus courts in \xe2\x80\x9cappropriate case[s]\xe2\x80\x9d may evaluate \xe2\x80\x9cthe burden on the\ndefendant,\xe2\x80\x9d \xe2\x80\x9cthe forum State\xe2\x80\x99s interest in adjudicating the dispute,\xe2\x80\x9d \xe2\x80\x9cthe plaintiff\xe2\x80\x99s interest in obtaining\nconvenient and effective relief,\xe2\x80\x9d \xe2\x80\x9cthe interstate judicial system\xe2\x80\x99s interest in obtaining the most efficient\nresolution of controversies,\xe2\x80\x9d and the \xe2\x80\x9cshared interest of the several States in furthering fundamental\nsubstantive social policies.\xe2\x80\x9d These considerations sometimes serve to establish the reasonableness of\njurisdiction upon a lesser showing of minimum contacts than would otherwise be required. [Citations]\nApplying these principles to the case at hand, we believe there is substantial record evidence supporting\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n142\n\n\x0cthe District Court\xe2\x80\x99s conclusion that the assertion of personal jurisdiction over Rudzewicz in Florida for the\nalleged breach of his franchise agreement did not offend due process.\xe2\x80\xa6\n\nIn this case, no physical ties to Florida can be attributed to Rudzewicz other than MacShara\xe2\x80\x99s brief\ntraining course in Miami. Rudzewicz did not maintain offices in Florida and, for all that appears from the\nrecord, has never even visited there. Yet this franchise dispute grew directly out of \xe2\x80\x9ca contract which had a\nsubstantial connection with that State.\xe2\x80\x9d Eschewing the option of operating an independent local\nenterprise, Rudzewicz deliberately \xe2\x80\x9creach[ed] out beyond\xe2\x80\x9d Michigan and negotiated with a Florida\ncorporation for the purchase of a long-term franchise and the manifold benefits that would derive from\naffiliation with a nationwide organization. Upon approval, he entered into a carefully structured 20-year\nrelationship that envisioned continuing and wide-reaching contacts with Burger King in Florida. In light\nof Rudzewicz\xe2\x80\x99 voluntary 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 Florida can in\nno 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 to make the\ncontractually required payments in Miami, and his continued use of Burger King\xe2\x80\x99s trademarks and\nconfidential business information after his termination, caused foreseeable injuries to the corporation in\nFlorida. For these reasons it was, at the very least, presumptively reasonable for Rudzewicz to be called to\naccount there for such injuries.\n\n\xe2\x80\xa6Because Rudzewicz established a substantial and continuing relationship with Burger King\xe2\x80\x99s Miami\nheadquarters, received fair notice from the contract documents and the course of dealing that he might be\nsubject to suit in Florida, and has failed to demonstrate how jurisdiction in that forum would otherwise be\nfundamentally unfair, we conclude that the District Court\xe2\x80\x99s exercise of jurisdiction pursuant to Fla. Stat.\n48.193(1)(g) (Supp. 1984) did not offend due process. The judgment of the Court of Appeals is accordingly\nreversed, and the case is remanded for further proceedings consistent with this opinion.\n\nIt is so ordered.\n\nC A SE QU ES TIO NS\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n143\n\n\x0c1. 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\npersonal jurisdiction over someone like Rudzewicz, why is the court talking about\nthe due process clause?\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\ncome to Florida? Explain.\n\nFerlito v. Johnson & Johnson\nFerlito v. Johnson & Johnson Products, Inc.\n\n771 F. Supp. 196 (U.S. District Ct., Eastern District of Michigan 1991)\n\nGadola, J.\n\nPlaintiffs Susan and Frank Ferlito, husband and wife, attended a Halloween party in 1984 dressed as\nMary (Mrs. Ferlito) and her little lamb (Mr. Ferlito). Mrs. Ferlito had constructed a lamb costume for her\nhusband by gluing cotton batting manufactured by defendant Johnson & Johnson Products (\xe2\x80\x9cJJP\xe2\x80\x9d) to a\nsuit of long underwear. She had also used defendant\xe2\x80\x99s product to fashion a headpiece, complete with ears.\nThe costume covered Mr. Ferlito from his head to his ankles, except for his face and hands, which were\nblackened with Halloween paint. At the party Mr. Ferlito attempted to light his cigarette by using a butane\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n144\n\n\x0clighter. The flame passed close to his left arm, and the cotton batting on his left sleeve ignited. Plaintiffs\nsued defendant for injuries they suffered from burns which covered approximately one-third of Mr.\nFerlito\xe2\x80\x99s body.\n\nFollowing a jury verdict entered for plaintiffs November 2, 1989, the Honorable Ralph M. Freeman\nentered a judgment for plaintiff Frank Ferlito in the amount of $555,000 and for plaintiff Susan Ferlito in\nthe amount of $ 70,000. Judgment was entered November 7, 1989. Subsequently, on November 16, 1989,\ndefendant JJP filed a timely motion for judgment notwithstanding the verdict pursuant to Fed.R.Civ.P.\n50(b) or, in the alternative, for new trial. Plaintiffs filed their response to defendant\xe2\x80\x99s motion December\n18, 1989; and defendant filed a reply January 4, 1990. Before reaching a decision on this motion, Judge\nFreeman died. The case was reassigned to this court April 12, 1990.\n\nMOTION FOR JUDGMENT NOTWITHSTANDING THE VERDICT\n\nDefendant JJP filed two motions for a directed verdict, the first on October 27, 1989, at the close of\nplaintiffs\xe2\x80\x99 proofs, and the second on October 30, 1989, at the close of defendant\xe2\x80\x99s proofs. Judge Freeman\ndenied both motions without prejudice. Judgment for plaintiffs was entered November 7, 1989; and\ndefendant\xe2\x80\x99s instant motion, filed November 16, 1989, was filed in a timely manner.\n\nThe standard for determining whether to grant a j.n.o.v. is identical to the standard for evaluating a\nmotion for directed verdict:\n\nIn determining whether the evidence is sufficient, the trial court may neither weigh the evidence, pass on\nthe credibility of witnesses nor substitute its judgment for that of the jury. Rather, the evidence must be\nviewed in the light most favorable to the party against whom the motion is made, drawing from that\nevidence all reasonable inferences in his favor. If after reviewing the evidence\xe2\x80\xa6the trial court is of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n145\n\n\x0copinion that reasonable minds could not come to the result reached by the jury, then the motion for\nj.n.o.v. should be granted.\n\nTo recover in a \xe2\x80\x9cfailure to warn\xe2\x80\x9d product liability action, a plaintiff must prove each of the following four\nelements of negligence: (1) that the defendant owed a duty to the plaintiff, (2) that the defendant violated\nthat duty, (3) that the defendant\xe2\x80\x99s breach of that duty was a proximate cause of the damages suffered by\nthe plaintiff, and (4) that the plaintiff suffered damages.\n\nTo establish a prima facie case that a manufacturer\xe2\x80\x99s breach of its duty to warn was a proximate cause of\nan injury sustained, a plaintiff must present evidence that the product would have been used differently\nhad the proffered warnings been given.\n\n[1]\n\n[Citations omitted] In the absence of evidence that a warning\n\nwould have prevented the harm complained of by altering the plaintiff\xe2\x80\x99s conduct, the failure to warn\ncannot be deemed a proximate cause of the plaintiff\xe2\x80\x99s injury as a matter of law. [In accordance with\nprocedure in a diversity of citizenship case, such as this one, the court cites Michigan case law as the basis\nfor its legal interpretation.]\n\xe2\x80\xa6\n\nA manufacturer has a duty \xe2\x80\x9cto warn the purchasers or users of its product about dangers associated with\nintended use.\xe2\x80\x9d Conversely, a manufacturer has no duty to warn of a danger arising from an unforeseeable\nmisuse of its product. [Citation] Thus, whether a manufacturer has a duty to warn depends on whether\nthe use of the product and the injury sustained by it are foreseeable. Gootee v. Colt Industries Inc., 712\nF.2d 1057, 1065 (6th Cir. 1983); Owens v. Allis-Chalmers Corp., 414 Mich. 413, 425, 326 N.W.2d 372\n(1982). Whether a plaintiff\xe2\x80\x99s use of a product is foreseeable is a legal question to be resolved by the court.\nTrotter, supra. Whether the resulting injury is foreseeable is a question of fact for the jury.\n\n[2]\n\nThomas v.\n\nInternational Harvester Co., 57 Mich. App. 79, 225 N.W.2d 175 (1974).\n\nIn the instant action no reasonable jury could find that JJP\xe2\x80\x99s failure to warn of the flammability of cotton\nbatting was a proximate cause of plaintiffs\xe2\x80\x99 injuries because plaintiffs failed to offer any evidence to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n146\n\n\x0cestablish that a flammability warning on JJP\xe2\x80\x99s cotton batting would have dissuaded them from using the\nproduct in the manner that they did.\n\nPlaintiffs repeatedly stated in their response brief that plaintiff Susan Ferlito testified that \xe2\x80\x9cshe would\nnever again use cotton batting to make a costume\xe2\x80\xa6However, a review of the trial transcript reveals that\nplaintiff Susan Ferlito never testified that she would never again use cotton batting to make a costume.\nMore importantly, the transcript contains no statement by plaintiff Susan Ferlito that a flammability\nwarning on defendant JJP\xe2\x80\x99s product would have dissuaded her from using the cotton batting to construct\nthe costume in the first place. At oral argument counsel for plaintiffs conceded that there was no\ntestimony during the trial that either plaintiff Susan Ferlito or her husband, plaintiff Frank J. Ferlito,\nwould have acted any different if there had been a flammability warning on the product\xe2\x80\x99s package. The\nabsence of such testimony is fatal to plaintiffs\xe2\x80\x99 case; for without it, plaintiffs have failed to prove\nproximate cause, one of the essential elements of their negligence claim.\n\nIn addition, both plaintiffs testified that they knew that cotton batting burns when it is exposed to flame.\nSusan Ferlito testified that she knew at the time she purchased the cotton batting that it would burn if\nexposed to an open flame. Frank Ferlito testified that he knew at the time he appeared at the Halloween\nparty that cotton batting would burn if exposed to an open flame. His additional testimony that he would\nnot have intentionally put a flame to the cotton batting shows that he recognized the risk of injury of\nwhich he claims JJP should have warned. Because both plaintiffs were already aware of the danger, a\nwarning by JJP would have been superfluous. Therefore, a reasonable jury could not have found that\nJJP\xe2\x80\x99s failure to provide a warning was a proximate cause of plaintiffs\xe2\x80\x99 injuries.\n\nThe evidence in this case clearly demonstrated that neither the use to which plaintiffs put JJP\xe2\x80\x99s product\nnor the injuries arising from that use were foreseeable. Susan Ferlito testified that the idea for the\ncostume was hers alone. As described on the product\xe2\x80\x99s package, its intended uses are for cleansing,\napplying medications, and infant care. Plaintiffs\xe2\x80\x99 showing that the product may be used on occasion in\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n147\n\n\x0cclassrooms for decorative purposes failed to demonstrate the foreseeability of an adult male encapsulating\nhimself from head to toe in cotton batting and then lighting up a cigarette.\nORDER\n\nNOW, THEREFORE, IT IS HEREBY ORDERED that defendant JJP\xe2\x80\x99s motion for judgment\nnotwithstanding the verdict is GRANTED.\n\nIT IS FURTHER ORDERED that the judgment entered November 2, 1989, is SET ASIDE.\n\nIT IS FURTHER ORDERED that the clerk will enter a judgment in favor of the defendant JJP.\n\nC A SE QU ES TIO NS\n1. The opinion focuses on proximate cause. As we will see inChapter 7 "Introduction\nto Tort Law", a negligence case cannot be won unless the plaintiff shows that the\ndefendant has breached a duty and that the defendant\xe2\x80\x99s breach has actually and\nproximately caused the damage complained of. What, exactly, is the alleged\nbreach of duty by the defendant here?\n2. Explain why Judge Gadola reasoning that JJP had no duty to warn in this case.\nAfter this case, would they then have a duty to warn, knowing that someone might\nuse their product in this way?\n[1] By \xe2\x80\x9cprima facie case,\xe2\x80\x9d the court means a case in which the plaintiff has presented all the\nbasic elements of the cause of action alleged in the complaint. If one or more elements of proof\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n148\n\n\x0care missing, then the plaintiff has fallen short of establishing a prima facie case, and the case\nshould be dismissed (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\nare for the jury. Here, \xe2\x80\x9cforeseeability\xe2\x80\x9d is a fact question, while the judge retains authority over\nquestions of law. The division between questions of fact and questions of law is not an easy\none, however.\n\nChapter 4\n\nConstitutional Law and US Commerce\nL EA R N IN G O B JEC T IV ES\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\npowers between the executive, legislative, and judicial branches of government.\n3. Locate the source of congressional power to regulate the economy under the\nConstitution, and explain what limitations there are to the reach of congressional\npower over interstate commerce.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n149\n\n\x0c4. Describe the different phases of congressional power over commerce, as adjudged\nby the US Supreme Court over time.\n5. Explain what power the states retain over commerce, and how the Supreme Court\nmay sometimes limit that power.\n6. Describe how the Supreme Court, under the supremacy clause of the Constitution,\nbalances state and federal laws that may be wholly or partly in conflict.\n7. Explain how the Bill of Rights relates to business activities in the United States.\n\nThe US Constitution is the foundation for all of US law. Business and commerce are directly affected by\nthe words, meanings, and interpretations of the Constitution. Because it speaks in general terms, its\nprovisions raise all kinds of issues for scholars, lawyers, judges, politicians, and commentators. For\nexample, arguments still rage over the nature and meaning of \xe2\x80\x9cfederalism,\xe2\x80\x9d the concept that there is\nshared governance between the states and the federal government. The US Supreme Court is the ultimate\narbiter of those disputes, and as such it has a unique role in the legal system. It has assumed the power\nof judicial review, unique among federal systems globally, through which it can strike down federal or\nstate statutes that it believes violate the Constitution and can even void the president\xe2\x80\x99s executive orders if\nthey are contrary to the Constitution\xe2\x80\x99s language. No knowledgeable citizen or businessperson can afford\nto be ignorant of its basic provisions.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n150\n\n\x0c4.1 Basic Aspects of the US Constitution\nL EA R N IN G O B JEC T IV ES\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\nparticularly significant.\n\nThe Constitution as Reflecting American Values\nIn the US, the one document to which all public officials and military personnel pledge their unswerving\nallegiance is the Constitution. If you serve, you are asked to \xe2\x80\x9csupport and defend\xe2\x80\x9d the Constitution\n\xe2\x80\x9cagainst all enemies, foreign and domestic.\xe2\x80\x9d The oath usually includes a statement that you swear that this\noath is taken freely, honestly, and without \xe2\x80\x9cany purpose of evasion.\xe2\x80\x9d This loyalty oath may be related to a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n151\n\n\x0ctime\xe2\x80\x94fifty years ago\xe2\x80\x94when \xe2\x80\x9cun-American\xe2\x80\x9d activities were under investigation in Congress and the press;\nthe fear of communism (as antithetical to American values and principles) was paramount. As you look at\nthe Constitution and how it affects the legal environment of business, please consider what basic values it\nmay impart to us and what makes it uniquely American and worth defending \xe2\x80\x9cagainst all enemies, foreign\nand domestic.\xe2\x80\x9d\nIn Article I, the Constitution places the legislature first and prescribes the ways in which representatives\nare elected to public office. Article I balances influence in the federal legislature between large states and\nsmall states by creating a Senate in which the smaller states (by population) as well as the larger states\nhave two votes. In Article II, the Constitution sets forth the powers and responsibilities of the branch\xe2\x80\x94the\npresidency\xe2\x80\x94and makes it clear that the president should be the commander in chief of the armed forces.\nArticle II also gives states rather than individuals (through the Electoral College) a clear role in the\nelection process. Article III creates the federal judiciary, and the Bill of Rights, adopted in 1791, makes\nclear that individual 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 various\nrights has been in flux. The \xe2\x80\x9cright\xe2\x80\x9d of a person to own another person was notably affirmed by the\nSupreme Court in the Dred Scott decision in 1857.\n\n[1]\n\nThe \xe2\x80\x9cright\xe2\x80\x9d of a child to freely contract for long,\n\ntedious hours of work was upheld by the court in Hammer v. Dagenhart in 1918. Both decisions were\nlater repudiated, just as the decision that a woman has a \xe2\x80\x9cright\xe2\x80\x9d to an abortion in the first trimester of\npregnancy could later be repudiated ifRoe v. Wade is overturned by the Supreme Court.\n\n[2]\n\nGeneral Structure of the Constitution\nLook at the Constitution. Notice that there are seven articles, starting with Article I (legislative powers),\nArticle II (executive branch), and Article III (judiciary). Notice that there is no separate article for\nadministrative agencies. The Constitution also declares that it is \xe2\x80\x9cthe supreme Law of the Land\xe2\x80\x9d (Article\nVI). Following Article VII are the ten amendments adopted in 1791 that are referred to as the Bill of\nRights. Notice also that in 1868, a new amendment, the Fourteenth, was adopted, requiring states to\nprovide \xe2\x80\x9cdue process\xe2\x80\x9d and \xe2\x80\x9cequal protection of the laws\xe2\x80\x9d to citizens of the United States.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n152\n\n\x0cFederalism\nThe 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 are\ndelegated to the national government, and other powers are reserved to the states. This is made explicit in\nthe Tenth Amendment.\n\nSeparation of Powers and Judicial Review\nBecause the Founding Fathers wanted to ensure that no single branch of the government, especially the\nexecutive branch, would be ascendant over the others, they created various checks and balances to ensure\nthat each of the three principal branches had ways to limit or modify the power of the others. This is\nknown as the separation of powers. Thus the president retains veto power, but the House of\nRepresentatives is entrusted with the power to initiate spending bills.\n\nPower sharing was evident in the basic design of Congress, the federal legislative branch. The basic power\nimbalance was between the large states (with greater population) and the smaller ones (such as\nDelaware). The smaller ones feared a loss of sovereignty if they could be outvoted by the larger ones, so\nthe federal legislature was constructed to guarantee two Senate seats for every state, no matter how small.\nThe Senate was also given great responsibility in ratifying treaties and judicial nominations. The net effect\nof this today is that senators from a very small number of states can block treaties and other important\nlegislation. The power of small states is also magnified by the Senate\xe2\x80\x99s cloture rule, which currently\nrequires sixty out of one hundred senators to vote to bring a bill to the floor for an up-or-down vote.\n\nBecause the Constitution often speaks in general terms (with broad phrases such as \xe2\x80\x9cdue process\xe2\x80\x9d and\n\xe2\x80\x9cequal protection\xe2\x80\x9d), reasonable people have disagreed as to how those terms apply in specific cases. The\nUnited States is unique among industrialized democracies in having a Supreme Court that reserves for\nitself that exclusive power to interpret what the Constitution means. The famous case of Marbury v.\nMadison began that tradition in 1803, when the Supreme Court had marginal importance in the new\nrepublic. The decision in Bush v. Gore, decided in December of 2000, illustrates the power of the court to\nshape our destiny as a nation. In that case, the court overturned a ruling by the Florida Supreme Court\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n153\n\n\x0cregarding the way to proceed on a recount of the Florida vote for the presidency. The court\xe2\x80\x99s ruling was\npurportedly based on the \xe2\x80\x9cequal protection of the laws\xe2\x80\x9d provision in the Fourteenth Amendment.\n\nFrom Marbury to the present day, the Supreme Court has articulated the view that the US Constitution\nsets the framework for all other US laws, whether statutory or judicially created. Thus any statute (or\nportion thereof) or legal ruling (judicial or administrative) in conflict with the Constitution is not\nenforceable. And as the Bush v. Goredecision indicates, the states are not entirely free to do what they\nmight choose; their own sovereignty is limited by their union with the other states in a federal sovereign.\n\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 Congress and\nthree-fourths of the states must make an amendment (Article V).\n\nBecause the Supreme Court has this power of judicial review, there have been many arguments about how\nit should be exercised and what kind of \xe2\x80\x9cphilosophy\xe2\x80\x9d a Supreme Court justice should have. President\nRichard Nixon often said that a Supreme Court justice should \xe2\x80\x9cstrictly construe\xe2\x80\x9d the Constitution and not\nadd to its language. Finding law in the Constitution was \xe2\x80\x9cjudicial activism\xe2\x80\x9d rather than \xe2\x80\x9cjudicial restraint.\xe2\x80\x9d\nThe general philosophy behind the call for \xe2\x80\x9cstrict constructionist\xe2\x80\x9d justices is that legislatures make laws in\naccord with the wishes of the majority, and so unelected judges should not make law according to their\nown views and values. Nixon had in mind the 1960s Warren court, which \xe2\x80\x9cfound\xe2\x80\x9d rights in the\nConstitution that were not specifically mentioned\xe2\x80\x94the right of privacy, for example. In later years, critics\nof the Rehnquist court would charge that it \xe2\x80\x9cfound\xe2\x80\x9d rights that were not specifically mentioned, such as\nthe right of 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), which held\nthat corporations are \xe2\x80\x9cpersons\xe2\x80\x9d with \xe2\x80\x9cfree speech rights\xe2\x80\x9d that include spending unlimited amounts of\nmoney in campaign donations and political advocacy.\n\n[3]\n\nBecause Roe v. Wade has been so controversial, this chapter includes a seminal case on \xe2\x80\x9cthe right of\nprivacy,\xe2\x80\x9d Griswold v. Connecticut,Section 4.6.1. Was the court was correct in recognizing a \xe2\x80\x9cright of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n154\n\n\x0cprivacy\xe2\x80\x9d in Griswold? This may not seem like a \xe2\x80\x9cbusiness case,\xe2\x80\x9d but consider: the manufacture and\ndistribution of birth control devices is a highly profitable (and legal) business in every US state. Moreover,\nGriswold illustrates another important and much-debated concept in US constitutional law: substantive\ndue process (see Section 4.5.3 "Fifth Amendment"). The problem of judicial review and its proper scope is\nbrought into sharp focus in the abortion controversy. Abortion became a lucrative service business\nafter Roe v. Wade was decided in 1973. That has gradually changed, with state laws that have limited\nrather than overruled Roe 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 understand that\nthere is no explicit mention in the Constitution of any right of privacy. As Justice Harry Blackmun argued\nin his majority opinion in Roe v. Wade,\n\nThe Constitution does not explicitly mention any right of privacy. In a line of decisions, however, the\nCourt has recognized that a right of personal privacy or a guarantee of certain areas or zones of privacy,\ndoes exist under the Constitution.\xe2\x80\xa6[T]hey also make it clear that the right has some extension to activities\nrelating to marriage\xe2\x80\xa6procreation\xe2\x80\xa6contraception\xe2\x80\xa6family relationships\xe2\x80\xa6and child rearing and\neducation.\xe2\x80\xa6The right of privacy\xe2\x80\xa6is broad enough to encompass a woman\xe2\x80\x99s decision whether or not to\nterminate her pregnancy.\n\nIn short, justices interpreting the Constitution wield quiet yet enormous power through judicial review. In\ndeciding that the right of privacy applied to a woman\xe2\x80\x99s decision to abort in the first trimester, the\nSupreme Court did not act on the basis of a popular mandate or clear and unequivocal language in the\nConstitution, and it made illegal any state or federal legislative or executive action contrary to its\ninterpretation. Only a constitutional amendment or the court\xe2\x80\x99s repudiation of Roe v. Wade as a precedent\ncould change that interpretation.\n\nK E Y TA K EA WAY\nThe Constitution gives voice to the idea that people have basic rights and that a\ncivilian president is also the commander in chief of the armed forces. It gives\ninstructions as to how the various branches of government must share power and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n155\n\n\x0calso tries to balance power between the states and the federal government. It\ndoes not expressly allow for judicial review, but the Supreme Court\xe2\x80\x99s ability to\ndeclare what laws are (or are not) constitutional has given the judicial branch a\nkind of power not seen in other industrialized democracies.\n\nE XE R C IS ES\n1. Suppose the Supreme Court declares that Congress and the president cannot\nauthorize the indefinite detention of terrorist suspects without a trial of some\nsort, whether military or civilian. Suppose also that the people of the United States\nfavor such indefinite detention and that Congress wants to pass a law rebuking the\ncourt\xe2\x80\x99s decision. What kind of law would have to be passed, by what institutions,\nand 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\ncourt have to wait one hundred years to overturn its prior case precedents?\n[1] In Scott v. Sanford (the Dred Scott decision), the court states that Scott should remain a\nslave, that as a slave he is not a citizen of the United States and thus not eligible to bring suit in\na federal court, and that as a slave he is personal property and thus has never been free.\n[2] Roe v. Wade, 410 US 113 (1973).\n[3] Kimel v. Florida Board of Regents, 528 US 62 (2000).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n156\n\n\x0c4.2 The Commerce Clause\nL EA R N IN G O B JEC T IV ES\n1. Name the specific clause through which Congress has the power to regulate\ncommerce. What, specifically, does this clause say?\n2. Explain how early decisions of the Supreme Court interpreted the scope of the\ncommerce clause and how that impacted the legislative proposals and programs of\nFranklin Delano Roosevelt during the Great Depression.\n3. Describe both the wider use of the commerce clause from World War II through the\n1990s and the limitations the Supreme Court imposed in Lopez and other cases.\n\nFirst, turn to Article I, Section 8. The commerce clause gives Congress the exclusive power to make laws\nrelating to foreign trade and commerce and to commerce among the various states. Most of the federally\ncreated legal environment springs from this one clause: if Congress is not authorized in the Constitution\nto make certain laws, then it acts unconstitutionally and its actions may be ruled unconstitutional by the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n157\n\n\x0cSupreme Court. Lately, the Supreme Court has not been shy about ruling acts of Congress\nunconstitutional.\nHere are the first five parts of Article I, Section 8, which sets forth the powers of the federal legislature.\nThe commerce clause is in boldface. It is short, but most federal legislation affecting business depends on\nthis very clause:\n\nSection 8\n[Clause 1] The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the\nDebts and provide for the common Defence and general Welfare of the United States; but all Duties,\nImposts and Excises shall be uniform throughout the United States;\n\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 States, and\nwith the Indian Tribes;\n\n[Clause 4] To establish a uniform Rule of Naturalization, and uniform Laws on the subject of\nBankruptcies throughout the United States;\n\n[Clause 5] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights\nand Measures;\n\nEarly Commerce Clause Cases\nFor many years, the Supreme Court was very strict in applying the commerce clause: Congress could only\nuse it to legislate aspects of the movement of goods from one state to another. Anything else was deemed\nlocal rather than national. For example, In Hammer v. Dagenhart, decided in 1918, a 1916 federal statute\nhad barred transportation in interstate commerce of goods produced in mines or factories employing\nchildren under fourteen or employing children fourteen and above for more than eight hours a day. A\ncomplaint was filed in the US District Court for the Western District of North Carolina by a father in his\nown behalf and on behalf of his two minor sons, one under the age of fourteen years and the other\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n158\n\n\x0cbetween fourteen and sixteen years, who were employees in a cotton mill in Charlotte, North Carolina.\nThe father\xe2\x80\x99s lawsuit asked the court to enjoin (block) the enforcement of the act of Congress intended to\nprevent interstate commerce in the products of child labor.\n\nThe Supreme Court saw the issue as whether Congress had the power under the commerce clause to\ncontrol interstate shipment of goods made by children under the age of fourteen. The court found that\nCongress did not. The court cited several cases that had considered what interstate commerce could be\nconstitutionally regulated by Congress. In Hipolite Egg Co. v. United States, the Supreme Court had\nsustained the power of Congress to pass the Pure Food and Drug Act, which prohibited the introduction\ninto the states by means of interstate commerce impure foods and drugs.\n\n[1]\n\nIn Hoke v. United States, the\n\nSupreme Court had sustained the constitutionality of the so-called White Slave Traffic Act of 1910,\nwhereby the transportation 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 interstate\ncommerce: \xe2\x80\x9cIf the facility of interstate transportation can be taken away from the demoralization of\nlotteries, the debasement of obscene literature, the contagion of diseased cattle or persons, the impurity of\nfood and drugs, the like facility can be taken away from the systematic enticement to, and the enslavement\nin prostitution and debauchery of women, and, more insistently, of girls.\xe2\x80\x9d\n\n[2]\n\nIn each of those instances, the Supreme Court said, \xe2\x80\x9c[T]he use of interstate transportation was necessary\nto the accomplishment of harmful results.\xe2\x80\x9d In other words, although the power over interstate\ntransportation was to regulate, that could only be accomplished by prohibiting the use of the facilities of\ninterstate commerce to effect the evil intended. But in Hammer v. Dagenhart, that essential element was\nlacking. The law passed by Congress aimed to standardize among all the states the ages at which children\ncould be employed in mining and manufacturing, while the goods themselves are harmless. Once the\nlabor is done and the articles have left the factory, the \xe2\x80\x9clabor of their production is over, and the mere fact\nthat they were intended for interstate commerce transportation does not make their production subject to\nfederal control under the commerce power.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n159\n\n\x0cIn short, the early use of the commerce clause was limited to the movement of physical goods between\nstates. Just because something might enter the channels of interstate commerce later on does not make it\na fit subject for national regulation. The production of articles intended for interstate commerce is a\nmatter of local regulation. The court therefore upheld the result from the district and circuit court of\nappeals; the application of the federal law was enjoined. Goods produced by children under the age of\nfourteen could be shipped anywhere in the United States without violating the federal law.\n\nFrom the New Deal to the New Frontier and the Great Society:1930s\xe2\x80\x93\n1970\nDuring the global depression of the 1930s, the US economy saw jobless rates of a third of all workers, and\nPresident Roosevelt\xe2\x80\x99s New Deal program required more active federal legislation. Included in the New\nDeal program was the recognition of a \xe2\x80\x9cright\xe2\x80\x9d to form labor unions without undue interference from\nemployers. Congress created the National Labor Relations Board (NLRB) in 1935 to investigate and to\nenjoin employer practices that violated this right.\n\nIn NLRB v. Jones & Laughlin Steel Corporation, a union dispute with management at a large steelproducing facility near Pittsburgh, Pennsylvania, became a court case. In this case, the NLRB had charged\nthe Jones & Laughlin Steel Corporation with discriminating against employees who were union members.\nThe company\xe2\x80\x99s position was that the law authorizing the NLRB was unconstitutional, exceeding\nCongress\xe2\x80\x99s powers. The court held that the act was narrowly constructed so as to regulate industrial\nactivities that had the potential to restrict interstate commerce. The earlier decisions under the commerce\nclause to the effect that labor relations had only an indirect effect on commerce were effectively reversed.\nSince the ability of employees to engage in collective bargaining (one activity protected by the act) is \xe2\x80\x9can\nessential condition 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 was,\nhowever, a close decision, and the switch of one justice made this ruling possible. Without this switch, the\nNew Deal agenda would have been effectively derailed.\n\nThe Substantial Effects Doctrine: World War II to the 1990s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n160\n\n\x0cSubsequent to NLRB v. Jones & Laughlin Steel Corporation, Congress and the courts generally accepted\nthat even modest impacts on interstate commerce were \xe2\x80\x9creachable\xe2\x80\x9d by federal legislation. For example,\nthe case of Wickard v. Filburn, from 1942, represents a fairly long reach for Congress in regulating what\nappear to be very local economic decisions (Section 4.6.2).\n\nWickard established that \xe2\x80\x9csubstantial effects\xe2\x80\x9d in interstate commerce could be very local indeed! But\ncommerce clause challenges to federal legislation continued. In the 1960s, the Civil Rights Act of 1964 was\nchallenged on the ground that Congress lacked the power under the commerce clause to regulate what\nwas otherwise fairly local conduct. For example, Title II of the act prohibited racial discrimination in\npublic accommodations (such as hotels, motels, and restaurants), leading to the famous case\nof Katzenbach v. McClung (1964).\nOllie McClung\xe2\x80\x99s barbeque place in Birmingham, Alabama, allowed \xe2\x80\x9ccolored\xe2\x80\x9d people to buy takeout at the\nback of the restaurant but not to sit down with \xe2\x80\x9cwhite\xe2\x80\x9d folks inside. The US attorney sought a court order\nto require Ollie to serve all races and colors, but Ollie resisted on commerce clause grounds: the federal\ngovernment had no business regulating a purely local establishment. Indeed, Ollie did not advertise\nnationally, or even regionally, and had customers only from the local area. But the court found that some\n42 percent of the supplies for Ollie\xe2\x80\x99s restaurant had moved in the channels of interstate commerce. This\nwas enough to sustain federal regulation based on the commerce clause.\n\n[3]\n\nFor nearly thirty years following, it was widely assumed that Congress could almost always find some\ninterstate commerce connection for any law it might pass. It thus came as something of a shock in 1995\nwhen the Rehnquist court decided U.S. v. Lopez. Lopez had been convicted under a federal law that\nprohibited possession of firearms within 1,000 feet of a school. The law was part of a twenty-year trend\n(roughly 1970 to 1990) for senators and congressmen to pass laws that were tough on crime. Lopez\xe2\x80\x99s\nlawyer admitted that Lopez had had a gun within 1,000 feet of a San Antonio school yard but challenged\nthe law itself, arguing that Congress exceeded its authority under the commerce clause in passing this\nlegislation. The US government\xe2\x80\x99s Solicitor General argued on behalf of the Department of Justice to the\nSupreme Court that Congress was within its constitutional rights under the commerce clause because\neducation of the future workforce was the foundation for a sound economy and because guns at or near\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n161\n\n\x0cschool yards detracted 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 anything.\nLopez went free because the law itself was unconstitutional, according to the court.\n\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 addressing\na problem that related to interstate commerce. In 1994, Congress passed the Violence Against Women Act\n(VAWA), having held hearings to establish why violence against women on a local level would impair\ninterstate commerce. In 1994, while enrolled at Virginia Polytechnic Institute (Virginia Tech), Christy\nBrzonkala alleged that Antonio Morrison and James Crawford, both students and varsity football players\nat Virginia Tech, had raped her. In 1995, Brzonkala filed a complaint against Morrison and Crawford\nunder Virginia Tech\xe2\x80\x99s sexual assault policy. After a hearing, Morrison was found guilty of sexual assault\nand sentenced to immediate suspension for two semesters. Crawford was not punished. A second hearing\nagain found Morrison guilty. After an appeal through the university\xe2\x80\x99s administrative system, Morrison\xe2\x80\x99s\npunishment was set aside, as it was found to be \xe2\x80\x9cexcessive.\xe2\x80\x9d Ultimately, Brzonkala dropped out of the\nuniversity. Brzonkala then sued Morrison, Crawford, and Virginia Tech in federal district court, alleging\nthat Morrison\xe2\x80\x99s and Crawford\xe2\x80\x99s attack violated 42 USC Section 13981, part of the VAWA), which provides\na federal civil remedy for the victims of gender-motivated violence. Morrison and Crawford moved to\ndismiss Brzonkala\xe2\x80\x99s suit on the ground that Section 13981\xe2\x80\x99s civil remedy was unconstitutional. In\ndismissing the complaint, the district court found that that Congress lacked authority to enact Section\n13981 under either the commerce clause or the Fourteenth Amendment, which Congress had explicitly\nidentified as the sources of federal authority for the VAWA. Ultimately, the court of appeals affirmed, as\ndid the Supreme Court.\n\nThe Supreme Court held that Congress lacked the authority to enact a statute under the commerce clause\nor the Fourteenth Amendment because the statute did not regulate an activity that substantially affected\ninterstate commerce nor did it redress harm caused by the state. Chief Justice William H. Rehnquist\nwrote for the court that \xe2\x80\x9cunder our federal system that remedy must be provided by the Commonwealth of\nVirginia, and not by the United States.\xe2\x80\x9d Dissenting, Justice Stephen G. Breyer argued that the majority\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n162\n\n\x0copinion \xe2\x80\x9cillustrates the difficulty of finding a workable judicial Commerce Clause touchstone.\xe2\x80\x9d Justice\nDavid H. Souter, dissenting, noted that VAWA contained a \xe2\x80\x9cmountain of data assembled by\nCongress\xe2\x80\xa6showing the effects of violence against women on interstate commerce.\xe2\x80\x9d\n\nThe absence of a workable judicial commerce clause touchstone remains. In 1996, California voters\npassed the Compassionate Use Act, legalizing marijuana for medical use. California\xe2\x80\x99s law conflicted with\nthe federal Controlled Substances Act (CSA), which banned possession of marijuana. After the Drug\nEnforcement Administration (DEA) seized doctor-prescribed marijuana from a patient\xe2\x80\x99s home, a group of\nmedical marijuana users sued the DEA and US Attorney General John Ashcroft in federal district court.\n\nThe medical marijuana users argued that the CSA\xe2\x80\x94which Congress passed using its constitutional power\nto regulate interstate commerce\xe2\x80\x94exceeded Congress\xe2\x80\x99s commerce clause power. The district court ruled\nagainst the group, but the Ninth Circuit Court of Appeals reversed and ruled the CSA unconstitutional\nbecause it applied to medical marijuana use solely within one state. In doing so, the Ninth Circuit relied\non U.S. v. Lopez (1995) and U.S. v. Morrison (2000) to say that using medical marijuana did not\n\xe2\x80\x9csubstantially affect\xe2\x80\x9d interstate commerce and therefore could not be regulated by Congress.\n\nBut by a 6\xe2\x80\x933 majority, the Supreme Court held that the commerce clause gave Congress authority to\nprohibit the local cultivation and use of marijuana, despite state law to the contrary. Justice John Paul\nStevens argued that the court\xe2\x80\x99s precedents established Congress\xe2\x80\x99s commerce clause power to regulate\npurely local activities that are part of a \xe2\x80\x9cclass of activities\xe2\x80\x9d with a substantial effect on interstate\ncommerce. The majority argued that Congress could ban local marijuana use because it was part of such a\nclass of activities: the national marijuana market. Local use affected supply and demand in the national\nmarijuana market, making the regulation of intrastate use \xe2\x80\x9cessential\xe2\x80\x9d to regulating the drug\xe2\x80\x99s national\nmarket.\n\nNotice how similar this reasoning is to the court\xe2\x80\x99s earlier reasoning inWickard v. Filburn (Section 4.6.2).\nIn contrast, the court\xe2\x80\x99s conservative wing was adamant that federal power had been exceeded. Justice\nClarence Thomas\xe2\x80\x99s dissent in Gonzalez v. Raich stated that Raich\xe2\x80\x99s local cultivation and consumption of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n163\n\n\x0cmarijuana was not \xe2\x80\x9cCommerce\xe2\x80\xa6among the several States.\xe2\x80\x9d Representing the \xe2\x80\x9coriginalist\xe2\x80\x9d view that the\nConstitution should mostly mean what the Founders meant it to mean, he also said that in the early days\nof the republic, it would have been unthinkable that Congress could prohibit the local cultivation,\npossession, and consumption of marijuana.\n\nK E Y TA K EA WAY\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\ncertain matters that are essentially local or intrastate, but the range of federal\ninvolvement in local matters is still considerable.\n\nE XE R C IS ES\n1. Why would Congress have power under the Civil Rights Act of 1964 to require\nrestaurants and hotels to not discriminate against interstate travelers on the basis of\nrace, color, sex, religion, or national origin? Suppose the Holiday Restaurant near I-80 in\nDes Moines, Iowa, has a sign that says, \xe2\x80\x9cWe reserve the right to refuse service to any\nMuslim or person of Middle Eastern descent.\xe2\x80\x9d Suppose also that the restaurant is very\npopular locally and that only 40 percent of its patrons are travelers on I-80. Are the\nowners of the Holiday Restaurant in violation of the Civil Rights Act of 1964? What would\nhappen if the owners resisted enforcement by claiming that Title II of the act (relating to\n\xe2\x80\x9cpublic accommodations\xe2\x80\x9d such as hotels, motels, and restaurants) was unconstitutional?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n164\n\n\x0c2. If the Supreme Court were to go back to the days of Hammer v. Dagenhart and rule that\nonly goods and services involving interstate movement could be subject to federal law,\nwhat kinds of federal programs might be lacking a sound basis in the commerce clause?\n\xe2\x80\x9cObamacare\xe2\x80\x9d? Medicare? Homeland security? Social Security? What other powers are\ngranted to Congress under the Constitution to legislate for the general good of society?\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\nL EA R N IN G O B JEC T IV ES\n1. Understand that when Congress does not exercise its powers under the\ncommerce clause, the Supreme Court may still limit state legislation that\ndiscriminates against interstate commerce or places an undue burden on\ninterstate commerce.\n2. Distinguish between \xe2\x80\x9cdiscrimination\xe2\x80\x9d dormant-commerce-clause cases and\n\xe2\x80\x9cundue burden\xe2\x80\x9d dormant-commerce-clause cases.\n\nCongress has the power to legislate under the commerce clause and often does legislate. For example,\nCongress might say that trucks moving on interstate highways must not be more than seventy feet in\nlength. But if Congress does not exercise its powers and regulate in certain areas (such as the size and\nlength of trucks on interstate highways), states may make their own rules. States may do so under the socalled historic police powers of states that were never yielded up to the federal government.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n165\n\n\x0cThese police powers can be broadly exercised by states for purposes of health, education, welfare, safety,\nmorals, and the environment. But the Supreme Court has reserved for itself the power to determine when\nstate action is excessive, even when Congress has not used the commerce clause to regulate. This power is\nclaimed to exist in thedormant commerce clause.\n\nThere are two ways that a state may violate the dormant commerce clause. If a state passes a law that is an\n\xe2\x80\x9cundue burden\xe2\x80\x9d on interstate commerce or that \xe2\x80\x9cdiscriminates\xe2\x80\x9d against interstate commerce, it will be\nstruck down. Kassel v. Consolidated Freightways, in Section 4.7 "Summary and Exercises", is an example\nof a case where Iowa imposed an undue burden on interstate commerce by prohibiting double trailers on\nits highways.\n\n[1]\n\nIowa\xe2\x80\x99s prohibition was judicially declared void when the Supreme Court judged it to be an\n\nundue burden.\n\nDiscrimination cases such as Hunt v. Washington Apple Advertising Commission (Section 4.6 "Cases")\npose a different standard. The court has been fairly inflexible here: if one state discriminates in its\ntreatment of any article of commerce based on its state of origin, the court will strike down the law. For\nexample, in Oregon Waste Systems v. Department of Environmental Quality, the state wanted to place a\nslightly higher charge on waste coming from out of state.\n\n[2]\n\nThe state\xe2\x80\x99s reasoning was that in-state\n\nresidents had already contributed to roads and other infrastructure and that tipping fees at waste facilities\nshould reflect the prior contributions of in-state companies and residents. Out-of-state waste handlers\nwho wanted to use Oregon landfills objected and won their dormant commerce clause claim that Oregon\xe2\x80\x99s\nlaw discriminated \xe2\x80\x9con its face\xe2\x80\x9d against interstate commerce. Under the Supreme Court\xe2\x80\x99s rulings, anything\nthat moves in channels of interstate commerce is \xe2\x80\x9ccommerce,\xe2\x80\x9d even if someone is paying to get rid of\nsomething instead of buying something.\n\nThus the states are bound by Supreme Court decisions under the dormant commerce clause to do nothing\nthat differentiates between articles of commerce that originate from within the state from those that\noriginate elsewhere. If Michigan were to let counties decide for themselves whether to take garbage from\noutside of the county or not, this could also be a discrimination based on a place of origin outside the\nstate. (Suppose, for instance, each county were to decide not to take waste from outside the county; then\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n166\n\n\x0call Michigan counties would effectively be excluding waste from outside of Michigan, which is\ndiscriminatory.)\n\n[3]\n\nThe Supreme Court probably would uphold any solid waste requirements that did not differentiate on the\nbasis of origin. If, for example, all waste had to be inspected for specific hazards, then the law would apply\nequally to in-state and out-of-state garbage. Because this is the dormant commerce clause, Congress could\nstill act (i.e., it could use its broad commerce clause powers) to say that states are free to keep out-of-state\nwaste from coming into their own borders. But Congress has declined to do so. What follows is a\nstatement from one of the US senators from Michigan, Carl Levin, in 2003, regarding the significant\namounts of waste that were 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 states and\nCanada.\n\nCanada is the largest source of waste imports to Michigan. Approximately 65 truckloads of waste come in\nto Michigan per day from Toronto alone, and an estimated 110\xe2\x80\x93130 trucks come in from Canada each day.\n\nThis problem isn\xe2\x80\x99t going to get any better. Ontario\xe2\x80\x99s waste shipments are growing as the Toronto area\nsigns new contracts for waste disposal here and closes its two remaining landfills. At the beginning of\n1999, the Toronto area was generating about 2.8 million tons of waste annually, about 700,000 tons of\nwhich were shipped to Michigan. By early this year, barring unforeseen developments, the entire 2.8\nmillion tons will be shipped to Michigan for disposal.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n167\n\n\x0cWhy can\xe2\x80\x99t Canada dispose of its trash in Canada? They say that after 20 years of searching they have not\nbeen able to find a suitable Ontario site for Toronto\xe2\x80\x99s garbage. Ontario has about 345,000 square miles\ncompared to Michigan\xe2\x80\x99s 57,000 square miles. With six times the land mass, that argument is laughable.\n\nThe Michigan Department of Environmental Quality estimates that, for every five years of disposal of\nCanadian waste at the current usage volume, Michigan is losing a full year of landfill capacity. The\nenvironmental impacts on landfills, including groundwater contamination, noise pollution and foul odors,\nare exacerbated by the significant increase in the use of our landfills from sources outside of Michigan.\n\nI have teamed up with Senator Stabenow and Congressman Dingell to introduce legislation that would\nstrengthen our ability to stop shipments of waste from Canada.\n\nWe have protections contained in a 17 year-old international agreement between the U.S. and Canada\ncalled the Agreement Concerning the Transboundary Movement of Hazardous Waste. The U.S. and\nCanada entered into this agreement in 1986 to allow the shipment of hazardous waste across the\nU.S./Canadian border for treatment, storage or disposal. In 1992, the two countries decided to add\nmunicipal solid waste to the agreement. To protect both countries, the agreement requires notification of\nshipments to the importing country and it also provides that the importing country may withdraw consent\nfor shipments. Both reasons are evidence that these shipments were intended to be limited. However, the\nagreement\xe2\x80\x99s provisions have not been enforced by the United States.\n\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 of us that\nintroduced this legislation believe that the Environmental Protection Agency has the authority to enforce\nthis agreement, they have not done so. Our bill would require the EPA [Environmental Protection Agency]\nto enforce the agreement.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n168\n\n\x0cIn order to protect the health and welfare of the citizens of Michigan and our environment, we must\nconsider the impact of the importation of trash on state and local recycling efforts, landfill capacity, air\nemissions, road deterioration resulting from increased vehicular traffic and public health and the\nenvironment.\n\nOur bill would require the EPA to consider these factors in determining whether to accept imports of trash\nfrom Canada. It is my strong view that such a review should lead the EPA to say \xe2\x80\x9cno\xe2\x80\x9d to the status quo of\ntrash imports.\n\nK E Y TA K EA WAY\nWhere Congress does not act pursuant to its commerce clause powers, the states\nare free to legislate on matters of commerce under their historic police powers.\nHowever, the Supreme Court has set limits on such powers. Specifically, states\nmay not impose undue burdens on interstate commerce and may not discriminate\nagainst articles in interstate commerce.\n\nE XE R C IS ES\n1. Suppose that the state of New Jersey wishes to limit the amount of hazardous\nwaste that enters into its landfills. The general assembly in New Jersey passes\na law that specifically forbids any hazardous waste from entering into the\nstate. All landfills are subject to tight regulations that will allow certain kinds\nof hazardous wastes originating in New Jersey to be put in New Jersey landfills\nbut that impose significant criminal fines on landfill operators that accept outSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n169\n\n\x0cof-state hazardous waste. The Baldessari Brothers Landfill in Linden, New\nJersey, is fined for taking hazardous waste from a New York State transporter\nand appeals that ruling on the basis that New Jersey\xe2\x80\x99s law is unconstitutional.\nWhat is the result?\n2. The state of Arizona determines through its legislature that trains passing\nthrough the state cannot be longer than seventy cars. There is some evidence\nthat in Eastern US states longer trains pose some safety hazards. There is less\nevidence that long trains are a problem in Western states. Several major\nrailroads find the Arizona legislation costly and burdensome and challenge the\nlegislation after applied-for permits for longer trains are denied. What kind of\ndormant commerce clause challenge is this, and what would it take for the\nchallenge to be successful?\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\n170\n\n\x0c4.4 Preemption: The Supremacy Clause\nL EA R N IN G O B JEC T IV ES\n1. Understand the role of the supremacy clause in the balance between state and\nfederal power.\n2. Give examples of cases where state legislation is preempted by federal law and\ncases where state legislation is not preempted by federal law.\n\nWhen Congress does use its power under the commerce clause, it can expressly state that it wishes to have\nexclusive regulatory authority. For example, when Congress determined in the 1950s to promote nuclear\npower (\xe2\x80\x9catoms for peace\xe2\x80\x9d), it set up the Nuclear Regulatory Commission and provided a limitation of\nliability for nuclear power plants in case of a nuclear accident. The states were expressly told to stay out of\nthe business of regulating nuclear power or the movement of nuclear materials. Thus Rochester,\nMinnesota, or Berkeley, California, could declare itself a nuclear-free zone, but the federal government\nwould have preempted such legislation. If Michigan wished to set safety standards at Detroit Edison\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n171\n\n\x0cFermi II nuclear reactor that were more stringent than the federal Nuclear Regulatory Commission\xe2\x80\x99s\nstandards, Michigan\xe2\x80\x99s standards would be preempted and thus be void.\n\nEven where Congress does not expressly preempt state action, such action may be impliedly pre-empted.\nStates cannot constitutionally pass laws that interfere with the accomplishment of the purposes of the\nfederal law. Suppose, for example, that Congress passes a comprehensive law that sets standards for\nforeign vessels to enter the navigable waters and ports of the United States. If a state creates a law that\nsets standards that conflict with the federal law or sets standards so burdensome that they interfere with\nfederal law, the doctrine of preemption will (in accordance with the supremacy clause) void the state\nlaw or whatever parts of it are inconsistent with federal law.\n\nBut Congress can allow what might appear to be inconsistencies; the existence of federal statutory\nstandards does not always mean that local and state standards cannot be more stringent. If California\nwants cleaner air or water than other states, it can set stricter standards\xe2\x80\x94nothing in the Clean Water Act\nor Clean Air Act forbids the state from setting stricter pollution standards. As the auto industry well\nknows, California has set stricter standards for auto emissions. Since the 1980s, most automakers have\nmade both a federal car and a California car, because federal Clean Air Act emissions restrictions do not\npreempt more rigorous state standards.\n\nLarge industries and companies actually prefer regulation at the national level. It is easier for a large\ncompany or industry association to lobby in Washington, DC, than to lobby in fifty different states.\nAccordingly, industry often asks Congress to put preemptive language into its statutes. The tobacco\nindustry is a case in point.\n\nThe cigarette warning legislation of the 1960s (where the federal government required warning labels on\ncigarette packages) effectively preempted state negligence claims based on failure to warn. When the\nfamily of a lifetime smoker who had died sued in New Jersey court, one cause of action was the company\xe2\x80\x99s\nfailure to warn of the dangers of its product. The Supreme Court reversed the jury\xe2\x80\x99s award based on the\nfederal preemption of failure to warn claims under state law.\nSaylor URL: http://www.saylor.org/books\n\n[1]\n\nSaylor.org\n172\n\n\x0cThe Supremacy Clause\nArticle VI\nThis Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all\nTreaties made, or which shall be made, under the Authority of the United States, shall be the supreme\nLaw of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or\nLaws of any State to the Contrary notwithstanding.\n\nThe preemption doctrine derives from the supremacy clause of the Constitution, which states that the\n\xe2\x80\x9cConstitution and the Laws of the United States\xe2\x80\xa6shall be the supreme Law of the Land\xe2\x80\xa6any Thing in the\nConstitutions or Laws of any State to the Contrary notwithstanding.\xe2\x80\x9d This means of course,\nthat any federal law\xe2\x80\x94even a regulation of a federal agency\xe2\x80\x94would control over any conflicting state law.\n\nPreemption can be either express or implied. When Congress chooses to expressly preempt state law, the\nonly question for courts becomes determining whether the challenged state law is one that the federal law\nis intended to preempt. Implied preemption presents more difficult issues. The court has to look beyond\nthe express language of federal statutes to determine whether Congress has \xe2\x80\x9coccupied the field\xe2\x80\x9d in which\nthe state is attempting to regulate, or whether a state law directly conflicts with federal law, or whether\nenforcement of the state law might frustrate federal purposes.\n\nFederal \xe2\x80\x9coccupation of the field\xe2\x80\x9d occurs, according to the court inPennsylvania v. Nelson (1956), when\nthere is \xe2\x80\x9cno room\xe2\x80\x9d left for state regulation. Courts are to look to the pervasiveness of the federal scheme of\nregulation, the federal interest at stake, and the danger of frustration of federal goals in making the\ndetermination as to whether a challenged state law can stand.\n\nIn Silkwood v. Kerr-McGee (1984), the court, voting 5\xe2\x80\x934, found that a $10 million punitive damages\naward (in a case litigated by famed attorney Gerry Spence) against a nuclear power plant was not\nimpliedly preempted by federal law. Even though the court had recently held that state regulation of the\nsafety aspects of a federally licensed nuclear power plant was preempted, the court drew a different\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n173\n\n\x0cconclusion with respect to Congress\xe2\x80\x99s desire to displace state tort law\xe2\x80\x94even though the tort actions might\nbe premised on a violation of federal safety regulations.\n\nCipollone v. Liggett Group (1993) was a closely watched case concerning the extent of an express\npreemption provision in two cigarette labeling laws of the 1960s. The case was a wrongful death action\nbrought against tobacco companies on behalf of Rose Cipollone, a lung cancer victim who had started\nsmoking cigarette in the 1940s. The court considered the preemptive effect on state law of a provision that\nstated, \xe2\x80\x9cNo requirement based on smoking and health shall be imposed under state law with respect to\nthe advertising and promotion of cigarettes.\xe2\x80\x9d The court concluded that several types of state tort actions\nwere preempted by the provision but allowed other types to go forward.\n\nK E Y TA K EA WAY\nIn cases of conflicts between state and federal law, federal law will preempt (or control)\nstate law because of the supremacy clause. Preemption can be express or implied. In\ncases where preemption is implied, the court usually finds that compliance with both\nstate and federal law is not possible or that a federal regulatory scheme is\ncomprehensive (i.e., \xe2\x80\x9coccupies the field\xe2\x80\x9d) and should not be modified by state actions.\n\nE XE R C IS ES\n1. For many years, the United States engaged in discussions with friendly nations as to\nthe reciprocal use of ports and harbors. These discussions led to various multilateral\nagreements between the nations as to the configuration of oceangoing vessels and\nhow they would be piloted. At the same time, concern over oil spills in Puget Sound\nled the state of Washington to impose fairly strict standards on oil tankers and\nrequirements for the training of oil tanker pilots. In addition, Washington\xe2\x80\x99s state law\nimposed many other requirements that went above and beyond agreed-upon\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n174\n\n\x0crequirements in the international agreements negotiated by the federal\ngovernment. Are the Washington state requirements preempted by federal law?\n2. The Federal Arbitration Act of 1925 requires that all contracts for arbitration be\ntreated as any other contract at common law. Suppose that the state of Alabama\nwishes to protect its citizens from a variety of arbitration provisions that they might\nenter into unknowingly. Thus the legislation provides that all predispute arbitration\nclauses be in bold print, that they be of twelve-point font or larger, that they be\nclearly placed within the first two pages of any contract, and that they have a\nseparate signature line where the customer, client, or patient acknowledges having\nread, understood, and signed the arbitration clause in addition to any other\nsignatures 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\nprovider; that is, with this legislation, consumers will not unknowingly waive their\nright to a trial at common law. Is the Alabama law preempted by the Federal\nArbitration Act?\n[1] Cippolone v. Liggett Group, 505 US 504 (1993).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n175\n\n\x0c4.5 Business and the Bill of Rights\nL EA R N IN G O B JEC T IV ES\n1. Understand and describe which articles in the Bill of Rights apply to business\nactivities and how they apply.\n2. Explain the application of the Fourteenth Amendment\xe2\x80\x94including the due\nprocess clause and the equal protection clause\xe2\x80\x94to various rights enumerated\nin the original Bill of Rights.\n\nWe have already seen the Fourteenth Amendment\xe2\x80\x99s application inBurger King v. Rudzewicz (Section 3.9\n"Cases"). In that case, the court considered whether it was constitutionally correct for a court to assert\npersonal jurisdiction over a nonresident. The states cannot constitutionally award a judgment against a\nnonresident if doing so would offend traditional notions of fair play and substantial justice. Even if the\nstate\xe2\x80\x99s long-arm statute would seem to allow such a judgment, other states should not give it full faith and\ncredit (see Article V of the Constitution). In short, a state\xe2\x80\x99s long-arm statute cannot confer personal\njurisdiction that the state cannot constitutionally claim.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n176\n\n\x0cThe Bill of Rights (the first ten amendments to the Constitution) was originally meant to apply to federal\nactions only. During the twentieth century, the court began to apply selected rights to state action as well.\nSo, for example, federal agents were prohibited from using evidence seized in violation of the Fourth\nAmendment, but state agents were not, until Mapp v. Ohio (1960), when the court applied the guarantees\n(rights) of the Fourth Amendment to state action as well. In this and in similar cases, the Fourteenth\nAmendment\xe2\x80\x99s due process clause was the basis for the court\xe2\x80\x99s action. The due process clause commanded\nthat states provide due process in cases affecting the life, liberty, or property of US citizens, and the court\nsaw in this command certain \xe2\x80\x9cfundamental guarantees\xe2\x80\x9d that states would have to observe. Over the years,\nmost of the important 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.\n\nHere are some very basic principles to remember:\n\n1.\n\nThe 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.\n\n2. In some cases, a private company may be regarded as participating in \xe2\x80\x9cstate action.\xe2\x80\x9d For example,\na private defense contractor that gets 90 percent of its business from the federal government has\nbeen held to be public for purposes of enforcing the constitutional right to free speech (the\ncompany had a rule barring its employees from speaking out in public against its corporate\nposition). It has even been argued that public regulation of private activity is sufficient to convert\nthe private into public activity, thus subjecting it to the requirements of due process. But the\nSupreme Court rejected this extreme view in 1974 when it refused to require private power\ncompanies, regulated by the state, to give customers a hearing before cutting off electricity for\nfailure to pay the bill.\n\n[1]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n177\n\n\x0c3. 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 never\nbeen simple. In Kimel v. Florida, for example, the Supreme Court found in the words of the\nEleventh 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 speech,\nor of the press.\xe2\x80\x9d The Founding Fathers believed that democracy would work best if people (and the press)\ncould talk or write freely, without governmental interference. But the First Amendment was also not\nintended to be as absolute as it sounded. Oliver Wendell Holmes\xe2\x80\x99s famous dictum that the law does not\npermit you to shout \xe2\x80\x9cFire!\xe2\x80\x9d in a crowded theater has seldom been answered, \xe2\x80\x9cBut why not?\xe2\x80\x9d And no one in\n1789 thought that defamation laws (torts for slander and libel) had been made unconstitutional.\nMoreover, because the apparent purpose of the First Amendment was to make sure that the nation had a\ncontinuing, vigorous debate over matters political, political speech has been given the highest level of\nprotection over such 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.\n\nBecause of its higher level of protection, political speech can be false, malicious, mean-spirited, or even a\npack of lies. A public official in the United States must be prepared to withstand all kinds of false\naccusations and cannot succeed in an action for defamation unless the defendant has acted with \xe2\x80\x9cmalice\xe2\x80\x9d\nand \xe2\x80\x9creckless disregard\xe2\x80\x9d of the truth. Public figures, such as CEOs of the largest US banks, must also be\nprepared to withstand accusations that are false. In any defamation action, truth is a defense, but a\ndefamation action brought by a public figure or public official must prove that the defendant not only has\nhis facts wrong but also lies to the public in a malicious way with reckless disregard of the truth.\nCelebrities such as Lindsay Lohan and Jon Stewart have the same burden to go forward with a defamation\naction. It is for this reason that the National Enquirer writes exclusively about public figures, public\nofficials, and celebrities; it is possible to say many things that aren\xe2\x80\x99t completely true and still have the\nprotection of the First Amendment.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n178\n\n\x0cPolitical speech is so highly protected that the court has recognized the right of people to support political\ncandidates through campaign contributions and thus promote the particular viewpoints and speech of\nthose candidates. Fearing the influence of money on politics, Congress has from time to time placed\nlimitations on corporate contributions to political campaigns. But the Supreme Court has had mixed\nreactions over time. Initially, the court recognized the First Amendment right of a corporation to donate\nmoney, subject to certain limits.\n\n[2]\n\nIn another case, Austin v. Michigan Chamber of Commerce (1990), the\n\nMichigan Campaign Finance Act prohibited corporations from using treasury money for independent\nexpenditures to support or oppose candidates in elections for state offices. But a corporation could make\nsuch expenditures if it set up an independent fund designated solely for political purposes. The law was\npassed on the 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 corruption.\xe2\x80\x9d\n\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 as a\nnonprofit organization, it was not really like a business firm. The court disagreed and upheld the Michigan\nlaw. Justice Marshall found that the chamber was akin to a business group, given its activities, linkages\nwith community business leaders, and high percentage of members (over 75 percent) that were business\ncorporations. Furthermore, Justice Marshall found that the statute was narrowly crafted and\nimplemented to achieve the important goal of maintaining integrity in the political process. But as you\nwill see in Citizens United v. Federal Election Commission (Section 4.6 "Cases"), Austin was overruled;\ncorporations are recognized as \xe2\x80\x9cpersons\xe2\x80\x9d with First Amendment political speech rights that cannot be\nimpaired by Congress or the states without some compelling governmental interest with restrictions on\nthose rights that are \xe2\x80\x9cnarrowly tailored.\xe2\x80\x9d\n\nFourth Amendment\nThe Fourth Amendment says, \xe2\x80\x9call persons shall be secure in their persons, houses, papers, and effects\nfrom unreasonable searches and seizures, and no warrants shall issue, but upon probable cause, before a\nmagistrate and upon Oath, specifically describing the persons to be searched and places to be seized.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n179\n\n\x0cThe court has read the Fourth Amendment to prohibit only those government searches or seizures that\nare \xe2\x80\x9cunreasonable.\xe2\x80\x9d Because of this, businesses that are in an industry that is \xe2\x80\x9cclosely regulated\xe2\x80\x9d can be\nsearched more frequently and can be searched without a warrant. In one case, an auto parts dealer at a\njunkyard was charged with receiving stolen auto parts. Part of his defense was to claim that the search\nthat found incriminating evidence was unconstitutional. But the court found the search reasonable,\nbecause the dealer was in a \xe2\x80\x9cclosely regulated industry.\xe2\x80\x9d\n\nIn the 1980s, Dow Chemical objected to an overflight by the US Environmental Protection Agency (EPA).\nThe EPA had rented an airplane to fly over the Midland, Michigan, Dow plant, using an aerial mapping\ncamera to photograph various pipes, ponds, and machinery that were not covered by a roof. Because the\ncourt\xe2\x80\x99s precedents allowed governmental intrusions into \xe2\x80\x9copen fields,\xe2\x80\x9d the EPA search was ruled\nconstitutional. Because the literal language of the Fourth Amendment protected \xe2\x80\x9cpersons, houses, papers,\nand effects,\xe2\x80\x9d anything searched by the government in \xe2\x80\x9copen fields\xe2\x80\x9d was reasonable. (The court\xe2\x80\x99s opinion\nsuggested that if Dow had really wanted privacy from governmental intrusion, it could have covered the\npipes and machinery that were otherwise outside and in open fields.)\n\nNote again that constitutional guarantees like the Fourth Amendment apply to governmental action. Your\nemployer or any private enterprise is not bound by constitutional limits. For example, if drug testing of all\nemployees every week is done by government agency, the employees may have a cause of action to object\nbased on the Fourth Amendment. However, if a private employer begins the same kind of routine drug\ntesting, employees have no constitutional arguments to make; they can simply leave that employer, or\nthey may pursue whatever statutory or common-law remedies are available.\n\nFifth Amendment\nThe Fifth Amendment states, \xe2\x80\x9cNo person shall be\xe2\x80\xa6deprived of life, liberty, or property, without due\nprocess of law; nor shall private property be taken for public use, without just compensation.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n180\n\n\x0cThe Fifth Amendment has three principal aspects: procedural due process, the takings clause, and\nsubstantive due process. In terms of procedural due process, the amendment prevents government\nfrom arbitrarily taking the life of a criminal defendant. In civil lawsuits, it is also constitutionally essential\nthat the proceedings be fair. This is why, for example, the defendant inBurger King v. Rudzewicz had a\nserious constitutional argument, even though he lost.\n\nThe takings clause of the Fifth Amendment ensures that the government does not take private property\nwithout just compensation. In the international setting, governments that take private property engage in\nwhat is called expropriation. The standard under customary international law is that when governments\ndo that, they must provide prompt, adequate, and effective compensation. This does not always happen,\nespecially where foreign owners\xe2\x80\x99 property is being expropriated. The guarantees of the Fifth Amendment\n(incorporated against state action by the Fourteenth Amendment) are available to property owners where\nstate, county, or municipal government uses the power of eminent domain to take private property for\npublic purposes. Just what is a public purpose is a matter of some debate. For example, if a city were to\ncondemn economically 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 served?\n\nIn Kelo v. City of New London, Mrs. Kelo and other residents fought the city of New London, in its\nattempt to use powers of eminent domain to create an industrial park and recreation area that would have\nPfizer & Co. as a principal tenant.\n\n[3]\n\nThe city argued that increasing its tax base was a sufficient public\n\npurpose. In a very close decision, the Supreme Court determined that New London\xe2\x80\x99s actions did not\nviolate the takings clause. However, political reactions in various states resulted in a great deal of new\nstate legislation that would limit the scope of public purpose in eminent domain takings and provide\nadditional compensation to property owners in many cases.\n\nIn addition to the takings clause and aspects of procedural due process, the Fifth Amendment is also the\nsource of what is called substantive due process. During the first third of the twentieth century, the\nSupreme Court often nullified state and federal laws using substantive due process. In 1905, for example,\nin Lochner v. New York, the Supreme Court voided a New York statute that limited the number of hours\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n181\n\n\x0cthat bakers could work in a single week. New York had passed the law to protect the health of employees,\nbut the court found that this law interfered with the basic constitutional right of private parties to freely\ncontract with one another. Over the next thirty years, dozens of state and federal laws were struck down\nthat aimed to improve working conditions, secure social welfare, or establish the rights of unions.\nHowever, in 1934, during the Great Depression, the court reversed itself and began upholding the kinds of\nlaws it had struck down earlier.\n\nSince then, the court has employed a two-tiered analysis of substantive due process claims. Under the first\ntier, legislation on economic matters, employment relations, and other business affairs is subject to\nminimal judicial scrutiny. This means that a law will be overturned only if it serves no rational\ngovernment purpose. Under the second tier, legislation concerning fundamental liberties is subject to\n\xe2\x80\x9cheightened judicial scrutiny,\xe2\x80\x9d meaning that a law will be invalidated unless it is \xe2\x80\x9cnarrowly tailored to\nserve a significant government purpose.\xe2\x80\x9d\nThe Supreme Court has identified two distinct categories of fundamental liberties. The first category\nincludes most of the liberties expressly enumerated in the Bill of Rights. Through a process known as\nselective incorporation, the court has interpreted the due process clause of the Fourteenth Amendment to\nbar states from denying their residents the most important freedoms guaranteed in the first ten\namendments to the federal Constitution. Only the Third Amendment right (against involuntary\nquartering of soldiers) and the Fifth Amendment right to be indicted by a grand jury have not been made\napplicable to the states. Because these rights are still not applicable to state governments, the Supreme\nCourt is often said to have \xe2\x80\x9cselectively incorporated\xe2\x80\x9d the Bill of Rights into the due process clause of the\nFourteenth Amendment.\n\nThe second category of fundamental liberties includes those liberties that are not expressly stated in the\nBill of Rights but that can be seen as essential to the concepts of freedom and equality in a democratic\nsociety. These unstated liberties come from Supreme Court precedents, common law, moral philosophy,\nand deeply rooted traditions of US legal history. The Supreme Court has stressed that he\nword liberty cannot be defined by a definitive list of rights; rather, it must be viewed as a rational\ncontinuum of freedom through which every aspect of human behavior is protected from arbitrary\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n182\n\n\x0cimpositions and random restraints. In this regard, as the Supreme Court has observed, the due process\nclause protects abstract liberty interests, including the right to personal autonomy, bodily integrity, selfdignity, and self-determination.\n\nThese liberty interests often are grouped to form a general right to privacy, which was first recognized\nin Griswold v. Connecticut (Section 4.6.1), where the Supreme Court struck down a state statute\nforbidding married adults from using, possessing, or distributing contraceptives on the ground that the\nlaw violated the sanctity of the marital relationship. According to Justice Douglas\xe2\x80\x99s plurality opinion, this\npenumbra of privacy, though not expressly mentioned in the Bill of Rights, must be protected to establish\na buffer zone or breathing space for those freedoms that are constitutionally enumerated.\n\nBut substantive due process has seen fairly limited use since the 1930s. During the 1990s, the Supreme\nCourt was asked to recognize a general right to die under the doctrine of substantive due process.\nAlthough the court stopped short of establishing such a far-reaching right, certain patients may exercise a\nconstitutional liberty to hasten their deaths under a narrow set of circumstances. In Cruzan v. Missouri\nDepartment of Health, the Supreme Court ruled that the due process clause guarantees the right of\ncompetent adults to make advanced directives for the withdrawal of life-sustaining measures should they\nbecome incapacitated by a disability that leaves them in a persistent vegetative state.\n\n[4]\n\nOnce it has been\n\nestablished by clear and convincing evidence that a mentally incompetent and persistently vegetative\npatient made such a prior directive, a spouse, parent, or other appropriate guardian may seek to terminate\nany form of artificial hydration or nutrition.\n\nFourteenth Amendment: Due Process and Equal Protection\nGuarantees\nThe Fourteenth Amendment (1868) requires that states treat citizens of other states with due process.\nThis can be either an issue of procedural due process (as in Section 3.9 "Cases", Burger King v.\nRudzewicz) or an issue of substantive due process. For substantive due process, consider what happened\n[5]\n\nin an Alabama court not too long ago.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n183\n\n\x0cThe plaintiff, Dr. Ira Gore, bought a new BMW for $40,000 from a dealer in Alabama. He later discovered\nthat the vehicle\xe2\x80\x99s exterior had been slightly damaged in transit from Europe and had therefore been\nrepainted by the North American distributor prior to his purchase. The vehicle was, by best estimates,\nworth about 10 percent less than he paid for it. The distributor, BMW of North America, had routinely\nsold slightly damaged cars as brand new if the damage could be fixed for less than 3 percent of the cost of\nthe car. In the trial, Dr. Gore sought $4,000 in compensatory damages and also punitive damages. The\nAlabama trial jury considered that BMW was engaging in a fraudulent practice and wanted to punish the\ndefendant for a number of frauds it estimated at somewhere around a thousand nationwide. The jury\nawarded not only the $4,000 in compensatory damages but also $4 million in punitive damages, which\nwas later reduced 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 reasonably\nnecessary 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, adopted in 1868.\nThe amendment provides that no state shall \xe2\x80\x9cdeny to any person within its jurisdiction the equal\nprotection of the laws.\xe2\x80\x9d This is the equal protection clause. It means that, generally speaking,\ngovernments must treat people equally. Unfair classifications among people or corporations will not be\npermitted. A well-known example of unfair classification would be race discrimination: requiring white\nchildren and black children to attend different public schools or requiring \xe2\x80\x9cseparate but equal\xe2\x80\x9d public\nservices, such as water fountains or restrooms. Yet despite the clear intent of the 1868 amendment,\n\xe2\x80\x9cseparate but equal\xe2\x80\x9d was the law of the land until Brown v. Board of Education (1954).\n\n[6]\n\nGovernments make classifications every day, so not all classifications can be illegal under the equal\nprotection clause. People with more income generally pay a greater percentage of their income in taxes.\nPeople with proper medical training are licensed to become doctors; people without that training cannot\nbe licensed and commit a criminal offense if they do practice medicine. To know what classifications are\npermissible under the Fourteenth Amendment, we need to know what is being classified. The court has\ncreated three classifications, and the outcome of any equal protection case can usually be predicted by\nknowing how the court is likely to classify the case:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n184\n\n\x0c\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.\n\nUnder minimal scrutiny for economic and social regulation, laws that regulate economic or social issues\nare presumed valid and will be upheld if they are rationally related to legitimate goals of government. So,\nfor example, if the city of New Orleans limits the number of street vendors to some rational number (more\nthan one but fewer than the total number that could possibly fit on the sidewalks), the local ordinance\nwould not be overturned as a violation of equal protection.\nUnder intermediate scrutiny, the city of New Orleans might limit the number of street vendors who are\nmen. For example, suppose that the city council decreed that all street vendors must be women, thinking\nthat would attract even more tourism. A classification like this, based on sex, will have to meet a sterner\ntest than a classification resulting from economic or social regulation. A law like this would have to\nsubstantially relate to important government objectives. Increasingly, courts have nullified government\nsex classifications as societal concern with gender equality has grown. (See Shannon Faulkner\xe2\x80\x99s case\nagainst The Citadel, an all-male state school.)\n\n[7]\n\nSuppose, however, that the city of New Orleans decided that no one of Middle Eastern heritage could\ndrive a taxicab or be a street vendor. That kind of classification would be examined with strict scrutiny to\nsee if there was any compelling justification for it. As noted, classifications such as this one are almost\nnever upheld. The law would be upheld only if it were necessary to promote a compelling state interest.\nVery few laws that have a racial or ethnic classification meet that test.\n\nThe strict scrutiny test will be applied to classifications involving racial and ethnic criteria as well as\nclassifications that interfere with a fundamental right. In Palmore v. Sidoti, the state refused to award\n[8]\n\ncustody to the mother because her new spouse was racially different from the child. This practice was\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n185\n\n\x0cdeclared unconstitutional because the state had made a racial classification; this was presumptively\ninvalid, and the government could not show a compelling need to enforce such a classification through its\nlaw. An example of government action interfering with a fundamental right will also receive strict\nscrutiny. When New York State gave an employment preference to veterans who had been state residents\nat the time of entering the military, the court declared that veterans who were new to the state were less\nlikely to get jobs and that therefore the statute interfered with the right to travel, which was deemed a\nfundamental right.\n\n[9]\n\nK E Y TA K EA WAY\nThe Bill of Rights, through the Fourteenth Amendment, largely applies to state\nactions. The Bill of Rights has applied to federal actions from the start. Both the Bill\nof Rights and the Fourteenth Amendment apply to business in various ways, but it\nis important to remember that the rights conferred are rights against\ngovernmental action and not the actions of private enterprise.\n\nE XE R C IS ES\n1. John Hanks works at ProLogis. The company decides to institute a drug-testing\npolicy. John is a good and longtime employee but enjoys smoking marijuana\non the weekends. The drug testing will involve urine samples and,\nsemiannually, a hair sample. It is nearly certain that the drug-testing protocol\nthat ProLogis proposes will find that Hanks is a marijuana user. The company\nhas 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n186\n\n\x0cto challenge the proposed testing as \xe2\x80\x9can unreasonable search and seizure.\xe2\x80\x9d\nCan he possibly succeed?\n2. Larry Reed, majority leader in the Senate, is attacked in his reelection\ncampaign by a series of ads sponsored by a corporation (Global Defense, Inc.)\nthat does not like his voting record. The corporation is upset that Reed would\nnot write a special provision that would favor Global Defense in a defense\nappropriations bill. The ads run constantly on television and radio in the\nweeks immediately preceding election day and contain numerous falsehoods.\nFor example, in order to keep the government running financially, Reed found\nit necessary to vote for a bill that included a last-minute rider that defunded a\nsmall government program for the handicapped, sponsored by someone in\nthe opposing party that wanted to privatize all programs for the handicapped.\nThe ad is largely paid for by Global Defense and depicts a handicapped child\nbeing 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\nCare for a Better Tomorrow. Is this protected speech? Why or why not? Can\nReed sue for defamation? Why or why not?\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n187\n\n\x0c4.6 Cases\nGriswold v. Connecticut\nGriswold v. Connecticut\n381 U.S. 479 (U.S. Supreme Court 1965)\n\nA nineteenth-century Connecticut law made the use, possession, or distribution of birth control devices\nillegal. The law also prohibited anyone from giving information about such devices. The executive\ndirector and medical director of a planned parenthood association were found guilty of giving out such\ninformation to a married couple that wished to delay having children for a few years. The directors\nwere fined $100 each.\n\nThey appealed throughout the Connecticut state court system, arguing that the state law violated\n(infringed) a basic or fundamental right of privacy of a married couple: to live together and have sex\ntogether without the restraining power of the state to tell them they may legally have intercourse but\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n188\n\n\x0cnot if they use condoms or other birth control devices. At each level (trial court, court of appeals, and\nConnecticut Supreme Court), the Connecticut courts upheld the constitutionality of the convictions.\n\nPlurality Opinion by Justice William O. Douglass\n\nWe do not sit as a super legislature to determine the wisdom, need, and propriety of laws that touch\neconomic problems, business affairs, or social conditions. The [Connecticut] law, however, operates\ndirectly on intimate relation of husband and wife and their physician\xe2\x80\x99s role in one aspect of that relation.\n\n[Previous] cases suggest that specific guarantees in the Bill of Rights have penumbras, formed by\nemanations from those guarantees that help give them life and substance.\xe2\x80\xa6Various guarantees create\nzones of privacy. The right of association contained in the penumbra of the First Amendment is one.\xe2\x80\xa6The\nThird Amendment in its prohibition against the quartering of soldiers \xe2\x80\x9cin any house\xe2\x80\x9d in time of peace\nwithout the consent of the owner is another facet of that privacy. The Fourth Amendment explicitly\naffirms the \xe2\x80\x9cright of the people to be secure in their persons, houses, papers and effects, against\nunreasonable searches and seizures.\xe2\x80\x9d The Fifth Amendment in its Self-Incrimination Clause enables the\ncitizen to create a zone of privacy which the government may not force him to surrender to his detriment.\nThe Ninth Amendment provides: \xe2\x80\x9cThe enumeration in the Constitution, of certain rights, shall not be\nconstrued to deny or disparage others retained by the people.\xe2\x80\x9d\n\nThe Fourth and Fifth Amendments were described\xe2\x80\xa6as protection against all governmental invasions \xe2\x80\x9cof\nthe sanctity of a man\xe2\x80\x99s home and the privacies of life.\xe2\x80\x9d We recently referred in Mapp v. Ohio\xe2\x80\xa6to the\nFourth Amendment as creating a \xe2\x80\x9cright to privacy, no less important than any other right carefully and\nparticularly reserved to the people.\xe2\x80\x9d\n\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 marital]\nrelationship. Such a law cannot stand.\xe2\x80\xa6Would we allow the police to search the sacred precincts of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n189\n\n\x0cmarital bedrooms for telltale signs of the use of contraceptives? The very idea is repulsive to the notions of\nprivacy surrounding the marital relationship.\n\nWe deal with a right of privacy older than the Bill of Rights\xe2\x80\x94older than our political parties, older than\nour school system. Marriage is a coming together for better or for worse, hopefully enduring, and intimate\nto the degree of being sacred. It is an association that promotes a way of life, not causes; a harmony in\nliving, not political faiths; a bilateral loyalty, not commercial or social projects. Yet it is an association for\nas noble a purpose as any involved in our prior decisions.\n\nMr. Justice Stewart, whom Mr. Justice Black joins, dissenting.\n\nSince 1879 Connecticut has had on its books a law which forbids the use of contraceptives by anyone. I\nthink this is an uncommonly silly law. As a practical matter, the law is obviously unenforceable, except in\nthe oblique context of the present case. As a philosophical matter, I believe the use of contraceptives in the\nrelationship of marriage should be left to personal and private choice, based upon each individual\xe2\x80\x99s moral,\nethical, and religious beliefs. As a matter of social policy, I think professional counsel about methods of\nbirth control should be available to all, so that each individual\xe2\x80\x99s choice can be meaningfully made. But we\nare not asked in this case to say whether we think this law is unwise, or even asinine. We are asked to hold\nthat it violates the United States Constitution. And that I cannot do.\n\nIn the course of its opinion the Court refers to no less than six Amendments to the Constitution: the First,\nthe Third, the Fourth, the Fifth, the Ninth, and the Fourteenth. But the Court does not say which of these\nAmendments, 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 invalidate this\nConnecticut law, even assuming that all those Amendments are fully applicable against the States. It has\nnot even been argued that this is a law \xe2\x80\x9crespecting an establishment of religion, or prohibiting the free\nexercise thereof.\xe2\x80\x9d And surely, unless the solemn process of constitutional adjudication is to descend to the\nlevel of a play on words, there is not involved here any abridgment of \xe2\x80\x9cthe freedom of speech, or of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n190\n\n\x0cpress; or the right of the people peaceably to assemble, and to petition the Government for a redress of\ngrievances.\xe2\x80\x9d No soldier has been quartered in any house. There has been no search, and no seizure.\nNobody has been compelled to be a witness against himself.\n\nThe Court also quotes the Ninth Amendment, and my Brother Goldberg\xe2\x80\x99s concurring opinion relies\nheavily upon it. But to say that the Ninth Amendment has anything to do with this case is to turn\nsomersaults with history. The Ninth Amendment, like its companion the Tenth, which this Court held\n\xe2\x80\x9cstates but a truism that all is retained which has not been surrendered,\xe2\x80\x9d United States v. Darby, 312 U.S.\n100, 124, was framed by James Madison and adopted by the States simply to make clear that the adoption\nof the Bill of Rights did not alter the plan that the Federal Government was to be a government of express\nand limited powers, and that all rights and powers not delegated to it were retained by the people and the\nindividual States. Until today no member of this Court has ever suggested that the Ninth Amendment\nmeant anything else, 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 caused James\nMadison no little wonder.\n\nWhat provision of the Constitution, then, does make this state law invalid? The Court says it is the right of\nprivacy \xe2\x80\x9ccreated by several fundamental constitutional guarantees.\xe2\x80\x9d With all deference, I can find no such\ngeneral right of privacy in the Bill of Rights, in any other part of the Constitution, or in any case ever\nbefore decided by this Court.\n\nAt the oral argument in this case we were told that the Connecticut law does not \xe2\x80\x9cconform to current\ncommunity standards.\xe2\x80\x9d But it is not the function of this Court to decide cases on the basis of community\nstandards. We are here to decide cases \xe2\x80\x9cagreeably to the Constitution and laws of the United States.\xe2\x80\x9d It is\nthe essence of judicial duty to subordinate our own personal views, our own ideas of what legislation is\nwise and what is not. If, as I should surely hope, the law before us does not reflect the standards of the\npeople of Connecticut, the people of Connecticut can freely exercise their true Ninth and Tenth\nAmendment rights to persuade their elected representatives to repeal it. That is the constitutional way to\ntake this law off the books.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n191\n\n\x0cC A SE QU ES TIO NS\n1. Which opinion is the strict constructionist opinion here\xe2\x80\x94Justice Douglas\xe2\x80\x99s or that of\nJustices Stewart 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\ncitizens of Connecticut would have persuaded their elected representatives to repeal the\nlaw challenged here?\n\nWickard v. Filburn\nWickard v. Filburn\n\n317 U.S. 111 (U.S. Supreme Court 1942)\n\nMr. Justice Jackson delivered the opinion of the Court.\n\nMr. Filburn for many years past has owned and operated a small farm in Montgomery County, Ohio,\nmaintaining a herd of dairy cattle, selling milk, raising poultry, and selling poultry and eggs. It has been\nhis practice to raise a small acreage of winter wheat, sown in the Fall and harvested in the following July;\nto sell a portion of the crop; to feed part to poultry and livestock on the farm, some of which is sold; to use\nsome in making flour for home consumption; and to keep the rest for the following seeding.\n\nHis 1941 wheat acreage allotment was 11.1 acres and a normal yield of 20.1 bushels of wheat an acre. He\nsowed, however, 23 acres, and harvested from his 11.9 acres of excess acreage 239 bushels, which under\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n192\n\n\x0cthe terms of the Act as amended on May 26, 1941, constituted farm marketing excess, subject to a penalty\nof 49 cents a bushel, or $117.11 in all.\n\nThe general scheme of the Agricultural Adjustment Act of 1938 as related to wheat is to control the\nvolume moving in interstate and foreign commerce in order to avoid surpluses and shortages and the\nconsequent abnormally low or high wheat prices and obstructions to commerce. [T]he Secretary of\nAgriculture is directed to ascertain and proclaim each year a national acreage allotment for the next crop\nof wheat, which is then apportioned to the states and their counties, and is eventually broken up into\nallotments for individual farms.\n\nIt is urged that under the Commerce Clause of the Constitution, Article I, \xc2\xa7 8, clause 3, Congress does not\npossess the power it has in this instance sought to exercise. The question would merit little consideration\nsince our decision in United States v. Darby, 312 U.S. 100, sustaining the federal power to regulate\nproduction of goods for commerce, except for the fact that this Act extends federal regulation to\nproduction not intended in any part for commerce but wholly for consumption on the farm.\n\nKassel v. Consolidated Freightways Corp.\nKassel v. Consolidated Freightways Corp.\n450 U.S. 662 (U.S. Supreme Court 1981)\n\nJUSTICE POWELL announced the judgment of the Court and delivered an opinion, in which JUSTICE\nWHITE, JUSTICE BLACKMUN, and JUSTICE STEVENS joined.\nThe question is whether an Iowa statute that prohibits the use of certain large trucks within the State\nunconstitutionally burdens interstate commerce.\n\nI\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n193\n\n\x0cAppellee Consolidated Freightways Corporation of Delaware (Consolidated) is one of the largest common\ncarriers in the country: it offers service in 48 States under a certificate of public convenience and necessity\nissued by the Interstate Commerce Commission. Among other routes, Consolidated carries commodities\nthrough Iowa on Interstate 80, the principal east-west route linking New York, Chicago, and the west\ncoast, and on Interstate 35, a major north-south route.\n\nConsolidated mainly uses two kinds of trucks. One consists of a three-axle tractor pulling a 40-foot twoaxle trailer. This unit, commonly called a single, or \xe2\x80\x9csemi,\xe2\x80\x9d is 55 feet in length overall. Such trucks have\nlong been used on the Nation\xe2\x80\x99s highways. Consolidated also uses a two-axle tractor pulling a single-axle\ntrailer which, in turn, pulls a single-axle dolly and a second single-axle trailer. This combination, known\nas a double, or twin, is 65 feet long overall. Many trucking companies, including Consolidated,\nincreasingly prefer to use doubles to ship certain kinds of commodities. Doubles have larger capacities,\nand the trailers can be detached and routed separately if necessary. Consolidated would like to use 65-foot\ndoubles on many of its trips through Iowa.\nThe State of Iowa, however, by statute, restricts the length of vehicles that may use its highways. Unlike all\nother States in the West and Midwest, Iowa generally prohibits the use of 65-foot doubles within its\nborders.\n\xe2\x80\xa6\nBecause of Iowa\xe2\x80\x99s statutory scheme, Consolidated cannot use its 65-foot doubles to move commodities\nthrough the State. Instead, the company must do one of four things: (i) use 55-foot singles; (ii) use 60-foot\ndoubles; (iii) detach the trailers of a 65-foot double and shuttle each through the State separately; or (iv)\ndivert 65-foot doubles around Iowa. Dissatisfied with these options, Consolidated filed this suit in the\nDistrict Court averring that Iowa\xe2\x80\x99s statutory scheme unconstitutionally burdens interstate commerce.\nIowa defended the law as a reasonable safety measure enacted pursuant to its police power. The State\nasserted that 65-foot doubles are more dangerous than 55-foot singles and, in any event, that the law\npromotes safety and reduces road wear within the State by diverting much truck traffic to other states.\n\nIn a 14-day trial, both sides adduced evidence on safety and on the burden on interstate commerce\nimposed by Iowa\xe2\x80\x99s law. On the question of safety, the District Court found that the \xe2\x80\x9cevidence clearly\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n194\n\n\x0cestablishes that the twin is as safe as the semi.\xe2\x80\x9d 475 F.Supp. 544, 549 (SD Iowa 1979). For that reason,\n\xe2\x80\x9cthere is no valid safety reason for barring twins from Iowa\xe2\x80\x99s highways because of their\nconfiguration.\xe2\x80\xa6The evidence convincingly, if not overwhelmingly, establishes that the 65-foot twin is as\nsafe as, if not safer than, the 60-foot twin and the 55-foot semi.\xe2\x80\xa6\xe2\x80\x9d\n\n\xe2\x80\x9cTwins and semis have different characteristics. Twins are more maneuverable, are less sensitive to wind,\nand create less splash and spray. However, they are more likely than semis to jackknife or upset. They can\nbe backed only for a short distance. The negative characteristics are not such that they render the twin less\nsafe than semis overall. Semis are more stable, but are more likely to \xe2\x80\x98rear-end\xe2\x80\x99 another vehicle.\xe2\x80\x9d\n\nIn light of these findings, the District Court applied the standard we enunciated in Raymond Motor\nTransportation, Inc. v. Rice, 434 U.S. 429 (1978), and concluded that the state law impermissibly\nburdened interstate commerce: \xe2\x80\x9c[T]he balance here must be struck in favor of the federal interests.\nThe total effect of the law as a safety measure in reducing accidents and casualties is so slight and\nproblematical that it does not outweigh the national interest in keeping interstate commerce free from\ninterferences that seriously impede it.\xe2\x80\x9d\n\nThe Court of Appeals for the Eighth Circuit affirmed. 612 F.2d 1064 (1979). It accepted the District Court\xe2\x80\x99s\nfinding that 65-foot doubles were as safe as 55-foot singles. Id. at 1069. Thus, the only apparent safety\nbenefit to Iowa was that resulting from forcing large trucks to detour around the State, thereby reducing\noverall truck traffic on Iowa\xe2\x80\x99s highways. The Court of Appeals noted that this was not a constitutionally\npermissible interest. It also commented that the several statutory exemptions identified above, such as\nthose applicable to border cities and the shipment of livestock, suggested that the law, in effect, benefited\nIowa residents at the expense of interstate traffic.Id. at 1070-1071. The combination of these exemptions\nweakened the 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 burdened\ninterstate commerce.\n\nIowa appealed, and we noted probable jurisdiction. 446 U.S. 950 (1980). We now affirm.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n195\n\n\x0cII\nIt is unnecessary to review in detail the evolution of the principles of Commerce Clause adjudication. The\nClause is both a \xe2\x80\x9cprolific \xe2\x80\x98 of national power and an equally prolific source of conflict with legislation of the\nstate[s].\xe2\x80\x9d H. P. Hood & Sons, Inc. v. Du Mond, 336 U.S. 525, 336 U.S. 534 (1949). The Clause permits\nCongress to legislate when it perceives that the national welfare is not furthered by the independent\nactions of the States. It is now well established, also, that the Clause itself is \xe2\x80\x9ca limitation upon state power\neven without congressional implementation.\xe2\x80\x9d Hunt v. Washington Apple Advertising Comm\xe2\x80\x99n, 432 U.S.\n333 at 350 (1977). The Clause requires that some aspects of trade generally must remain free from\ninterference by the States. When a State ventures excessively into the regulation of these aspects of\ncommerce, it \xe2\x80\x9ctrespasses upon national interests,\xe2\x80\x9d Great A&P Tea Co. v. Cottrell, 424 U.S. 366, 424 U.S.\n373 (1976), and the courts will hold the state regulation invalid under the Clause alone.\n\nThe Commerce Clause does not, of course, invalidate all state restrictions on commerce. It has long been\nrecognized that, \xe2\x80\x9cin the absence of conflicting legislation by Congress, there is a residuum of power in the\nstate to make laws governing matters of local concern which nevertheless in some measure affect\ninterstate commerce or even, to some extent, regulate it.\xe2\x80\x9d Southern Pacific Co. v. Arizona, 325 U.S. 761\n(1945).\n\nThe extent of permissible state regulation is not always easy to measure. It may be said with confidence,\nhowever, that a State\xe2\x80\x99s power to regulate commerce is never greater than in matters traditionally of local\nconcern. Washington Apple Advertising Comm\xe2\x80\x99n, supra at 432 U.S. 350. For example, regulations that\ntouch upon safety\xe2\x80\x94especially highway safety\xe2\x80\x94are those that \xe2\x80\x9cthe Court has been most reluctant to\ninvalidate.\xe2\x80\x9d Raymond, supra at 434 U.S. 443 (and other cases cited). Indeed, \xe2\x80\x9cif safety justifications are\nnot illusory, the Court will not second-guess legislative judgment about their importance in comparison\nwith related burdens on interstate commerce.\xe2\x80\x9d Raymond, supra at 434 U.S. at 449. Those who would\nchallenge such bona fide safety regulations must overcome a \xe2\x80\x9cstrong presumption of validity.\xe2\x80\x9dBibb v.\nNavajo Freight Lines, Inc., 359 U.S. 520 at (1959).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n196\n\n\x0cBut the incantation of a purpose to promote the public health or safety does not insulate a state law from\nCommerce Clause attack. Regulations designed for that salutary purpose nevertheless may further the\npurpose so marginally, and interfere with commerce so substantially, as to be invalid under the\nCommerce Clause. In the Court\xe2\x80\x99s recent unanimous decision in Raymond we declined to \xe2\x80\x9caccept the\nState\xe2\x80\x99s contention that the inquiry under the Commerce Clause is ended without a weighing of the\nasserted safety purpose against the degree of interference with interstate commerce.\xe2\x80\x9d This \xe2\x80\x9cweighing\xe2\x80\x9d by a\ncourt requires\xe2\x80\x94and indeed the constitutionality of the state regulation depends on\xe2\x80\x94\xe2\x80\x9ca sensitive\nconsideration of the weight and nature of the state regulatory concern in light of the extent of the burden\nimposed on the course of interstate commerce.\xe2\x80\x9d Id. at 434 U.S. at 441; accord, Pike v. Bruce Church, Inc.,\n397 U.S. 137 at 142 (1970); Bibb, supra, at 359 U.S. at 525-530.\n\nIII\nApplying these general principles, we conclude that the Iowa truck length limitations unconstitutionally\nburden interstate commerce.\n\nIn Raymond Motor Transportation, Inc. v. Rice, the Court held that a Wisconsin statute that precluded\nthe use of 65-foot doubles violated the Commerce Clause. This case is Raymond revisited. Here, as\ninRaymond, the State failed to present any persuasive evidence that 65-foot doubles are less safe than 55foot singles. Moreover, Iowa\xe2\x80\x99s law is now out of step with the laws of all other Midwestern and Western\nStates. Iowa thus substantially burdens the interstate flow of goods by truck. In the absence of\ncongressional action to set uniform standards, some burdens associated with state safety regulations must\nbe tolerated. But where, as here, the State\xe2\x80\x99s safety interest has been found to be illusory, and its\nregulations impair significantly the federal interest in efficient and safe interstate transportation, the state\nlaw cannot be harmonized with the Commerce Clause.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n197\n\n\x0cA\nIowa made a more serious effort to support the safety rationale of its law than did Wisconsin in Raymond,\nbut its effort was no more persuasive. As noted above, the District Court found that the \xe2\x80\x9cevidence clearly\nestablishes that the twin is as safe as the semi.\xe2\x80\x9d The record supports this finding. The trial focused on a\ncomparison of the performance of the two kinds of trucks in various safety categories. The evidence\nshowed, and the District Court found, that the 65-foot double was at least the equal of the 55-foot single in\nthe ability to brake, turn, and maneuver. The double, because of its axle placement, produces less splash\nand spray in wet weather. And, because of its articulation in the middle, the double is less susceptible to\ndangerous \xe2\x80\x9coff-tracking,\xe2\x80\x9d and to wind.\n\nNone of these findings is seriously disputed by Iowa. Indeed, the State points to only three ways in which\nthe 55-foot single is even arguably superior: singles take less time to be passed and to clear intersections;\nthey may back up for longer distances; and they are somewhat less likely to jackknife.\n\nThe first two of these characteristics are of limited relevance on modern interstate highways. As the\nDistrict Court found, the negligible difference in the time required to pass, and to cross intersections, is\ninsignificant on 4-lane divided highways, because passing does not require crossing into oncoming traffic\nlanes, Raymond, 434 U.S. at 444, and interstates have few, if any, intersections. The concern over backing\ncapability also is insignificant, because it seldom is necessary to back up on an interstate. In any event, no\nevidence suggested any difference in backing capability between the 60-foot doubles that Iowa permits\nand the 65-foot doubles that it bans. Similarly, although doubles tend to jackknife somewhat more than\nsingles, 65-foot doubles actually are less likely to jackknife than 60-foot doubles.\n\nStatistical studies supported the view that 65-foot doubles are at least as safe overall as 55-foot singles and\n60-foot doubles. One such study, which the District Court credited, reviewed Consolidated\xe2\x80\x99s comparative\naccident experience in 1978 with its own singles and doubles. Each kind of truck was driven 56 million\nmiles on identical routes. The singles were involved in 100 accidents resulting in 27 injuries and one\nfatality. The 65-foot doubles were involved in 106 accidents resulting in 17 injuries and one fatality. Iowa\xe2\x80\x99s\nexpert statistician admitted that this study provided \xe2\x80\x9cmoderately strong evidence\xe2\x80\x9d that singles have a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n198\n\n\x0chigher injury rate than doubles. Another study, prepared by the Iowa Department of Transportation at the\nrequest of the state legislature, concluded that \xe2\x80\x9c[s]ixty-five foot twin trailer combinations have notbeen\nshown by experiences in other states to be less safe than 60-foot twin trailer\ncombinations or conventional tractor-semitrailers.\xe2\x80\x9d\n\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 commerce.\nTrucking companies that wish to continue to use 65-foot doubles must route them around Iowa or detach\nthe trailers of the doubles and ship them through separately. Alternatively, trucking companies must use\nthe smaller 55-foot singles or 65-foot doubles permitted under Iowa law. Each of these options engenders\ninefficiency and added expense. The record shows that Iowa\xe2\x80\x99s law added about $12.6 million each year to\nthe costs of trucking companies.\n\nConsolidated alone incurred about $2 million per year in increased costs.\n\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 accidents. Fiftyfive-foot singles carry less freight than 65-foot doubles. Either more small trucks must be used to carry the\nsame quantity of goods through Iowa or the same number of larger trucks must drive longer distances to\nbypass Iowa. In either case, as the District Court noted, the restriction requires more highway miles to be\ndriven to transport the same quantity of goods. Other things being equal, accidents are proportional to\ndistance traveled. Thus, if 65-foot doubles are as safe as 55-foot singles, Iowa\xe2\x80\x99s law tends to increase the\nnumber of accidents and to shift the incidence of them from Iowa to other States.\n\n[IV. Omitted]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n199\n\n\x0cV\nIn sum, the statutory exemptions, their history, and the arguments Iowa has advanced in support of its\nlaw in this litigation all suggest that the deference traditionally accorded a State\xe2\x80\x99s safety judgment is not\nwarranted. See Raymond, supra at 434 U.S. at 444-447. The controlling factors thus are the findings of\nthe District Court, accepted by the Court of Appeals, with respect to the relative safety of the types of\ntrucks at issue, and the substantiality of the burden on interstate commerce.\nBecause Iowa has imposed this burden without any significant countervailing safety interest, its statute\nviolates the Commerce Clause. The judgment of the Court of Appeals is affirmed.\nIt is so ordered.\n\nC A SE QU ES TIO NS\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\ntruck size or weight that could be limited by Iowa law, or must Iowa simply accept\nfederal standards or, if none, impose no standards at all?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n200\n\n\x0cHunt v. Washington Apple Advertising Commission\nHunt v. Washington Apple Advertising Commission\n432 U.S. 33 (U.S. Supreme Court 1977)\n\nMR. CHIEF JUSTICE BURGER delivered the opinion of the Court.\n\nIn 1973, North Carolina enacted a statute which required, inter alia, all closed containers of apples sold,\noffered for sale, or shipped into the State to bear \xe2\x80\x9cno grade other than the applicable U.S. grade or\nstandard.\xe2\x80\x9d\xe2\x80\xa6Washington State is the Nation\xe2\x80\x99s largest producer of apples, its crops accounting for\napproximately 30% of all apples grown domestically and nearly half of all apples shipped in closed\ncontainers in interstate commerce. [Because] of the importance of the apple industry to the State, its\nlegislature has undertaken to protect and enhance the reputation of Washington apples by establishing a\nstringent, mandatory inspection program [that] requires all apples shipped in interstate commerce to be\ntested under strict quality standards and graded accordingly. In all cases, the Washington State grades\n[are] the equivalent of, or superior to, the comparable grades and standards adopted by the [U.S. Dept. of]\nAgriculture (USDA).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n201\n\n\x0c[In] 1972, the North Carolina Board of Agriculture adopted an administrative regulation, unique in the 50\nStates, which in effect required all closed containers of apples shipped into or sold in the State to display\neither the applicable USDA grade or a notice indicating no classification. State grades were expressly\nprohibited. In addition to its obvious consequence\xe2\x80\x94prohibiting the display of Washington State apple\ngrades on containers of apples shipped into North Carolina\xe2\x80\x94the regulation presented the Washington\napple industry with a marketing problem of potentially nationwide significance. Washington apple\ngrowers annually ship in commerce approximately 40 million closed containers of apples, nearly 500,000\nof which eventually find their way into North Carolina, stamped with the applicable Washington State\nvariety and grade. [Compliance] with North Carolina\xe2\x80\x99s unique regulation would have required\nWashington growers to obliterate the printed labels on containers shipped to North Carolina, thus giving\ntheir product a damaged appearance. Alternatively, they could have changed their marketing practices to\naccommodate the needs of the North Carolina market, i.e., repack apples to be shipped to North Carolina\nin containers bearing only the USDA grade, and/or store the estimated portion of the harvest destined for\nthat market in such special containers. As a last resort, they could discontinue the use of the preprinted\ncontainers entirely. None of these costly and less efficient options was very attractive to the industry.\nMoreover, in the event a number of other States followed North Carolina\xe2\x80\x99s lead, the resultant inability to\ndisplay the Washington grades could force the Washington growers to abandon the State\xe2\x80\x99s expensive\ninspection and grading system which their customers had come to know and rely on over the 60-odd\nyears of its existence.\xe2\x80\xa6\n\nUnsuccessful in its attempts to secure administrative relief [with North Carolina], the Commission\ninstituted this action challenging the constitutionality of the statute. [The] District Court found that the\nNorth Carolina statute, while neutral on its face, actually discriminated against Washington State growers\nand dealers in favor of their local counterparts [and] concluded that this discrimination [was] not justified\nby the asserted local interest\xe2\x80\x94the elimination of deception and confusion from the marketplace\xe2\x80\x94arguably\nfurthered by the [statute].\n\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n202\n\n\x0c[North Carolina] maintains that [the] burdens on the interstate sale of Washington apples were far\noutweighed by the local benefits flowing from what they contend was a valid exercise of North Carolina\xe2\x80\x99s\n[police powers]. Prior to the statute\xe2\x80\x99s enactment,\xe2\x80\xa6apples from 13 different States were shipped into North\nCarolina for sale. Seven of those States, including [Washington], had their own grading systems which,\nwhile differing in their standards, used similar descriptive labels (e.g., fancy, extra fancy, etc.). This\nmultiplicity of inconsistent state grades [posed] dangers of deception and confusion not only in the North\nCarolina market, but in the Nation as a whole. The North Carolina statute, appellants claim, was enacted\nto eliminate this source of deception and confusion. [Moreover], it is contended that North Carolina\nsought to accomplish this goal of uniformity in an evenhanded manner as evidenced by the fact that its\nstatute applies to all apples sold in closed containers in the State without regard to their point of origin.\n\n[As] the appellants properly point out, not every exercise of state authority imposing some burden on the\nfree flow of commerce is invalid, [especially] when the State acts to protect its citizenry in matters\npertaining to the sale of foodstuffs. By the same token, however, a finding that state legislation furthers\nmatters of legitimate local concern, even in the health and consumer protection areas, does not end the\ninquiry. Rather, when such state legislation comes into conflict with the Commerce Clause\xe2\x80\x99s overriding\nrequirement of a national \xe2\x80\x9ccommon market,\xe2\x80\x9d we are confronted with the task of effecting an\naccommodation of the competing national and local interests. We turn to that task.\n\nAs the District Court correctly found, the challenged statute has the practical effect of not only burdening\ninterstate sales of Washington apples, but also discriminating against them. This discrimination takes\nvarious forms. The first, and most obvious, is the statute\xe2\x80\x99s consequence of raising the costs of doing\nbusiness in the North Carolina market for Washington apple growers and dealers, while leaving those of\ntheir North Carolina counterparts unaffected. [This] disparate effect results from the fact that North\nCarolina apple producers, unlike their Washington competitors, were not forced to alter their marketing\npractices in order to comply with the statute. They were still free to market their wares under the USDA\ngrade or none at all as they had done prior to the statute\xe2\x80\x99s enactment. Obviously, the increased costs\nimposed by the statute would tend to shield the local apple industry from the competition of Washington\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n203\n\n\x0capple growers and dealers who are already at a competitive disadvantage because of their great distance\nfrom the North Carolina market.\n\nSecond, the statute has the effect of stripping away from the Washington apple industry the competitive\nand economic advantages it has earned for itself through its expensive inspection and grading system. The\nrecord demonstrates that the Washington apple-grading system has gained nationwide acceptance in the\napple trade. [The record] contains numerous affidavits [stating a] preference [for] apples graded under\nthe Washington, as opposed to the USDA, system because of the former\xe2\x80\x99s greater consistency, its\nemphasis on color, and its supporting mandatory inspections. Once again, the statute had no similar\nimpact on the North Carolina apple industry and thus operated to its benefit.\n\nThird, by prohibiting Washington growers and dealers from marketing apples under their State\xe2\x80\x99s grades,\nthe statute has a leveling effectwhich insidiously operates to the advantage of local apple producers.\n[With] free market forces at work, Washington sellers would normally enjoy a distinct market advantage\nvis-\xc3\xa0-vis local producers in those categories where the Washington grade is superior. However, because of\nthe statute\xe2\x80\x99s operation, Washington apples which would otherwise qualify for and be sold under the\nsuperior Washington grades will now have to be marketed under their inferior USDA counterparts. Such\n\xe2\x80\x9cdowngrading\xe2\x80\x9d offers the North Carolina apple industry the very sort of protection against competing outof-state products that the Commerce Clause was designed to prohibit. At worst, it will have the effect of an\nembargo against those Washington apples in the superior grades as Washington dealers withhold them\nfrom the North Carolina market. At best, it will deprive Washington sellers of the market premium that\nsuch apples would otherwise command.\n\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 record to\nthat effect. The most glaring is the response of the North Carolina Agriculture Commissioner to the\nCommission\xe2\x80\x99s request for an exemption following the statute\xe2\x80\x99s passage in which he indicated that before\nhe could support such an exemption, he would \xe2\x80\x9cwant to have the sentiment from our apple\nproducers since they were mainly responsible for this legislation being passed.\xe2\x80\x9d [Moreover], we find it\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n204\n\n\x0csomewhat suspect that North Carolina singled out only closed containers of apples, the very means by\nwhich apples are transported in commerce, to effectuate the statute\xe2\x80\x99s ostensible consumer protection\npurpose when apples are not generally sold at retail in their shipping containers. However, we need not\nascribe an economic protection motive to the North Carolina Legislature to resolve this case; we conclude\nthat the challenged statute cannot stand insofar as it prohibits the display of Washington State grades\neven if enacted 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 grades was not\nof the type that led to the statute\xe2\x80\x99s enactment. Since Washington grades are in all cases equal or superior\nto their USDA counterparts, they could only \xe2\x80\x9cdeceive\xe2\x80\x9d or \xe2\x80\x9cconfuse\xe2\x80\x9d a consumer to his benefit, hardly a\nharmful result.\n\nIn addition, it appears that nondiscriminatory alternatives to the outright ban of Washington State grades\nare readily available. For example, North Carolina could effectuate its goal by permitting out-of-state\ngrowers to utilize state grades only if they also marked their shipments with the applicable USDA label. In\nthat case, the USDA grade would serve as a benchmark against which the consumer could evaluate the\nquality of the various state grades.\xe2\x80\xa6\n\n[The court affirmed the lower court\xe2\x80\x99s holding that the North Carolina statute was unconstitutional.]\n\nC A SE QU ES TIO NS\n1. Was the North Carolina law discriminatory on its face? Was it, possibly, an undue\nburden on interstate commerce? Why wouldn\xe2\x80\x99t it be?\n2. What evidence was there of discriminatory intent behind the North Carolina law?\nDid that evidence even matter? Why or why not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n205\n\n\x0cCitizens United v. Federal Election Commission\nCitizens United v. Federal Election Commission\n\n588 U.S. ____; 130 S.Ct. 876 (U.S. Supreme Court 2010)\n\nJustice Kennedy delivered the opinion of the Court.\n\nFederal 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 speech\nexpressly advocating the election or defeat of a candidate. 2 U.S.C. \xc2\xa7441b. Limits on electioneering\ncommunications were upheld in McConnell v. Federal Election Comm\xe2\x80\x99n, 540 U.S. 93, 203\xe2\x80\x93209 (2003).\nThe holding of McConnell rested to a large extent on an earlier case, Austin v. Michigan Chamber of\nCommerce, 494 U.S. 652 (1990). Austin had held that political speech may be banned based on the\nspeaker\xe2\x80\x99s corporate identity.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n206\n\n\x0cIn 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 Comm\xe2\x80\x99n\nv. Wisconsin Right to Life, Inc., 551 U.S. 449, 490 (2007) (WRTL) (Scalia, J., concurring in part and\nconcurring in judgment). We agree with that conclusion and hold that stare decisis does not compel the\ncontinued acceptance of Austin. The Government may regulate corporate political speech through\ndisclaimer and disclosure requirements, but it may not suppress that speech altogether. We turn to the\ncase now before us.\n\nI\nA\nCitizens United is a nonprofit corporation. It has an annual budget of about $12 million. Most of its funds\nare from donations by individuals; but, in addition, it accepts a small portion of its funds from for-profit\ncorporations.\nIn January 2008, Citizens United released a film entitled Hillary: The Movie. We refer to the film\nas Hillary. It is a 90-minute documentary about then-Senator Hillary Clinton, who was a candidate in the\nDemocratic Party\xe2\x80\x99s 2008 Presidential primary elections. Hillarymentions Senator Clinton by name and\ndepicts interviews with political commentators and other persons, most of them quite critical of Senator\nClinton.\xe2\x80\xa6\n\nIn December 2007, a cable company offered, for a payment of $1.2 million, to make Hillary available on a\nvideo-on-demand channel called \xe2\x80\x9cElections \xe2\x80\x9908.\xe2\x80\x9d\xe2\x80\xa6Citizens United was prepared to pay for the video-ondemand; and to promote the film, it produced two 10-second ads and one 30-second ad for Hillary. Each\nad includes a short (and, in our view, pejorative) statement about Senator Clinton, followed by the name\nof the movie and the movie\xe2\x80\x99s Website address. Citizens United desired to promote the video-on-demand\noffering by running advertisements on broadcast and cable television.\n\nB\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n207\n\n\x0cBefore the Bipartisan Campaign Reform Act of 2002 (BCRA), federal law prohibited\xe2\x80\x94and still does\nprohibit\xe2\x80\x94corporations and unions from using general treasury funds to make direct contributions to\ncandidates or independent expenditures that expressly advocate the election or defeat of a candidate,\nthrough any form of media, in connection with certain qualified federal elections.\xe2\x80\xa6BCRA \xc2\xa7203 amended\n\xc2\xa7441b to prohibit any \xe2\x80\x9celectioneering communication\xe2\x80\x9d as well. An electioneering communication is\ndefined as \xe2\x80\x9cany broadcast, cable, or satellite communication\xe2\x80\x9d that \xe2\x80\x9crefers to a clearly identified candidate\nfor Federal office\xe2\x80\x9d and is made within 30 days of a primary or 60 days of a general election. \xc2\xa7434(f)(3)(A).\nThe Federal Election Commission\xe2\x80\x99s (FEC) regulations further define an electioneering communication as\na communication that is \xe2\x80\x9cpublicly distributed.\xe2\x80\x9d 11 CFR \xc2\xa7100.29(a)(2) (2009). \xe2\x80\x9cIn the case of a candidate\nfor nomination for President\xe2\x80\xa6publicly distributed means\xe2\x80\x9d that the communication \xe2\x80\x9c[c]an be received by\n50,000 or more persons in a State where a primary election\xe2\x80\xa6is being held within 30 days.\xe2\x80\x9d 11 CFR\n\xc2\xa7100.29(b)(3)(ii). Corporations and unions are barred from using their general treasury funds for express\nadvocacy or electioneering communications. They may establish, however, a \xe2\x80\x9cseparate segregated fund\xe2\x80\x9d\n(known as a political action committee, or PAC) for these purposes. 2 U.S.C. \xc2\xa7441b(b)(2). The moneys\nreceived by the segregated fund are limited to donations from stockholders and employees of the\ncorporation or, in the case of unions, members of the union. Ibid.\n\nC\nCitizens United wanted to make Hillary available through video-on-demand within 30 days of the 2008\nprimary elections. It feared, however, that both the film and the ads would be covered by \xc2\xa7441b\xe2\x80\x99s ban on\ncorporate-funded independent expenditures, thus subjecting the corporation to civil and criminal\npenalties under \xc2\xa7437g. In December 2007, Citizens United sought declaratory and injunctive relief against\nthe FEC. It argued that (1) \xc2\xa7441b is unconstitutional as applied to Hillary; and (2) BCRA\xe2\x80\x99s disclaimer and\ndisclosure requirements, BCRA \xc2\xa7\xc2\xa7201 and 311, are unconstitutional as applied toHillary and to the three\nads for the movie.\n\nThe District Court denied Citizens United\xe2\x80\x99s motion for a preliminary injunction, and then granted the\nFEC\xe2\x80\x99s motion for summary judgment.\n\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n208\n\n\x0cThe court held that \xc2\xa7441b was facially constitutional under McConnell, and that \xc2\xa7441b was constitutional\nas applied to Hillary because it was \xe2\x80\x9csusceptible of no other interpretation than to inform the electorate\nthat Senator Clinton is unfit for office, that the United States would be a dangerous place in a President\nHillary Clinton world, and that viewers should vote against her.\xe2\x80\x9d 530 F. Supp. 2d, at 279. The court also\nrejected Citizens United\xe2\x80\x99s challenge to BCRA\xe2\x80\x99s disclaimer and disclosure requirements. It noted that \xe2\x80\x9cthe\nSupreme Court has written approvingly of disclosure provisions triggered by political speech even though\nthe speech itself was constitutionally 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 does not\ninvolve constitutional issues.]\n\nIII\nThe First Amendment provides that \xe2\x80\x9cCongress shall make no law\xe2\x80\xa6abridging the freedom of speech.\xe2\x80\x9d\nLaws enacted to control or suppress speech may operate at different points in the speech process.\xe2\x80\xa6The\nlaw before us is an outright ban, backed by criminal sanctions. Section 441b makes it a felony for all\ncorporations\xe2\x80\x94including nonprofit advocacy corporations\xe2\x80\x94either to expressly advocate the election or\ndefeat of candidates or to broadcast electioneering communications within 30 days of a primary election\nand 60 days of a general election. Thus, the following acts would all be felonies under \xc2\xa7441b: The Sierra\nClub runs an ad, within the crucial phase of 60 days before the general election, that exhorts the public to\ndisapprove of a Congressman who favors logging in national forests; the National Rifle Association\npublishes a book urging the public to vote for the challenger because the incumbent U.S. Senator supports\na handgun ban; and the American Civil Liberties Union creates a Web site telling the public to vote for a\nPresidential candidate in light of that candidate\xe2\x80\x99s defense of free speech. These prohibitions are classic\nexamples of censorship.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n209\n\n\x0cSection 441b is a ban on corporate speech notwithstanding the fact that a PAC created by a corporation\ncan still speak. PACs are burdensome alternatives; they are expensive to administer and subject to\nextensive regulations. For example, every PAC must appoint a treasurer, forward donations to the\ntreasurer promptly, keep detailed records of the identities of the persons making donations, preserve\nreceipts for three years, and file an organization statement and report changes to this information within\n10 days.\n\nAnd that is just the beginning. PACs must file detailed monthly reports with the FEC, which are due at\ndifferent times depending on the type of election that is about to occur.\xe2\x80\xa6\n\nPACs have to comply with these regulations just to speak. This might explain why fewer than 2,000 of the\nmillions of corporations in this country have PACs. PACs, furthermore, must exist before they can speak.\nGiven the onerous restrictions, a corporation may not be able to establish a PAC in time to make its views\nknown 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 during a\ncampaign,\xe2\x80\x9d that statute \xe2\x80\x9cnecessarily reduces the quantity of expression by restricting the number of issues\ndiscussed, the depth of their exploration, and the size of the audience reached.\xe2\x80\x9d Buckley v. Valeo, 424 U.S.\n1 at 19 (1976).\xe2\x80\xa6\n\nSpeech is an essential mechanism of democracy, for it is the means to hold officials accountable to the\npeople. See Buckley, supra, at 14\xe2\x80\x9315 (\xe2\x80\x9cIn a republic where the people are sovereign, the ability of the\ncitizenry to make informed choices among candidates for office is essential.\xe2\x80\x9d) The right of citizens to\ninquire, to hear, to speak, and to use information to reach consensus is a precondition to enlightened selfgovernment and a necessary means to protect it. The First Amendment \xe2\x80\x9c\xe2\x80\x98has its fullest and most urgent\napplication\xe2\x80\x99 to speech uttered during a campaign for political office.\xe2\x80\x9d\n\nFor these reasons, political speech must prevail against laws that would suppress it, whether by design or\ninadvertence. Laws that burden political speech are \xe2\x80\x9csubject to strict scrutiny,\xe2\x80\x9d which requires the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n210\n\n\x0cGovernment to prove that the restriction \xe2\x80\x9cfurthers a compelling interest and is narrowly tailored to\nachieve that interest.\xe2\x80\x9d\n\xe2\x80\xa6\nThe Court has recognized that First Amendment protection extends to corporations. This protection has\nbeen extended by explicit holdings to the context of political speech. Under the rationale of these\nprecedents, political speech does not lose First Amendment protection \xe2\x80\x9csimply because its source is a\ncorporation.\xe2\x80\x9d Bellotti, supra, at 784. The Court has thus rejected the argument that political speech of\ncorporations or other associations should be treated differently under the First Amendment simply\nbecause such associations are not \xe2\x80\x9cnatural persons.\xe2\x80\x9d\n\nThe purpose and effect of this law is to prevent corporations, including small and nonprofit corporations,\nfrom presenting both facts and opinions to the public. This makes Austin\xe2\x80\x99s antidistortion rationale all the\nmore an aberration. \xe2\x80\x9c[T]he First Amendment protects the right of corporations to petition legislative and\nadministrative 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 elected\nofficials, although smaller corporations may not have the resources to do so. And wealthy individuals and\nunincorporated associations can spend unlimited amounts on independent expenditures. See, e.g., WRTL,\n551 U.S., at 503\xe2\x80\x93504 (opinion of Scalia, J.) (\xe2\x80\x9cIn the 2004 election cycle, a mere 24 individuals contributed\nan astounding total of $142 million to [26 U.S.C. \xc2\xa7527 organizations]\xe2\x80\x9d). Yet certain disfavored\nassociations of citizens\xe2\x80\x94those that have taken on the corporate form\xe2\x80\x94are penalized for engaging in the\nsame political speech.\n\nWhen Government seeks to use its full power, including the criminal law, to command where a person\nmay get his or her information or what distrusted source he or she may not hear, it uses censorship to\ncontrol thought. This is unlawful. The First Amendment confirms the freedom to think for ourselves.\n\nWhat we have said also shows the invalidity of other arguments made by the Government. For the most\npart relinquishing the anti-distortion rationale, the Government falls back on the argument that corporate\npolitical speech can be banned in order to prevent corruption or its appearance.\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n211\n\n\x0cWhen Congress finds that a problem exists, we must give that finding due deference; but Congress may\nnot choose an unconstitutional remedy. If elected officials succumb to improper influences from\nindependent expenditures; if they surrender their best judgment; and if they put expediency before\nprinciple, then surely there is cause for concern. We must give weight to attempts by Congress to seek to\ndispel either the appearance or the reality of these influences. The remedies enacted by law, however,\nmust comply with the First Amendment; and, it is our law and our tradition that more speech, not less, is\nthe governing rule. An outright ban on corporate political speech during the critical preelection period is\nnot a permissible remedy. Here Congress has created categorical bans on speech that are asymmetrical to\npreventing quid pro quo corruption.\n\nOur precedent is to be respected unless the most convincing of reasons demonstrates that adherence to it\nputs us on a course that is sure error. \xe2\x80\x9cBeyond workability, the relevant factors in deciding whether to\nadhere to the principle of stare decisis include the antiquity of the precedent, the reliance interests at\nstake, and of course whether the decision was well reasoned.\xe2\x80\x9d [citing prior cases]\n\nThese considerations counsel in favor of rejecting Austin, which itself contravened this Court\xe2\x80\x99s earlier\nprecedents in Buckley and Bellotti. \xe2\x80\x9cThis Court has not hesitated to overrule decisions offensive to the\nFirst Amendment.\xe2\x80\x9d WRTL, 551 U.S., at 500 (opinion of Scalia, J.). \xe2\x80\x9c[S]tare decisis is a principle of policy\nand not a mechanical formula of adherence to the latest decision.\xe2\x80\x9d Helvering v. Hallock, 309 U.S. 106 at\n119 (1940).\n\nAustin is undermined by experience since its announcement. Political speech is so ingrained in our\nculture that speakers find ways to circumvent campaign finance laws. See, e.g., McConnell, 540 U.S., at\n176\xe2\x80\x93177 (\xe2\x80\x9cGiven BCRA\xe2\x80\x99s tighter restrictions on the raising and spending of soft money, the incentives\xe2\x80\xa6to\nexploit [26 U.S.C. \xc2\xa7527] organizations will only increase\xe2\x80\x9d). Our Nation\xe2\x80\x99s speech dynamic is changing, and\ninformative voices should not have to circumvent onerous restrictions to exercise their First Amendment\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n212\n\n\x0crights. Speakers have become adept at presenting citizens with sound bites, talking points, and scripted\nmessages that dominate the 24-hour news cycle. Corporations, like individuals, do not have monolithic\nviews. On certain topics corporations may possess valuable expertise, leaving them the best equipped to\npoint out errors 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 expression\xe2\x80\x94\ncounsel against upholding a law that restricts political speech in certain media or by certain speakers.\nToday, 30-second television ads may be the most effective way to convey a political message. Soon,\nhowever, it may be that Internet sources, such as blogs and social networking Web sites, will provide\ncitizens with significant information about political candidates and issues. Yet, \xc2\xa7441b would seem to ban a\nblog post expressly advocating the election or defeat of a candidate if that blog were created with\ncorporate funds. The First Amendment does not permit Congress to make these categorical distinctions\nbased on the corporate 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 the\nprinciple established in Buckley and Bellotti that the Government may not suppress political speech on\nthe basis of the speaker\xe2\x80\x99s corporate identity. No sufficient governmental interest justifies limits on the\npolitical 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 of\nGovernment, some officials sought, by persuasion, to discourage its distribution. See Smoodin,\n\xe2\x80\x9cCompulsory\xe2\x80\x9d Viewing for Every Citizen: Mr. Smith and the Rhetoric of Reception, 35 Cinema Journal 3,\n19, and n. 52 (Winter 1996) (citing Mr. Smith Riles Washington, Time, Oct. 30, 1939, p. 49); Nugent,\nCapra\xe2\x80\x99s Capitol Offense, N. Y. Times, Oct. 29, 1939, p. X5. UnderAustin, though, officials could have done\nmore than discourage its distribution\xe2\x80\x94they could have banned the film. After all, it, like Hillary,was\nspeech funded by a corporation that was critical of Members of Congress. Mr. Smith Goes to\nWashington may be fiction and caricature; but fiction and caricature can be a powerful force.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n213\n\n\x0cModern day movies, television comedies, or skits on YouTube.com might portray public officials or public\npolicies in unflattering ways. Yet if a covered transmission during the blackout period creates the\nbackground for candidate endorsement or opposition, a felony occurs solely because a corporation, other\nthan an exempt media corporation, has made the \xe2\x80\x9cpurchase, payment, distribution, loan, advance,\ndeposit, or gift of money or anything of value\xe2\x80\x9d in order to engage in political speech. 2 U.S.C.\n\xc2\xa7431(9)(A)(i). Speech would be suppressed in the realm where its necessity is most evident: in the public\ndialogue preceding a real election. Governments are often hostile to speech, but under our law and our\ntradition it seems stranger than fiction for our Government to make this political speech a crime. Yet this\nis the statute\xe2\x80\x99s purpose and design.\n\nSome members of the public might consider Hillary to be insightful and instructive; some might find it to\nbe neither high art nor a fair discussion on how to set the Nation\xe2\x80\x99s course; still others simply might\nsuspend judgment on these points but decide to think more about issues and candidates. Those choices\nand assessments, however, are not for the Government to make. \xe2\x80\x9cThe First Amendment underwrites the\nfreedom to experiment and to create in the realm of thought and speech. Citizens must be free to use new\nforms, and new forums, for the expression of ideas. The civic discourse belongs to the people, and the\nGovernment may not prescribe the means used to conduct it.\xe2\x80\x9dMcConnell, supra, at 341 (opinion of\nKennedy, J.).\n\nThe judgment of the District Court is reversed with respect to the constitutionality of 2 U.S.C. \xc2\xa7441b\xe2\x80\x99s\nrestrictions on corporate independent expenditures. The case is remanded for further proceedings\nconsistent with this opinion.\n\nIt is so ordered.\n\nC A SE QU ES TIO NS\n1. What does the case say about disclosure? Corporations have a right of free speech\nunder the First Amendment and may exercise that right through unrestricted\ncontributions of money to political parties and candidates. Can the government\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n214\n\n\x0ccondition that right by requiring that the parties and candidates disclose to the\npublic the amount and origin of the contribution? What would justify such a\ndisclosure requirement?\n2. Are a corporation\xe2\x80\x99s contributions to political parties and candidates tax deductible\nas a business expense? Should they be?\n3. How is the donation of money equivalent to speech? Is this a strict construction of\nthe Constitution 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?\nWas that purpose consistent (or inconsistent) with anything in the Constitution, or is\nthe Constitution essentially silent on this issue?\n\n4.7 Summary and Exercises\nSummary\nThe US. Constitution sets the framework for all other laws of the United States, at both the federal and the\nstate level. It creates a shared balance of power between states and the federal government (federalism)\nand shared power among the branches of government (separation of powers), establishes individual rights\nagainst governmental action (Bill of Rights), and provides for federal oversight of matters affecting\ninterstate commerce and commerce with foreign nations. Knowing the contours of the US legal system is\nnot possible without understanding the role of the US Constitution.\nThe Constitution is difficult to amend. Thus when the Supreme Court uses its power of judicial review to\ndetermine that a law is unconstitutional, it actually shapes what the Constitution means. New meanings\nthat emerge must do so by the process of amendment or by the passage of time and new appointments to\nthe court. Because justices serve for life, the court changes its philosophical outlook slowly.\nThe Bill of Rights is an especially important piece of the Constitutional framework. It provides legal\ncauses of action for infringements of individual rights by government, state or federal. Through the due\nprocess clause of the Fifth Amendment and the Fourteenth Amendment, both procedural and (to some\nextent) substantive due process rights are given to individuals.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n215\n\n\x0cE XE R C IS ES\n1. For many years, the Supreme Court believed that \xe2\x80\x9ccommercial speech\xe2\x80\x9d\nwas entitled to less protection than other forms of speech. One defining\nelement of commercial speech is that its dominant theme is to propose a\ncommercial transaction. This kind of speech is protected by the First\nAmendment, but the government is permitted to regulate it more closely\nthan other forms of speech. However, the government must make\nreasonable distinctions, must narrowly tailor the rules restricting\ncommercial speech, and must show that government has a legitimate goal\nthat the law furthers.\n2. Edward 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\nhim to remove the signs because they violated the city\xe2\x80\x99s sign code, which\nprohibited covering more than 30 percent of a store\xe2\x80\x99s windows with signs.\nSalib sued, claiming that the sign code violated his First Amendment\nrights. What was the result, and why?\n3. Jennifer is a freshman at her local public high school. Her sister, Jackie,\nattends a nearby private high school. Neither school allows them to join its\nrespective wrestling team; only boys can wrestle at either school. Do either of\nthem have a winning case based on the equal protection clause of the\nFourteenth Amendment?\n4. The employees of the US Treasury Department that work the border crossing\nbetween the United States and Mexico learned that they will be subject to\nroutine drug testing. The customs bureau, which is a division of the treasury\ndepartment, announces this policy along with its reasoning: since customs\nagents must routinely search for drugs coming into the United States, it makes\nsense that border guards must themselves be completely drug-free. Many\nborder guards do not use drugs, have no intention of using drugs, and object\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n216\n\n\x0cto the invasion of their privacy. What is the constitutional basis for their\nobjection?\n5. Happy Time Chevrolet employs Jim Bydalek as a salesman. Bydalek takes part\nin a Gay Pride March in Los Angeles, is interviewed by a local news camera\ncrew, and reports that he is gay and proud of it. His employer is not, and he is\nfired. Does he have any constitutional causes of action against his employer?\n6. You begin work at the Happy-Go-Lucky Corporation on Halloween. On your\nsecond day at work, you wear a political button on your coat, supporting your\nchoice for US senator in the upcoming election. Your boss, who is of a\ndifferent political persuasion, looks at the button and says, \xe2\x80\x9cTake that stupid\nbutton off or you\xe2\x80\x99re fired.\xe2\x80\x9d Has your boss violated your constitutional rights?\n7. David Lucas paid $975,000 for two residential parcels on the Isle of Palms near\nCharleston, South Carolina. His intention was to build houses on them. Two\nyears later, the South Carolina legislature passed a statute that prohibited\nbuilding beachfront properties. The purpose was to leave the dunes system in\nplace to mitigate the effects of hurricanes and strong storms. The South\nCarolina Coastal Commission created the rules and regulations with\nsubstantial input from the community and from experts and with protection\nof the dune system primarily in mind. People had been building on the\nshoreline for years, with harmful results to localities and the state treasury.\nWhen Lucas applied for permits to build two houses near the shoreline, his\npermits were rejected. He sued, arguing that the South Carolina legislation\nhad effectively \xe2\x80\x9ctaken\xe2\x80\x9d his property. At trial, South Carolina conceded that\nbecause of the legislation, Lucas\xe2\x80\x99s property was effectively worth zero. Has\nthere been a taking under the Fifth Amendment (as incorporated through the\nFourteenth Amendment), and if so, what should the state owe to Lucas?\nSuppose that Lucas could have made an additional $1 million by building a\nhouse on each of his parcels. Is he entitled to recover his original purchase\nprice or his potential profits?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n217\n\n\x0cS EL F -T E ST QU EST IO N S\n1. Harvey filed a suit against the state of Colorado, claiming that a Colorado\nstate law violates the commerce clause. The court will agree if the statute\na. places an undue burden on interstate commerce\nb. promotes the public health, safety, morals, or general welfare of\nColorado\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\nwith both the state and the federal law.\na. Because of federalism, the state law will have priority, as long as\nMaine is using its police powers.\nb. Because there\xe2\x80\x99s a conflict, both laws are invalid; the state and the\nfederal government will have to work out a compromise of some\nsort.\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\nconstitutional rights, especially those found in the Bill of Rights. Most of\nthese rights apply to the states under\na. the supremacy clause\nb. the protection clause\nc. the due process clause of the Fourteenth Amendment\nd. the Tenth Amendment\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n218\n\n\x0cMinnesota 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,\nClarence \xe2\x80\x9cCab\xe2\x80\x9d Calloway, create unique beer that they decide to call Old\nFart Ale. In their marketing, the brothers have a label in which an older man\nin a dirty T-shirt is sitting in easy chair, looking disheveled and having a\nthree-day growth of stubble on his chin. It appears that the man is in the\nprocess of belching. He is also holding a can of Old Fart Ale. The Minnesota\nliquor commission orders all Minnesota restaurants, bars, and grocery\nstores to remove Old Fart Ale from their shelves. The state statute and the\ncommission\xe2\x80\x99s order are likely to be held by a court to be\na. a violation of the Tenth Amendment\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\nprevent an article of commerce from entering into Minnesota\xe2\x80\x99s\nmarket\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\nCourt\xe2\x80\x99s definition underMiller v. California) and includes child pornography.\nNorth Carolina has a statute that criminalizes obscenity. What are possible\nresults if a store in Raleigh, North Carolina, carries Raunch merchandise?\na. The partners could be arrested in North Carolina and may well be\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\nfree speech.\nd. The materials are protected under state law.\ne. a and b\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n219\n\n\x0cS EL F -T E ST A NSW E R S\n1. a\n2. c\n3. c\n4. b\n5. e\n\nChapter 5\nAdministrative Law\nL EA R N IN G O B JEC T IV ES\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\nagencies.\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.\n\nFrom the 1930s on, administrative agencies, law, and procedures have virtually remade our government\nand much of private life. Every day, business must deal with rules and decisions of state and federal\nadministrative agencies. Informally, such rules are often called regulations, and they differ (only in their\nsource) from laws passed by Congress and signed into law by the president. The rules created by agencies\nare voluminous: thousands of new regulations pour forth each year. The overarching question of whether\nthere is too much regulation\xe2\x80\x94or the wrong kind of regulation\xe2\x80\x94of our economic activities is an important\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n220\n\n\x0cone but well beyond the scope of this chapter, in which we offer an overview of the purpose of\nadministrative agencies, their structure, and their impact on business.\n\n5.1 Administrative Agencies: Their Structure and\nPowers\nL EA R N IN G O B JEC T IV ES\n1. Explain the reasons why we have federal administrative agencies.\n2. Explain the difference between executive branch agencies and independent\nagencies.\n3. Describe the constitutional issue that questions whether administrative agencies\ncould have authority to make enforceable rules that affect business.\n\nWhy Have Administrative Agencies?\nThe US Constitution mentions only three branches of government: legislative, executive, and judicial\n(Articles I, II, and III). There is no mention of agencies in the Constitution, even though federal agencies\nare sometimes referred to as \xe2\x80\x9cthe fourth branch of government.\xe2\x80\x9d The Supreme Court has recognized the\nlegitimacy of federal administrative agencies to make rules that have the same binding effect as\nstatutes by Congress.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n221\n\n\x0cMost commentators note that having agencies with rule-making power is a practical necessity: (1)\nCongress does not have the expertise or continuity to develop specialized knowledge in various areas (e.g.,\ncommunications, the environment, aviation). (2) Because of this, it makes sense for Congress to set forth\nbroad statutory guidance to an agency and delegate authority to the agency to propose rules that further\nthe statutory purposes. (3) As long as Congress makes this delegating guidance sufficiently clear, it is not\ndelegating improperly. If Congress\xe2\x80\x99s guidelines are too vague or undefined, it is (in essence) giving away\nits constitutional power to some 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, happen in\nthe natural course of human events but are not always desirable. To fix this, well-conceived and\nobjectively enforced competition law (what is called antitrust law in the United States) is needed.\n\nNegative externalities must be \xe2\x80\x9cfixed,\xe2\x80\x9d as well. For example, as we see in tort law (Chapter 7 "Introduction\nto Tort Law"), people and business organizations often do things that impose costs (damages) on others,\nand the legal system will try\xe2\x80\x94through the award of compensatory damages\xe2\x80\x94to make fair adjustments. In\nterms of the ideal conditions for a free market, think of tort law as the legal system\xe2\x80\x99s attempt to\ncompensate for negative externalities: those costs imposed on people who have not voluntarily consented\nto bear those costs.\n\nIn terms of freedoms to enter or leave the market, the US constitutional guarantees of equal protection\ncan prevent local, state, and federal governments from imposing discriminatory rules for commerce that\nwould keep minorities, women, and gay people from full participation in business. For example, if the\nsmall town of Xenophobia, Colorado, passed a law that required all business owners and their employees\nto be Christian, heterosexual, and married, the equal protection clause (as well as numerous state and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n222\n\n\x0cfederal equal opportunity employment laws) would empower plaintiffs to go to court and have the law\nstruck down as unconstitutional.\n\nKnowing that information is power, we will see many laws administered by regulatory agencies that seek\nto level the playing field of economic competition by requiring disclosure of the most pertinent\ninformation for consumers (consumer protection laws), investors (securities laws), and citizens (e.g., the\ntoxics release inventory laws in environmental law).\n\nIdeal Conditions for a Free Market\n1.\n\nThere are many buyers and many sellers, and none of them has a substantial share of the market.\n\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 have\nstrong preferences as to which seller or buyer they deal with.\n5.\n\nThe 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)\n\n6. All buyers and sellers are utility maximizers; each participant in the market tries to get as much as\npossible for as little as possible.\n7.\n\nThere are no parties, institutions, or governmental units regulating the price, quantity, or quality\nof any of the goods being bought and sold in the market.\n\nIn short, some forms of legislation and regulation are needed to counter a tendency toward consolidation\nof economic power ((Reference mayer_1.0-ch48 not found in Book)) and discriminatory attitudes toward\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n223\n\n\x0ccertain individuals and groups ((Reference mayer_1.0-ch50 not found in Book)) and to insist that people\nand companies clean up their own messes and not hide information that would empower voluntary\nchoices in the free market.\n\nBut there are additional reasons to regulate. For example, in economic systems, it is likely for natural\nmonopolies to occur. These are where one firm can most efficiently supply all of the good or service.\nHaving duplicate (or triplicate) systems for supplying electricity, for example, would be inefficient, so\nmost states have a public utilities commission to determine both price and quality of service. This is direct\nregulation.\n\nSometimes destructive competition can result if there is no regulation. Banking and insurance are good\nexamples of this. Without government regulation of banks (setting standards and methods), open and\nfierce competition would result in widespread bank failures. That would erode public confidence in banks\nand business generally. The current situation (circa 2011) of six major banks that are \xe2\x80\x9ctoo big to fail\xe2\x80\x9d is,\nhowever, an example of destructive noncompetition.\n\nOther market imperfections can yield a demand for regulation. For example, there is a need to regulate\nfrequencies for public broadcast on radio, television, and other wireless transmissions (for police, fire,\nnational defense, etc.). Many economists would also list an adequate supply of public goods as something\nthat must be created by government. On its own, for example, the market would not provide public goods\nsuch as education, a highway system, lighthouses, a military for defense.\n\nTrue laissez-faire capitalism\xe2\x80\x94a market free from any regulation\xe2\x80\x94would not try to deal with market\nimperfections and would also allow people to freely choose products, services, and other arrangements\nthat historically have been deemed socially unacceptable. These would include making enforceable\ncontracts for the sale and purchase of persons (slavery), sexual services, \xe2\x80\x9cstreet drugs\xe2\x80\x9d such as heroin or\ncrack cocaine, votes for public office, grades for this course in business law, and even marriage\npartnership.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n224\n\n\x0cThus the free market in actual terms\xe2\x80\x94and not in theory\xe2\x80\x94consists of commerce legally constrained by\nwhat is economically desirable and by what is socially desirable as well. Public policy objectives in the\nsocial arena include ensuring equal opportunity in employment, protecting employees from unhealthy or\nunsafe work environments, preserving environmental quality and resources, and protecting consumers\nfrom unsafe products. Sometimes these objectives are met by giving individuals statutory rights that can\nbe used in bringing a complaint (e.g., Title VII of the Civil Rights Act of 1964, for employment\ndiscrimination), and sometimes they are met by creating agencies with the right to investigate and\nmonitor and enforce statutory law and regulations created to enforce such law (e.g., the Environmental\nProtection Agency, for bringing 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 between\nthe states and with foreign nations. The earliest federal agency therefore dealt with trucking and railroads,\nto literally set the rules of the road for interstate commerce. The first federal agency, the Interstate\nCommerce Commission (ICC), was created in 1887. Congress delegated to the ICC the power to enforce\nfederal laws against railroad rate discrimination and other unfair pricing practices. By the early part of\nthis century, the ICC gained the power to fix rates. From the 1970s through 1995, however, Congress\npassed deregulatory measures, and the ICC was formally abolished in 1995, with its powers transferred to\nthe Surface Transportation Board.\n\nBeginning with the Federal Trade Commission (FTC) in 1914, Congress has created numerous other\nagencies, many of them familiar actors in American government. Today more than eighty-five federal\nagencies have jurisdiction to regulate some form of private activity. Most were created since 1930, and\nmore than a third since 1960. A similar growth has occurred at the state level. Most states now have\ndozens of regulatory agencies, many of them overlapping in function with the federal bodies.\n\nClassification of Agencies\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n225\n\n\x0cIndependent agencies are different from federal executive departments and other executive agencies by\ntheir structural and functional characteristics. Most executive departments have a single director,\nadministrator, or secretary appointed by the president of the United States. Independent agencies almost\nalways have a commission or board consisting of five to seven members who share power over the agency.\nThe president appoints the commissioners or board subject to Senate confirmation, but they often serve\nwith staggered terms and often for longer terms than a usual four-year presidential term. They cannot be\nremoved except for \xe2\x80\x9cgood cause.\xe2\x80\x9d This means that most presidents will not get to appoint all the\ncommissioners of a given independent agency. Most independent agencies have a statutory requirement\nof bipartisan membership on the commission, so the president cannot simply fill vacancies with members\nof his own political party.\n\nIn addition to the ICC and the FTC, the major independent agencies are the Federal Communications\nCommission (1934), Securities and Exchange Commission (1934), National Labor Relations Board (1935),\nand Environmental Protection Agency (1970). See Note 5.4 "Ideal Conditions for a Free Market" in the\nsidebar.\n\nBy contrast, members of executive branch agencies serve at the pleasure of the president and are therefore\nfar more amenable to political control. One consequence of this distinction is that the rules that\nindependent agencies promulgate may not be reviewed by the president or his staff\xe2\x80\x94only Congress may\ndirectly overrule them\xe2\x80\x94whereas the White House or officials in the various cabinet departments may\noversee the work of the agencies contained within them (unless specifically denied the power by\nCongress).\n\nPowers of Agencies\nAgencies have a variety of powers. Many of the original statutes that created them, like the Federal\nCommunications Act, gave them licensing power. No party can enter into the productive activity covered\nby the act without prior license from the agency\xe2\x80\x94for example, no utility can start up a nuclear power\nplant unless first approved by the Nuclear Regulatory Commission. In recent years, the move toward\nderegulation of the economy has led to diminution of some licensing power. Many agencies also have the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n226\n\n\x0cauthority to set the rates charged by companies subject to the agency\xe2\x80\x99s jurisdiction. Finally, the agencies\ncan regulate business practices. The FTC has general jurisdiction over all business in interstate commerce\nto monitor and root out \xe2\x80\x9cunfair acts\xe2\x80\x9d and \xe2\x80\x9cdeceptive practices.\xe2\x80\x9d The Securities and Exchange Commission\n(SEC) oversees the issuance of corporate securities and other investments and monitors the practices of\nthe stock exchanges.\n\nUnlike courts, administrative agencies are charged with the responsibility of carrying out a specific\nassignment or reaching a goal or set of goals. They are not to remain neutral on the various issues of the\nday; they must act. They have been given legislative powers because in a society growing ever more\ncomplex, Congress does not know how to legislate with the kind of detail that is necessary, nor would it\nhave the time to approach all the sectors of society even if it tried. Precisely because they are to do what\ngeneral legislative bodies cannot do, agencies are specialized bodies. Through years of experience in\ndealing with similar problems they accumulate a body of knowledge that they can apply to accomplish\ntheir statutory duties.\n\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 relatively\nlimited terms. Below them is a more or less permanent staff\xe2\x80\x94the bureaucracy. Much policy making\noccurs at the staff level, because these employees are in essential control of gathering facts and presenting\ndata and argument to the commissioners, who wield the ultimate power of the agencies.\n\nThe Constitution and Agencies\nCongress can establish an agency through legislation. When Congress gives powers to an agency, the\nlegislation is known as an enabling act. The concept that Congress can delegate power to an agency is\nknown as the delegation doctrine. Usually, the agency will have all three kinds of power: executive,\nlegislative, and judicial. (That is, the agency can set the rules that business must comply with, can\ninvestigate and prosecute those businesses, and can hold administrative hearings for violations of those\nrules. They are, in effect, rule maker, prosecutor, and judge.) Because agencies have all three types of\ngovernmental powers, important constitutional questions were asked when Congress first created them.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n227\n\n\x0cThe most important question was whether Congress was giving away its legislative power. Was the\nseparation of powers violated if agencies had power to make rules that were equivalent to legislative\nstatutes?\n\nIn 1935, in Schechter Poultry Corp. v. United States, the Supreme Court overturned the National\nIndustrial Recovery Act on the ground that the congressional delegation of power was too broad.\n\n[1]\n\nUnder\n\nthe law, industry trade groups were granted the authority to devise a code of fair competition for the\nentire industry, and these codes became law if approved by the president. No administrative body was\ncreated to scrutinize the arguments for a particular code, to develop evidence, or to test one version of a\ncode against another. Thus it was unconstitutional for the Congress to transfer all of its legislative powers\nto an agency. In later decisions, it was made clear that Congress could delegate some of its legislative\npowers, but only if the delegation of authority was not overly broad.\n\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 rules to\nprovide for safe and healthful working conditions in US workplaces. Such a broad initiative power gives\nOSHA considerable discretion. But, as noted in Section 5.2 "Controlling Administrative Agencies", there\nare both executive and judicial controls over administrative agency activities, as well as ongoing control by\nCongress through funding and the continuing oversight of agencies, both in hearings and through\nsubsequent statutory amendments.\n\nK E Y TA K EA WAY\nCongress creates administrative agencies through enabling acts. In these acts, Congress\nmust delegate authority by giving the agency some direction as to what it wants the\nagency to do. Agencies are usually given broad powers to investigate, set standards\n(promulgating regulations), and enforce those standards. Most agencies are executive\nbranch agencies, but some are independent.\n\nE XE R C IS ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n228\n\n\x0c1. Explain why Congress needs to delegate rule-making authority to a specialized\nagency.\n2. Explain why there is any need for interference in the market by means of laws or\nregulations.\n[1] Schechter Poultry Corp. v. United States, 295 US 495 (1935).\n\n5.2 Controlling Administrative Agencies\nL EA R N IN G O B JEC T IV ES\n1. Understand how the president controls administrative agencies.\n2. Understand how Congress controls administrative agencies.\n3. Understand how the courts can control administrative agencies.\n\nDuring the course of the past seventy years, a substantial debate has been conducted, often in shrill terms,\nabout the legitimacy of administrative lawmaking. One criticism is that agencies are \xe2\x80\x9ccaptured\xe2\x80\x9d by the\nindustry they are directed to regulate. Another is that they overregulate, stifling individual initiative and\nthe ability to compete. During the 1960s and 1970s, a massive outpouring of federal law created many new\nagencies and greatly strengthened the hands of existing ones. In the late 1970s during the Carter\nadministration, Congress began to deregulate American society, and deregulation increased under the\nReagan administration. But the accounting frauds of WorldCom, Enron, and others led to the SarbanesOxley Act of 2002, and the financial meltdown of 2008 has led to reregulation of the financial sector. It\nremains to be seen 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 bodies,\nincorporating facets of legislative, executive, and judicial power in a hybrid form that fits uneasily at best\nin the framework of American government (see Figure 5.1 "Major Administrative Agencies of the United\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n229\n\n\x0cStates"). They are necessarily at the center of tugging and hauling by the legislature, the executive branch,\nand the judiciary, each of which has different means of exercising political control over them. In early\n1990, for example, the Bush administration approved a Food and Drug Administration regulation that\nlimited disease-prevention claims by food packagers, reversing a position by the Reagan administration in\n1987 permitting such claims.\n\nFigure 5.1 Major Administrative Agencies of the United States\n\nLegislative Control\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n230\n\n\x0cCongress can always pass a law repealing a regulation that an agency promulgates. Because this is a timeconsuming process that runs counter to the reason for creating administrative bodies, it happens rarely.\nAnother approach to controlling agencies is to reduce or threaten to reduce their appropriations. By\nretaining ultimate control of the purse strings, Congress can exercise considerable informal control over\nregulatory policy.\n\nExecutive Control\nThe president (or a governor, for state agencies) can exercise considerable control over agencies that are\npart of his cabinet departments and that are not statutorily defined as independent. Federal agencies,\nmoreover, are subject to the fiscal scrutiny of the Office of Management and Budget (OMB), subject to the\ndirect control of the president. Agencies are not permitted to go directly to Congress for increases in\nbudget; these requests must be submitted through the OMB, giving the president indirect leverage over\nthe continuation of administrators\xe2\x80\x99 programs and policies.\n\nJudicial Review of Agency Actions\nAdministrative agencies are creatures of law and like everyone else must obey the law. The courts have\njurisdiction to hear claims that the agencies have overstepped their legal authority or have acted in some\nunlawful manner.\nCourts are unlikely to overturn administrative actions, believing in general that the agencies are better\nsituated to judge their own jurisdiction and are experts in rulemaking for those matters delegated to them\nby Congress. Some agency activities are not reviewable, for a number of reasons. However, after a\nbusiness (or some other interested party) has exhausted all administrative remedies, it may seek judicial\nreview of a final agency decision. The reviewing court is often asked to strike down or modify agency\nactions on several possible bases (see Section 5.5.2 "Strategies for Obtaining Judicial Review" on\n\xe2\x80\x9cStrategies for Obtaining Judicial Review\xe2\x80\x9d).\n\nK E Y TA K EA WAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n231\n\n\x0cAdministrative agencies are given unusual powers: to legislate, investigate, and\nadjudicate. But these powers are limited by executive and legislative controls and by\njudicial review.\n\nE XE R C IS ES\n\n1. Find the website of the Consumer Product Safety Commission (CPSC). Identify from\nthat site a product that has been banned by the CPSC for sale in the United States.\nWhat reasons were given 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\nmandate to guide the agency? What could Congress do if the CPSC does something\nthat may be outside of the scope of its powers? What can an affected business do?\n\n5.3 The Administrative Procedure Act\nL EA R N IN G O B JEC T IV ES\n1. Understand why the Administrative Procedure Act was needed.\n2. Understand how hearings are conducted under the act.\n3. Understand how the act affects rulemaking by agencies.\n\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 cases or\nissuing regulations, the two basic tasks of administration. At the state level, the Model State\nAdministrative Procedure Act, issued in 1946 and revised in 1961, has been adopted in twenty-eight states\nand the District of Columbia; three states have adopted the 1981 revision. The other states have statutes\nthat 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 (FTC) is\nempowered to charge a company with having violated the Federal Trade Commission Act. Perhaps a seller\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n232\n\n\x0cis accused of making deceptive claims in its advertising. Proceeding in a manner similar to a court, staff\ncounsel will prepare a case against the company, which can defend itself through its lawyers. The case is\ntried before an administrative law judge (ALJ), formerly known as an administrative hearing\nexaminer. The change in nomenclature was made in 1972 to enhance the prestige of ALJs and more\naccurately reflect their duties. Although not appointed for life as federal judges are, the ALJ must be free\nof assignments inconsistent with the judicial function and is not subject to supervision by anyone in the\nagency who carries on an investigative or prosecutorial function.\n\nThe accused parties are entitled to receive notice of the issues to be raised, to present evidence, to argue,\nto cross-examine, and to appear with their lawyers. Ex parte (eks PAR-tay) communications\xe2\x80\x94contacts\nbetween the ALJ and outsiders or one party when both parties are not present\xe2\x80\x94are prohibited. However,\nthe usual burden-of-proof standard followed in a civil proceeding in court does not apply: the ALJ is not\nbound to decide in favor of that party producing the more persuasive evidence. The rule in most\nadministrative proceedings is \xe2\x80\x9csubstantial evidence,\xe2\x80\x9d evidence that is not flimsy or weak, but is not\nnecessarily overwhelming evidence, either. The ALJ in most cases will write an opinion. That opinion is\nnot the decision of the agency, which can be made only by the commissioners or agency head. In effect,\nthe ALJ\xe2\x80\x99s opinion is appealed to the commission itself.\n\nCertain types of agency actions that have a direct impact on individuals need not be filtered through a fullscale hearing. Safety and quality inspections (grading of food, inspection of airplanes) can be made on the\nspot by skilled inspectors. Certain licenses can be administered through tests without a hearing (a test for\na driver\xe2\x80\x99s license), and some decisions can be made by election of those affected (labor union elections).\n\nRulemaking\nTrial-type hearings generally impose on particular parties liabilities based on past or present facts.\nBecause these cases will serve as precedents, they are a partial guide to future conduct by others. But they\ndo not directly apply to nonparties, who may argue in a subsequent case that their conduct does not fit\nwithin the holding announced in the case. Agencies can affect future conduct far more directly by\nannouncing rules that apply to all who come within the agency\xe2\x80\x99s jurisdiction.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n233\n\n\x0cThe 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 has been\nimmense. The APA directs agencies about to engage in rulemaking to give notice in\nthe Federal Register of their intent to do so. The Federal Register is published daily, Monday through\nFriday, in Washington, DC, and contains notice of various actions, including announcements of proposed\nrulemaking and regulations as adopted. The notice must specify the time, place, and nature of the\nrulemaking and 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 Agencies are not\nlegally required to air debate over proposed rules, though they often do so.\n\nThe procedure just described is known as \xe2\x80\x9cinformal\xe2\x80\x9d rulemaking. A different procedure is required for\n\xe2\x80\x9cformal\xe2\x80\x9d rulemaking, defined as those instances in which the enabling legislation directs an agency to\nmake rules \xe2\x80\x9con the record after opportunity for an agency hearing.\xe2\x80\x9d When engaging in formal rulemaking,\nagencies must hold an adversary hearing.\n\nAdministrative regulations are not legally binding unless they are published. Agencies must publish in\nthe Federal Register the text of final regulations, which ordinarily do not become effective until thirty\ndays later. Every year the annual output of regulations is collected and reprinted in\nthe Code of Federal Regulations, a multivolume paperback series containing all federal rules and\nregulations keyed to the fifty titles of the US Code (the compilation ofall federal statutes enacted by\nCongress and grouped according to subject).\n\nK E Y TA K EA WAY\nAgencies make rules that have the same effect as laws passed by Congress and the\npresident. But such rules (regulations) must allow for full participation by\ninterested parties. The Administrative Procedure Act (APA) governs both\nrulemaking and the agency enforcement of regulations, and it provides a process\nfor fair hearings.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n234\n\n\x0cE XE R C IS ES\n1. Go to http://www.regulations.gov/search/Regs/home.html#home. Browse\nthe site. Find a topic that interests you, and then find a proposed regulation.\nNotice how comments on the proposed 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\nL EA R N IN G O B JEC T IV ES\n1. Describe the paperwork burden imposed by administrative agencies.\n2. Explain why agencies have the power of investigation, and what limits there\nare to that power.\n3. Explain the need for the Freedom of Information Act and how it works in the\nUS legal system.\n\nThe Paperwork Burden\nThe administrative process is not frictionless. The interplay between government agency and private\nenterprise can burden business operations in a number of ways. Several of these are noted in this section.\n\nDeciding whether and how to act are not decisions that government agencies reach out of the blue. They\nrely heavily on information garnered from business itself. Dozens of federal agencies require corporations\nto keep hundreds of types of records and to file numerous periodic reports. The Commission on Federal\nPaperwork, established during the Ford administration to consider ways of reducing the paperwork\nburden, estimated in its final report in 1977 that the total annual cost of federal paperwork amounted to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n235\n\n\x0c$50 billion and that the 10,000 largest business enterprises spent $10 billion annually on paperwork\nalone. The paperwork involved in licensing a single nuclear power plant, the commission said, costs\nupward of $15 million.\n\nNot surprisingly, therefore, businesses have sought ways of avoiding requests for data. Since the 1940s,\nthe Federal Trade Commission (FTC) has collected economic data on corporate performance from\nindividual companies for statistical purposes. As long as each company engages in a single line of\nbusiness, data are comparable. When the era of conglomerates began in the 1970s, with widely divergent\ntypes of businesses brought together under the roof of a single corporate parent, the data became useless\nfor purposes of examining the competitive behavior of different industries. So the FTC ordered dozens of\nlarge companies to break out their economic information according to each line of business that they\ncarried on. The companies resisted, but the US Court of Appeals for the District of Columbia Circuit,\nwhere much of the litigation over federal administrative action is decided, directed the companies to\ncomply with the commission\xe2\x80\x99s order, holding that the Federal Trade Commission Act clearly permits the\nagency to collect information for investigatory purposes.\n\n[1]\n\nIn 1980, responding to cries that businesses, individuals, and state and local governments were being\nswamped by federal demands for paperwork, Congress enacted the Paperwork Reduction Act. It gives\npower to the federal Office of Management and Budget (OMB) to develop uniform policies for\ncoordinating the gathering, storage, and transmission of all the millions of reports flowing in each year to\nthe scores of federal departments and agencies requesting information. These reports include tax and\nMedicare forms, financial loan and job applications, questionnaires of all sorts, compliance reports, and\ntax and business records. The OMB was given the power also to determine whether new kinds of\ninformation are needed. In effect, any agency that wants to collect new information from outside must\nobtain the OMB\xe2\x80\x99s approval.\n\nInspections\nNo one likes surprise inspections. A section of the Occupational Safety and Health Act of 1970 empowers\nagents of the Occupational Safety and Health Administration (OSHA) to search work areas for safety\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n236\n\n\x0chazards and for violations of OSHA regulations. The act does not specify whether inspectors are required\nto obtain search warrants, required under the Fourth Amendment in criminal cases. For many years, the\ngovernment insisted that surprise inspections are not unreasonable and that the time required to obtain a\nwarrant would defeat the 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 entitled\nto refuse police demands to search the premises unless a court has issued a search warrant.\n\n[2]\n\nBut where a certain type of business is closely regulated, surprise inspections are the norm, and no\nwarrant is required. For example, businesses with liquor licenses that might sell to minors are subject to\nboth overt and covert inspections (e.g., an undercover officer may \xe2\x80\x9csearch\xe2\x80\x9d a liquor store by sending an\nunderage patron to the store). Or a junkyard that specializes in automobiles and automobile parts may\nalso be subject to surprise inspections, on the rationale that junkyards are highly likely to be active in the\nresale of stolen autos or stolen auto parts.\n\n[3]\n\nIt is also possible for inspections to take place without a search warrant and without the permission of the\nbusiness. For example, the Environmental Protection Agency (EPA) wished to inspect parts of the Dow\nChemical facility in Midland, Michigan, without the benefit of warrant. When they were refused, agents of\nthe EPA obtained a fairly advanced aerial mapping camera and rented an airplane to fly over the Dow\nfacility. Dow went to court for a restraining order against the EPA and a request to have the EPA turn over\nall photographs taken. But the Supreme Court ruled that the areas photographed were \xe2\x80\x9copen fields\xe2\x80\x9d and\nnot subject to the protections of the Fourth Amendment.\n\n[4]\n\nAccess to Business Information in Government Files\nIn 1966, Congress enacted the Freedom of Information Act (FOIA), opening up to the citizenry many of\nthe files of the government. (The act was amended in 1974 and again in 1976 to overcome a tendency of\nmany agencies to stall or refuse access to their files.) Under the FOIA, any person has a legally enforceable\nright of access to all government documents, with nine specific exceptions, such as classified military\nintelligence, medical files, and trade secrets and commercial or financial information if \xe2\x80\x9cobtained from a\nperson and privileged or confidential.\xe2\x80\x9d Without the trade-secret and financial-information exemptions,\nbusiness competitors could, merely by requesting it, obtain highly sensitive competitive information\nsitting in government files.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n237\n\n\x0cA federal agency is required under the FOIA to respond to a document request within ten days. But in\npractice, months or even years may pass before the government actually responds to an FOIA request.\nRequesters must also pay the cost of locating and copying the records. Moreover, not all documents are\navailable for public inspection. Along with the trade-secret and financial-information exemptions, the\nFOIA specifically exempts the following:\n\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\n\nNote that the government may provide such information but is not required to provide such information;\nit retains discretion to provide information or not.\n\nRegulated companies are often required to submit confidential information to the government. For these\ncompanies, submitting such information presents a danger under the FOIA of disclosure to competitors.\nTo protect information from disclosure, the company is well advised to mark each document as privileged\nand confidential so that government officials reviewing it for a FOIA request will not automatically\ndisclose it. Most agencies notify a company whose data they are about to disclose. But these practices are\nnot legally required under the FOIA.\n\nK E Y TA K EA WAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n238\n\n\x0cGovernment agencies, in order to do their jobs, collect a great deal of information\nfrom businesses. This can range from routine paperwork (often burdensome) to\ninspections, those with warrants and those without. Surprise inspections are\nallowed for closely regulated industries but are subject to Fourth Amendment\nrequirements in general. Some information collected by agencies can be accessed\nusing the Freedom of Information Act.\n\nE XE R C IS ES\n1. Give two examples of a closely regulated industry. Explain why some\nwarrantless searches would be allowed.\n2. Find out why FOIA requests often take months or years to accomplish.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n239\n\n\x0c5.5 The Scope of Judicial Review\nL EA R N IN G O B JEC T IV ES\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.\n\nNeither an administrative agency\xe2\x80\x99s adjudication nor its issuance of a regulation is necessarily final. Most\nfederal agency decisions are appealable to the federal circuit courts. To get to court, the appellant must\novercome numerous complex hurdles. He or she must have standing\xe2\x80\x94that is, be in some sense directly\naffected by the decision or regulation. The case must be ripe for review; administrative remedies such as\nfurther appeal within the agency must have been exhausted.\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 level, there\nmust have been a decision reached that was unfavorable to you, and you must have appealed the decision\nto the full board. The full board must rule against you, and only then will you be heard by a court. The\nbroadest exception to this exhaustion of administrative remedies requirement is if the agency had no\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n240\n\n\x0cauthority to issue the rule or regulation in the first place, if exhaustion of remedies would be impractical\nor futile, or if great harm would happen should the rule or regulation continue to apply. Also, if the agency\nis 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 might\nassert that the agency\xe2\x80\x99s action was ultra vires (UL-truh VI-reez)\xe2\x80\x94beyond the scope of its authority as set\ndown in the statute. This attack is rarely successful. A somewhat more successful claim is that the agency\ndid not abide by its own procedures or those imposed upon it by the Administrative Procedure Act.\nIn formal rulemaking, the appellant also might insist that the agency lacked substantial evidence for the\ndetermination that it made. If there is virtually no evidence to support the agency\xe2\x80\x99s findings, the court\nmay reverse. But findings of fact are not often overturned by the courts.\n\nLikewise, there has long been a presumption that when an agency issues a regulation, it has the authority\nto do so: those opposing the regulation must bear a heavy burden in court to upset it. This is not a\nsurprising rule, for otherwise courts, not administrators, would be the authors of regulations.\nNevertheless, regulations cannot exceed the scope of the authority conferred by Congress on the agency.\nIn an important 1981 case before the Supreme Court, the issue was whether the secretary of labor, acting\nthrough the Occupational Health and Safety Administration (OSHA), could lawfully issue a standard\nlimiting exposure to cotton dust in the workplace without first undertaking a cost-benefit analysis. A\ndozen cotton textile manufacturers and the American Textile Manufacturers Institute, representing 175\ncompanies, asserted 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. See Section 5.6\n"Cases", American Textile Manufacturers Institute v. Donovan.\n\nIn summary, then, an individual or a company may (after exhaustion of administrative remedies)\nchallenge agency action where such action is the following:\n\n\xe2\x80\xa2\n\nnot in accordance with the agency\xe2\x80\x99s scope of authority\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n241\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\n\nSection 706 of the Administrative Procedure Act sets out those standards. While it is difficult to show that\nan agency\xe2\x80\x99s action is arbitrary and capricious, there are cases that have so held. For example, after the\nReagan administration set aside a Carter administration rule from the National Highway Traffic and\nSafety Administration on passive restraints in automobiles, State Farm and other insurance companies\nchallenged the reversal as arbitrary and capricious. Examining the record, the Supreme Court found that\nthe agency had failed to state enough reasons for its reversal and required the agency to review the record\nand the rule and provide adequate reasons for its reversal. State Farm and other insurance companies\nthus gained a legal benefit by keeping an agency rule that placed costs on automakers for increased\npassenger safety and potentially reducing the number of injury claims from those it had insured.\n\n[1]\n\nSuing the Government\nIn the modern administrative state, the range of government activity is immense, and administrative\nagencies frequently get in the way of business enterprise. Often, bureaucratic involvement is wholly\nlegitimate, compelled by law; sometimes, however, agencies or government officials may overstep their\nbounds, in a fit of zeal or spite. What recourse does the private individual or company have?\n\nMainly for historical reasons, it has always been more difficult to sue the government than to sue private\nindividuals or corporations. For one thing, the government has long had recourse to the doctrine of\nsovereign immunity as a shield against lawsuits. Yet in 1976, Congress amended the Administrative\nProcedure Act to waive any federal claim to sovereign immunity in cases of injunctive or other\nnonmonetary relief. Earlier, in 1946, in the Federal Tort Claims Act, Congress had waived sovereign\nimmunity of the federal government for most tort claims for money damages, although the act contains\nseveral exceptions for specific agencies (e.g., one cannot sue for injuries resulting from fiscal operations of\nthe Treasury Department or for injuries stemming from activities of the military in wartime). The act also\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n242\n\n\x0ccontains a major exception for claims \xe2\x80\x9cbased upon [an official\xe2\x80\x99s] exercise or performance or the failure to\nexercise or 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 against\nofficials whose decision to ship explosive materials by public carrier leads to mass deaths and injuries\nfollowing an explosion en route.\n\n[2]\n\nIn recent years, the Supreme Court has been stripping away the traditional immunity enjoyed by many\ngovernment officials against personal suits. Some government employees\xe2\x80\x94judges, prosecutors,\nlegislators, and the president, for example\xe2\x80\x94have absolute immunity against suit for official actions. But\nmany public administrators and government employees have at best a qualified immunity. Under a\nprovision of the Civil Rights Act of 1871 (so-called Section 1983 actions), state officials can be sued in\nfederal court for money damages whenever \xe2\x80\x9cunder color of any state law\xe2\x80\x9d they deprive anyone of his\nrights under the Constitution or federal law. In Bivens v. Six Unknown Federal Narcotics Agents, the\nSupreme Court held that federal agents may be sued for violating the plaintiff\xe2\x80\x99s Fourth Amendment rights\nagainst an unlawful search of his home.\n\n[3]\n\nSubsequent cases have followed this logic to permit suits for\n\nviolations of other constitutional provisions. This area of the law is in a state of flux, and it is likely to\ncontinue to evolve.\n\nSometimes damage is done to an individual or business because the government has given out erroneous\ninformation. For example, suppose that Charles, a bewildered, disabled navy employee, is receiving a\nfederal disability annuity. Under the regulations, he would lose his pension if he took a job that paid him\nin each of two succeeding years more than 80 percent of what he earned in his old navy job. A few years\nlater, Congress changed the law, making him ineligible if he earned more than 80 percent in anyone year.\nFor many years, Charles earned considerably less than the ceiling amount. But then one year he got the\nopportunity to make some extra money. Not wishing to lose his pension, he called an employee relations\nspecialist in the US Navy and asked how much he could earn and still keep his pension. The specialist\ngave him 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 the salary\nlimit, and so the government cut off his pension during the time he earned too much. Charles sues to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n243\n\n\x0crecover his lost pension. He argues that he relied to his detriment on false information supplied by the\nnavy and that in fairness the government should be estopped from denying his claim.\n\nUnfortunately for Charles, he will lose his case. In Office of Personnel Management v. Richmond, the\nSupreme Court reasoned that it would be unconstitutional to permit recovery.\n\n[4]\n\nThe appropriations\n\nclause of Article I says that federal money can be paid out only through an appropriation made by law.\nThe law prevented this particular payment to be made. If the court were to make an exception, it would\npermit executive officials in effect to make binding payments, even though unauthorized, simply by\nmisrepresenting the facts. The harsh reality, therefore, is that mistakes of the government are generally\nheld against the individual, not the government, unless the law specifically provides for recompense (as,\nfor example, in the Federal Tort Claims Act just discussed).\n\nK E Y TA K EA WAY\nAfter exhausting administrative remedies, there are numerous grounds for seeking\njudicial review of an agency\xe2\x80\x99s order or of a final rule. While courts defer to agencies to\nsome degree, an agency must follow its own rules, comply with the Administrative\nProcedure Act, act within the scope of its delegated authority, avoid acting in an\narbitrary manner, and make final rules that are supported by substantial evidence.\n\nE XE R C IS ES\n1. Why would US courts require that someone seeking judicial review of an agency\norder first exhaust administrative remedies?\n2. On the Internet, find a case where someone has successfully sued the US\ngovernment under the Federal Tort Claims Act. What kind of case was it? Did the\ngovernment argue sovereign immunity? Does sovereign immunity even make sense\nto you?\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).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n244\n\n\x0c[3] Bivens v. Six Unknown Federal Narcotics Agents, 403 US 388 (1971).\n[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.\n\n436 U.S. 307 (U.S. Supreme Court 1978)\n\nMR. JUSTICE WHITE delivered the opinion of the Court.\n\nSection 8(a) of the Occupational Safety and Health Act of 1970 (OSHA or Act) empowers agents of the\nSecretary of Labor (Secretary) to search the work area of any employment facility within the Act\xe2\x80\x99s\njurisdiction. The purpose of the search is to inspect for safety hazards and violations of OSHA regulations.\nNo search warrant or other process is expressly required under the Act.\n\nOn the morning of September 11, 1975, an OSHA inspector entered the customer service area of Barlow\xe2\x80\x99s,\nInc., an electrical and plumbing installation business located in Pocatello, Idaho. The president and\ngeneral manager, Ferrol G. \xe2\x80\x9cBill\xe2\x80\x9d Barlow, was on hand; and the OSHA inspector, after showing his\ncredentials, informed Mr. Barlow that he wished to conduct a search of the working areas of the business.\nMr. Barlow inquired whether any complaint had been received about his company. The inspector\nanswered no, but that Barlow\xe2\x80\x99s, Inc., had simply turned up in the agency\xe2\x80\x99s selection process. The inspector\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n245\n\n\x0cagain asked to enter the nonpublic area of the business; Mr. Barlow\xe2\x80\x99s response was to inquire whether the\ninspector had a search warrant.\n\nThe inspector had none. Thereupon, Mr. Barlow refused the inspector admission to the employee area of\nhis business. He said he was relying on his rights as guaranteed by the Fourth Amendment of the United\nStates Constitution.\n\nThree months later, the Secretary petitioned the United States District Court for the District of Idaho to\nissue an order compelling Mr. Barlow to admit the inspector. The requested order was issued on\nDecember 30, 1975, and was presented to Mr. Barlow on January 5, 1976. Mr. Barlow again refused\nadmission, and he sought his own injunctive relief against the warrantless searches assertedly permitted\nby OSHA.\xe2\x80\xa6The Warrant Clause of the Fourth Amendment protects commercial buildings as well as\nprivate homes. To hold otherwise would belie the origin of that Amendment, and the American colonial\nexperience.\n\nAn important forerunner of the first 10 Amendments to the United States Constitution, the Virginia Bill of\nRights, specifically opposed \xe2\x80\x9cgeneral warrants, whereby an officer or messenger may be commanded to\nsearch suspected places without evidence of a fact committed.\xe2\x80\x9d The general warrant was a recurring point\nof contention in the Colonies immediately preceding the Revolution. The particular offensiveness it\nengendered was acutely felt by the merchants and businessmen whose premises and products were\ninspected for compliance with the several parliamentary revenue measures that most irritated the\ncolonists.\xe2\x80\xa6\n***\nThis Court has already held that warrantless searches are generally unreasonable, and that this rule\napplies to commercial premises as well as homes. In Camara v. Municipal Court, we held:\n\n[E]xcept in certain carefully defined classes of cases, a search of private property without proper consent\nis \xe2\x80\x98unreasonable\xe2\x80\x99 unless it has been authorized by a valid search warrant.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n246\n\n\x0cOn the same day, we also ruled: As we explained in Camara, a search of private houses is presumptively\nunreasonable if conducted without a warrant. The businessman, like the occupant of a residence, has a\nconstitutional right to go about his business free from unreasonable official entries upon his private\ncommercial property. The businessman, too, has that right placed in jeopardy if the decision to enter and\ninspect for violation of regulatory laws can be made and enforced by the inspector in the field without\nofficial authority evidenced by a warrant. These same cases also held that the Fourth Amendment\nprohibition against unreasonable searches protects against warrantless intrusions during civil as well as\ncriminal investigations. 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 officials.\xe2\x80\x9d If\nthe government intrudes on a person\xe2\x80\x99s property, the privacy interest suffers whether the government\xe2\x80\x99s\nmotivation is to investigate violations of criminal laws or breaches of other statutory or regulatory\nstandards.\xe2\x80\xa6\n\n[A]n exception from the search warrant requirement has been recognized for \xe2\x80\x9cpervasively regulated\nbusiness[es],\xe2\x80\x9d United States v. Biswell, 406 U.S. 311, 316 (1972), and for \xe2\x80\x9cclosely regulated\xe2\x80\x9d industries\n\xe2\x80\x9clong subject to close supervision and inspection,\xe2\x80\x9d Colonnade Catering Corp. v. United States, 397 U.S.\n72, 74, 77 (1970). These cases are indeed exceptions, but they represent responses to relatively unique\ncircumstances. Certain industries have such a history of government oversight that no reasonable\nexpectation of privacy could exist for a proprietor over the stock of such an enterprise. Liquor\n(Colonnade) and firearms (Biswell) are industries of this type when an entrepreneur embarks upon such a\nbusiness, he has voluntarily chosen to subject himself to a full arsenal of governmental regulation.\n***\nThe clear import of our cases is that the closely regulated industry of the type involved\nin Colonnade and Biswell is the exception. The Secretary would make it the rule. Invoking the WalshHealey Act of 1936, 41 U.S.C. \xc2\xa7 35 et seq., the Secretary attempts to support a conclusion that all\nbusinesses involved in interstate commerce have long been subjected to close supervision of employee\nsafety and health conditions. But\xe2\x80\xa6it is quite unconvincing to argue that the imposition of minimum\nwages and maximum hours on employers who contracted with the Government under the Walsh-Healey\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n247\n\n\x0cAct prepared the entirety of American interstate commerce for regulation of working conditions to the\nminutest detail. Nor can any but the most fictional sense of voluntary consent to later searches be found in\nthe single fact that one conducts a business affecting interstate commerce. Under current practice and\nlaw, few businesses 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 Government\nagent. Employees are not being prohibited from reporting OSHA violations. What they observe in their\ndaily functions is undoubtedly beyond the employer\xe2\x80\x99s reasonable expectation of privacy. The Government\ninspector, however, is not an employee. Without a warrant he stands in no better position than a member\nof the public. What is observable by the public is observable, without a warrant, by the Government\ninspector as well. The owner of a business has not, by the necessary utilization of employees in his\noperation, thrown open the areas where employees alone are permitted to the warrantless scrutiny of\nGovernment agents. That 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 agents to\nenter a place of business from which the public is restricted and to conduct their own warrantless search.\n***\n[The District Court judgment is affirmed.]\n\nC A SE QU ES TIO NS\n1. State, as briefly and clearly as possible, the argument that Barlow\xe2\x80\x99s is making\nin this case.\n2. Why would some industries or businesses be \xe2\x80\x9cclosely regulated\xe2\x80\x9d? What are\nsome of those businesses?\n3. The Fourth Amendment speaks of \xe2\x80\x9cpeople\xe2\x80\x9d being secure in their \xe2\x80\x9cpersons,\nhouses, papers, and effects.\xe2\x80\x9d Why would the Fourth Amendment apply to a\nbusiness, which is not in a \xe2\x80\x9chouse\xe2\x80\x9d?\n4. If the Fourth Amendment does not distinguish between closely regulated\nindustries and those that are not, why does the court do so?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n248\n\n\x0cAmerican Textile Manufacturers Institute v. Donovan\nAmerican Textile Manufacturers Institute v. Donovan\n\n452 U.S. 490 (1981)\n\nJUSTICE BRENNAN delivered the opinion of the Court.\n\nCongress enacted the Occupational Safety and Health Act of 1970 (Act) \xe2\x80\x9cto assure so far as possible every\nworking man and woman in the Nation safe and healthful working conditions.\xe2\x80\xa6\xe2\x80\x9cThe Act authorizes the\nSecretary of Labor to establish, after notice and opportunity to comment, mandatory nationwide\nstandards governing health and safety in the workplace. In 1978, the Secretary, acting through the\nOccupational Safety and Health Administration (OSHA), promulgated a standard limiting occupational\nexposure to cotton dust, an airborne particle byproduct of the preparation and manufacture of cotton\nproducts, exposure to which produces a \xe2\x80\x9cconstellation of respiratory effects\xe2\x80\x9d known as \xe2\x80\x9cbyssinosis.\xe2\x80\x9d This\ndisease was one of the expressly recognized health hazards that led to passage of the Act.\n\nPetitioners in these consolidated cases representing the interests of the cotton industry, challenged the\nvalidity of the \xe2\x80\x9cCotton Dust Standard\xe2\x80\x9d in the Court of Appeals for the District of Columbia Circuit\npursuant to \xc2\xa7 6 (f) of the Act, 29 U.S.C. \xc2\xa7 655 (f). They contend in this Court, as they did below, that the\nAct requires OSHA to demonstrate that its Standard reflects a reasonable relationship between the costs\nand benefits associated with the Standard. Respondents, the Secretary of Labor and two labor\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n249\n\n\x0corganizations, counter that Congress balanced the costs and benefits in the Act itself, and that the Act\nshould therefore be construed not to require OSHA to do so. They interpret the Act as mandating that\nOSHA enact the most protective standard possible to eliminate a significant risk of material health\nimpairment, subject to the constraints of economic and technological feasibility.\n\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 presented but\nnot decided in last Term\xe2\x80\x99sIndustrial Union Dept. v. American Petroleum Institute, 448 U.S. 607 (1980),\nand 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 occupational hazard\nassociated with cotton mills. In 1966, the American Conference of Governmental Industrial Hygienists\n(ACGIH), a private organization, recommended that exposure to total cotton dust be limited to a\n\xe2\x80\x9cthreshold limit value\xe2\x80\x9d of 1,000 micrograms per cubic meter of air (1,000 g/m3.) averaged over an 8-hour\nworkday. See 43 Fed. Reg. 27351, col. 1 (1978). The United States Government first regulated exposure to\ncotton dust in 1968, when the Secretary of Labor, pursuant to the Walsh-Healey Act, 41 U.S.C. 35 (e),\npromulgated airborne contaminant threshold limit values, applicable to public contractors, that included\nthe 1,000 g/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 Act, 84 Stat.\n1593, 29 U.S.C. 655 (a), a provision designed to guarantee immediate protection of workers for the period\nbetween enactment of the statute and promulgation of permanent standards.\n\nThat same year, the Director of the National Institute for Occupational Safety and Health (NIOSH),\npursuant to the Act, 29 U.S.C. \xc2\xa7\xc2\xa7 669(a)(3), 671 (d)(2), submitted to the Secretary of Labor a\nrecommendation for a cotton dust standard with a permissible exposure limit (PEL) that \xe2\x80\x9cshould be set at\nthe lowest level feasible, but in no case at an environmental concentration as high as 0.2 mg lint-free\ncotton dust/cu m,\xe2\x80\x9d or 200 g/m3. of lint-free respirable dust. Several months later, OSHA published an\nAdvance Notice of Proposed Rulemaking, 39 Fed.Reg. 44769 (1974), requesting comments from\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n250\n\n\x0cinterested parties on the NIOSH recommendation and other related matters. Soon thereafter, the Textile\nWorker\xe2\x80\x99s Union of America, joined by the North Carolina Public Interest Research Group, petitioned the\nSecretary, urging a more stringent PEL of 100 g/m3.\n\nOn December 28, 1976, OSHA published a proposal to replace the existing federal standard on cotton dust\nwith a new permanent standard, pursuant to \xc2\xa7 6(b)(5) of the Act, 29 U.S.C. \xc2\xa7 655(b)(5). 41 Fed.Reg.\n56498. The proposed standard contained a PEL of 200 g/m3of vertical elutriated lint-free respirable\ncotton dust for all segments of the cotton industry. Ibid. It also suggested an implementation strategy for\nachieving the PEL that relied on respirators for the short term and engineering controls for the long-term.\nOSHA invited interested parties to submit 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, 29 U.S.C.\n\xc2\xa7 655(b)(5) (emphasis added), provides:\n\nThe Secretary, in promulgating standards dealing with toxic materials or harmful physical agents under\nthis subsection, shall set the standard which most adequately assures, to the extent feasible, on the\nbasis of the best available evidence, that no employee will suffer material impairment of health or\nfunctional capacity even if such employee has regular exposure to the hazard dealt with by such standard\nfor the period of his working life. Although their interpretations differ, all parties agree that the phrase \xe2\x80\x9cto\nthe extent feasible\xe2\x80\x9d contains the critical language in \xc2\xa7 6(b)(5) for purposes of these cases.\n\nThe plain meaning of the word \xe2\x80\x9cfeasible\xe2\x80\x9d supports respondents\xe2\x80\x99 interpretation of the statute. According to\nWebster\xe2\x80\x99s Third New International Dictionary of the English Language 831 (1976), \xe2\x80\x9cfeasible\xe2\x80\x9d means\n\xe2\x80\x9ccapable of being done, executed, or effected.\xe2\x80\x9d In accord, the Oxford English Dictionary 116 (1933)\n(\xe2\x80\x9cCapable of being done, accomplished or carried out\xe2\x80\x9d); Funk & Wagnalls New \xe2\x80\x9cStandard\xe2\x80\x9d Dictionary of\nthe English Language 903 (1957) (\xe2\x80\x9cThat may be done, performed or effected\xe2\x80\x9d). Thus, \xc2\xa7 6(b)(5) directs the\nSecretary to issue the standard that \xe2\x80\x9cmost adequately assures\xe2\x80\xa6that no employee will suffer material\nimpairment of health,\xe2\x80\x9d limited only by the extent to which this is \xe2\x80\x9ccapable of being done.\xe2\x80\x9d In effect then,\nas the Court of Appeals held, Congress itself defined the basic relationship between costs and benefits, by\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n251\n\n\x0cplacing the \xe2\x80\x9cbenefit\xe2\x80\x9d of worker health above all other considerations save those making attainment of this\n\xe2\x80\x9cbenefit\xe2\x80\x9d unachievable. 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 command set forth\nin \xc2\xa7 6(b)(5). Thus, cost-benefit analysis by OSHA is not required by the statute because feasibility analysis\nis.\n\nWhen Congress has intended that an agency engage in cost-benefit analysis, it has clearly indicated such\nintent on the face of the statute. One early example is the Flood Control Act of 1936, 33 U.S.C. \xc2\xa7 701:\n\n[T]he Federal Government should improve or participate in the improvement of navigable waters or their\ntributaries, including watersheds thereof, for flood control purposes if the benefits to whomsoever\nthey may accrue are in excess of the estimated costs, and if the lives and social security of people\nare otherwise adversely affected. (emphasis added)\n\nA more recent example is the Outer Continental Shelf Lands Act Amendments of 1978, providing that\noffshore drilling operations shall use the best available and safest technologies which the Secretary\ndetermines to be economically feasible, wherever failure of equipment would have a significant effect on\nsafety, health, or the environment, except where the Secretary determines that the incremental benefits\nare clearly insufficient to justify the incremental costs of using such technologies.\n\nThese and other statutes demonstrate that Congress uses specific language when intending that an agency\nengage in cost-benefit analysis. Certainly in light of its ordinary meaning, the word \xe2\x80\x9cfeasible\xe2\x80\x9d cannot be\nconstrued to articulate such congressional intent. We therefore reject the argument that Congress\nrequired cost-benefit analysis in \xc2\xa7 6(b)(5).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n252\n\n\x0cC A SE QU ES TIO NS\n1. What is byssinosis? Why should byssinosis be anything that the textile\ncompanies are responsible for, ethically or legally? If it is well-known that\ntextile workers get cotton dust in their systems and develop brown lung, don\xe2\x80\x99t\nthey nevertheless choose to work there and assume the risk of all injuries?\n2. By imposing costs on the textile industry, what will be the net effect on US\ntextile manufacturing jobs?\n3. How is byssinosis a \xe2\x80\x9cnegative externality\xe2\x80\x9d that is not paid for by either the\nmanufacturer or the consumer of textile products? How should the market, to\nbe fair and efficient, adjust for these negative externalities other than by\nsetting a reasonable standard that shares the burden between manufacturers\nand their employees? Should all the burden be on the manufacturer?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n253\n\n\x0c5.7 Summary and Exercises\nSummary\nAdministrative rules and regulations constitute the largest body of laws that directly affect business.\nThese regulations are issued by dozens of federal and state agencies that regulate virtually every aspect of\nmodern business life, including the natural environment, corporate finance, transportation,\ntelecommunications, energy, labor relations, and trade practices. The administrative agencies derive their\npower to promulgate regulations from statutes passed by Congress or state legislatures.\nThe agencies have a variety of powers. They can license companies to carry on certain activities or prohibit\nthem from doing so, lay down codes of conduct, set rates that companies may charge for their services,\nand supervise various aspects of business.\n\nE XE R C IS ES\n1. The Equal Employment Opportunity Commission seeks data about the racial\ncomposition of Terrific Textiles\xe2\x80\x99 labor force. Terrific refuses on the grounds that\ninadvertent disclosure of the numbers might cause certain \xe2\x80\x9celements\xe2\x80\x9d to picket its\nfactories. The EEOC takes Terrific to court to get the data. What is the result?\n2. In order to police the profession, the state legislature has just passed a law\npermitting the State Plumbers\xe2\x80\x99 Association the power to hold hearings to determine\nwhether a particular plumber has violated the plumbing code of ethics, written by\nthe association. Sam, a plumber, objects to the convening of a hearing when he is\naccused by Roger, a fellow plumber, of acting unethically by soliciting business from\nRoger\xe2\x80\x99s customers. Sam goes to court, seeking to enjoin the association\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n254\n\n\x0cdisciplinary committee from holding the hearing. What is the result? How would you\nargue 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\npledging in his campaign to \xe2\x80\x9cdo away with bureaucrats who interfere in your lives.\xe2\x80\x9d\nThe day he takes the oath of office he determines to carry out his pledge. Discuss\nwhich of the following courses he may lawfully follow: (a) Fire all incumbent\ncommissioners of federal agencies in order to install new appointees. (b) Demand\nthat all pending regulations being considered by federal agencies be submitted to\nthe White House for review and redrafting, if necessary. (c) Interview potential\nnominees for agency positions to determine whether their regulatory philosophy is\nconsistent with his.\n4. Dewey owned a mine in Wisconsin. He refused to allow Department of Labor agents\ninto the mine to conduct warrantless searches to determine whether previously\nfound safety violations had been corrected. The Federal Mine Safety and Health\nAmendments Act of 1977 authorizes four warrantless inspections per year. Is the\nprovision for warrantless inspections by this agency constitutional? [1]\n5. In determining the licensing requirements for nuclear reactors, the Nuclear\nRegulatory Commission (NRC) adopted a zero-release assumption: that the\npermanent storage of certain nuclear waste would have no significant\nenvironmental impact and that potential storage leakages should not be a factor\ndiscussed in the appropriate environmental impact statement (EIS) required before\npermitting construction of a nuclear power plant. This assumption is based on the\nNRC\xe2\x80\x99s belief that technology would be developed to isolate the wastes from the\nenvironment, and it was clear from the record that the NRC had \xe2\x80\x9cdigested a massive\nmaterial 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\nwater leakage into the storage facility. An environmental NGO sued, asserting that\nthe NRC had violated the regulations governing the EIS by arbitrarily and capriciously\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n255\n\n\x0cignoring the potential contamination. The court of appeals agreed, and the power\nplant appealed. Had the NRC acted arbitrarily and capriciously? [2]\n\nS EL F -T E ST QU EST IO N S\n1. Most federal administrative agencies are created by\na. an executive order by the president\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 federal\ngovernment, is part of\na. the executive branch of government\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. in the Congressional record\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 Federal\nTrade Commission, is found in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n256\n\n\x0ca. the Administrative Procedure Act\nb. the US Constitution\nc. the commerce clause\nd. none of the above\n\nThe Federal Trade Commission, like other administrative agencies, has the\npower to\na. issue proposed rules\nb. undertake investigations of firms that may have violated FTC regulations\nc. prosecute firms that have violated FTC regulations\nd. none of the above\ne. all of the above\n\nS EL F -T E ST A NSW E R S\n1. c\n2. a\n3. b\n4. b\n5. e\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n257\n\n\x0cChapter 6\nCriminal Law\nL EA R N IN G O B JEC T IV ES\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.\n\nAt times, unethical behavior by businesspeople can be extreme enough that society will respond by\ncriminalizing certain kinds of activities. Ponzi schemes, arson, various kinds of fraud, embezzlement,\nracketeering, foreign corrupt practices, tax evasion, and insider trading are just a few. A corporation can\nface large fines, and corporate managers can face both fines and jail sentences for violating criminal laws.\nThis chapter aims to explain how criminal law differs from civil law, to discuss various types of crimes,\nand to relate the basic principles of criminal procedure.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n258\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 explain\nit, but the explanations often include many complex and subtle distinctions. A traditional criminal law\ncourse would include a lot of discussions on criminal intent, the nature of criminal versus civil\nresponsibility, and the constitutional rights accorded the accused. But in this chapter, we will consider\nonly the most basic aspects of intent, responsibility, and constitutional rights.\n\nUnlike civil actions, where plaintiffs seek compensation or other remedies for themselves, crimes involve\n\xe2\x80\x9cthe state\xe2\x80\x9d (the federal government, a state government, or some subunit of state government). This is\nbecause crimes involve some \xe2\x80\x9charm to society\xe2\x80\x9d and not just harm to certain individuals. But \xe2\x80\x9charm to\nsociety\xe2\x80\x9d is not always evident in the act itself. For example, two friends of yours at a party argue, take the\nargument outside, and blows are struck; one has a bloody nose and immediately goes home. The crimes of\nassault and battery have been committed, even though no one else knows about the fight and the friends\nlater make up. By contrast, suppose a major corporation publicly announces that it is closing operations in\nyour community and moving operations to Southeast Asia. There is plenty of harm to society as the plant\ncloses down and no new jobs take the place of the company\xe2\x80\x99s jobs. Although the effects on society are\ngreater in the second example, only the first example is a crime.\n\nCrimes are generally defined by legislatures, in statutes; the statutes describe in general terms the nature\nof the conduct they wish to criminalize. For government punishment to be fair, citizens must have clear\nnotice of what is criminally prohibited. Ex post facto laws\xe2\x80\x94laws created \xe2\x80\x9cafter the fact\xe2\x80\x9d to punish an act\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n259\n\n\x0cthat was legal at the time\xe2\x80\x94are expressly prohibited by the US Constitution. Overly vague statutes can also\nbe struck down by courts under a constitutional doctrine known as \xe2\x80\x9cvoid for vagueness.\xe2\x80\x9d\n\nWhat is considered a crime will also vary from society to society and from time to time. For example,\nwhile cocaine use was legal in the United States at one time, it is now a controlled substance, and\nunauthorized use is now a crime. Medical marijuana was not legal fifty years ago when its use began to\nbecome widespread, and in some states its use or possession was a felony. Now, some states make it legal\nto use or possess it under some circumstances. In the United States, you can criticize and make jokes\nabout the president of the United States without committing a crime, but in many countries it is a serious\ncriminal act to criticize a public official.\n\nAttitudes about appropriate punishment for crimes will also vary considerably from nation to nation.\nUganda has decreed long prison sentences for homosexuals and death to repeat offenders. In Saudi\nArabia, the government has proposed to deliberately paralyze a criminal defendant who criminally\nassaulted someone and unintentionally caused the victim\xe2\x80\x99s paralysis. Limits on punishment are set in the\nUnited States through the Constitution\xe2\x80\x99s prohibition on \xe2\x80\x9ccruel or unusual punishments.\xe2\x80\x9d\n\nIt is often said that ignorance of the law is no excuse. But there are far too many criminal laws for anyone\nto know them all. Also, because most people do not actually read statutes, the question of \xe2\x80\x9ccriminal\nintent\xe2\x80\x9d comes up right away: if you don\xe2\x80\x99t know that the legislature has made driving without a seat belt\nfastened a misdemeanor, you cannot have intended to harm society. You might even argue that there is no\nharm to anyone but yourself!\n\nThe usual answer to this is that the phrase \xe2\x80\x9cignorance of the law is no excuse\xe2\x80\x9d means that society (through\nits elected representatives) gets to decide what is harmful to society, not you. Still, you may ask, \xe2\x80\x9cIsn\xe2\x80\x99t it\nmy choice whether to take the risk of failing to wear a seat belt? Isn\xe2\x80\x99t this a victimless crime? Where is the\nharm to society?\xe2\x80\x9d A policymaker or social scientist may answer that your injuries, statistically, are\ngenerally going to be far greater if you don\xe2\x80\x99t wear one and that your choice may actually impose costs on\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n260\n\n\x0csociety. For example, you might not have enough insurance, so that a public hospital will have to take care\nof your head injuries, injuries that would likely have been avoided by your use of a seat belt.\n\nBut, as just noted, it is hard to know the meaning of some criminal laws. Teenagers hanging around the\nsidewalks on Main Street were sometimes arrested for \xe2\x80\x9cloitering.\xe2\x80\x9d The constitutional void-for-vagueness\ndoctrine has led the courts to overturn statutes that are not clear. For example, \xe2\x80\x9cvagrancy\xe2\x80\x9d was long held\nto be a crime, but US courts began some forty years ago to overturn vagrancy and \xe2\x80\x9csuspicious person\xe2\x80\x9d\nstatutes on the grounds that they are too vague for people to know what they are being asked not to do.\nThis requirement that criminal statutes not be vague does not mean that the law always defines crimes in\nways that can be easily and clearly understood. Many statutes use terminology developed by the commonlaw courts. For example, a California statute defines murder as \xe2\x80\x9cthe unlawful killing of a human being,\nwith malice aforethought.\xe2\x80\x9d If no history backed up these words, they would be unconstitutionally vague.\nBut there is a rich history of judicial decisions that provides meaning for much of the arcane language like\n\xe2\x80\x9cmalice aforethought\xe2\x80\x9d strewn about in the statute books.\n\nBecause a crime is an act that the legislature has defined as socially harmful, the parties involved cannot\nagree among themselves to forget a particular incident, such as a barroom brawl, if the authorities decide\nto prosecute. This is one of the critical distinctions between criminal and civil law. An assault is both a\ncrime and a tort. The person who was assaulted may choose to forgive his assailant and not to sue him for\ndamages. But he cannot stop the prosecutor from bringing an indictment against the assailant. (However,\nbecause of crowded dockets, a victim that declines to press charges may cause a busy prosecutor to choose\nto not to bring an indictment.)\n\nA crime consists of an act defined as criminal\xe2\x80\x94an actus reus\xe2\x80\x94and the requisite \xe2\x80\x9ccriminal intent.\xe2\x80\x9d\nSomeone who has a burning desire to kill a rival in business or romance and who may actually intend to\nmurder but does not act on his desire has not committed a crime. He may have a \xe2\x80\x9cguilty mind\xe2\x80\x9d\xe2\x80\x94the\ntranslation of the Latin phrase mens rea\xe2\x80\x94but he is guilty of no crime. A person who is forced to commit a\ncrime at gunpoint is not guilty of a crime, because although there was an act defined as criminal\xe2\x80\x94an actus\nreus\xe2\x80\x94there was no criminal intent.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n261\n\n\x0cK E Y TA K EA WAY\nCrimes are usually defined by statute and constitute an offense against society. In\neach case, there must be both an act and some mens rea (criminal intent).\n\nE XE R C IS ES\n1. Other than deterring certain kinds of conduct, what purpose does the criminal\nlaw serve?\n2. Why is ignorance of the law no excuse? Why shouldn\xe2\x80\x99t it be an excuse, when\ncriminal laws can be complicated and sometimes ambiguous?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n262\n\n\x0c6.2 Types of Crimes\nL EA R N IN G O B JEC T IV ES\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.\n\nMost classifications of crime turn on the seriousness of the act. In general, seriousness is defined by the\nnature or duration of the punishment set out in the statute. A felony is a crime punishable (usually) by\nimprisonment of more than one year or by death. (Crimes punishable by death are sometimes known as\ncapital crimes; they are increasingly rare in the United States.) The major felonies include murder, rape,\nkidnapping, armed robbery, embezzlement, insider trading, fraud, and racketeering. All other crimes are\nusually known as misdemeanors, petty offenses, or infractions. Another way of viewing crimes is by the\ntype of social harm the statute is intended to prevent or deter, such as offenses against the person,\noffenses against property, and white-collar crime.\n\nOffenses against the Person\nHomicide\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n263\n\n\x0cHomicide is the killing of one person by another. Not every killing is criminal. When the law permits one\nperson to kill another\xe2\x80\x94for example, a soldier killing an enemy on the battlefield during war, or a killing in\nself-defense\xe2\x80\x94the death is considered the result of justifiable homicide. An excusable homicide, by\ncontrast, is one in which death results from an accident in which the killer is not at fault.\n\nAll other homicides are criminal. The most severely punished form is murder, defined as homicide\ncommitted with \xe2\x80\x9cmalice aforethought.\xe2\x80\x9d This is a term with a very long history. Boiled down to its\nessentials, it means that the defendant had the intent to kill. A killing need not be premeditated for any\nlong period of time; the premeditation might be quite sudden, as in a bar fight that escalates in that\nmoment when one of the fighters reaches for a knife with the intent to kill.\nSometimes a homicide can be murder even if there is no intent to kill; an intent to inflict great bodily\nharm can be murder if the result is the death of another person. A killing that takes place while a felony\n(such as armed robbery) is being committed is also murder, whether or not the killer intended any harm.\nThis is the so-called felony murder rule. Examples are the accidental discharge of a gun that kills an\ninnocent bystander or the asphyxiation death of a fireman from smoke resulting from a fire set by an\narsonist. The felony murder rule is more significant than it sounds, because it also applies to the\naccomplices of one who does the killing. Thus the driver of a getaway car stationed a block away from the\nscene of the robbery can be convicted of murder if a gun accidentally fires during the robbery and\nsomeone is killed. Manslaughter is an act of killing that does not amount to murder. Voluntary\nmanslaughter is an intentional killing, but one carried out in the \xe2\x80\x9csudden heat of passion\xe2\x80\x9d as the result of\nsome provocation. An example is a fight that gets out of hand. Involuntary manslaughter entails a lesser\ndegree of willfulness; it usually occurs when someone has taken a reckless action that results in death\n(e.g., a death resulting 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, that is\na battery\xe2\x80\x94the unlawful application of force to another person. The force need not be violent. Indeed, a\nman who kisses a woman is guilty of a battery if he does it against her will. The other person may consent\nto the force. That is one reason why surgeons require patients to sign consent forms, giving the doctor\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n264\n\n\x0cpermission to operate. In the absence of such a consent, an operation is a battery. That is also why football\nplayers are not constantly being charged with battery. Those who agree to play football agree to submit to\nthe rules of the game, which of course include the right to tackle. But the consent does not apply to all acts\nof physical force: a hockey player who hits an opponent over the head with his stick can be prosecuted for\nthe crime of battery.\n\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 have\ncommitted an assault. Some states limit an assault to an attempt to commit a battery by one who has a\n\xe2\x80\x9cpresent ability\xe2\x80\x9d to do so. Pointing an unloaded gun and threatening to shoot would not be an assault, nor,\nof course, could it be a battery. The modem tendency, however, is to define an assault as an attempt to\ncommit a battery by one with an apparent ability to do so.\n\nAssault and battery may be excused. For example, a bar owner (or her agent, the bouncer) may use\nreasonable force to remove an unruly patron. If the use of force is excessive, the bouncer can be found\nguilty of assault and battery, and a civil action could arise against the bar owner as well.\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 aspects of the\nact of stealing. Criminal law distinguishes among many different crimes that are popularly known as theft.\nMany technical words have entered the language\xe2\x80\x94burglary, larceny, robbery\xe2\x80\x94but are often used\ninaccurately. Brief definitions of the more common terms are discussed here.\n\nThe basic crime of stealing personal property is larceny. By its old common-law definition, still in use\ntoday, larceny is the wrongful \xe2\x80\x9ctaking and carrying away of the personal property of another with intent to\nsteal the same.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n265\n\n\x0cThe separate elements of this offense have given rise to all kinds of difficult cases. Take the theft of fruit,\nfor example, with regard to the essential element of \xe2\x80\x9cpersonal property.\xe2\x80\x9d If a man walking through an\norchard plucks a peach from a tree and eats it, he is not guilty of larceny because he has not taken\naway personal property (the peach is part of the land, being connected to the tree). But if he picks up a\npeach lying on the ground, he is guilty of larceny. Or consider the element of \xe2\x80\x9ctaking\xe2\x80\x9d or \xe2\x80\x9ccarrying away.\xe2\x80\x9d\nSneaking into a movie theater without paying is not an act of larceny (though in most states it is a criminal\nact). Taking electricity by tapping into the power lines of an electric utility was something that baffled\njudges late in the nineteenth century because it was not clear whether electricity is a \xe2\x80\x9csomething\xe2\x80\x9d that can\nbe taken. Modern statutes have tended to make clear that electricity can be the object of larceny. Or\nconsider the element of an \xe2\x80\x9cintent to steal the same.\xe2\x80\x9d If you borrow your friend\xe2\x80\x99s BMW without his\npermission in order to go to the grocery store, intending to return it within a few minutes and then do\nreturn it, you have not committed larceny. But if you meet another friend at the store who convinces you\nto take a long joyride with the car and you return hours later, you may have committed larceny.\n\nA particular form of larceny is robbery, which is defined as larceny from a person by means of violence\nor intimidation.\n\nLarceny involves the taking of property from the possession of another. Suppose that a person legitimately\ncomes to possess the property of another and wrongfully appropriates it\xe2\x80\x94for example, an automobile\nmechanic entrusted with your car refuses to return it, or a bank teller who is entitled to temporary\npossession of cash in his drawer takes it home with him. The common law had trouble with such cases\nbecause the thief in these cases already had possession; his crime was in assuming ownership. Today,\nsuch wrongful conversion, known as embezzlement, has been made a statutory offense in all states.\n\nStatutes against larceny and embezzlement did not cover all the gaps in the law. A conceptual problem\narises in the case of one who is tricked into giving up his title to property. In larceny and embezzlement,\nthe thief gains possession or ownership without any consent of the owner or custodian of the property.\nSuppose, however, that an automobile dealer agrees to take his customer\xe2\x80\x99s present car as a trade-in. The\ncustomer says that he has full title to the car. In fact, the customer is still paying off an installment loan\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n266\n\n\x0cand the finance company has an interest in the old car. If the finance company repossesses the car, the\ncustomer\xe2\x80\x94who got a new car at a discount because of his false representation\xe2\x80\x94cannot be said to have\ntaken the new car by larceny or embezzlement. Nevertheless, he tricked the dealer into selling, and the\ndealer will have lost the value of the repossessed car. Obviously, the customer is guilty of a criminal act;\nthe statutes 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 defraud.\n\nA number of problems have arisen in the judicial interpretation of false-pretense statutes. One concerns\nwhether the taking is permanent or only temporary. The case of State v. Mills (Section 6.7 "Cases") shows\nthe subtle questions that can be presented and the dangers inherent in committing \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 used\ninstead for another. This is a false representation of fact. Suppose, by contrast, that a person\nmisrepresents his state of mind: \xe2\x80\x9cI will pay you back tomorrow,\xe2\x80\x9d he says, knowing full well that he does\nnot intend to. Can such a misrepresentation amount to false pretenses punishable as a criminal offense?\nIn most jurisdictions it cannot. A false-pretense violation relates to a past event or existing fact, not to a\nstatement of intention. If it were otherwise, anyone failing to pay a debt might find himself facing criminal\nprosecution, and business would be less prone to take risks.\n\nThe problem of proving intent is especially difficult when a person has availed himself of the services of\nanother without paying. A common example is someone leaving a restaurant without paying for the meal.\nIn 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 or\nmisdemeanor, depending on the value of the property. The receipt need not be personal; if the property is\ndelivered to a place under the control of the receiver, then he is deemed to have received it. \xe2\x80\x9cKnowledge\xe2\x80\x9d\nis construed broadly: not merely actual knowledge, but (correct) belief and suspicion (strong enough not\nto investigate for fear that the property will turn out to have been stolen) are sufficient for conviction.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n267\n\n\x0cForgery\nForgery is false writing of a document of legal significance (or apparent legal significance!) with intent to\ndefraud. It includes the making up of a false document or the alteration of an existing one. The writing\nneed not be done by hand but can be by any means\xe2\x80\x94typing, printing, and so forth. Documents commonly\nthe subject of forgery are negotiable instruments (checks, money orders, and the like), deeds, receipts,\ncontracts, and bills of lading. The forged instrument must itself be false, not merely contain a falsehood. If\nyou fake your neighbor\xe2\x80\x99s signature on one of his checks made out to cash, you have committed forgery.\nBut if you sign a check of your own that is made out to cash, knowing that there is no money in your\nchecking account, the instrument is not forged, though the act may be criminal if done with the intent to\ndefraud.\nThe mere making of a forged instrument is unlawful. So is the \xe2\x80\x9cuttering\xe2\x80\x9d (or presentation) of such an\ninstrument, whether or not the one uttering it actually forged it. The usual example of a false signature is\nby no means the only way to commit forgery. If done with intent to defraud, the backdating of a\ndocument, the modification of a corporate name, or the filling in of lines left blank on a form can all\nconstitute 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 inspector who\nrefuses to issue a permit unless the permittee pays him. Under modern statutes, the crime of extortion has\nbeen broadened to include the wrongful collection of money or something else of value by anyone by\nmeans of a threat (short of a threat of immediate physical violence, for such a threat would make the\ndemand an act of robbery). This kind of extortion is usually called blackmail. The blackmail threat\ncommonly is to expose some fact of the victim\xe2\x80\x99s private 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 dwelling of\nanother in the nighttime with intent to commit a felony.\xe2\x80\x9d The intent to steal is not an issue: a man who\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n268\n\n\x0csneaks into a woman\xe2\x80\x99s home intent on raping her has committed a burglary, even if he does not carry out\nthe act. The student doing critical thinking will no doubt notice that the definition provides plenty of room\nfor argument. What is \xe2\x80\x9cbreaking\xe2\x80\x9d? (The courts do not require actual destruction; the mere opening of a\nclosed door, even if unlocked, is enough.) What is entry? When does night begin? What kind of intent?\nWhose dwelling? Can a landlord burglarize the dwelling of his tenant? (Yes.) Can a person burglarize his\nown home? (No.)\n\nArson\nUnder common law, arson was the malicious burning of the dwelling of another. Burning one\xe2\x80\x99s own\nhouse for purposes of collecting insurance was not an act of arson under common law. The statutes today\nmake it a felony intentionally to set fire to any building, whether or not it is a dwelling and whether or not\nthe purpose is to collect insurance.\n\nBribery\nBribery is a corrupt payment (or receipt of such a payment) for official action. The payment can be in\ncash or in the form of any goods, intangibles, or services that the recipient would find valuable. Under\ncommon law, only a public official could be bribed. In most states, bribery charges can result from the\nbribe of anyone performing a public function.\n\nBribing a public official in government procurement (contracting) can result in serious criminal charges.\nBribing a public official in a foreign country to win a contract can result in charges under the Foreign\nCorrupt 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). To be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n269\n\n\x0cperjurious, the oath must have been made corruptly\xe2\x80\x94that is, with knowledge that it was false or without\nsincere belief that it was true. An innocent mistake is not perjury. A statement, though true, is perjury if\nthe maker of it believes it to be false. Statements such as \xe2\x80\x9cI don\xe2\x80\x99t remember\xe2\x80\x9d or \xe2\x80\x9cto the best of my\nknowledge\xe2\x80\x9d are not sufficient to protect a person who is lying from conviction for perjury. To support a\ncharge of perjury, however, the false statement must be \xe2\x80\x9cmaterial,\xe2\x80\x9d meaning that the statement is relevant\nto 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 carried\nout in a nonviolent way, usually connected with business. Armed bank robbery is not a white-collar crime,\nbut embezzlement by a teller or bank officer is. Many white-collar crimes are included within the statutory\ndefinitions of embezzlement and false pretenses. Most are violations of state law. Depending on how they\nare carried out, many of these same crimes are also violations of federal law.\n\nAny act of fraud in which the United States postal system is used or which involves interstate phone calls\nor Internet connections is a violation of federal law. Likewise, many different acts around the buying and\nselling of securities can run afoul of federal securities laws. Other white-collar crimes include tax fraud;\nprice fixing; violations of food, drug, and environmental laws; corporate bribery of foreign companies;\nand\xe2\x80\x94the newest form\xe2\x80\x94computer fraud. Some of these are discussed here; others are covered in later\nchapters.\n\nMail and Wire Fraud\nFederal law prohibits the use of the mails or any interstate electronic communications medium for the\npurpose of furthering a \xe2\x80\x9cscheme or artifice to defraud.\xe2\x80\x9d The statute is broad, and it is relatively easy for\nprosecutors to prove a violation. The law also bans attempts to defraud, so the prosecutor need not show\nthat the scheme worked or that anyone suffered any losses. \xe2\x80\x9cFraud\xe2\x80\x9d is broadly construed: anyone who\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n270\n\n\x0cuses the mails or telephone to defraud anyone else of virtually anything, not just of money, can be\nconvicted under the law. In one case, a state governor was convicted of mail fraud when he took bribes to\ninfluence the setting of racing dates. The court\xe2\x80\x99s theory was that he defrauded the citizenry of its right to\nhis \xe2\x80\x9chonest and faithful services\xe2\x80\x9d as governor.\n\n[1]\n\nViolations of Antitrust Law\nIn (Reference mayer_1.0-ch43 not found in Book), (Reference mayer_1.0-ch44 not found in Book),\nand (Reference mayer_1.0-ch45 not found in Book), we consider the fundamentals of antitrust law, which\nfor the most part affects the business enterprise civilly. But violations of Section 1 of the Sherman Act,\nwhich condemns activities in \xe2\x80\x9crestraint of trade\xe2\x80\x9d (including price fixing), are also crimes.\n\nViolations of the Food and Drug Act\nThe federal Food, Drug, and Cosmetic Act prohibits any person or corporation from\nsending into interstate commerce any adulterated or misbranded food, drug, cosmetics,\nor related device. For example, in a 2010 case, Allergen had to pay a criminal fine for\nmarketing Botox as a headache or pain reliever, a use that had not been approved by the\nFood and Drug Administration. Unlike most criminal statutes, willfulness or deliberate\nmisconduct is not an element of the act. As theUnited States v. Park case (Section 6.7\n"Cases") shows, an executive can be held criminally liable even though he may have had\nno personal knowledge of the violation.\n\nEnvironmental Crimes\nMany federal environmental statutes have criminal provisions. These include the Federal Water Pollution\nControl Act (commonly called the Clean Water Act); the Rivers and Harbors Act of 1899 (the Refuse Act);\nthe Clean Air Act; the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA); the Toxic Substances\nControl Act (TSCA); and the Resource Conservation and Recovery Act (RCRA). Under the Clean Water\nAct, for example, wrongful discharge of pollutants into navigable waters carries a fine ranging from\n$2,500 to $25,000 per day and imprisonment for up to one year. \xe2\x80\x9cResponsible corporate officers\xe2\x80\x9d are\nspecifically included as potential defendants in criminal prosecutions under the act. They can include\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n271\n\n\x0cofficers who have responsibility over a project where subcontractors and their employees actually caused\nthe discharge.\n\n[2]\n\nViolations of the Foreign Corrupt Practices Act\nAs a byproduct of Watergate, federal officials at the Securities and Exchange Commission and the Internal\nRevenue Service uncovered many instances of bribes paid by major corporations to officials of foreign\ngovernments to win contracts with those governments. Congress responded in 1977 with the Foreign\nCorrupt Practices Act, which imposed a stringent requirement that the disposition of assets be accurately\nand fairly accounted for in a company\xe2\x80\x99s books and records. The act also made illegal the payment of bribes\nto foreign officials or to anyone who will transmit the money to a foreign official to assist the payor (the\none offering and delivering the money) 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), aimed at\nending organized crime\xe2\x80\x99s infiltration into legitimate business. The act tells courts to construe its language\nbroadly \xe2\x80\x9cto effectuate its remedial purpose,\xe2\x80\x9d and many who are not part of organized crime have been\nsuccessfully prosecuted under the act. It bans a \xe2\x80\x9cpattern of racketeering,\xe2\x80\x9d defined as the commission of at\nleast two acts within ten years of any of a variety of already-existing crimes, including mail, wire, and\nsecurities fraud. The act thus makes many types 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 acquisition of\ninformation. The main federal statutory framework for many computer crimes is the Computer Fraud and\nAbuse Act (CFAA; seeTable 6.1 "Summary of Provisions of the Computer Fraud and Abuse Act"). Congress\nonly prohibited computer fraud and abuse where there was a federal interest, as where computers of the\ngovernment were involved or where the crime was interstate in nature.\n\nTable 6.1 Summary of Provisions of the Computer Fraud and Abuse Act\nObtaining national security information\nSec. (a)(1) 10 years maximum (20 years second\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n272\n\n\x0coffense)\nTrespassing in a government computer\n\nSec. (a)(3)\n\n1 year (5)\n\nCompromising the confidentiality of a\ncomputer\n\nSec. (a)(2)\n\n1 year (10)\n\nAccessing a computer to defraud and\nobtain value\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\nK E Y TA K EA WAY\nOffenses can be against persons, against property, or against public policy (as when you\nbribe a public official, commit perjury, or use public goods such as the mails or the\nInternet to commit fraud, violate antitrust laws, or commit other white-collar crimes).\n\nE XE R C IS ES\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\nbaking a cherry pie and sets it in the open windowsill to cool. Harold smells the pie\nfrom the sidewalk. It is twilight; while still light, the sun has officially set. Harold\nreaches into the window frame and removes the pie. Technically, has Harold\ncommitted burglary? What are the issues here based on the definition of burglary?\n4. What is fraud? How is it different from dishonesty? Is being dishonest a criminal\noffense? If so, have you been a criminal already today?\n[1] United States v. Isaacs, 493 F.2d 1124 (7th Cir. 1974), cert. denied, 417 US 976 (1974).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n273\n\n\x0c[2] U.S. v. Hanousek, 176 F.3d 1116 (9th Cir. 1999).\n\n6.3 The Nature of a Criminal Act\nL EA R N IN G O B JEC T IV ES\n1. Understand how it is possible to commit a criminal act without actually doing\nanything that you think might be criminal.\n2. Analyze and explain the importance of intention in criminal law and criminal\nprosecutions.\n3. Explain how a corporation can be guilty of a crime, even though it is a corporation\xe2\x80\x99s\nagents that commit the crime.\n\nTo be guilty of a crime, you must have acted. Mental desire or intent to do so is insufficient. But what\nconstitutes an act? This question becomes important when someone begins to commit a crime, or does so\nin association with others, or intends to do one thing but winds up doing something else.\n\nAttempt\nIt is not necessary to commit the intended crime to be found guilty of a criminal offense. An attempt to\ncommit the crime is punishable as well, though usually not as severely. For example, Brett points a gun at\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n274\n\n\x0cAshley, intending to shoot her dead. He pulls the trigger but his aim is off, and he misses her heart by four\nfeet. He is guilty of an attempt to murder. Suppose, however, that earlier in the day, when he was\npreparing to shoot Ashley, Brett had been overheard in his apartment muttering to himself of his\nintention, and that a neighbor called the police. When they arrived, he was just snapping his gun into his\nshoulder holster.\n\nAt that point, courts in most states would not consider him guilty of an attempt because he had not passed\nbeyond the stage of preparation. After having buttoned his jacket he might have reconsidered and put the\ngun away. Determining when the accused has passed beyond mere preparation and taken an actual step\ntoward perpetrating the crime is often difficult and is usually for the jury to decide.\n\nImpossibility\nWhat if a defendant is accused of attempting a crime that is factually impossible? For example, suppose\nthat men believed they were raping a drunken, unconscious woman, and were later accused of attempted\nrape, but defended on the grounds of factual impossibility because the woman was actually dead at the\ntime sexual intercourse took place? Or suppose that a husband intended to poison his wife with\nstrychnine in her coffee, but put sugar in the coffee instead? The \xe2\x80\x9cmens rea\xe2\x80\x9d or criminal intent was there,\nbut the act itself was not criminal (rape requires a live victim, and murder by poisoning requires the use of\npoison). States are divided on this, but thirty-seven states have ruled out factual impossibility as a defense\nto the crime of attempt.\n\nLegal impossibility is different, and is usually acknowledged as a valid defense. If the defendant completes\nall of his intended acts, but those acts do not fulfill all the required elements of a crime, there could be a\nsuccessful \xe2\x80\x9cimpossibility\xe2\x80\x9d defense. If Barney (who has poor sight), shoots at a tree stump, thinking it is his\nneighbor, Ralph, intending to kill him, has he committed an attempt? Many courts would hold that he has\nnot. But the distinction between factual impossibility and legal impossibility is not always clear, and the\ntrend seems to be to punish the intended attempt.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n275\n\n\x0cConspiracy\nUnder both federal and state laws, it is a separate offense to work with others toward the commission of a\ncrime. When two or more people combine to carry out an unlawful purpose, they are engaged in a\nconspiracy. The law of conspiracy is quite broad, especially when it is used by prosecutors in connection\nwith white-collar crimes. Many people can be swept up in the net of conspiracy, because it is unnecessary\nto show that the actions they took were sufficient to constitute either the crime or an attempt. Usually, the\nprosecution needs to show only (1) an agreement and (2) a single overt act in furtherance of the\nconspiracy. Thus if three people agree to rob a bank, and if one of them goes to a store to purchase a gun\nto be used in the holdup, the three can be convicted of conspiracy to commit robbery. Even the purchase\nof an automobile to be 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 not\nmatter, for instance, that only one of the bank robbers fired the gun that killed a guard. All can be\nconvicted of murder. That is so even if one of the conspirators was stationed as a lookout several blocks\naway and even if he specifically told the others that his agreement to cooperate would end \xe2\x80\x9cjust as soon as\nthere 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 \xe2\x80\x9cimputing\xe2\x80\x9d the\nguilt of the actor to another is that both were engaged in a conspiracy. But imputation of guilt is not\nlimited to a conspiracy. The agent may be innocent even though he participates. A corporate officer\ndirects a junior employee to take a certain bag and deliver it to the officer\xe2\x80\x99s home. The employee\nreasonably believes that the officer is entitled to the bag. Unbeknownst to the employee, the bag contains\nmoney that belongs to the company, and the officer wishes to keep it. This is not a conspiracy. The\nemployee is not guilty of larceny, but the officer is, because the agent\xe2\x80\x99s act is imputed to him.\n\nSince intent is a necessary component of crime, an agent\xe2\x80\x99s intent cannot be imputed to his principal if the\nprincipal did not share the intent. The company president tells her sales manager, \xe2\x80\x9cGo make sure our\nbiggest customer renews his contract for next year\xe2\x80\x9d\xe2\x80\x94by which she meant, \xe2\x80\x9cDon\xe2\x80\x99t ignore our biggest\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n276\n\n\x0ccustomer.\xe2\x80\x9d Standing before the customer\xe2\x80\x99s purchasing agent, the sales manager threatens to tell the\npurchasing agent\xe2\x80\x99s boss that the purchasing agent has been cheating on his expense account, unless he\nsigns a new contract. The sales manager could be convicted of blackmail, but the company president could\nnot.\n\nCan a corporation be guilty of a crime? For many types of crimes, the guilt of individual employees may be\nimputed to the corporation. Thus the antitrust statutes explicitly state that the corporation may be\nconvicted and fined for violations by employees. This is so even though the shareholders are the ones who\nultimately must pay the price\xe2\x80\x94and who may have had nothing to do with the crime nor the power to stop\nit. The law of corporate criminal responsibility has been changing in recent years. The tendency is to hold\nthe corporation liable under criminal law if the act has been directed by a responsible officer or group\nwithin the corporation (the president or board of directors).\n\nK E Y TA K EA WAY\nAlthough proving the intent to commit a crime (the mens rea) is essential, the intent can\nbe established by inference (circumstantially). Conspirators may not actually commit a\ncrime, for example, but in preparing for a criminal act, they may be guilty of the crime of\nconspiracy. Certain corporate officers, as well, may not be directly committing criminal\nacts but may be held criminally responsible for acts of their agents and contractors.\n\nE XE R C IS ES\n1. Give an example of how someone can intend to commit a crime but fail to commit\none.\n2. Describe a situation where there is a conspiracy to commit a crime without the\ncrime actually taking place.\n3. Create a scenario based on current events where a corporation could be found\nguilty of committing a crime even though the CEO, the board of directors, and the\nshareholders have not themselves done a criminal act.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n277\n\n\x0c6.4 Responsibility\nL EA R N IN G O B JEC T IV ES\n1. Explain why criminal law generally requires that the defendant charged with a crime\nhave criminal "intent."\n2. Know and explain the possible excuses relating to responsibility that are legally\nrecognized by courts, including lack of capacity.\n\nIn General\nThe mens rea requirement depends on the nature of the crime and all the circumstances surrounding the\nact. In general, though, the requirement means that the accused must in some way have intended the\ncriminal consequences of his act. Suppose, for example, that Charlie gives Gabrielle a poison capsule to\nswallow. That is the act. If Gabrielle dies, is Charlie guilty of murder? The answer depends on what his\nstate of mind was. Obviously, if he gave it to her intending to kill her, the act was murder.\n\nWhat if he gave it to her knowing that the capsule was poison but believing that it would only make her\nmildly ill? The act is still murder, because we are all liable for the consequences of any intentional act that\nmay cause harm to others. But suppose that Gabrielle had asked Harry for aspirin, and he handed her two\npills that he reasonably believed to be aspirin (they came from the aspirin bottle and looked like aspirin)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n278\n\n\x0cbut that turned out to be poison, the act would not be murder, because he had neither intent nor a state of\nknowledge from which intent could be inferred.\n\nNot every criminal law requires criminal intent as an ingredient of the crime. Many regulatory codes\ndealing with the public health and safety impose strict requirements. Failure to adhere to such\nrequirements 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 considerations\ninvolved in mens rea.\n\nExcuses 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 right on a red\nlight but the city ordinance prohibits it, your belief, even if reasonable, does not excuse your violation of\nthe law. Under certain circumstances, however, ignorance of law will be excused. If a statute imposes\ncriminal penalties for an action taken without a license, and if the government official responsible for\nissuing the license formally tells you that you do not need one (though in fact you do), a conviction for\nviolating the statute cannot stand. In rare cases, a lawyer\xe2\x80\x99s advice, contrary to the statute, will be held to\nexcuse the client, but usually the client is responsible for his attorney\xe2\x80\x99s mistakes. Otherwise, as it is said,\nthe lawyer would be superior to the law.\n\nIgnorance or mistake of fact more frequently will serve as an excuse. If you take a coat from a restaurant,\nbelieving it to be yours, you cannot be convicted of larceny if it is not. Your honest mistake of fact negates\nthe requisite intent. In general, the rule is that a mistaken belief of fact will excuse criminal responsibility\nif (1) the belief is honestly held, (2) it is reasonable to hold it, and (3) the act would not have been criminal\nif the facts were as the accused supposed them to have been.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n279\n\n\x0cEntrapment\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 in which\nostensibly stolen goods are \xe2\x80\x9csold\xe2\x80\x9d to underworld \xe2\x80\x9cfences.\xe2\x80\x9d Sometimes these methods are the only way by\nwhich certain kinds of crime can be rooted out and convictions secured.\n\nBut a rule against entrapment limits the legal ability of the police to play the role of criminals. The\npolice are permitted to use such techniques to detect criminal activity; they are not permitted to do so to\ninstigate crime. The distinction is usually made between a person who intends to commit a crime and one\nwho does not. If the police provide the former with an opportunity to commit a criminal act\xe2\x80\x94the sale of\ndrugs to an undercover agent, for example\xe2\x80\x94there is no defense of entrapment. But if the police knock on\nthe door of one not known to be a drug user and persist in a demand that he purchase drugs from them,\nfinally overcoming his will to resist, a conviction for purchase and possession of drugs can be overturned\non the ground of entrapment.\n\nOther Excuses\nA number of other circumstances can limit or excuse criminal liability. These include compulsion (a gun\npointed at one\xe2\x80\x99s head by a masked man who apparently is unafraid to use the weapon and who demands\nthat you help him rob a store), honest consent of the \xe2\x80\x9cvictim\xe2\x80\x9d (the quarterback who is tackled), adherence\nto the requirements of legitimate public authority lawfully exercised (a policeman directs a towing\ncompany to remove a car parked in a tow-away zone), the proper exercise of domestic authority (a parent\nmay spank a child, within limits), and defense of self, others, property, and habitation. Each of these\nexcuses is a complex subject in itself.\n\nLack of Capacity\nA further defense to criminal prosecution is the lack of mental capacity to commit the crime. Infants and\nchildren are considered incapable of committing a crime; under common law any child under the age of\nseven could not be prosecuted for any act. That age of incapacity varies from state to state and is now\nusually defined by statutes. Likewise, insanity or mental disease or defect can be a complete defense.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n280\n\n\x0cIntoxication can be a defense to certain crimes, but the mere fact of drunkenness is not ordinarily\nsufficient.\n\nK E Y TA K EA WAY\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\nE XE R C IS ES\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?\nWhy or why not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n281\n\n\x0c6.5 Procedure\nL EA R N IN G O B JEC T IV ES\n1. Describe the basic steps in pretrial criminal procedure that follow a\ngovernment\'s determination to arrest someone for an alleged criminal act.\n2. Describe the basic elements of trial and posttrial criminal procedure.\n\nThe procedure for criminal prosecutions is complex. Procedures will vary from state to state. A criminal\ncase begins with an arrest if the defendant is caught in the act or fleeing from the scene; if the defendant is\nnot caught, a warrant for the defendant\xe2\x80\x99s arrest will issue. The warrant is issued by a judge or a magistrate\nupon receiving a complaint detailing the charge of a specific crime against the accused. It is not enough\nfor a police officer to go before a judge and say, \xe2\x80\x9cI\xe2\x80\x99d like you to arrest Bonnie because I think she\xe2\x80\x99s just\nmurdered Clyde.\xe2\x80\x9d She must supply enough information to satisfy the magistrate that there is probable\ncause (reasonable grounds) to believe that the accused committed the crime. The warrant will be issued to\nany officer or agency that has power to arrest the accused with warrant in hand.\n\nThe accused will be brought before the magistrate for a preliminary hearing. The purpose of the hearing is\nto determine whether there is sufficient reason to hold the accused for trial. If so, the accused can be sent\nto jail or be permitted to make bail. Bail is a sum of money paid to the court to secure the defendant\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n282\n\n\x0cattendance at trial. If he fails to appear, he forfeits the money. Constitutionally, bail can be withheld only\nif there is reason to believe that the accused will flee the jurisdiction.\n\nOnce the arrest is made, the case is in the hands of the prosecutor. In the fifty states, prosecution is a\nfunction of the district attorney\xe2\x80\x99s office. These offices are usually organized on a county-by-county basis.\nIn the federal system, criminal prosecution is handled by the office of the US attorney, one of whom is\nappointed for every federal district.\n\nFollowing the preliminary hearing, the prosecutor must either file an information (a document stating\nthe crime of which the person being held is accused) or ask the grand jury for an indictment. The\ngrand jury consists of twenty-three people who sit to determine whether there is sufficient evidence to\nwarrant a prosecution. It does not sit to determine guilt or innocence. The indictment is the grand jury\xe2\x80\x99s\nformal declaration of charges on which the accused will be tried. If indicted, the accused formally becomes\na defendant.\n\nThe defendant will then be arraigned, that is, brought before a judge to answer the accusation in the\nindictment. The defendant may plead guilty or not guilty. If he pleads not guilty, the case will be tried\nbefore a jury (sometimes referred to as a petit jury). The jury cannot convict unless it finds the defendant\nguilty beyond a reasonable doubt.\n\nThe defendant might have pleaded guilty to the offense or to a lesser charge (often referred to as a \xe2\x80\x9clesser\nincluded offense\xe2\x80\x9d\xe2\x80\x94simple larceny, for example, is a lesser included offense of robbery because the\ndefendant may not have used violence but nevertheless stole from the victim). Such a plea is usually\narranged through plea bargaining with the prosecution. In return for the plea, the prosecutor promises\nto recommend to the judge that the sentence be limited. The judge most often, but not always, goes along\nwith the prosecutor\xe2\x80\x99s recommendation.\n\nThe defendant is also permitted to file a plea of nolo contendere (no contest) in prosecutions for certain\ncrimes. In so doing, he neither affirms nor denies his guilt. He may be sentenced as though he had\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n283\n\n\x0cpleaded guilty, although usually a nolo plea is the result of a plea bargain. Why plead nolo? In some\noffenses, such as violations of the antitrust laws, the statutes provide that private plaintiffs may use a\nconviction or a guilty plea as proof that the defendant violated the law. This enables a plaintiff to prove\nliability without putting on witnesses or evidence and reduces the civil trial to a hearing about the\ndamages to plaintiff. The nolo plea permits the defendant to avoid this, so that any plaintiff will have to\nnot only prove damages but also establish civil liability.\n\nFollowing a guilty plea or a verdict of guilt, the judge will impose a sentence after presentencing reports\nare written by various court officials (often, probation officers). Permissible sentences are spelled out in\nstatutes, though these frequently give the judge a range within which to work (e.g., twenty years to life).\nThe judge may sentence the defendant to imprisonment, a fine, or both, or may decide to suspend\nsentence (i.e., the defendant will not have to serve the sentence as long as he stays out of trouble).\n\nSentencing usually comes before appeal. As in civil cases, the defendant, now convicted, has the right to\ntake at least one appeal to higher courts, where issues of procedure and constitutional rights may be\nargued.\n\nK E Y TA K EA WAY\nCriminal procedure in US courts is designed to provide a fair process to both\ncriminal defendants and to society. The grand jury system, prosecutorial\ndiscretion, plea bargains, and appeals for lack of a fair trial are all part of US\ncriminal procedure.\n\nE XE R C IS ES\n1. Harold is charged with the crime of assault with a deadly weapon with intent\nto kill or inflict serious bodily injury. It is a more serious crime than simple\nassault. Harold\xe2\x80\x99s attorney wants the prosecutor to give Harold a break, but\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n284\n\n\x0cHarold is guilty of at least simple assault and may also have had the intent to\nkill. What is Harold\xe2\x80\x99s attorney likely to do?\n2. Kumar was driving his car, smoking marijuana, and had an accident with\nanother vehicle. The other driver was slightly injured. When the officer\narrived, she detected a strong odor of marijuana in Kumar\xe2\x80\x99s car and a small\namount of marijuana in the glove compartment. The other driver expects to\nbring a civil action against Kumar for her injuries after Kumar\xe2\x80\x99s criminal case.\nWhat should Kumar plead in the criminal case\xe2\x80\x94careless driving or driving\nunder the influence?\n\n6.6 Constitutional Rights of the Accused\nL EA R N IN G O B JEC T IV ES\n1. Describe the most significant constitutional rights of defendants in US courts, and\nname the source 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 amendments that\nmake up the Bill of Rights (Amendments Four, Five, Six, and Eight). For the most part, these\namendments have been held to apply to both the federal and the state governments. The Fourth\nAmendment says in part that \xe2\x80\x9cthe right of the people to be secure in their persons, houses, papers, and\neffects, against unreasonable searches and seizures, shall not be violated.\xe2\x80\x9d Although there are numerous\nand tricky exceptions to the general rule, ordinarily the police may not break into a person\xe2\x80\x99s house or\nconfiscate his papers or arrest him unless they have a warrant to do so. This means, for instance, that a\npoliceman cannot simply stop you on a street corner and ask to see what is in your pockets (a power the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n285\n\n\x0cpolice enjoy in many other countries), nor can your home be raided without probable cause to believe that\nyou have committed a crime. What if the police do search or seize unreasonably?\n\nThe courts have devised a remedy for the use at trial of the fruits of an unlawful search or seizure.\nEvidence that is unconstitutionally seized is excluded from the trial. This is the so-called exclusionary\nrule, first made applicable in federal cases in 1914 and brought home to the states in 1961.\nThe exclusionary rule is highly controversial, and there are numerous exceptions to it. But it remains\ngenerally true that the prosecutor may not use evidence willfully taken by the police in violation of\nconstitutional rights generally, and most often in the violation of Fourth Amendment rights. (The fruits of\na coerced confession are also excluded.)\n\nDouble Jeopardy\nThe Fifth Amendment prohibits the government from prosecuting a person twice for the same offense.\nThe amendment says that no person shall be \xe2\x80\x9csubject for the same offence to be twice put in jeopardy of\nlife or limb.\xe2\x80\x9d If a defendant is acquitted, the government may not appeal. If a defendant is convicted and\nhis conviction is upheld on appeal, he may not thereafter be reprosecuted 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 \xe2\x80\x9cshall be\ncompelled in any criminal case to be a witness against himself\xe2\x80\x9d). The debate over the limits of this right\nhas given rise to an immense literature. In broadest outline, the right against self-incrimination means\nthat the prosecutor may not call a defendant to the witness stand during trial and may not comment to the\njury on the defendant\xe2\x80\x99s failure to take the stand. Moreover, a defendant\xe2\x80\x99s confession must be excluded\nfrom evidence if it was not voluntarily made (e.g., if the police beat the person into giving a confession).\nIn Miranda v. Arizona, the Supreme Court ruled that no confession is admissible if the police have not\nfirst advised a suspect of his constitutional rights, including the right to have a lawyer present to advise\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n286\n\n\x0chim during the questioning.\n\n[1]\n\nThese so-called Miranda warnings have prompted scores of follow-up cases\n\nthat 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 delay is too\nlong depends on the circumstances in each case. In 1975, Congress enacted the Speedy Trial Act to give\npriority to criminal cases in federal courts. It requires all criminal prosecutions to go to trial within\nseventy-five days (though the law lists many permissible reasons for delay).\n\nCross-Examination\nThe Sixth Amendment also says that the defendant shall have the right to confront witnesses against him.\nNo testimony is permitted to be shown to the jury unless the person making it is present and subject to\ncross-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 defense counsel.\nDuring the eighteenth century and before, the British courts frequently refused to permit defendants to\nhave lawyers in the courtroom during trial. The right to counsel is much broader in this country, as the\nresult of Supreme Court decisions that require the state to pay for a lawyer for indigent defendants in\nmost criminal cases.\n\nCruel and Unusual Punishment\nPunishment under the common law was frequently horrifying. Death was a common punishment for\nrelatively minor crimes. In many places throughout the world, punishments still persist that seem cruel\nand unusual, such as the practice of stoning someone to death. The guillotine, famously in use during and\nafter the French Revolution, is no longer used, nor are defendants put in stocks for public display and\nhumiliation. In pre-Revolutionary America, an unlucky defendant who found himself convicted could face\nbrutal torture before death.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n287\n\n\x0cThe Eighth Amendment banned these actions with the words that \xe2\x80\x9ccruel and unusual punishments [shall\nnot be] inflicted.\xe2\x80\x9d Virtually all such punishments either never were enacted or have been eliminated from\nthe statute books in the United States. Nevertheless, the Eighth Amendment has become a source of\ncontroversy, first with the Supreme Court\xe2\x80\x99s ruling in 1976 that the death penalty, as haphazardly applied\nin the various states, amounted to cruel and unusual punishment. Later Supreme Court opinions have\nmade it easier for states to administer the death penalty. As of 2010, there were 3,300 defendants on\ndeath row in the United States. Of course, no corporation is on death row, and no corporation\xe2\x80\x99s charter\nhas ever been revoked by a US state, even though some corporations have repeatedly been indicted and\nconvicted of criminal 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 juries must\nbe properly instructed that the defendant is innocent until proven guilty. This is the origin of the \xe2\x80\x9cbeyond\nall reasonable doubt\xe2\x80\x9d standard of proof and is an instruction given to juries in each criminal case. The\nFifth Amendment notes the right of \xe2\x80\x9cdue process\xe2\x80\x9d in federal proceedings, and the Fourteenth Amendment\nrequires that each state provide \xe2\x80\x9cdue process\xe2\x80\x9d to defendants.\n\nK E Y TA K EA WAY\nThe US Constitution provides several important protections for criminal defendants,\nincluding a prohibition on the use of evidence that has been obtained by\nunconstitutional means. This would include evidence seized in violation of the Fourth\nAmendment and confessions obtained in violation of the Fifth Amendment.\n\nE XE R C IS ES\n1. Do you think it is useful to have a presumption of innocence in criminal cases? What\nif there were not a presumption of innocence in criminal cases?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n288\n\n\x0c2. Do you think public humiliation, public execution, and unusual punishments would\nreduce the 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\ntoward criminal defendants?\n[1] Miranda v. Arizona, 384 US 436 (1966).\n\n6.7 Cases\nFalse Pretenses\nState v. Mills\n\n96 Ariz. 377, 396 P.2d 5 (Ariz. 1964)\n\nLOCKWOOD, VICE CHIEF JUSTICE\n\nDefendants appeal from a conviction on two counts of obtaining money by false pretenses in violation of\nAR.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 favorable to sustaining\nthe conviction,\xe2\x80\x9d are as follows: Defendant William Mills was a builder and owned approximately 150\nhomes in Tucson in December, 1960. Mills conducted his business in his home. In 1960 defendant\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n289\n\n\x0cWinifred Mills, his wife, participated in the business generally by answering the telephone, typing, and\nreceiving clients who came to the office.\n\nIn December 1960, Mills showed the complainant, Nathan Pivowar, a house at 1155 Knox Drive and\nanother at 1210 Easy Street, and asked Pivowar if he would loan money on the Knox Drive house. Pivowar\ndid not indicate at that time whether he would agree to such a transaction. Later in the same month\nNathan Pivowar told the defendants that he and his brother, Joe Pivowar, would loan $5,000 and $4,000\non the two houses. Three or four days later Mrs. Mills, at Pivowar\xe2\x80\x99s request, showed him these homes\nagain.\n\nMills had prepared two typed mortgages for Pivowar. Pivowar objected to the wording, so in Mills\xe2\x80\x99 office\nMrs. Mills retyped the mortgages under Pivowar\xe2\x80\x99s dictation. After the mortgages had been recorded on\nDecember 31, 1960, Pivowar gave Mills a bank check for $5,791.87, some cash, and a second mortgage\nformerly obtained from Mills in the approximate sum of $3,000. In exchange Mills gave Pivowar two\npersonal notes in the sums of $5,250.00 and $4,200.00 and the two mortgages as security for the loan.\nAlthough the due date for Mills\xe2\x80\x99 personal notes passed without payment being made, the complainant did\nnot present the notes for payment, did not demand that they be paid, and did not sue upon them. In 1962\nthe complainant learned that the mortgages which he had taken as security in the transaction were not\nfirst mortgages on the Knox Drive and Easy Street properties. These mortgages actually covered two\nvacant lots on which there were outstanding senior mortgages. On learning this, Pivowar signed a\ncomplaint charging the defendants with the crime of theft by false pretenses.\n\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 the\ncrime of theft. Since the complainant had the right to sue on the defendants\xe2\x80\x99 notes, the defendants assert\nthat complainant cannot be said to have been deprived of his property permanently. Defendants\nmisconceive the elements of the crime of theft by false pretenses. Stated in a different form, their\nargument is that although the complainant has parted with his cash, a bank check, and a second\nmortgage, the defendants intend to repay the loan.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n290\n\n\x0cDefendants 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 creditor has a\nright to determine for himself whether he wishes to be a secured or an unsecured creditor. In the former\ncase, he has a right to know about the security. If he extends credit in reliance upon security which is\nfalsely represented to be adequate, he has been defrauded even if the debtor intends to repay the debt. His\nposition is now that of an unsecured creditor. At the very least, an unreasonable risk of loss has been\nforced upon him by reason of the deceit. This risk which he did not intend to assume has been imposed\nupon him by the intentional act of the debtor, and such action constitutes an intent to defraud.\n***\n\nThe cases cited by defendants in support of their contention are distinguishable from the instant case in\nthat they involved theft by larceny. Since the crime of larceny is designed to protect a person\xe2\x80\x99s possessory\ninterest in property whereas the crime of false pretenses protects one\xe2\x80\x99s title interest, the requirement of a\npermanent deprivation is appropriate to the former. Accordingly, we hold that an intent to repay a loan\nobtained on the basis of a false representation of the security for the loan is no defense.\n***\nAffirmed in part, reversed in part, and remanded for resentencing.\n\nC A SE QU ES TIO NS\n1. False pretenses is a crime of obtaining ownership of property of another by\nmaking untrue representations of fact with intent to defraud. What were the\nuntrue representations of fact made by Mills?\n2. Concisely state the defendant\xe2\x80\x99s argument as to why Pivowar has not been\ndeprived of any property.\n3. If Pivowar had presented the notes and Mills had paid, would a crime have\nbeen committed?\n\nWhite-Collar Crimes\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n291\n\n\x0cUnited States v. Park\n\n421 U.S. 658 (1975)\n\nMR. CHIEF JUSTICE BURGER delivered the opinion of the Court.\n\nWe granted certiorari to consider whether the jury instructions in the prosecution of a corporate officer\nunder \xc2\xa7 301 (k) of the Federal Food, Drug, and Cosmetic Act, 52 Stat. 1042, as amended, 21 U.S.C. \xc2\xa7 331\n(k), were appropriate under United States v. Dotterweich, 320 U.S. 277 (1943). Acme Markets, Inc., is a\nnational retail food chain with approximately 36,000 employees, 874 retail outlets, 12 general\nwarehouses, and four special warehouses. Its headquarters, including the office of the president,\nrespondent Park, who is chief executive officer of the corporation, are located in Philadelphia,\nPennsylvania. In a five-count information filed in the United States District Court for the District of\nMaryland, the Government charged Acme and respondent with violations of the Federal Food, Drug, and\nCosmetic Act. Each count of the information alleged that the defendants had received food that had been\nshipped in interstate commerce and that, while the food was being held for sale in Acme\xe2\x80\x99s Baltimore\nwarehouse following shipment in interstate commerce, they caused it to be held in a building accessible to\nrodents and to be exposed to contamination by rodents. These acts were alleged to have resulted in the\nfood\xe2\x80\x99s being 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. \xc2\xa7\n331 (k).\n\nAcme pleaded guilty to each count of the information. Respondent pleaded not guilty. The evidence at\ntrial demonstrated that in April 1970 the Food and Drug Administration (FDA) advised respondent by\nletter of insanitary conditions in Acme\xe2\x80\x99s Philadelphia warehouse. In 1971 the FDA found that similar\nconditions existed in the firm\xe2\x80\x99s Baltimore warehouse. An FDA consumer safety officer testified concerning\nevidence of rodent infestation and other insanitary conditions discovered during a 12-day inspection of\nthe Baltimore warehouse in November and December 1971. He also related that a second inspection of the\nwarehouse had been conducted in March 1972. On that occasion the inspectors found that there had been\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n292\n\n\x0cimprovement in the sanitary conditions, but that \xe2\x80\x9cthere was still evidence of rodent activity in the building\nand in the warehouses and we found some rodent-contaminated lots of food items.\xe2\x80\x9d\n\nThe Government also presented testimony by the Chief of Compliance of the FDA\xe2\x80\x99s Baltimore office, who\ninformed respondent by letter of the conditions at the Baltimore warehouse after the first inspection.\nThere was testimony by Acme\xe2\x80\x99s Baltimore division vice president, who had responded to the letter on\nbehalf of Acme and respondent and who described the steps taken to remedy the insanitary conditions\ndiscovered by both inspections. The Government\xe2\x80\x99s final witness, Acme\xe2\x80\x99s vice president for legal affairs\nand assistant secretary, identified respondent as the president and chief executive officer of the company\nand read a bylaw prescribing the duties of the chief executive officer. He testified that respondent\nfunctioned by delegating \xe2\x80\x9cnormal operating duties\xe2\x80\x9d including sanitation, but that he retained \xe2\x80\x9ccertain\nthings, which are the big, broad, principles of the operation of the company and had \xe2\x80\x9cthe responsibility of\nseeing that they all work together.\xe2\x80\x9d\n\nAt the close of the Government\xe2\x80\x99s case in chief, respondent moved for a judgment of acquittal on the\nground that \xe2\x80\x9cthe evidence in chief has shown that Mr. Park is not personally concerned in this Food and\nDrug violation.\xe2\x80\x9d The trial judge denied the motion, stating that United States v. Dotterweich, 320 U.S. 277\n(1943), was controlling.\n\nRespondent was the only defense witness. He testified that, although all of Acme\xe2\x80\x99s employees were in a\nsense under his general direction, the company had an \xe2\x80\x9corganizational structure for responsibilities for\ncertain functions\xe2\x80\x9d according to which different phases of its operation were \xe2\x80\x9cassigned to individuals who,\nin turn, have staff and departments under them.\xe2\x80\x9d He identified those individuals responsible for\nsanitation, and related that upon receipt of the January 1972 FDA letter, he had conferred with the vice\npresident for legal affairs, who informed him that the Baltimore division vice president \xe2\x80\x9cwas investigating\nthe situation immediately and would be taking corrective action and would be preparing a summary of the\ncorrective action to reply to the letter.\xe2\x80\x9d Respondent stated that he did not \xe2\x80\x9cbelieve there was anything [he]\ncould have done more constructively than what [he] found was being done.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n293\n\n\x0cOn cross-examination, respondent conceded that providing sanitary conditions for food offered for sale to\nthe public was something that he was \xe2\x80\x9cresponsible for in the entire operation of the company\xe2\x80\x9d and he\nstated that it was one of many phases of the company that he assigned to \xe2\x80\x9cdependable subordinates.\xe2\x80\x9d\nRespondent was asked about and, over the objections of his counsel, admitted receiving, the April 1970\nletter addressed to him from the FDA regarding insanitary conditions at Acme\xe2\x80\x99s Philadelphia warehouse.\nHe acknowledged that, with the exception of the division vice president, the same individuals had\nresponsibility for sanitation in both Baltimore and Philadelphia. Finally, in response to questions\nconcerning the Philadelphia and Baltimore incidents, respondent admitted that the Baltimore problem\nindicated the system for handling sanitation \xe2\x80\x9cwasn\xe2\x80\x99t working perfectly\xe2\x80\x9d and that as Acme\xe2\x80\x99s chief executive\nofficer he was \xe2\x80\x9cresponsible for any result which occurs in our company.\xe2\x80\x9d\n\nAt the close of the evidence, respondent\xe2\x80\x99s renewed motion for a judgment of acquittal was denied. The\nrelevant portion of the trial judge\xe2\x80\x99s instructions to the jury challenged by respondent is set out in the\nmargin. Respondent\xe2\x80\x99s counsel objected to the instructions on the ground that they failed fairly to reflect\nour decision in United States v. Dotterweich supra, and to define \xe2\x80\x9c\xe2\x80\x98responsible relationship.\xe2\x80\x99\xe2\x80\x9d The trial\njudge overruled the objection. The jury found respondent guilty on all counts of the information, and he\nwas subsequently sentenced to pay a fine of $50 on each count. The Court of Appeals reversed the\nconviction and remanded for a new trial.\n***\n\nThe question presented by the Government\xe2\x80\x99s petition for certiorari inUnited States v. Dotterweich, and\nthe focus of this Court\xe2\x80\x99s opinion, was whether the manager of a corporation, as well as the corporation\nitself, may be prosecuted under the Federal Food, Drug, and Cosmetic Act of 1938 for the introduction of\nmisbranded and adulterated articles into interstate commerce. In Dotterweich, a jury had disagreed as to\nthe corporation, a jobber purchasing drugs from manufacturers and shipping them in interstate\ncommerce under its own label, but had convicted Dotterweich, the corporation\xe2\x80\x99s president and general\nmanager. The Court of Appeals reversed the conviction on the ground that only the drug dealer, whether\ncorporation or individual, was subject to the criminal provisions of the Act, and that where the dealer was\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n294\n\n\x0ca corporation, an individual connected therewith might be held personally only if he was operating the\ncorporation as his \xe2\x80\x98alter ego.\xe2\x80\x99\n\nIn reversing the judgment of the Court of Appeals and reinstating Dotterweich\xe2\x80\x99s conviction, this Court\nlooked to the purposes of the Act and noted that they \xe2\x80\x9ctouch phases of the lives and health of people\nwhich, in the circumstances of modern industrialism, are largely beyond self-protection. It observed that\nthe Act is of \xe2\x80\x9ca now familiar type\xe2\x80\x9d which \xe2\x80\x9cdispenses with the conventional requirement for criminal\nconduct-awareness of some wrongdoing: In the interest of the larger good it puts the burden of acting at\nhazard upon a person otherwise innocent but standing in responsible relation to a public danger. Central\nto the Court\xe2\x80\x99s conclusion that individuals other than proprietors are subject to the criminal provisions of\nthe Act was the reality that the only way in which a corporation can act is through the individuals, who act\non its behalf.\n***\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 business\nprocess resulting in\xe2\x80\x9d a violation.\xe2\x80\xa6The rule that corporate employees who have \xe2\x80\x9ca responsible share in the\nfurtherance of the transaction which the statute outlaws\xe2\x80\x9d are subject to the criminal provisions of the Act\nwas not formulated in a vacuum. Cf. Morissette v. United States, 342 U.S. 246, 258 (1952). Cases under\nthe Federal Food and Drugs Act of 1906 reflected the view both that knowledge or intent were not\nrequired to be proved in prosecutions under its criminal provisions, and that responsible corporate agents\ncould be subjected to the liability thereby imposed.\n***\n\nThe rationale of the interpretation given the Act in Dotterweich\xe2\x80\xa6has been confirmed in our subsequent\ncases. Thus, the Court has reaffirmed the proposition that the public interest in the purity of its food is so\ngreat as to warrant the imposition of the highest standard of care on distributors.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n295\n\n\x0cThus Dotterweich and the cases which have followed reveal that in providing sanctions which reach and\ntouch the individuals who execute the corporate mission\xe2\x80\x94and this is by no means necessarily confined to\na single corporate agent or employee\xe2\x80\x94the Act imposes not only a positive duty to seek out and remedy\nviolations when they occur but also, and primarily, a duty to implement measures that will insure that\nviolations will not occur. The requirements of foresight and vigilance imposed on responsible corporate\nagents are beyond question demanding, and perhaps onerous, but they are no more stringent than the\npublic has a right to expect of those who voluntarily assume positions of authority in business enterprises\nwhose services and products affect the health and well-being of the public that supports them.\n***\n\nReading the entire charge satisfies us that the jury\xe2\x80\x99s attention was adequately focused on the issue of\nrespondent\xe2\x80\x99s authority with respect to the conditions that formed the basis of the alleged violations.\nViewed as a whole, the charge did not permit the jury to find guilt solely on the basis of respondent\xe2\x80\x99s\nposition in the corporation; rather, it fairly advised the jury that to find guilt it must find respondent \xe2\x80\x9chad\na responsible relation to the situation,\xe2\x80\x9d and \xe2\x80\x9cby virtue of his position\xe2\x80\xa6had\xe2\x80\xa6authority and responsibility\xe2\x80\x9d\nto deal with the situation.\n\nThe situation referred to could only be \xe2\x80\x9cfood\xe2\x80\xa6held in unsanitary conditions in a warehouse with the result\nthat it consisted, in part, of filth or\xe2\x80\xa6may have been contaminated with filth.\xe2\x80\x9d\n\nOur conclusion that the Court of Appeals erred in its reading of the jury charge suggests as well our\ndisagreement with that court concerning the admissibility of evidence demonstrating that respondent was\nadvised by the FDA in 1970 of insanitary conditions in Acme\xe2\x80\x99s Philadelphia warehouse. We are satisfied\nthat the Act imposes the highest standard of care and permits conviction of responsible corporate officials\nwho, in light of this standard of care, have the power to prevent or correct violations of its provisions.\n***\nReversed.\n\nC A SE QU ES TIO NS\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n296\n\n\x0c1. Did Park have criminal intent to put adulterated food into commerce? If not,\nhow can Park\xe2\x80\x99s conduct be criminalized?\n2. To get a conviction, what does the prosecutor have to show, other than that\nPark was the CEO of Acme and therefore responsible for what his company\ndid 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 a specific\nintent to commit the prohibited act (although a very few economic acts, made criminal by modern\nlegislation, dispense with the requirement of intent). In this way, criminal law differs from much of civil\nlaw\xe2\x80\x94for example, from the tort of negligence, in which carelessness, rather than intent, can result in\nliability.\n\nMajor crimes are known as felonies. Minor crimes are known as misdemeanors. Most people have a\ngeneral notion about familiar crimes, such as murder and theft. But conventional knowledge does not\nsuffice for understanding technical distinctions among related crimes, such as larceny, robbery, and false\npretenses. These distinctions can be important because an individual can be found guilty not merely for\ncommitting one of the acts defined in the criminal law but also for attempting or conspiring to commit\nsuch an act. It is usually easier to convict someone of attempt or conspiracy than to convict for the main\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n297\n\n\x0ccrime, and a person involved in a conspiracy to commit a felony may find that very little is required to put\nhim into serious trouble.\n\nOf major concern to the business executive is white-collar crime, which encompasses a host of offenses,\nincluding bribery, embezzlement, fraud, restraints of trade, and computer crime. Anyone accused of crime\nshould know that they always have the right to consult with a lawyer and should always do so.\n\nE XE R C IS ES\n1. Bill is the chief executive of a small computer manufacturing company that\ndesperately needs funds to continue operating. One day a stranger comes to\nBill to induce him to take part in a cocaine smuggling deal that would net Bill\nmillions of dollars. Unbeknownst to Bill, the stranger is an undercover\npoliceman. Bill tells the stranger to go away. The stranger persists, and after\nfive months of arguing and cajoling, the stranger wears down Bill\xe2\x80\x99s will to\nresist. Bill agrees to take delivery of the cocaine and hands over a down\npayment of $10,000 to the undercover agent, who promptly arrests him for\nconspiracy to violate the narcotics laws. What defenses does Bill have?\n2. You are the manager of a bookstore. A customer becomes irritated at having\nto stand in line and begins to shout at the salesclerk for refusing to wait on\nhim. You come out of your office and ask the customer to calm down. He\nshouts at you. You tell him to leave. He refuses. So you and the salesclerk pick\nhim up and shove him bodily out the door. He calls the police to have you\narrested 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\nand federal law. She is convicted in state court and sentenced to five years in\njail. Then the federal government decides to prosecute her for the same\noffense. Does she have a double-jeopardy defense against the federal\nprosecution?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n298\n\n\x0c4. Tectonics, a US corporation, is bidding on a project in Nigeria, and its\nemployee wins the bid by secretly giving $100,000 to the Nigerian public\nofficial that has the most say about which company will be awarded the\ncontract. The contract is worth $80 million, and Tectonics expects to make at\nleast $50 million on the project. Has a crime under US law been committed?\n5. Suppose that the CEO of Tectonics, Ted Nelson, is not actually involved in\nbribery of the Nigerian public official Adetutu Adeleke. Instead, suppose that\nthe CFO, Jamie Skillset, is very accomplished at insulating both top\nmanagement and the board of directors from some of the \xe2\x80\x9coperational\nrealities\xe2\x80\x9d within the company. Skillset knows that Whoopi Goldmine, a\nNigerian employee of Tectonics, has made the deal with Adeleke and secured\nthe contract for Tectonics. Is it possible that Nelson, as well as Skillset, can be\nfound guilty of a crime?\n6. You have graduated from college and, after working hard for ten years, have\nscraped enough money together to make a down payment on a forty-acre\nfarm within driving distance to the small city where you work in Colorado. In\ntown at lunch one day, you run into an old friend from high school, Hayley\nMills, 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\nfew months until she has enough money to go into business. Over the\nfollowing weeks, however, you realize that old acquaintances from high\nschool are stopping by almost daily for short visits. When you bring this up to\nHayley, she admits that many old friends are now relying on her for\nmarijuana. She is not a licensed caregiver in Colorado and is clearly violating\nthe law. Out of loyalty, you tell her that she has three weeks to move out, but\nyou do not prevent her from continuing sales while she is there. What crime\nhave you committed?\n7. The Center Art Galleries\xe2\x80\x94Hawaii sells artwork, and much of it involves art by\nthe famous surrealist painter Salvador Dali. The federal government suspected\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n299\n\n\x0cthe center of selling forged Dali artwork and obtained search warrants for six\nlocations controlled by the center. The warrants told the executing officer to\nseize any items that were \xe2\x80\x9cevidence of violations of federal criminal law.\xe2\x80\x9d The\nwarrants did not describe the specific crime suspected, nor did the warrants\nlimit the seizure of items solely to Dali artwork or suspected Dali forgeries. Are\nthese search warrants valid? [1]\n\nS EL F -T E ST QU EST IO N S\n1. Jared has made several loans to debtors who have declared bankruptcy.\nThese are unsecured claims. Jared \xe2\x80\x9cdoctors\xe2\x80\x9d the documentation to show\namounts owed that are higher than the debtors actually owe. Later, Jared is\ncharged with the federal criminal offense of filing false claims. The standard\n(or \xe2\x80\x9cburden\xe2\x80\x9d) of proof that 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. one year\nb. two years\nc. five years\nd. none of the above\nYuan is charged with a crime. To find him guilty, the prosecutor must show\na. actus reus and mens rea\nb. mens rea only\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n300\n\n\x0cc. 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\na. a 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\nthe city\xe2\x80\x99s construction code. Paul accepts the money and overlooks the\nviolations. Later, Candace is charged with the crime of bribery. This\noccurred when\na. Candace offered the bribe.\nb. Paul accepted the bribe.\nc. Paul overlooked the violations.\nd. none of the above\n\nS EL F -T E ST A NSW E R S\n1. b\n2. a\n3. a\n4. d\n5. a\n[1] Center Art Galleries\xe2\x80\x94Hawaii, Inc. v. United States, 875 F.2d 747 (9th Cir. 1989).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n301\n\n\x0cChapter 7\nIntroduction to Tort Law\nL EA R N IN G O B JEC T IV ES\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\nsystem.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n302\n\n\x0cIn civil litigation, contract and tort claims are by far the most numerous. The law attempts to adjust for\nharms done by awarding damages to a successful plaintiff who demonstrates that the defendant was the\ncause of the plaintiff\xe2\x80\x99s losses. Torts can be intentional torts, negligent torts, or strict liability torts.\nEmployers must be aware that in many circumstances, their employees may create liability in tort. This\nchapter explains the different kind of torts, as well as available defenses to tort claims.\n\n7.1 Purpose of Tort Laws\nL EA R N IN G O B JEC T IV ES\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 from the\nLatin word tortum, which means twisted or crooked or wrong, in contrast to the word rectum, which\nmeans straight (rectitude uses that Latin root). Thus conduct that is twisted or crooked and not straight is\na tort. The term was introduced into the English law by the Norman jurists.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n303\n\n\x0cLong ago, tort was used in everyday speech; today it is left to the legal system. A judge will instruct a jury\nthat a tort is usually defined as a wrong for which the law will provide a remedy, most often in the form of\nmoney damages. The law does not remedy all \xe2\x80\x9cwrongs.\xe2\x80\x9d The preceding definition of tort does not reveal\nthe underlying principles that divide wrongs in the legal sphere from those in the moral sphere. Hurting\nsomeone\xe2\x80\x99s feelings may be more devastating than saying something untrue about him behind his back; yet\nthe law will not provide a remedy for saying something cruel to someone directly, while it may provide a\nremedy for "defaming" someone, orally or in writing, to others.\n\nAlthough the word is no longer in general use, tort suits are the stuff of everyday headlines. More and\nmore people injured by exposure to a variety of risks now seek redress (some sort of remedy through the\ncourts). Headlines boast of multimillion-dollar jury awards against doctors who bungled operations,\nagainst newspapers that libeled subjects of stories, and against oil companies that devastate entire\necosystems. All are examples of tort suits.\n\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 rely on the\ncommon law (judicial decisions). Through thousands of cases, the courts have fashioned a series of rules\nthat govern the conduct of individuals in their noncontractual dealings with each other. Through\ncontracts, individuals can craft their own rights and responsibilities toward each other. In the absence of\ncontracts, tort law holds individuals legally accountable for the consequences of their actions. Those who\nsuffer losses at the hands of others can be compensated.\n\nMany acts (like homicide) are both criminal and tortious. But torts and crimes are different, and the\ndifference is worth noting. A crime is an act against the people as a whole. Society punishes the murderer;\nit does not usually compensate the family of the victim. Tort law, on the other hand, views the death as a\nprivate wrong for which damages are owed. In a civil case, the tort victim or his family, not the state,\nbrings the action. The judgment against a defendant in a civil tort suit is usually expressed in monetary\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n304\n\n\x0cterms, not in terms of prison times or fines, and is the legal system\xe2\x80\x99s way of trying to make up for the\nvictim\xe2\x80\x99s loss.\n\nKinds of Torts\nThere are three kinds of torts: intentional torts, negligent torts, and strict liability torts. Intentional torts\narise from intentional acts, whereas unintentional torts often result from carelessness (e.g., when a\nsurgical team fails to remove a clamp from a patient\xe2\x80\x99s abdomen when the operation is finished). Both\nintentional torts and negligent torts imply some fault on the part of the defendant. In strict liability torts,\nby contrast, there may be no fault at all, but tort law will sometimes require a defendant to make up for\nthe victim\xe2\x80\x99s losses even where the defendant was not 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 careless\n(negligent) or has intentionally caused harm. Using the concepts that we are free and autonomous beings\nwith basic rights, we can see that when others interfere with either our freedom or our autonomy, we will\nusually react negatively. As the old saying goes, \xe2\x80\x9cYour right to swing your arm ends at the tip of my nose.\xe2\x80\x9d\nThe law takes this even one step further: under intentional tort law, if you frighten someone by swinging\nyour arms toward the tip of her nose, you may have committed the tort of assault, even if there is no actual\ntouching (battery).\n\nUnder a capitalistic market system, rational economic rules also call for no negative externalities. That is,\nactions of individuals, either alone or in concert with others, should not negatively impact third parties.\nThe law will try to compensate third parties who are harmed by your actions, even as it knows that a\nmoney judgment cannot actually mend a badly injured victim.\n\nFigure 7.1 Dimensions of Tort Liability\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n305\n\n\x0cDimensions of Tort: Fault\nTort principles can be viewed along different dimensions. One is the fault dimension. Like criminal law,\ntort law requires a wrongful act by a defendant for the plaintiff to recover. Unlike criminal law, however,\nthere need not be a specific intent. Since tort law focuses on injury to the plaintiff, it is less concerned than\ncriminal law about the reasons for the defendant\xe2\x80\x99s actions. An innocent act or a relatively innocent one\nmay still provide the basis for liability. Nevertheless, tort law\xe2\x80\x94except for strict liability\xe2\x80\x94relies on\nstandards of fault, or blameworthiness.\n\nThe most obvious standard is willful conduct. If the defendant (often called the tortfeasor\xe2\x80\x94i.e., the one\ncommitting the tort) intentionally injures another, there is little argument about tort liability. Thus all\ncrimes resulting in injury to a person or property (murder, assault, arson, etc.) are also torts, and the\nplaintiff may bring a separate lawsuit to recover damages for injuries to his person, family, or property.\nMost tort suits do not rely on intentional fault. They are based, rather, on negligent conduct that in the\ncircumstances is careless or poses unreasonable risks of causing damage. Most automobile accident and\nmedical malpractice suits are examples of negligence suits.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n306\n\n\x0cThe fault dimension is a continuum. At one end is the deliberate desire to do injury. The middle ground is\noccupied by careless conduct. At the other end is conduct that most would consider entirely blameless, in\nthe moral sense. The defendant may have observed all possible precautions and yet still be held liable.\nThis is called strict liability. An example is that incurred by the manufacturer of a defective product that\nis placed on the market despite all possible precautions, including quality-control inspection. In many\nstates, if the product causes injury, the 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 person\n(assault, battery, infliction of emotional distress, negligent exposure to toxic pollutants, wrongful death)\nor property (trespass, nuisance, arson, interference with contract). Mental suffering can be redressed if it\nis a result of physical injury (e.g., shock and depression following an automobile accident). A few states\nnow permit recovery for mental distress alone (a mother\xe2\x80\x99s shock at seeing her son injured by a car while\nboth were crossing the street). Other protected interests include a person\xe2\x80\x99s reputation (injured by\ndefamatory statements or writings), privacy (injured by those who divulge secrets of his personal life), and\neconomic interests (misrepresentation to secure an economic advantage, certain forms of unfair\ncompetition).\n\nDimensions of Tort: Excuses\nA third element in the law of torts is the excuse for committing an apparent wrong. The law does not\ncondemn every act that ultimately results in injury.\n\nOne common rule of exculpation is assumption of risk. A baseball fan who sits along the third base line\nclose to the infield assumes the risk that a line drive foul ball may fly toward him and strike him. He will\nnot be permitted to complain in court that the batter should have been more careful or that management\nshould have either warned him or put up a protective barrier.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n307\n\n\x0cAnother excuse is negligence of the plaintiff. If two drivers are careless and hit each other on the highway,\nsome states will refuse to permit either to recover from the other. Still another excuse is consent: two\nboxers in the ring consent to being struck with fists (but not to being bitten on the ear).\n\nDamages\nSince the purpose of tort law is to compensate the victim for harm actually done, damages are usually\nmeasured by the extent of the injury. Expressed in money terms, these include replacement of property\ndestroyed, compensation for lost wages, reimbursement for medical expenses, and dollars that are\nsupposed to approximate the pain that is suffered. Damages for these injuries are called\ncompensatory damages.\n\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 award\n(sometimes called exemplary damages) is at odds with the general purpose of tort law, it is allowable only\nin aggravated situations. The law in most states permits recovery of punitive damages only when the\ndefendant has deliberately committed a wrong with malicious intent or has otherwise done something\noutrageous.\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. Punitive\ndamages are intended not only to punish the wrongdoer, by exacting an additional and sometimes heavy\npayment (the exact amount is left to the discretion of jury and judge), but also to deter others from similar\nconduct. The punitive damage award has been subject to heavy criticism in recent years in cases in which\nit has been awarded against manufacturers. One fear is that huge damage awards on behalf of a multitude\nof victims could swiftly bankrupt the defendant. Unlike compensatory damages, punitive damages are\ntaxable.\n\nK E Y TA K EA WAY\nThere are three kinds of torts, and in two of them (negligent torts and strict\nliability torts), damages are usually limited to making the victim whole through an\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n308\n\n\x0cenforceable judgment for money damages. These compensatory damages\nawarded by a court accomplish only approximate justice for the injuries or\nproperty damage caused by a tortfeasor. Tort laws go a step further toward\ndeterrence, beyond compensation to the plaintiff, in occasionally awarding\npunitive damages against a defendant. These are almost always in cases where an\nintentional tort has been committed.\n\nE XE R C IS ES\n1. Why is deterrence needed for intentional torts (where punitive damages are\nawarded) rather than negligent torts?\n2. Why are costs imposed on others without their consent problematic for a\nmarket economy? What if the law did not try to reimpose the victim\xe2\x80\x99s costs\nonto the tortfeasor? What would a totally nonlitigious society be like?\n\n7.2 Intentional Torts\nL EA R N IN G O B JEC T IV ES\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\nthat causes injury to property, and one that causes injury to a reputation.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n309\n\n\x0cThe analysis of most intentional torts is straightforward and parallels the substantive crimes already\ndiscussed in . When physical injury or damage to property is caused, there is rarely debate over liability if\nthe plaintiff deliberately undertook to produce the harm. Certain other intentional torts are worth noting\nfor 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 serve to\nrestrain individuals from using physical force on others. Assault is (1) the threat of immediate harm or\noffense of contact or (2) any act that would arouse reasonable apprehension of imminent harm. Battery is\nunauthorized and harmful or offensive physical contact with another person that causes injury.\n\nOften an assault results in battery, but not always. In Western Union Telegraph Co. v. Hill, for example,\nthe defendant did not touch the plaintiff\xe2\x80\x99s wife, but the case presented an issue of possible assault even\nwithout an actual battery; the defendant employee attempted to kiss a customer across the countertop,\ncouldn\'t quite reach her, but nonetheless created actionable fear (or, as the court put it, \xe2\x80\x9capprehension\xe2\x80\x9d)\non the part of the plaintiff\'s wife. It is also possible to have a battery without an assault. For example, if\nsomeone hits you on the back of the head with an iron skillet and you didn\xe2\x80\x99t see it coming, there is a\nbattery but no assault. Likewise, if Andrea passes out from drinking too much at the fraternity party and a\nstranger (Andre) kisses her on the lips while she is passed out, she would not be aware of any threat of\noffensive contact and would have no apprehension of any harm. Thus there has been no tort of assault,\nbut she could 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 in time and\nthe impact is felt by Hermione instead, English law (and American law) would transfer Draco\xe2\x80\x99s intent\nfrom the target to the actual victim of the act. Thus Hermione could sue Draco for battery for any damages\nshe had suffered.\n\nFalse Imprisonment\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n310\n\n\x0cThe tort of false imprisonment originally implied a locking up, as in a prison, but today it can occur if a\nperson is restrained in a room or a car or even if his or her movements are restricted while walking down\nthe street. People have a right to be free to go as they please, and anyone who without cause deprives\nanother of personal freedom has committed a tort. Damages are allowed for time lost, discomfort and\nresulting ill health, mental suffering, humiliation, loss of reputation or business, and expenses such as\nattorneys\xe2\x80\x99 fees incurred as a result of the restraint (such as a false arrest). But as the case of Lester v.\nAlbers Super Markets, Inc. () shows, the defendant must be shown to have restrained the plaintiff in\norder for damages 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 the jury, the\ncourts required that the mental distress result from some physical injury. In recent years, many courts\nhave overthrown the older rule and now recognize the so-called new tort. In an employment context,\nhowever, it is rare to find a case where a plaintiff is able to recover. The most difficult hurdle is proving\nthat the conduct was \xe2\x80\x9cextreme\xe2\x80\x9d or \xe2\x80\x9coutrageous.\xe2\x80\x9d\n\nIn an early California case, bill collectors came to the debtor\xe2\x80\x99s home repeatedly and threatened the\ndebtor\xe2\x80\x99s pregnant wife. Among other things, they claimed that the wife would have to deliver her child in\nprison. The wife miscarried and had emotional and physical complications. The court found that the\nbehavior of the collection company\xe2\x80\x99s two agents was sufficiently outrageous to prove the tort of\nintentional infliction of emotional distress. In Roche v. Stern (New York), the famous cable television talk\nshow host Howard Stern had tastelessly discussed the remains of Deborah Roche, a topless dancer and\ncable access television host.\n\n[1]\n\nThe remains had been brought to Stern\xe2\x80\x99s show by a close friend of Roche,\n\nChaunce Hayden, and a number of crude comments by Stern and Hayden about the remains were\nvideotaped and broadcast on a national cable television station. Roche\xe2\x80\x99s sister and brother sued Howard\nStern and Infinity broadcasting and were able to get past the defendant\xe2\x80\x99s motion to dismiss to have a jury\nconsider their claim.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n311\n\n\x0cA plaintiff\xe2\x80\x99s burden in these cases is to show that the mental distress is severe. Many states require that\nthis distress must result in physical symptoms such as nausea, headaches, ulcers, or, as in the case of the\npregnant wife, a miscarriage. Other states have not required physical symptoms, finding that shame,\nembarrassment, fear, and anger constitute severe mental distress.\n\nTrespass and Nuisance\nTrespass is intentionally going on land that belongs to someone else or putting something on someone\nelse\xe2\x80\x99s property and refusing to remove it. This part of tort law shows how strongly the law values the rights\nof property owners. The right to enjoy your property without interference from others is also found in\ncommon law of nuisance. There are limits to property owners\xe2\x80\x99 rights, however. In Katko v. Briney, for\nexample, the plaintiff was injured by a spring gun while trespassing on the defendant\xe2\x80\x99s property.\n\n[2]\n\nThe\n\ndefendant had set up No Trespassing signs after ten years of trespassing and housebreaking events, with\nthe loss of some household items. Windows had been broken, and there was \xe2\x80\x9cmessing up of the property\nin general.\xe2\x80\x9d The defendants had boarded up the windows and doors in order to stop the intrusions and\nfinally had set up a shotgun trap in the north bedroom of the house. One defendant had cleaned and oiled\nhis 20-gauge shotgun and taken it to the old house where it was secured to an iron bed with the barrel\npointed at the bedroom door. \xe2\x80\x9cIt was rigged with wire from the doorknob to the gun\xe2\x80\x99s trigger so would fire\nwhen the door was opened.\xe2\x80\x9d The angle of the shotgun was adjusted to hit an intruder in the legs. The\nspring could not be seen from the outside, and no warning of its presence was posted.\n\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 found\nseveral old bottles and fruit jars that they took and added to their collection of antiques. When they made\na second trip to the property, they entered by removing a board from a porch window. When the plaintiff\nopened the north bedroom door, the shotgun went off and struck him in the right leg above the ankle\nbone. Much of his leg was blown away. While Katko knew he had no right to break and enter the house\nwith intent to steal bottles and fruit jars, the court held that a property owner could not protect an\nunoccupied boarded-up farmhouse by using a spring gun capable of inflicting death or serious injury.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n312\n\n\x0cIn Katko, there is an intentional tort. But what if someone trespassing is injured by the negligence of the\nlandowner? States have differing rules about trespass and negligence. In some states, a trespasser is only\nprotected against the gross negligence of the landowner. In other states, trespassers may be owed the duty\nof due care on the part of the landowner. The burglar who falls into a drained swimming pool, for\nexample, may have a case against the homeowner unless the courts or legislature of that state have made\nit clear that trespassers are owed the limited duty to avoid gross negligence. Or a very small child may\nwander off his own property and fall into a gravel pit on a nearby property and suffer death or serious\ninjury; if the pit should (in the exercise of due care) have been filled in or some barrier erected around it,\nthen there was negligence. 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 may not be\nowed 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:\n\n1.\n\nThere was a contract between the plaintiff and a third party.\n\n2. The defendant knew of the contract.\n3. The defendant improperly induced the third party to breach the contract or made performance of\nthe contract impossible.\n4. There was injury to the plaintiff.\n\nIn a famous case of contract interference, Texaco was sued by Pennzoil for interfering with an agreement\nthat Pennzoil had with Getty Oil. After complicated negotiations between Pennzoil and Getty, a takeover\nshare price was struck, a memorandum of understanding was signed, and a press release announced the\nagreement in principle between Pennzoil and Getty. Texaco\xe2\x80\x99s lawyers, however, believed that Getty oil was\n\xe2\x80\x9cstill in play,\xe2\x80\x9d and before the lawyers for Pennzoil and Getty could complete the paperwork for their\nagreement, Texaco announced it was offering Getty shareholders an additional $12.50 per share over\nwhat Pennzoil had offered.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n313\n\n\x0cTexaco later increased its offer to $228 per share, and the Getty board of directors soon began dealing\nwith Texaco instead of Pennzoil. Pennzoil decided to sue in Texas state court for tortious interference with\na contract. After a long trial, the jury returned an enormous verdict against Texaco: $7.53 billion in actual\ndamages and $3 billion in punitive damages. The verdict was so large that it would have bankrupted\nTexaco. Appeals from the verdict centered on an obscure rule of the Securities and Exchange Commission\n(SEC), Rule 10(b)-13, and Texaco\xe2\x80\x99s argument was based on that rule and the fact that the contract had not\nbeen completed. If there was no contract, Texaco could not have legally interfered with one. After the SEC\nfiled a brief that supported Texaco\xe2\x80\x99s interpretation of the law, Texaco agreed to pay $3 billion to Pennzoil\nto dismiss 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, knowing that\nthere was no probable cause to believe that the plaintiff committed the crime. The plaintiff must show that\nthe defendant acted with malice or with some purpose other than bringing the guilty to justice. A mere\ncomplaint to the authorities is insufficient to establish the tort, but any official proceeding will support the\nclaim\xe2\x80\x94for example, a warrant for the plaintiff\xe2\x80\x99s arrest. The criminal proceeding must terminate in the\nplaintiff\xe2\x80\x99s favor in order for his suit to be sustained.\n\nA majority of US courts, though by no means all, permit a suit for wrongful civil proceedings. Civil\nlitigation is usually costly and burdensome, and one who forces another to defend himself against baseless\naccusations should not be permitted to saddle the one he sues with the costs of defense. However,\nbecause, as a matter of public policy, litigation is favored as the means by which legal rights can be\nvindicated\xe2\x80\x94indeed, the Supreme Court has even ruled that individuals have a constitutional right to\nlitigate\xe2\x80\x94the plaintiff must meet a heavy burden in proving his case. The mere dismissal of the original\nlawsuit against the plaintiff is not sufficient proof that the suit was unwarranted. The plaintiff in a suit for\nwrongful civil proceedings must show that the defendant (who was the plaintiff in the original suit) filed\nthe action for an improper purpose and had no reasonable belief that his cause was legally or factually\nwell grounded.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n314\n\n\x0cDefamation\nDefamation is injury to a person\xe2\x80\x99s good name or reputation. In general, if the harm is done through the\nspoken word\xe2\x80\x94one person to another, by telephone, by radio, or on television\xe2\x80\x94it is called slander. If the\ndefamatory statement is published in written form, it is called libel.\n\nThe Restatement (Second) of Torts defines a defamatory communication as one that \xe2\x80\x9cso tends to harm the\nreputation of another as to lower him in the estimation of the community or to deter third persons from\nassociating or dealing with him.\xe2\x80\x9d\n\n[3]\n\nA statement is not defamatory unless it is false. Truth is an absolute defense to a charge of libel or slander.\nMoreover, the statement must be \xe2\x80\x9cpublished\xe2\x80\x9d\xe2\x80\x94that is, communicated to a third person. You cannot be\nlibeled by one who sends you a letter full of false accusations and scurrilous statements about you unless a\nthird person opens it first (your roommate, perhaps). Any living person is capable of being defamed, but\nthe dead are not. Corporations, partnerships, and other forms of associations can also be defamed, if the\nstatements tend to injure their ability to do business or to garner contributions.\n\nThe statement must have reference to a particular person, but he or she need not be identified by name. A\nstatement that \xe2\x80\x9cthe company president is a crook\xe2\x80\x9d is defamatory, as is a statement that \xe2\x80\x9cthe major\nnetwork weathermen are imposters.\xe2\x80\x9d The company president and the network weathermen could show\nthat the words were aimed at them. But statements about large groups will not support an action for\ndefamation (e.g., \xe2\x80\x9call doctors are butchers\xe2\x80\x9d is not defamatory of any 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 newspaper,\nmagazine, or corporate brochure can be sufficient to make out a case of libel. Even the exercise of due care\nis usually no excuse if the statement is in fact communicated. Repeating a libel is itself a libel; a libel\ncannot be justified by showing that you were quoting someone else. Though a plaintiff may be able to\nprove that a statement was defamatory, he is not necessarily entitled to an award of damages. That is\nbecause the law contains a number of privileges that excuse the defamation.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n315\n\n\x0cPublishing false information about another business\xe2\x80\x99s product constitutes the tort of slander of quality, or\ntrade libel. In some states, this is known as the tort of product disparagement. It may be difficult to\nestablish damages, however. A plaintiff must prove that actual damages proximately resulted from the\nslander of quality and must show the extent of the economic harm as well.\n\nAbsolute Privilege\nStatements made during the course of judicial proceedings are absolutely privileged, meaning that they\ncannot serve as the basis for a defamation suit. Accurate accounts of judicial or other proceedings are\nabsolutely privileged; a newspaper, for example, may pass on the slanderous comments of a judge in\ncourt. \xe2\x80\x9cJudicial\xe2\x80\x9d is broadly construed to include most proceedings of administrative bodies of the\ngovernment. The Constitution exempts members of Congress from suits for libel or slander for any\nstatements made in connection with legislative business. The courts have constructed a similar privilege\nfor many executive branch officials.\n\nQualified Privilege\nAbsolute privileges pertain to those in the public sector. A narrower privilege exists for private citizens. In\ngeneral, a statement that would otherwise be actionable is held to be justified if made in a reasonable\nmanner and for a reasonable purpose. Thus you may warn a friend to beware of dealing with a third\nperson, and if you had reason to believe that what you said was true, you are privileged to issue the\nwarning, even though false. Likewise, an employee may warn an employer about the conduct or character\nof a fellow or prospective employee, and a parent may complain to a school board about the competence\nor conduct of a child\xe2\x80\x99s teacher. There is a line to be drawn, however, and a defendant with nothing but an\nidle interest in the matter (an \xe2\x80\x9cofficious intermeddler\xe2\x80\x9d) must take the risk that his information is wrong.\n\nIn 1964, the Supreme Court handed down its historic decision in New York Times v. Sullivan, holding\nthat under the First Amendment a libel judgment brought by a public official against a newspaper cannot\nstand unless the plaintiff has shown \xe2\x80\x9cactual malice,\xe2\x80\x9d which in turn was defined as \xe2\x80\x9cknowledge that [the\nstatement] was false or with a reckless disregard of whether it was false or not.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\n[4]\n\nIn subsequent cases,\nSaylor.org\n316\n\n\x0cthe court extended the constitutional doctrine further, applying it not merely to government officials but\nto public figures, people who voluntarily place themselves in the public eye or who involuntarily find\nthemselves the objects of public scrutiny. Whether a private person is or is not a public figure is a difficult\nquestion that has so far eluded rigorous definition and has been answered only from case to case. A CEO\nof a private corporation 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 twentieth\ncentury, and its legal formulation is still evolving. In fact there is no single right of privacy. Courts and\ncommentators have discerned at least four different types of interests: (1) the right to control the\nappropriation of your name and picture for commercial purposes, (2) the right to be free of intrusion on\nyour \xe2\x80\x9cpersonal space\xe2\x80\x9d or seclusion, (3) freedom from public disclosure of embarrassing and intimate facts\nof your personal life, and (4) the right not to be presented 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: someone else\nplacing your photograph on a billboard or cereal box as a model or using your name as endorsing a\nproduct or in the product name. A New York statute makes it a misdemeanor to use the name, portrait, or\npicture of any person for advertising purposes or for the purposes of trade (business) without first\nobtaining written consent. The law also permits the aggrieved person to sue and to recover damages for\nunauthorized profits and also to have the court enjoin (judicially block) any further unauthorized use of\nthe plaintiff\xe2\x80\x99s name, likeness, or image. This is particularly useful to celebrities.\n\nBecause the publishing and advertising industries are concentrated heavily in New York, the statute plays\nan important part in advertising decisions made throughout the country. Deciding what \xe2\x80\x9ccommercial\xe2\x80\x9d or\n\xe2\x80\x9ctrade\xe2\x80\x9d purposes are is not always easy. Thus a newsmagazine may use a baseball player\xe2\x80\x99s picture on its\ncover without first obtaining written permission, but a chocolate manufacturer could not put the player\xe2\x80\x99s\npicture on a candy wrapper without consent.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n317\n\n\x0cPersonal Space\nOne form of intrusion upon a person\xe2\x80\x99s solitude\xe2\x80\x94trespass\xe2\x80\x94has long been actionable under common law.\nPhysical invasion of home or other property is not a new tort. But in recent years, the notion of intrusion\nhas been broadened considerably. Now, taking photos of someone else with your cell phone in a locker\nroom could constitute invasion of the right to privacy. Reading someone else\xe2\x80\x99s mail or e-mail could also\nconstitute an invasion of the right to privacy. Photographing someone on a city street is not tortious, but\nsubsequent use of the photograph could be. Whether the invasion is in a public or private space, the\namount of damages will depend 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 defamation.\nWhat about true statements that might be every bit as damaging\xe2\x80\x94for example, disclosure of someone\xe2\x80\x99s\nincome tax return, revealing how much he earned? The general rule is that if the facts are truly private\nand of no \xe2\x80\x9clegitimate\xe2\x80\x9d concern to the public, then their disclosure is a violation of the right to privacy. But\na person who is in the public eye cannot claim the same protection.\n\nFalse Light\nA final type of privacy invasion is that which paints a false picture in a publication. Though false, it might\nnot be libelous, since the publication need contain nothing injurious to reputation. Indeed, the publication\nmight even glorify the plaintiff, making him seem more heroic than he actually is. Subject to the First\nAmendment requirement that the plaintiff must show intent or extreme recklessness, statements that put\na person in a false light, like a fictionalized biography, are actionable.\n\nK E Y TA K EA WAY\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\ncase of intentional tort, the plaintiff must show that the defendant intended harm, but\nthe intent to harm does not need to be directed at a particular person and need not be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n318\n\n\x0cmalicious, as long as the resulting harm is a direct consequence of the defendant\xe2\x80\x99s\nactions.\n\nE XE R C IS ES\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\nproperty.\n3. Why are intentional torts more likely to result in a verdict not only for compensatory\ndamages but also for punitive damages?\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\nL EA R N IN G O B JEC T IV ES\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n319\n\n\x0cElements of Negligence\nPhysical harm need not be intentionally caused. A pedestrian knocked over by an automobile does not\nhurt less because the driver intended no wrong but was merely careless. The law imposes a duty of care on\nall of us in our everyday lives. Accidents caused by negligence are actionable.\n\nDetermining negligence is not always easy. If a driver runs a red light, we can say that he is negligent\nbecause a driver must always be careful to ascertain whether the light is red and be able to stop if it is.\nSuppose that the driver was carrying a badly injured person to a nearby hospital and that after slowing\ndown at an intersection, went through a red light, blowing his horn, whereupon a driver to his right,\nseeing him, drove into the intersection anyway and crashed into him. Must one always stop at a red light?\nIs proof that the light was red always proof of negligence? Usually, but not always: negligence is an\nabstract concept that must always be applied to concrete and often widely varying sets of circumstances.\nWhether someone was or was not negligent is almost always a question of fact for a jury to decide. Rarely\nis it a legal question that a judge can settle.\n\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 damage or\nloss. Even if a plaintiff can prove each of these aspects, the defendant may be able to show that the law\nexcuses the conduct that is the basis for the tort claim. We examine each of these 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 child dart\nout in front of your car, and if the noise from your tires gives someone in a nearby house a heart attack,\nyou have not acted negligently toward the person in the house. The purpose of the negligence standard is\nto protect others against the risk of injury that foreseeably would ensue from unreasonably dangerous\nconduct.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n320\n\n\x0cGiven the infinite variety of human circumstances and conduct, no general statement of a reasonable\nstandard of care is possible. Nevertheless, the law has tried to encapsulate it in the form of the famous\nstandard of \xe2\x80\x9cthe reasonable man.\xe2\x80\x9d This fictitious person \xe2\x80\x9cof ordinary prudence\xe2\x80\x9d is the model that juries\nare instructed to compare defendants with in assessing whether those defendants have acted negligently.\nAnalysis of this mythical personage has baffled several generations of commentators. How much\nknowledge must he have of events in the community, of technology, of cause and effect? With what\nphysical attributes, courage, or wisdom is this nonexistent person supposedly endowed? If the defendant\nis a person with specialized knowledge, like a doctor or an automobile designer, must the jury also treat\nthe \xe2\x80\x9creasonable man\xe2\x80\x9d as having this knowledge, even though the average person in the community will\nnot? (Answer: in most cases, yes.)\n\nDespite the many difficulties, the concept of the reasonable man is one on which most negligence cases\nultimately turn. If a defendant has acted \xe2\x80\x9cunreasonably under the circumstances\xe2\x80\x9d and his conduct posed\nan unreasonable risk of injury, then he is liable for injury caused by his conduct. Perhaps in most\ninstances, it is not difficult to divine what the reasonable man would do. The reasonable man stops for\ntraffic lights and always drives at reasonable speeds, does not throw baseballs through windows, performs\nsurgical operations according to the average standards of the medical profession, ensures that the floors of\nhis grocery store are kept free of fluids that would cause a patron to slip and fall, takes proper precautions\nto avoid spillage of oil from his supertanker, and so on. The "reasonable man" standard imposes hindsight\non the decisions and actions of people in society; the circumstances of life are such that courts may\nsometimes impose a standard of due care that many people might not find reasonable.\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 would all, in\nthis interdependent world, be our brothers\xe2\x80\x99 keepers, constantly unsure whether any action we took might\nsubject us to liability for its effect on someone else. The law copes with this difficulty by limiting the\nnumber of people toward whom we owe a duty to be careful.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n321\n\n\x0cIn general, the law imposes no obligation to act in a situation to which we are strangers. We may pass the\ndrowning child without risking a lawsuit. But if we do act, then the law requires us to act carefully. The\nlaw of negligence requires us to behave with due regard for the foreseeable consequences of our actions in\norder to avoid unreasonable risks of injury.\n\nDuring 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 was once the\ncase. For example, it was once believed that a manufacturer or supplier owed a duty of care only to\nimmediate purchasers, not to others who might use the product or to whom the product might be resold.\nThis limitation was known as the rule of privity. And users who were not immediate purchasers were said\nnot to be in privity with a supplier or manufacturer. In 1916, Judge Benjamin N. Cardozo, then on the\nNew York Court of Appeals, penned an opinion in a celebrated case that exploded the theory of privity,\nthough it would take half a century before the last state\xe2\x80\x94Mississippi in 1966\xe2\x80\x94would fall in line.\n\nDetermining a duty of care can be a vexing problem. Physicians, for example, are bound by principles of\nmedical ethics to respect the confidences of their patients. Suppose a patient tells a psychiatrist that he\nintends to kill his girlfriend. Does the physician then have a higher legal duty to warn prospective victim?\nThe California Supreme Court has said yes.\n\n[1]\n\nEstablishing a breach of the duty of due care where the defendant has violated a statute or municipal\nordinance is eased considerably with the doctrine of negligence per se, a doctrine common to all US state\ncourts. If a legislative body sets a minimum standard of care for particular kinds of acts to protect a\ncertain set of people from harm and a violation of that standard causes harm to someone in that set, the\ndefendant is negligent per se. If Harvey is driving sixty-five miles per hour in a fifty-five-mile-per-hour\nzone when he crashes into Haley\xe2\x80\x99s car and the police accident report establishes that or he otherwise\nadmits to going ten miles per hour over the speed limit, Haley does not have to prove that Harvey has\nbreached a duty of due care. She will only have to prove that the speeding was an actual and proximate\ncause of the collision and will also have to prove the extent of the resulting damages to her.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n322\n\n\x0cCausation: 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 injury can be\ntraced to some preceding cause. The problem for the law is to know when to draw the line between causes\nthat are immediate and causes too remote for liability reasonably to be assigned to them. In tort theory,\nthere are two kinds of causes that a plaintiff must prove: actual cause and proximate cause.\nActual cause (causation in fact) can be found if the connection between the defendant\xe2\x80\x99s act and the\nplaintiff\xe2\x80\x99s injuries passes the \xe2\x80\x9cbut for\xe2\x80\x9d test: if an injury would not have occurred \xe2\x80\x9cbut for\xe2\x80\x9d the defendant\xe2\x80\x99s\nconduct, then the defendant is the cause of the injury. Still, this is not enough causation to create liability.\nThe injuries to the plaintiff must also be foreseeable, or not \xe2\x80\x9ctoo remote,\xe2\x80\x9d for the defendant\xe2\x80\x99s act to create\nliability. This is proximate cause: a cause that is not too remote or unforseeable.\n\nSuppose that the person who was injured was not one whom a reasonable person could have expected to\nbe harmed. Such a situation was presented in one of the most famous US tort cases, Palsgraf v. Long\nIsland Railroad (Section 7.5 "Cases"), which was decided by Judge Benjamin Cardozo. Although Judge\nCardozo persuaded four of his seven brethren to side with his position, the closeness of the case\ndemonstrates the difficulty that unforeseeable consequences 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 she might\nbe injured in the future is not a sufficient basis for a suit. This rule has proved troublesome in medical\nmalpractice and industrial disease cases. A doctor\xe2\x80\x99s negligent act or a company\xe2\x80\x99s negligent exposure of a\nworker to some form of contamination might not become manifest in the body for years. In the meantime,\nthe tort statute of limitations might have run out, barring the victim from suing at all. An increasing\nnumber of courts have eased the plaintiff\xe2\x80\x99s predicament by ruling that the statute of limitations does not\nbegin to run until the victim discovers that she has been injured or contracted a disease.\n\nThe law allows an exception to the general rule that damages must be shown when the plaintiff stands in\ndanger of immediate injury from a hazardous activity. If you discover your neighbor experimenting with\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n323\n\n\x0cexplosives in his basement, you could bring suit to enjoin him from further experimentation, even though\nhe 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.\n\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. Factual\nissues are for the jury to resolve. Since it is frequently difficult to make out the requisite proof, the law\nallows certain presumptions and rules of evidence that ease the plaintiff\xe2\x80\x99s task, on the ground that without\nthem substantial injustice would be done. One important rule goes by the Latin\nphrase res ipsa loquitur, meaning \xe2\x80\x9cthe thing speaks for itself.\xe2\x80\x9d The best evidence is always the most\ndirect evidence: an eyewitness account of the acts in question. But eyewitnesses are often unavailable, and\nin any event they frequently cannot testify directly to the reasonableness of someone\xe2\x80\x99s conduct, which\ninevitably can only be inferred from the circumstances.\n\nIn many cases, therefore, circumstantial evidence (evidence that is indirect) will be the only evidence\nor will constitute the bulk of the evidence. Circumstantial evidence can often be quite telling: though no\none saw anyone leave the building, muddy footprints tracing a path along the sidewalk are fairly\nconclusive. Res ipsa loquitur is a rule of circumstantial evidence that permits the jury to draw an inference\nof negligence. A common statement of the rule is the following: \xe2\x80\x9cThere must be reasonable evidence of\nnegligence but where the thing is shown to be under the management of the defendant or his servants,\nand the accident is such as in the ordinary course of things does not happen if those who have the\nmanagement use proper care, it affords reasonable evidence, in the absence of explanation by the\ndefendants, that the accident arose from want of care.\xe2\x80\x9d\n\n[2]\n\nIf a barrel of flour rolls out of a factory window and hits someone, or a soda bottle explodes, or an airplane\ncrashes, courts in every state permit juries to conclude, in the absence of contrary explanations by the\ndefendants, that there was negligence. The plaintiff is not put to the impossible task of explaining\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n324\n\n\x0cprecisely how the accident occurred. A defendant can always offer evidence that he acted reasonably\xe2\x80\x94for\nexample, that the flour barrel was securely fastened and that a bolt of lightning, for which he was not\nresponsible, broke its bands, causing it to roll out the window. But testimony by the factory employees\nthat they secured the barrel, in the absence of any further explanation, will not usually serve to rebut the\ninference. That the defendant was negligent does not conclude the inquiry or automatically entitle the\nplaintiff to a judgment. Tort law provides the defendant with several excuses, some of which are discussed\nbriefly in the next section.\n\nExcuses\nThere are more excuses (defenses) than are listed here, but contributory negligence or comparative\nnegligence, assumption of risk, and act of God are among the principal defenses that will completely or\npartially 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 negligence suit\nwas himself negligent. Even if the plaintiff was only mildly negligent, most of the fault being chargeable to\nthe defendant, the court would dismiss the suit if the plaintiff\xe2\x80\x99s conduct contributed to his injury. In a few\nstates today, this rule of contributory negligence is still in effect. Although referred to as negligence,\nthe rule encompasses a narrower form than that with which the defendant is charged, because the\nplaintiff\xe2\x80\x99s only error in such cases is in being less careful of himself than he might have been, whereas the\ndefendant is charged with conduct careless toward others. This rule was so manifestly unjust in many\ncases that most states, either by statute or judicial decision, have changed to some version of\ncomparative negligence. Under the rule of comparative negligence, damages are apportioned\naccording to the defendant\xe2\x80\x99s degree of culpability. For example, if the plaintiff has sustained a $100,000\ninjury and is 20 percent responsible, the defendant will be liable for $80,000 in damages.\n\nAssumption of Risk\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n325\n\n\x0cRisk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply because they\ntook a risk and lost. The law provides, therefore, that when a person knowingly takes a risk, he or she\nmust suffer the consequences.\n\nThe assumption of risk doctrine comes up in three ways. The plaintiff may have formally agreed with the\ndefendant before entering a risky situation that he will relieve the defendant of liability should injury\noccur. (\xe2\x80\x9cYou can borrow my car if you agree not to sue me if the brakes fail, because they\xe2\x80\x99re worn and I\nhaven\xe2\x80\x99t had a chance to replace them.\xe2\x80\x9d) Or the plaintiff may have entered into a relationship with the\ndefendant knowing that the defendant is not in a position to protect him from known risks (the fan who is\nhit by a line drive in a ballpark). Or the plaintiff may act in the face of a risky situation known in advance\nto have been created by the defendant\xe2\x80\x99s negligence (failure to leave, while there was an opportunity to do\nso, such as getting into an automobile when the driver is known to be drunk).\n\nThe difficulty in many cases is to determine the dividing line between subjectivity and objectivity. If the\nplaintiff had no actual knowledge of the risk, he cannot be held to have assumed it. On the other hand, it is\neasy to claim that you did not appreciate the danger, and the courts will apply an objective standard of\ncommunity knowledge (a \xe2\x80\x9cbut you should have known\xe2\x80\x9d test) in many situations. When the plaintiff has no\nreal alternative, however, assumption of risk fails as a defense (e.g., a landlord who negligently fails to\nlight the exit to the street cannot claim that his tenants assumed the risk of using it).\n\nAt the turn of the century, courts applied assumption of risk in industrial cases to bar relief to workers\ninjured on the job. They were said to assume the risk of dangerous conditions or equipment. This rule has\nbeen 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 orforce majeure as it is sometimes\ncalled, is not an excuse but a defense premised on a lack of causation. If a force of nature caused the harm,\nthen the defendant was not negligent in the first place. A marina, obligated to look after boats moored at\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n326\n\n\x0cits dock, is not liable if a sudden and fierce storm against which no precaution was possible destroys\nsomeone\xe2\x80\x99s vessel. However, if it is foreseeable that harm will flow from a negligent condition triggered by\na natural event, then there is liability. For example, a work crew failed to remove residue explosive gas\nfrom an oil barge. Lightning hit the barge, exploded the gas, and injured several workmen. The plaintiff\nrecovered damages against the company because the negligence consisted in the failure to guard against\nany one of a number of chance occurrences that could ignite the gas.\n\n[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 vicarious liability\nis often called respondeat superior, meaning that the higher authority must respond to claims brought\nagainst one of its agents. Respondeat superior is not limited to the employment relationship but extends\nto a number of other agency relationships as well.\n\nLegislatures in many states have enacted laws that make people vicariously liable for acts of certain people\nwith whom they have a relationship, though not necessarily one of agency. It is common, for example, for\nthe owner of an automobile to be liable for the negligence of one to whom the owner lends the car. Socalled dram shop statutes place liability on bar and tavern owners and others who serve too much alcohol\nto one who, in an intoxicated state, later causes injury to others. In these situations, although the injurious\nact of the drinker stemmed from negligence, the one whom the law holds vicariously liable (the bartender)\nis not himself necessarily negligent\xe2\x80\x94the law is holding him strictly liable, and to this concept we now\nturn.\n\nK E Y TA K EA WAY\nThe most common tort claim is based on the negligence of the defendant. In each\nnegligence claim, the plaintiff must establish by a preponderance of the evidence that\n(1) the defendant had a duty of due care, (2) the defendant breached that duty, (3) that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n327\n\n\x0cthe breach of duty both actually and approximately has caused harm to the plaintiff, and\n(4) that the harm is measurable in money damages.\nIt is also possible for the negligence of one person to be imputed to another, as in the\ncase of respondeat superior, or in the case of someone who loans his automobile to\nanother driver who is negligent and causes injury. There are many excuses (defenses) to\nclaims of negligence, including assumption of risk and comparative negligence. In those\nfew jurisdictions where contributory negligence has not been modified to comparative\nnegligence, plaintiffs whose negligence contributes to their own injuries will be barred\nfrom any recovery.\n\nE XE R C IS ES\n\n1. Explain the difference between comparative negligence and contributory\nnegligence.\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[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\nL EA R N IN G O B JEC T IV ES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n328\n\n\x0c1. 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\ndefenses to a lawsuit in products-liability cases.\n\nHistorical Basis of Strict Liability: Animals and Ultrahazardous\nActivities\nTo this point, we have considered principles of liability that in some sense depend upon the \xe2\x80\x9cfault\xe2\x80\x9d of the\ntortfeasor. This fault is not synonymous with moral blame.\n\nAside from acts intended to harm, the fault lies in a failure to live up to a standard of reasonableness or\ndue care. But this is not the only basis for tort liability. Innocent mistakes can be a sufficient basis. As we\nhave already seen, someone who unknowingly trespasses on another\xe2\x80\x99s property is liable for the damage\nthat he does, even if he has a reasonable belief that the land is his. And it has long been held that someone\nwho engages in ultrahazardous (or sometimes, abnormally dangerous) activities is liable for damage that\nhe causes, even though he has taken every possible precaution to avoid harm to someone else.\n\nLikewise, the owner of animals that escape from their pastures or homes and damage neighboring\nproperty may be liable, even if the reason for their escape was beyond the power of the owner to stop (e.g.,\na fire started by lightning that burns open a barn door). In such cases, the courts invoke the principle of\nstrict liability, or, as it is sometimes called, liability without fault. The reason for the rule is explained\nin Klein v. Pyrodyne Corporation (Section 7.5 "Cases").\n\nStrict Liability for Products\nBecause of the importance of products liability, this text devotes an entire chapter to it (Chapter 11\n"Products Liability"). Strict liability may also apply as a legal standard for products, even those that are\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n329\n\n\x0cnot ultrahazardous. In some national legal systems, strict liability is not available as a cause of action to\nplaintiffs seeking to recover a judgment of products liability against a manufacturer, wholesaler,\ndistributor, or retailer. (Some states limit liability to the manufacturer.) But it is available in the United\nStates and initially was created by a California Supreme Court decision in the 1962 case of Greenman v.\nYuba Power Products, Inc.\n\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 using the\napproved lathe attachment to the Shopsmith to fashion a wooden chalice. The case was decided on the\npremise that Greenman had done nothing wrong in using the machine but that the machine had a defect\nthat was \xe2\x80\x9clatent\xe2\x80\x9d (not easily discoverable by the consumer). Rather than decide the case based on\nwarranties, or requiring that Greenman prove how the defendant had been negligent, Justice Traynor\nfound for the plaintiff based on the overall social utility of strict liability in cases of defective products.\nAccording to his decision, the purpose of such liability is to ensure that the \xe2\x80\x9ccost of injuries resulting from\ndefective products is borne by the manufacturers\xe2\x80\xa6rather than by the injured persons who are powerless\nto protect themselves.\xe2\x80\x9d\n\nToday, the majority of US states recognize strict liability for defective products, although some states limit\nstrict liability actions to damages for personal injuries rather than property damage. Injured plaintiffs\nhave to prove the product caused the harm but do not have to prove exactly how the manufacturer was\ncareless. Purchasers of the product, as well as injured guests, bystanders, and others with no direct\nrelationship with the product, may sue for damages caused by the product.\n\nThe Restatement of the Law of Torts, Section 402(a), was originally issued in 1964. It is a widely accepted\nstatement of the liabilities of sellers of goods for defective products. The Restatement specifies six\nrequirements, all of which must be met for a plaintiff to recover using strict liability for a product that the\nplaintiff claims is defective:\n\n1.\n\nThe product must be in a defective condition when the defendant sells it.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n330\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.\n\nThe defective condition must be the proximate cause of the injury or damage.\n\n6. The goods must not have been substantially changed from the time the product was sold to the\ntime the injury was sustained.\n\nSection 402(a) also explicitly makes clear that a defendant can be held liable even though the defendant\nhas exercised \xe2\x80\x9call possible care.\xe2\x80\x9d Thus in a strict liability case, the plaintiff does not need to show \xe2\x80\x9cfault\xe2\x80\x9d\n(or negligence).\n\nFor defendants, who can include manufacturers, distributors, processors, assemblers, packagers, bottlers,\nretailers, and wholesalers, there are a number of defenses that are available, including assumption of risk,\nproduct misuse and comparative negligence, commonly known dangers, and the knowledgeable-user\ndefense. We have already seen assumption of risk and comparative negligence in terms of negligence\nactions; the application of these is similar in products-liability actions.\n\nUnder product misuse, a plaintiff who uses a product in an unexpected and unusual way will not recover\nfor injuries caused by such misuse. For example, suppose that someone uses a rotary lawn mower to trim\na hedge and that after twenty minutes of such use loses control because of its weight and suffers serious\ncuts to his abdomen after dropping it. Here, there would be a defense of product misuse, as well as\ncontributory negligence. Consider the urban (or Internet) legend of Mervin Gratz, who supposedly put his\nWinnebago on autopilot to go back and make coffee in the kitchen, then recovered millions after his\nWinnebago turned over and he suffered serious injuries. There are multiple defenses to this alleged\naction; these would include the defenses of contributory negligence, comparative negligence, and product\nmisuse. (There was never any such case, and certainly no such recovery; it is not known who started this\nlegend, or why.)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n331\n\n\x0cAnother defense against strict liability as a cause of action is the knowledgeable user defense. If the\nparents of obese teenagers bring a lawsuit against McDonald\xe2\x80\x99s, claiming that its fast-food products are\ndefective and that McDonald\xe2\x80\x99s should have warned customers of the adverse health effects of eating its\nproducts, a defense based on the knowledgeable user is available. In one case, the court found that the\nhigh levels of cholesterol, fat, salt, and sugar in McDonald\xe2\x80\x99s food is well known to users. The court stated,\n\xe2\x80\x9cIf consumers know (or reasonably should know) the potential ill health effects of eating at McDonald\xe2\x80\x99s,\nthey cannot blame McDonald\xe2\x80\x99s if they, nonetheless, choose to satiate their appetite with a surfeit of\nsupersized McDonald\xe2\x80\x99s products.\xe2\x80\x9d\n\n[1]\n\nK E Y TA K EA WAY\nCommon-law courts have long held that certain activities are inherently dangerous\nand that those who cause damage to others by engaging in those activities will be\nheld strictly liable. More recently, courts in the United States have applied strict\nliability to defective products. Strict liability, however, is not absolute liability, as\nthere are many defenses available to defendants in lawsuits based on strict\nliability, such as comparative negligence and product abuse.\n\nE XE R C IS ES\n1. Someone says, \xe2\x80\x9cStrict liability means that you\xe2\x80\x99re liable for whatever you\nmake, no matter what the consumer does with your product. It\xe2\x80\x99s a crazy\nsystem.\xe2\x80\x9d Respond to and refute this statement.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n332\n\n\x0c2. What is the essential difference between strict liability torts and negligent\ntorts? Should the US legal system even allow strict liability torts? What\nreasons seem persuasive to you?\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\n333\n\n\x0c94 Ohio App. 313, 114 N.E.2d 529 (Ohio 1952)\n\nFacts: The plaintiff, carrying a bag of rolls purchased at another store, entered the defendant\xe2\x80\x99s grocery\nstore to buy some canned fruit. Seeing her bus outside, she stepped out of line and put the can on the\ncounter. The store manager intercepted her and repeatedly demanded that she submit the bag to be\nsearched. Finally she acquiesced; he looked inside and said she could go. She testified that several people\nwitnessed the scene, which lasted about fifteen minutes, and that she was humiliated. The jury awarded\nher $800. She also testified that no one laid a hand on her or made a move to restrain her from leaving by\nany one of numerous exits.\n***\n\nMATTHEWS, JUDGE.\nAs we view the record, it raises the fundamental question of what is imprisonment. Before any need for a\ndetermination of illegality arises there must be proof of imprisonment. In 35 Corpus Juris Secundum\n(C.J.S.), False Imprisonment, \xc2\xa7 II, pages 512\xe2\x80\x9313, it is said: \xe2\x80\x9cSubmission to the mere verbal direction of\nanother, unaccompanied by force or by threats of any character, cannot constitute a false imprisonment,\nand there is no false imprisonment where an employer interviewing an employee declines to terminate the\ninterview if no force or threat of force is used and false imprisonment may not be predicated on a person\xe2\x80\x99s\nunfounded belief that he was restrained.\xe2\x80\x9d\n\nMany cases are cited in support of the text.\n***\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 leave the\nstore; that Mr. Krause stood where she could not pass him in going out. She does not say that he made any\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n334\n\n\x0cattempt to intercept her. She says he escorted her back to the desk, that he asked her to let him see the\nchange.\n\n\xe2\x80\xa6She does not say that she went unwillingly\xe2\x80\xa6Evidence is wholly lacking to show that she was detained by\nforce or threats. It was probably a disagreeable experience, a humiliating one to her, but she came out\nvictorious and was allowed to go when she desired with the assurance of Mr. Krause that it was all right.\nThe demurrer to the evidence on both counts was properly sustained.\n\nThe result of the cases is epitomized in 22 Am.Jur. 368, as follows:\n\nA customer or patron who apparently has not paid for what he has received may be detained for a\nreasonable 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, and it is\nfalse imprisonment for a private individual to detain one for an unreasonable time, or under unreasonable\ncircumstances, for the purpose of investigating a dispute over the payment of a bill alleged to be owed by\nthe person detained for cash services.\n***\n\nFor these reasons, the judgment is reversed and final judgment entered for the defendant-appellant.\n\nC A SE QU ES TIO NS\n1. The court begins by saying what false imprisonment is not. What is the legal\ndefinition of false imprisonment?\n2. What kinds of detention are permissible for a store to use in accosting those that\nmay have been shoplifting?\n3. Jody broke up with Jeremy and refused to talk to him. Jeremy saw Jody get into her\ncar near the business school and parked right behind her so she could not move. He\nthen stood next to the driver\xe2\x80\x99s window for fifteen minutes, begging Jody to talk to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n335\n\n\x0chim. She kept saying, \xe2\x80\x9cNo, let me leave!\xe2\x80\x9d Has Jeremy committed the tort of false\nimprisonment?\n\nNegligence: Duty of Due Care\nWhitlock v. University of Denver\n\n744 P.2d 54 (Supreme Court of Colorado1987)\n\nOn June 19, 1978, at approximately 10:00 p.m., plaintiff Oscar Whitlock suffered a paralyzing injury while\nattempting to complete a one-and-three-quarters front flip on a trampoline. The injury rendered him a\nquadriplegic. The trampoline was owned by the Beta Theta Pi fraternity (the Beta house) and was situated\non the front yard of the fraternity premises, located on the University campus. At the time of his injury,\nWhitlock was twenty years old, attended the University of Denver, and was a member of the Beta house,\nwhere he held the office of acting house manager. The property on which the Beta house was located was\nleased to the local chapter house association of the Beta Theta Pi fraternity by the defendant University of\nDenver.\n\nWhitlock had extensive experience jumping on trampolines. He began using trampolines in junior high\nschool and continued to do so during his brief tenure as a cadet at the United States Military Academy at\nWest Point, where he learned to execute the one-and-three-quarters front flip. Whitlock testified that he\nutilized the trampoline at West Point every other day for a period of two months. He began jumping on\nthe trampoline owned by the Beta house in September of 1977. Whitlock recounted that in the fall and\nspring prior to the date of his injury, he jumped on the trampoline almost daily. He testified further that\nprior to the date of his injury, he had successfully executed the one-and-three-quarters front flip between\nseventy-five and one hundred times.\nDuring the evening of June 18 and early morning of June 19, 1978, Whitlock attended a party at the Beta\nhouse, where he drank beer, vodka and scotch until 2:00 a.m. Whitlock then retired and did not awaken\nuntil 2:00 p.m. on June 19. He testified that he jumped on the trampoline between 2:00 p.m. and 4:00\np.m., and again at 7:00 p.m. At 10:00 p.m., the time of the injury, there again was a party in progress at\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n336\n\n\x0cthe Beta house, and Whitlock was using the trampoline with only the illumination from the windows of\nthe fraternity house, the outside light above the front door of the house, and two street lights in the area.\nAs Whitlock attempted to perform the one-and-three-quarters front flip, he landed on the back of his\nhead, causing his neck to break.\n\nWhitlock brought suit against the manufacturer and seller of the trampoline, the University, the Beta\nTheta Pi fraternity and its local chapter, and certain individuals in their capacities as representatives of\nthe Beta Theta Pi organizations. Whitlock reached settlements with all of the named defendants except\nthe University, so only the negligence action against the University proceeded to trial. The jury returned a\nverdict in favor of Whitlock, assessing his total damages at $ 7,300,000. The jury attributed twenty-eight\npercent of causal negligence to the conduct of Whitlock and seventy-two percent of causal negligence to\nthe conduct of the University. The trial court accordingly reduced the amount of the award against the\nUniversity to $ 5,256,000.\n\nThe University moved for judgment notwithstanding the verdict, or, in the alternative, a new trial. The\ntrial court granted the motion for judgment notwithstanding the verdict, holding that as a matter of law,\nno reasonable jury could have found that the University was more negligent than Whitlock, and that the\njury\xe2\x80\x99s monetary award was the result of sympathy, passion or prejudice.\n\nA panel of the court of appeals reversed\xe2\x80\xa6by a divided vote. Whitlock v. University of Denver, 712 P.2d\n1072 (Colo. App. 1985). The court of appeals held that the University owed Whitlock a duty of due care to\nremove the trampoline from the fraternity premises or to supervise its use.\xe2\x80\xa6The case was remanded to\nthe trial court with orders to reinstate the verdict and damages as determined by the jury. The University\nthen petitioned for certiorari review, and we granted that petition.\n\nII.\nA negligence claim must fail if based on circumstances for which the law imposes no duty of care upon the\ndefendant for the benefit of the plaintiff. [Citations] Therefore, if Whitlock\xe2\x80\x99s judgment against the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n337\n\n\x0cUniversity is to be upheld, it must first be determined that the University owed a duty of care to take\nreasonable measures to protect him against the injury that he sustained.\n\nWhether a particular defendant owes a legal duty to a particular plaintiff is a question of law. [Citations]\n\xe2\x80\x9cThe court determines, as a matter of law, the existence and scope of the duty\xe2\x80\x94that is, whether the\nplaintiff\xe2\x80\x99s interest that has been infringed by the conduct of the defendant is entitled to legal protection.\xe2\x80\x9d\n[Citations] In Smith v. City & County of Denver, 726 P.2d 1125 (Colo. 1986), we set forth several factors to\nbe considered in determining the existence of duty in a particular case:\n\nWhether the law should impose a duty requires consideration of many factors including, for example, the\nrisk involved, the foreseeability and likelihood of injury as weighed against the social utility of the actor\xe2\x80\x99s\nconduct, the magnitude of the burden of guarding against injury or harm, and the consequences of placing\nthe burden upon the actor.\n\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 those\nconsiderations of policy which lead the law to say that the plaintiff is [or is not] entitled to protection.\xe2\x80\x9d\n\xe2\x80\xa6\n\nWe believe that the fact that the University is charged with negligent failure to act rather than negligent\naffirmative action is a critical factor that strongly militates against imposition of a duty on the University\nunder the facts of this case. In determining whether a defendant owes a duty to a particular plaintiff, the\nlaw has long recognized a distinction between action and a failure to act\xe2\x80\x94\xe2\x80\x9cthat is to say, between active\nmisconduct working positive injury to others [misfeasance] and passive inaction or a failure to take steps\nto protect them from harm [nonfeasance].\xe2\x80\x9d W. Keeton, \xc2\xa7 56, at 373. Liability for nonfeasance was slow to\nreceive recognition in the law. \xe2\x80\x9cThe reason for the distinction may be said to lie in the fact that by\n\xe2\x80\x98misfeasance\xe2\x80\x99 the defendant has created a new risk of harm to the plaintiff, while by \xe2\x80\x98nonfeasance\xe2\x80\x99 he has\nat least made his situation 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 follows:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n338\n\n\x0cThe fact that an actor realizes or should realize that action on his part is necessary for another\xe2\x80\x99s aid or\nprotection does not of itself impose upon him a duty to take such action.\n\nImposition of a duty in all such cases would simply not meet the test of fairness under contemporary\nstandards.\n\nIn nonfeasance cases the existence of a duty has been recognized only during the last century in situations\ninvolving a limited group of special relationships between parties. Such special relationships are\npredicated on \xe2\x80\x9csome definite relation between the parties, of such a character that social policy justifies\nthe imposition of a duty to act.\xe2\x80\x9d W. Keeton, \xc2\xa7 56, at 374. Special relationships that have been recognized\nby various courts for the purpose of imposition of a duty of care include common carrier/passenger,\ninnkeeper/guest, possessor of land/invited entrant, employer/employee, parent/child, and\nhospital/patient. See Restatement (Second) of Torts \xc2\xa7 314 A (1965); 3 Harper and James, \xc2\xa7 18.6, at 722\xe2\x80\x93\n23. The authors of the Restatement (Second) of Torts \xc2\xa7 314 A, comment b (1965), state that \xe2\x80\x9cthe law\nappears\xe2\x80\xa6to be working slowly toward a recognition of the duty to aid or protect in any relation of\ndependence or of mutual dependence.\xe2\x80\x9d\n\xe2\x80\xa6\n\nIII.\nThe present case involves the alleged negligent failure to act, rather than negligent action. The plaintiff\ndoes not complain of any affirmative action taken by the University, but asserts instead that the\nUniversity owed to Whitlock the duty to assure that the fraternity\xe2\x80\x99s trampoline was used only under\nsupervised conditions comparable to those in a gymnasium class, or in the alternative to cause the\ntrampoline to be removed from the front lawn of the Beta house.\xe2\x80\xa6If such a duty is to be recognized, it\nmust be grounded on a special relationship between the University and Whitlock. According to the\nevidence, there are only two possible sources of a special relationship out of which such a duty could arise\nin this case: the status of Whitlock as a student at the University, and the lease between the University and\nthe fraternity of which Whitlock was a member. We first consider the adequacy of the student-university\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n339\n\n\x0crelationship as 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 generally agreed\nthat a university is not an insurer of its students\xe2\x80\x99 safety. [Citations] The relationship between a university\nand its students has experienced important change over the years. At one time, college administrators and\nfaculties stood in loco parentis to their students, which created a special relationship \xe2\x80\x9cthat imposed a duty\non the college to exercise control over student conduct and, reciprocally, gave the students certain rights\nof protection by the college.\xe2\x80\x9d Bradshaw, 612 F.2d at 139. However, in modern times there has evolved a\ngradual reapportionment 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 are\nregarded as educational institutions rather than custodial ones. Beach, 726 P.2d at 419 (contrasting\ncolleges and universities with elementary and high schools).\n\xe2\x80\xa6\n\n\xe2\x80\xa6By imposing a duty on the University in this case, the University would be encouraged to exercise more\ncontrol over private student recreational choices, thereby effectively taking away much of the\nresponsibility recently recognized in students for making their own decisions with respect to private\nentertainment and personal safety. Such an allocation of responsibility would \xe2\x80\x9cproduce a repressive and\ninhospitable environment, largely inconsistent with the objectives of a modern college\neducation.\xe2\x80\x9d Beach, 726 P.2d at 419.\n\nThe evidence demonstrates that only in limited instances has the University attempted to impose\nregulations or restraints on the private recreational pursuits of its students, and the students have not\nlooked to the University to assure the safety of their recreational choices. Nothing in the University\xe2\x80\x99s\nstudent handbook, which contains certain regulations concerning student conduct, reflects an effort by\nthe University to control the risk-taking decisions of its students in their private recreation.\xe2\x80\xa6Indeed,\nfraternity and sorority self-governance with minimal supervision appears to have been fostered by the\nUniversity.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n340\n\n\x0c\xe2\x80\xa6\n\nAside from advising the Beta house on one occasion to put the trampoline up when not in use, there is no\nevidence that the University officials attempted to assert control over trampoline use by the fraternity\nmembers. We conclude from this record that the University\xe2\x80\x99s very limited actions concerning safety of\nstudent recreation did not give Whitlock or the other members of campus fraternities or sororities any\nreason to depend upon the University for evaluation of the safety of trampoline use.\xe2\x80\xa6Therefore, we\nconclude that the student-university relationship is not a special relationship of the type giving rise to a\nduty of the University to take reasonable measures to protect the members of fraternities and sororities\nfrom risks of engaging in extra-curricular trampoline jumping.\n\nThe plaintiff asserts, however, that we should recognize a duty of the University to take affirmative action\nto protect fraternity members because of the foreseeability of the injury, the extent of the risks involved in\ntrampoline use, the seriousness of potential injuries, and the University\xe2\x80\x99s superior knowledge concerning\nthese matters. The argument in essence is that a duty should spring from the University\xe2\x80\x99s natural interest\nin the welfare and safety of its students, its superior knowledge of the nature and degree of risk involved\nin trampoline use, and its knowledge of the use of trampolines on the University campus. The evidence\namply supports a conclusion that trampoline use involves risks of serious injuries and that the potential\nfor an injury 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 clinic, and\nthat University administrators were aware of the number and severity of trampoline injuries nationwide.\n\nThe record, however, also establishes through Whitlock\xe2\x80\x99s own testimony that he was aware of the risk of\nan accident and injury of the very nature that he experienced.\xe2\x80\xa6\n\nWe conclude that the relationship between the University and Whitlock was not one of dependence with\nrespect to the activities at issue here, and provides no basis for the recognition of a duty of the University\nto take measures for protection of Whitlock against the injury that he suffered.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n341\n\n\x0cB.\nWe next examine the lease between the University and the fraternity to determine whether a special\nrelationship between the University and Whitlock can be predicated on that document. The lease was\nexecuted in 1929, extends for a ninety-nine year term, and gives the fraternity the option to extend the\nterm for another ninety-nine years. The premises are to be occupied and used by the fraternity \xe2\x80\x9cas a\nfraternity house, clubhouse, dormitory and boarding house, and generally for religious, educational, social\nand fraternal purposes.\xe2\x80\x9d Such occupation is to be \xe2\x80\x9cunder control of the tenant.\xe2\x80\x9d (emphasis added) The\nannual rental at all times relevant to this case appears from the record to be one dollar. The University has\nthe obligation to maintain the grounds and make necessary repairs to the building, and the fraternity is to\nbear the cost of such maintenance and repair.\n\xe2\x80\xa6\n\nWe conclude that the lease, and the University\xe2\x80\x99s actions pursuant to its rights under the lease, provide no\nbasis of dependence by the fraternity members upon which a special relationship can be found to exist\nbetween the University and the fraternity members that would give rise to a duty upon the University to\ntake affirmative action to assure that recreational equipment such as a trampoline is not used under\nunsafe conditions.\n\nIV.\nConsidering all of the factors presented, we are persuaded that under the facts of this case the University\nof Denver had no duty to Whitlock to eliminate the private use of trampolines on its campus or to\nsupervise that use. There exists no special relationship between the parties that justifies placing a duty\nupon the University to protect Whitlock from the well-known dangers of using a trampoline. Here, a\nconclusion that a special relationship existed between Whitlock and the University sufficient to warrant\nthe imposition of liability for nonfeasance would directly contravene the competing social policy of\nfostering an educational environment of student autonomy and independence.\nWe reverse the judgment of the court of appeals and return this case to that court with directions to\nremand it to the trial court for dismissal of Whitlock\xe2\x80\x99s complaint against the University.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n342\n\n\x0cC A SE QU ES TIO NS\n1. How are comparative negligence numbers calculated by the trial court? How can the\njury say that the university is 72 percent negligent and that Whitlock is 28 percent\nnegligent?\n2. Why is this not an assumption of risk case?\n3. Is there any evidence that Whitlock was contributorily negligent? If not, why would\nthe court engage in comparative negligence calculations?\n\nNegligence: Proximate Cause\nPalsgraf v. Long Island R.R.\n\n248 N.Y. 339,162 N.E. 99 (N.Y. 1928)\n\nCARDOZO, Chief Judge\n\nPlaintiff was standing on a platform of defendant\xe2\x80\x99s railroad after buying a ticket to go to Rockaway Beach.\nA train stopped at the station, bound for another place. Two men ran forward to catch it. One of the men\nreached the platform of the car without mishap, though the train was already moving. The other man,\ncarrying a package, jumped aboard the car, but seemed unsteady as if about to fall. A guard on the car,\nwho had held the door open, reached forward to help him in, and another guard on the platform pushed\nhim from behind. In this act, the package was dislodged, and fell upon the rails. It was a package of small\nsize, about fifteen inches long, and was covered by a newspaper. In fact it contained fireworks, but there\nwas nothing in its appearance to give notice of its contents. The fireworks when they fell exploded. The\nshock of\xc2\xb7 the explosion threw down some scales at the other end of the platform many feet away. The\nscales struck the plaintiff, causing injuries for which she sues.\n\nThe conduct of the defendant\xe2\x80\x99s guard, if a wrong in its relation to the holder of the package, was not a\nwrong in its relation to the plaintiff, standing far away. Relatively to her it was not negligence at all.\nNothing in the situation gave notice that the falling package had in it the potency of peril to persons thus\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n343\n\n\x0cremoved. Negligence is not actionable unless it involves the invasion of a legally protected interest, the\nviolation of a right. \xe2\x80\x9cProof of negligence in the air, so to speak, will not do.\xe2\x80\xa6If no hazard was apparent to\nthe eye of ordinary vigilance, an act innocent and harmless, at least to outward seeming, with reference to\nher, did not take to itself the quality of a tort because it happened to be a wrong, though apparently not\none involving the risk of bodily insecurity, with reference to someone else.\xe2\x80\xa6The plaintiff sues in her own\nright for a wrong personal to her, and not as the vicarious beneficiary of a breach of duty to another.\n\nA different conclusion will involve us, and swiftly too, in a maze of contradictions. A guard stumbles over\na package which has been left upon a platform.\n\nIt seems to be a bundle of newspapers. It turns out to be a can of dynamite. To the eye of ordinary\nvigilance, the bundle is abandoned waste, which may be kicked or trod on with impunity. Is a passenger at\nthe other end of the platform protected by the law against the unsuspected hazard concealed beneath the\nwaste? If not, is the result to be any different, so far as the distant passenger is concerned, when the guard\nstumbles over a valise which a truckman or a porter has left upon the walk?\xe2\x80\xa6The orbit of the danger as\ndisclosed to the eye of reasonable vigilance would be the orbit of the duty. One who jostles one\xe2\x80\x99s neighbor\nin a crowd does not invade the rights of others standing at the outer fringe when the unintended contact\ncasts a bomb 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 nature\ntransformed, before prevision so extravagant can be accepted as the norm of conduct, the customary\nstandard to which behavior must conform.\n\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; i.e., a\nviolation of her own right, and not merely a \xe2\x80\x9cwrong\xe2\x80\x9d to someone else, nor conduct \xe2\x80\x9cwrongful\xe2\x80\x9d because\nunsocial, but not a \xe2\x80\x9cwrong\xe2\x80\x9d to anyone. We are told that one who drives at reckless speed through a\ncrowded city street is guilty of a negligent act and therefore of a wrongful one, irrespective of the\nconsequences.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n344\n\n\x0cNegligent the act is, and wrongful in the sense that it is unsocial, but wrongful and unsocial in relation to\nother travelers, only because the eye of vigilance perceives the risk of damage. If the same act were to be\ncommitted on a speedway or a race course, it would lose its wrongful quality. The risk reasonably to be\nperceived defines the duty to be obeyed, and risk imports relation; it is risk to another or to others within\nthe range of apprehension. This does not mean, of course, that one who launches a destructive force is\nalways relieved of liability, if the force, though known to be destructive, pursues an unexpected\npath.\xe2\x80\xa6Some acts, such as shooting are so imminently dangerous to anyone who may come within reach of\nthe missile however unexpectedly, as to impose a duty of prevision not far from that of an insurer. Even\ntoday, and much 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, like risk, is\nthus a term of relation.\n\nNegligence in the abstract, apart from things related, is surely not a tort, if indeed it is understandable at\nall.\xe2\x80\xa6One who seeks redress at law does not make out a cause of action by showing without more that\nthere has been damage to his person. If the harm was not willful, he must show that the act as to him had\npossibilities of danger so many and apparent as to entitle him to be protected against the doing of it\nthough the harm was unintended.\n***\n\nThe judgment of the Appellate Division and that of the Trial Term should be reversed, and the complaint\ndismissed, with costs in all courts.\n\nC A SE QU ES TIO NS\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\nthat were caused by the negligence of the Long Island Rail Road?\n3. How is this accident not foreseeable?\n\nKlein v. Pyrodyne Corporation\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n345\n\n\x0cKlein v. Pyrodyne Corporation\n\n810 P.2d 917 (Supreme Court of Washington 1991)\n\nPyrodyne Corporation (Pyrodyne) is a licensed fireworks display company that contracted to display\nfireworks at the Western Washington State Fairgrounds in Puyallup, Washington, on July 4,1987. During\nthe fireworks display, one of the mortar launchers discharged a rocket on a horizontal trajectory parallel\nto the earth. The rocket exploded near a crowd of onlookers, including Danny Klein. Klein\xe2\x80\x99s clothing was\nset on fire, and he suffered facial burns and serious injury to his eyes. Klein sued Pyrodyne for strict\nliability to recover for his injuries. Pyrodyne asserted that the Chinese manufacturer of the fireworks was\nnegligent in producing the rocket and therefore Pyrodyne should not be held liable. The trial court applied\nthe doctrine of strict liability and held in favor of Klein. Pyrodyne appealed.\n\nSection 519 of the Restatement (Second) of Torts provides that any party carrying on an \xe2\x80\x9cabnormally\ndangerous activity\xe2\x80\x9d is strictly liable for ensuing damages. The public display of fireworks fits this\ndefinition. The court stated: \xe2\x80\x9cAny time a person ignites rockets with the intention of sending them aloft to\nexplode in the presence of large crowds of people, a high risk of serious personal injury or property\ndamage is created. That risk arises because of the possibility that a rocket will malfunction or be\nmisdirected.\xe2\x80\x9d Pyrodyne argued that its liability was cut off by the Chinese manufacturer\xe2\x80\x99s negligence. The\ncourt rejected this argument, stating, \xe2\x80\x9cEven if negligence may properly be regarded as an intervening\ncause, it cannot function to relieve Pyrodyne from strict liability.\xe2\x80\x9d\nThe Washington Supreme Court held that the public display of fireworks is an abnormally dangerous\nactivity that warrants the imposition of strict liability.\n\nAffirmed.\n\nC A SE QU ES TIO NS\n1. Why would certain activities be deemed ultrahazardous or abnormally dangerous so\nthat strict liability is imposed?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n346\n\n\x0c2. If the activities are known to be abnormally dangerous, did Klein assume the risk?\n3. Assume that the fireworks were negligently manufactured in China. Should Klein\xe2\x80\x99s\nonly remedy be against the Chinese company, as Pyrodyne argues? Why or why\nnot?\n\n7.6 Summary and Exercises\nSummary\nThe principles of tort law pervade modern society because they spell out the duties of care that we owe\neach other in our private lives. Tort law has had a significant impact on business because modern\ntechnology poses significant dangers and the modern market is so efficient at distributing goods to a wide\nclass of consumers.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n347\n\n\x0cUnlike criminal law, tort law does not require the tortfeasor to have a specific intent to commit the act for\nwhich he or she will be held liable to pay damages. Negligence\xe2\x80\x94that is, carelessness\xe2\x80\x94is a major factor in\ntort liability. In some instances, especially in cases involving injuries caused by products, a no-fault\nstandard called strict liability is applied.\n\nWhat constitutes a legal injury depends very much on the circumstances. A person can assume a risk or\nconsent to the particular action, thus relieving the person doing the injury from tort liability. To be liable,\nthe tortfeasor must be the proximate cause of the injury, not a remote cause. On the other hand, certain\npeople are held to answer for the torts of another\xe2\x80\x94for example, an employer is usually liable for the torts\nof his employees, and a bartender might be liable for injuries caused by someone to whom he sold too\nmany drinks. Two types of statutes\xe2\x80\x94workers\xe2\x80\x99 compensation and no-fault automobile insurance\xe2\x80\x94have\neliminated tort liability for certain kinds of accidents and replaced it with an immediate insurance\npayment plan.\n\nAmong the torts of particular importance to the business community are wrongful death and personal\ninjury caused by products or acts of employees, misrepresentation, defamation, and interference with\ncontractual relations.\n\nE XE R C IS ES\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\nprovided no medical care for six hours, and she died. The woman\xe2\x80\x99s family\nsued the store for wrongful death. What arguments could the store make that\nit was not liable? What arguments could the family make? Which seem the\nstronger arguments? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n348\n\n\x0c3. The signals on a railroad crossing are defective. Although the railroad\ncompany was notified of the problem a month earlier, the railroad inspector\nhas failed to come by and repair them. Seeing the all-clear signal, a car drives\nup and stalls on the tracks as a train rounds the bend. For the past two weeks\nthe car had been stalling, and the driver kept putting off taking the car to the\nshop for a tune-up. As the train rounds the bend, the engineer is distracted by\na conductor and does not see the car until it is too late to stop. Who is\nnegligent? Who must bear the liability for the damage to the car and to the\ntrain?\n4. Suppose in the Katko v. Briney case (Section 7.2 "Intentional Torts") that\ninstead of setting such a device, the defendants had simply let the floor\nimmediately inside the front door rot until it was so weak that anybody who\ncame in and took two steps straight ahead would fall through the floor and to\nthe cellar. Will the defendant be liable in this case? What if they invited a\nrealtor 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\nno money except a valid insurance policy by which she was entitled to $5,000.\nInsurance Company refused to pay, delaying and refusing payment and\nmeanwhile \xe2\x80\x9cinviting\xe2\x80\x9d Plaintiff to accept less than $5,000, hinting that it had a\ndefense. Plaintiff was reduced to accepting housing and charity from relatives.\nShe sued the insurance company for bad-faith refusal to settle the claim and\nfor the intentional infliction of emotional distress. The lower court dismissed\nthe case. Should the court of appeals allow the matter to proceed to trial?\n\nS EL F -T E ST QU EST IO N S\n1. Catarina falsely accuses Jeff of stealing from their employer. The statement\nis defamatory only if\na. a third party hears it\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n349\n\n\x0cb. 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\nTwitter\nGarrett 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\nprovided some evidence to back the claim). To win his case, Garrett will\nhave to show that Colossal acted with\na. malice\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\nBig Burger well knows. Its intent is to get some customers to shift loyalty\nfrom Burger World to Big Burger. Burger World\xe2\x80\x99s best cause of action\nwould be\na. trespass 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\ninto three people on the sidewalk. Which statement is true?\na. He is liable for an intentional tort.\nb. He is liable for a negligent tort.\nc. He is not liable for a negligent tort.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n350\n\n\x0cd. He is liable under strict liability, because driving a car is abnormally\ndangerous.\nJonathan carelessly bumps into Amanda, knocking her to the ground. He\nhas committed the tort of negligence\na. only if Amanda is injured\nb. only if Amanda is not injured\nc. whether or not Amanda is injured\n\nS EL F -T E ST A NSW E R S\n\n1. a\n2. d\n3. c\n4. c\n5. a\n\nChapter 8\nIntroduction to Sales and Leases\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n351\n\n\x0c1. Why the law of commercial transactions is separate from the common law\n2. What is meant by \xe2\x80\x9ccommercial transactions\xe2\x80\x9d and how the Uniform Commercial\nCode (UCC) deals with them in general\n3. The scope of Article 2, Article 2A, and the Convention on Contracts for the\nInternational Sale of Goods\n4. What obligations similar to the common law\xe2\x80\x99s are imposed on parties to a UCC\ncontract, and what obligations different from the common law\xe2\x80\x99s are imposed\n5. The difference between a consumer lease and a finance lease\n\n8.1 Commercial Transactions: the Uniform Commercial\nCode\nL EA R N IN G O B JEC T IV ES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n352\n\n\x0c1. Understand why there is a separate body of law governing commercial\ntransactions.\n2. Be aware of the scope of the Uniform Commercial Code.\n3. Have a sense of this text\xe2\x80\x99s presentation of the law of commercial transactions.\n\nHistory of the UCC\nIn (Reference mayer_1.0-ch08 not found in Book) we introduced the Uniform Commercial Code. As we\nnoted, the UCC has become a national law, adopted in every state\xe2\x80\x94although Louisiana has not enacted\nArticle 2, and differences in the law exist from state to state. Of all the uniform laws related to commercial\ntransactions, the UCC is by far the most successful, and its history goes back to feudal times.\n\nIn a mostly agricultural, self-sufficient society there is little need for trade, and almost all law deals with\nthings related to land (real estate): its sale, lease, and devising (transmission of ownership by\ninheritance); services performed on the land; and damages to the land or to things related to it or to its\nproductive capacity (torts). Such trade as existed in England before the late fourteenth century was\ndominated by foreigners. But after the pandemic of the Black Death in 1348\xe2\x80\x9349 (when something like 30\npercent to 40 percent of the English population died), the self-sufficient feudal manors began to break\ndown. There was a shortage of labor. People could move off the manors to find better work, and no longer\ntied immediately to the old estates, they migrated to towns. Urban centers\xe2\x80\x94cities\xe2\x80\x94began to develop.\nUrbanization inevitably reached the point where citizens\xe2\x80\x99 needs could not be met locally. Enterprising\npeople recognized that some places had a surplus of a product and that other places were in need of that\nsurplus and had a surplus of their own to exchange for it. So then, by necessity, people developed the\nmeans to transport the surpluses. Enter ships, roads, some medium of exchange, standardized weights\nand measures, accountants, lawyers, and rules governing merchandising. And enter merchants.\nThe power of merchants was expressed through franchises obtained from the government which entitled\nmerchants to create their own rules of law and to enforce these rules through their own courts. Franchises\nto hold fairs [retail exchanges] were temporary; but the franchises of the staple cities, empowered to deal\nin certain basic commodities [and to have mercantile courts], were permanent.\xe2\x80\xa6Many trading towns had\ntheir own adaptations of commercial law.\xe2\x80\xa6 The seventeenth century movement toward national\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n353\n\n\x0cgovernments resulted in a decline of separate mercantile franchises and their courts. The staple\ntowns\xe2\x80\xa6had outlived their usefulness. When the law merchant became incorporated into a national system\nof laws enforced by national courts of general jurisdiction, the local codes were finally extinguished. But\nnational systems of law necessarily depended upon the older codes for their stock of ideas and on the\nchanging customs of merchants for new developments.\n\n[1]\n\nWhen the American colonies declared independence from Britain, they continued to use British law,\nincluding the laws related to commercial transactions. By the early twentieth century, the states had\ninconsistent rules, making interstate commerce difficult and problematic. Several uniform laws affecting\ncommercial transactions were floated in the late nineteenth century, but few were widely adopted. In\n1942, the American Law Institute (ALI)\n\n[2]\n\nhired staff to begin work on a rationalized, simplified, and\n\nharmonized national body of modern commercial law. The ALI\xe2\x80\x99s first draft of the UCC was completed in\n1951.The UCC was adopted by Pennsylvania two years later, and other states followed in the 1950s and\n1960s.\n\nIn the 1980s and 1990s, the leasing of personal property became a significant factor in commercial\ntransactions, and although the UCC had some sections that were applicable to leases, the law regarding\nthe sale of goods was inadequate to address leases. Article 2A governing the leasing of goods was\napproved by the ALI in 1987. It essentially repeats Article 2 but applies to leases instead of sales. In 2001,\namendments to Article 1\xe2\x80\x94which applies to the entire UCC\xe2\x80\x94were proposed and subsequently have been\nadopted by over half the states. No state has yet adopted the modernizing amendments to Article 2 and 2A\nthat the ALI proposed in 2003.\n\nThat\xe2\x80\x99s the short history of why the body of commercial transaction law is separate from the common law.\n\nScope of the UCC and This Text\xe2\x80\x99s Presentation of the UCC\nThe UCC embraces the law of commercial transactions, a term of some ambiguity. A commercial\ntransaction may seem to be a series of separate transactions; it may include, for example, the making of a\ncontract for the sale of goods, the signing of a check, the endorsement of the check, the shipment of goods\nunder a bill of lading, and so on. However, the UCC presupposes that each of these transactions is a facet\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n354\n\n\x0cof one single transaction: the lease or sale of, and payment for, goods. The code deals with phases of this\ntransaction from start to finish. These phases are organized according to the following articles:\n\n\xe2\x80\xa2\n\nSales (Article 2)\n\n\xe2\x80\xa2\n\nLeases (Article 2A)\n\n\xe2\x80\xa2\n\nCommercial Paper (Article 3)\n\n\xe2\x80\xa2\n\nBank Deposits and Collections (Article 4)\n\n\xe2\x80\xa2\n\nFunds Transfers (Article 4A)\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)\n\nAlthough the UCC comprehensively covers commercial transactions, it does not deal with every aspect of\ncommercial law. Among the subjects not covered are the sale of real property, mortgages, insurance\ncontracts, suretyship transactions (unless the surety is party to a negotiable instrument), and bankruptcy.\nMoreover, common-law principles of contract law that were examined in previous chapters continue to\napply to many transactions covered in a particular way by the UCC. These principles include capacity to\ncontract, misrepresentation, coercion, and mistake. Many federal laws supersede the UCC; these include\nthe Bills of Lading Act, the Consumer Credit Protection Act, the warranty provisions of the MagnusonMoss Act, and other regulatory statutes.\n\nWe follow the general outlines of the UCC in this chapter and inChapter 9 "Title and Risk of\nLoss" and Chapter 10 "Performance and Remedies". In this chapter, we cover the law governing sales\n(Article 2) and make some reference to leases (Article 2A), though space constraints preclude an\nexhaustive analysis of leases. The use of documents of title to ship and store goods is closely related to\nsales, and so we cover documents of title (Article 7) as well as the law of bailments in Chapter 12\n"Bailments and the Storage, Shipment, and Leasing of Goods".\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n355\n\n\x0cIn Chapter 13 "Nature and Form of Commercial Paper", Chapter 14 "Negotiation of Commercial\nPaper", Chapter 15 "Holder in Due Course and Defenses", and Chapter 16 "Liability and Discharge", we\ncover the giving of a check, draft, or note (commercial paper) for part or all of the purchase price and the\nnegotiation of the commercial paper (Article 3). Related matters, such as bank deposits and collections\n(Article 4), funds transfers (Article 4A), and letters of credit (Article 5), are also covered there.\n\nIn Chapter 19 "Secured Transactions and Suretyship" we turn to acceptance of security by the seller or\nlender for financing the balance of the payment due. Key to this area is the law of secured transactions\n(Article 9), but other types of security (e.g., mortgages and suretyship) not covered in the UCC will also be\ndiscussed in Chapter 20 "Mortgages and Nonconsensual Liens". Chapter 18 "Consumer Credit\nTransactions" covers consumer credit transactions and Chapter 21 "Bankruptcy" covers bankruptcy law;\nthese topics are important for all creditors, even those lacking some form of security.\nFinally, the specialized topic of Article 8, investment securities (e.g., corporate stocks and bonds), is\ntreated in (Reference mayer_1.0-ch43 not found in Book).\n\nWe now turn our attention to the sale\xe2\x80\x94the first facet, and the cornerstone, of the commercial transaction.\n\nK E Y TA K EA WAY\nIn the development of the English legal system, commercial transactions were\noriginally of such little importance that the rules governing them were left to the\nmerchants themselves. They had their own courts and adopted their own rules\nbased on their customary usage. By the 1700s, the separate courts had been\nabsorbed into the English common law, but the distinct rules applicable to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n356\n\n\x0ccommercial transactions remained and have carried over to the modern UCC. The\nUCC treats commercial transactions in phases, and this text basically traces those\nphases.\n\nE XE R C IS ES\n1. Why were medieval merchants compelled to develop their own rules about\ncommercial transactions?\n2. Why was the UCC developed, and when was the period of its initial adoption\nby states?\n[1] Frederick G. Kempin Jr., Historical Introduction to Anglo-American Law(Eagan, MN: West,\n1973), 217\xe2\x80\x9318, 219\xe2\x80\x9320, 221.\n[2] American Law Insitute, \xe2\x80\x9cALI Overview,\xe2\x80\x9d accessed March 1,\n2011,http://www.ali.org/index.cfm?fuseaction=about.overview.\n\n8.2 Introduction to Sales and Lease Law, and the\nConvention on Contracts for the International Sale of\nGoods\nL EA R N IN G O B JEC T IV ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n357\n\n\x0c1. Understand that the law of sales not only incorporates many aspects of\ncommon-law contract but also addresses some distinct issues that do not\noccur in contracts for the sale of real estate or services.\n2. Understand the scope of Article 2 and the definitions of sale andgoods.\n3. Learn how courts deal with hybrid situations: mixtures of the sale of goods\nand of real estate, mixtures of goods and services.\n4. Recognize the scope of Article 2A and the definitions of lease,consumer lease,\nand finance lease.\n5. Learn about the Convention on Contracts for the International Sale of Goods\nand why it is relevant to our discussion of Article 2.\n\nScope of Articles 2 and 2A and Definitions\nIn dealing with any statute, it is of course very important to understand the statute\xe2\x80\x99s scope or coverage.\n\nArticle 2 does not govern all commercial transactions, only sales. It does not cover all sales, only the sale\nof goods. Article 2A governs leases, but only of personal property (goods), not real estate. The Convention\non Contracts for the International Sale of Goods (CISG)\xe2\x80\x94kind of an international Article 2\xe2\x80\x94\xe2\x80\x9capplies to\ncontracts of sale of goods between parties whose places of business are in different States [i.e., countries]\xe2\x80\x9d\n(CISG, Article 1). So we need to consider the definitions ofsale, goods, and lease.\n\nDefinition of Sale\nA sale \xe2\x80\x9cconsists in the passing of title from the seller to the buyer for a price.\xe2\x80\x9d\n\n[1]\n\nSales are distinguished from gifts, bailments, leases, and secured transactions. Article 2 sales should be\ndistinguished from gifts, bailments, leases, and secured transactions. A gift is the transfer of title without\nconsideration, and a \xe2\x80\x9ccontract\xe2\x80\x9d for a gift of goods is unenforceable under the Uniform Commercial Code\n(UCC) or otherwise (with some exceptions). A bailment is the transfer of possession but not title or use;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n358\n\n\x0cparking your car in a commercial garage often creates a bailment with the garage owner. A lease (see the\nformal definition later in this chapter) is a fixed-term arrangement for possession and use of something\xe2\x80\x94\ncomputer equipment, for example\xe2\x80\x94and does not transfer title. In a secured transaction, the ownerdebtor gives a security interest in collateral to a creditor that allows the creditor to repossess the collateral\nif the owner defaults.\n\nDefinition of Goods\nEven if the transaction is considered a sale, the question still remains whether the contract concerns the\nsale of goods. Article 2 applies only to goods; sales of real estate and services are governed by non-UCC\nlaw. Section 2-105(1) of the UCC defines goods as \xe2\x80\x9call things\xe2\x80\xa6which 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 Money can be\nconsidered goods subject to Article 2 if it is the object of the contract\xe2\x80\x94for example, foreign currency.\nIn certain cases, the courts have difficulty applying this definition because the item in question can also be\nviewed as realty or service. Most borderline cases raise one of two general questions:\n\n1.\n\nIs the contract for the sale of the real estate, or is it for the sale of goods?\n\n2. Is the contract for the sale of goods, or is it for services?\n\nReal Estate versus Goods\nThe dilemma is this: A landowner enters into a contract to sell crops, timber, minerals, oil, or gas. If the\nitems have already been detached from the land\xe2\x80\x94for example, timber has been cut and the seller agrees to\nsell logs\xe2\x80\x94they are goods, and the UCC governs the sale. But what if, at the time the contract is made, the\nitems are still part of the land? Is a contract for the sale of uncut timber governed by the UCC or by real\nestate law?\n\nThe UCC governs under either of two circumstances: (1) if the contract calls for the seller to sever the\nitems or (2) if the contract calls for the buyer to sever the items and if the goods can be severed without\nmaterial harm to the real estate.\n\n[2]\n\nThe second provision specifically includes growing crops and timber.\n\nBy contrast, the law of real property governs if the buyer\xe2\x80\x99s severance of the items will materially harm the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n359\n\n\x0creal estate; for example, the removal of minerals, oil, gas, and structures by the buyer will cause the law of\nreal property to govern. (See Figure 8.1 "Governing Law".)\n\nFigure 8.1 Governing Law\n\nGoods versus Services\nDistinguishing goods from services is the other major difficulty that arises in determining the nature of\nthe object of a sales contract. The problem: how can goods and services be separated in contracts calling\nfor the seller to deliver a combination of goods and services? That issue is examined in Section 8.5.1\n"Mixed Goods and Services Contracts: The \xe2\x80\x9cPredominant Factor\xe2\x80\x9d Test" (Pittsley v. Houser), where the\ncourt applied the common \xe2\x80\x9cpredominant factor\xe2\x80\x9d (also sometimes \xe2\x80\x9cpredominate purpose\xe2\x80\x9d or\n\xe2\x80\x9cpredominant thrust\xe2\x80\x9d) test\xe2\x80\x94that is, it asked whether the transaction was predominantly a contract for\ngoods or for services. However, the results of this analysis are not always consistent. Compare Epstein v.\nGiannattasio, in which the court held that no sale of goods had been made because the plaintiff received a\ntreatment in which the cosmetics were only incidentally used, withNewmark v. Gimble\xe2\x80\x99s, Inc., in which\nthe court said \xe2\x80\x9c[i]f the permanent wave lotion were sold\xe2\x80\xa6for home consumption\xe2\x80\xa6unquestionably an\nimplied warranty of fitness for that purpose would have been an integral incident of the sale.\xe2\x80\x9d\n\n[3]\n\nThe New\n\nJersey court rejected the defendant\xe2\x80\x99s argument that by actually applying the lotion to the patron\xe2\x80\x99s head,\nthe salon lessened the liability it otherwise would have had if it had simply sold her the lotion.\n\nIn two areas, state legislatures have taken the goods-versus-services issue out of the courts\xe2\x80\x99 hands and\nresolved the issue through legislation. Food sold in restaurants is a sale of goods, whether it is to be\nconsumed on or off the premises. Blood transfusions (really the sale of blood) in hospitals have been\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n360\n\n\x0clegislatively declared a service, not a sale of goods, in more than forty states, thus relieving the suppliers\nand hospitals of an onerous burden for liability from selling blood tainted with the undetectable hepatitis\nvirus.\n\nDefinition of Lease\nSection 2A-103(j) of the UCC defines a lease as \xe2\x80\x9ca transfer of the right to possession and use of goods for\na term in return for consideration.\xe2\x80\x9d The lessor is the one who transfers the right to possession to the\nlessee. If Alice rents a party canopy from Equipment Supply, Equipment Supply is the lessor and Alice is\nthe lessee.\n\nTwo Types of Leases\nThe UCC recognizes two kinds of leases: consumer leases and finance leases. A consumer lease is used\nwhen a lessor leases goods to \xe2\x80\x9can individual\xe2\x80\xa6primarily for personal, family, or household purposes,\xe2\x80\x9d\nwhere total lease payments are less than $25,000.\n\n[4]\n\nThe UCC grants some special protections to\n\nconsumer lessees. A finance lease is used when a lessor \xe2\x80\x9cacquires the goods or the right to [them]\xe2\x80\x9d and\nleases them to the lessee.\n\n[5]\n\nThe person from whom the lessor acquires the goods is a supplier, and the\n\nlessor is simply financing the deal. Jack wants to lease a boom lift (personnel aerial lift, also known as a\ncherry picker) for a commercial roof renovation. First Bank agrees to buy (or itself lease) the machine\nfrom Equipment Supply and in turn lease it to Jack. First Bank is the lessor, Jack is the lessee, and\nEquipment Supply is the supplier.\n\nInternational Sales of Goods\nThe UCC is, of course, American law, adopted by the states of the United States. The reason it has been\nadopted is because of the inconvenience of doing interstate business when each state had a different law\nfor the sale of goods. The same problem presents itself in international transactions. As a result, the\nUnited Nations Commission on International Trade Law developed an international equivalent of the\nUCC, the Convention on Contracts for the International Sale of Goods (CISG), first mentioned\nin (Reference mayer_1.0-ch08 not found in Book). It was promulgated in Vienna in 1980. As of July 2010,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n361\n\n\x0cthe convention (a type of treaty) has been adopted by seventy-six countries, including the United States\nand all its major trading partners except the United Kingdom. One commentator opined on why the\nUnited Kingdom is an odd country out: it is \xe2\x80\x9cperhaps because of pride in its longstanding common law\nlegal imperialism or in its long-treasured feeling of the superiority of English law to anything else that\ncould even challenge it.\xe2\x80\x9d\n\n[6]\n\nThe CISG is interesting for two reasons. First, assuming globalization continues, the CISG will become\nincreasingly important around the world as the law governing international sale contracts. Its preamble\nstates, \xe2\x80\x9cThe adoption of uniform rules which govern contracts for the international sale of goods and take\ninto account the different social, economic and legal systems [will] contribute to the removal of legal\nbarriers in international trade and promote the development of international trade.\xe2\x80\x9d Second, it is\ninteresting to compare the legal culture informing the common law to that informing the CISG, which is\nnot of the English common-law tradition. Throughout our discussion of Article 2, we will make reference\nto the CISG, the complete text of which is available online.\n\n[7]\n\nReferences to the CISG are in bold.\n\nAs to the CISG\xe2\x80\x99s scope, CISG Article 1 provides that it \xe2\x80\x9capplies to contracts of sale of goods\nbetween parties whose places of business are in different States [i.e., countries]; it\n\xe2\x80\x9cgoverns only the formation of the contract of sale and the rights and obligations of the\nseller and the buyer arising from such a contract,\xe2\x80\x9d and has nothing to do \xe2\x80\x9cwith the validity\nof the contract or of any of its provisions or of any usage\xe2\x80\x9d (Article 4). It excludes sales (a) of\ngoods bought for personal, family or household use, unless the seller, at any time before or\nat the conclusion of the contract, neither knew nor ought to have known that the goods\nwere bought for any such use; (b) by auction; (c) on execution or otherwise by authority of\nlaw; (d) of stocks, shares, investment securities, negotiable instruments or money; (e) of\nships, vessels, hovercraft or aircraft; (f) of electricity (Article 2).\n\nParties are free to exclude the application of the Convention or, with a limited exception,\nvary the effect of any of its provisions (Article 6).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n362\n\n\x0cK E Y TA K EA WAY\nArticle 2 of the UCC deals with the sale of goods. Sale and goods have defined\nmeanings. Article 2A of the UCC deals with the leasing of goods. Lease has a\ndefined meaning, and the UCC recognizes two types of leases: consumer leases\nand finance leases. Similar in purpose to the UCC of the United States is the\nConvention on Contracts for the International Sale of Goods, which has been\nwidely adopted around the world.\n\nE XE R C IS ES\n1. Why is there a separate body of statutory law governing contracts for the sale\nof goods as opposed to the common law, which governs contracts affecting\nreal estate and services?\n2. What is a consumer lease? A finance lease?\n3. What is the Convention on Contracts for the International Sale of Goods?\n[1] Uniform Commercial Code, Section 2-106.\n[2] Uniform Commercial Code, Section 2-107.\n[3] Epstein v. Giannattasio 197 A.2d 342 (Conn. 1963); Newmark v. Gimble\xe2\x80\x99s, Inc., 258 A.2d 697\n(N.J. 1969).\n[4] Uniform Commercial Code, Section 2A-103(e).\n[5] Uniform Commercial Code, Section 2A-103(g).\n[6] A. F. M. Maniruzzaman, quoted by Albert H. Kritzer, Pace Law School Institute of\nInternational Commercial Law, CISG: Table of Contracting States, accessed March 1,\n2011,http://www.cisg.law.pace.edu/cisg/countries/cntries.html.\n[7] Pace Law School, \xe2\x80\x9cUnited Nations Convention on Contracts for the International Sale of\nGoods (1980) [CISG]\xe2\x80\x9d CISG Database, accessed March 1,\n2011, http://www.cisg.law.pace.edu/cisg/text/treaty.html.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n363\n\n\x0c8.3 Sales Law Compared with Common-Law Contracts\nand the CISG\nL EA R N IN G O B JEC T IV E\n1. Recognize the differences and similarities among the Uniform Commercial\nCode (UCC), common-law contracts, and the CISG as related to the\nfollowing contract issues:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n364\n\n\x0co Offer and acceptance\no Revocability\no Consideration\no The requirement of a writing and contractual interpretation (form\nand meaning)\n\nSales law deals with the sale of goods. Sales law is a special type of contract law, but the common law\ninforms much of Article 2 of the UCC\xe2\x80\x94with some differences, however. Some of the similarities and\ndifferences were discussed in previous chapters that covered common-law contracts, but a review here is\nappropriate, and we can refer briefly to the CISG\xe2\x80\x99s treatment of similar issues.\n\nMutual Assent: Offer and Acceptance\nDefiniteness of the Offer\nThe common law requires more definiteness than the UCC. Under the UCC, a contractual obligation may\narise even if the agreement has open terms. Under Section 2-204(3), such an agreement for sale is not\nvoidable for indefiniteness, as in the common law, if the parties have intended to make a contract and the\ncourt can find a reasonably certain basis for giving an appropriate remedy. Perhaps the most important\nexample is the open price term.\n\nThe open price term is covered in detail in Section 2-305. At common law, a contract that fails to specify\nprice or a means of accurately ascertaining price will almost always fail. This is not so under the UCC\nprovision regarding open price terms. If the contract says nothing about price, or if it permits the parties\nto agree on price but they fail to agree, or if it delegates the power to fix price to a third person who fails to\ndo so, then Section 2-305(1) \xe2\x80\x9cplugs\xe2\x80\x9d the open term and decrees that the price to be awarded is a\n\xe2\x80\x9creasonable price at the time for delivery.\xe2\x80\x9d When one party is permitted to fix the price, Section 2-305(2)\nrequires that it be fixed in good faith. However, if the parties intend not to be bound unless the price is\nfirst fixed or agreed on, and it is not fixed or agreed on, then no contract results.\n\nSaylor URL: http://www.saylor.org/books\n\n[1]\n\nSaylor.org\n365\n\n\x0cAnother illustration of the open term is in regard to particulars of performance. Section 2-311(1) provides\nthat a contract for sale of goods is not invalid just because it leaves to one of the parties the power to\nspecify a particular means of performing. However, \xe2\x80\x9cany such specification must be made in good faith\nand within limits set by commercial reasonableness.\xe2\x80\x9d (Performance will be covered in greater detail\nin Chapter 9 "Title and Risk of Loss".)\n\nThe CISG (Article 14) provides the following: \xe2\x80\x9cA proposal for concluding a contract addressed to\none or more specific persons constitutes an offer if it is sufficiently definite and indicates\nthe intention of the offeror to be bound in case of acceptance. A proposal is sufficiently\ndefinite if it indicates the goods and expressly or implicitly fixes or makes provision for\ndetermining the quantity and the price.\xe2\x80\x9d\n\nAcceptance Varying from Offer: Battle of the Forms\nThe concepts of offer and acceptance are basic to any agreement, but the UCC makes a change from the\ncommon law in its treatment of an acceptance that varies from the offer (this was discussed in (Reference\nmayer_1.0-ch08 not found in Book)). At common law, where the \xe2\x80\x9cmirror image rule\xe2\x80\x9d reigns, if the\nacceptance differs from the offer, no contract results. If that were the rule for sales contracts, with the\npervasive use of form contracts\xe2\x80\x94where each side\xe2\x80\x99s form tends to favor that side\xe2\x80\x94it would be very\nproblematic.\nSection 2-207 of the UCC attempts to resolve this \xe2\x80\x9cbattle of the forms\xe2\x80\x9d by providing that additional terms\nor conditions in an acceptance operate as such unless the acceptance is conditioned on the offeror\xe2\x80\x99s\nconsent to the new or different terms. The new terms are construed as offers but are automatically\nincorporated in any contract between merchants for the sale of goods unless \xe2\x80\x9c(a) the offer expressly limits\nacceptance to the terms of the offer; (b) [the terms] materially alter it; or (c) notification of objection to\nthem has already been given or is given within a reasonable time after notice of them is received.\xe2\x80\x9d In any\ncase, Section 2-207 goes on like this: \xe2\x80\x9cConduct by both parties which recognizes the existence of a\ncontract is sufficient to establish a contract for sale although the writings of the parties do not otherwise\nestablish a contract. In such case the terms of the particular contract consist of those terms on which the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n366\n\n\x0cwritings of the parties agree, together with any supplementary terms incorporated under any other\nprovisions of this Act.\xe2\x80\x9d\n\n[2]\n\nAs to international contracts, the CISG says this about an acceptance that varies from the\noffer (Article 19), and it\xe2\x80\x99s pretty much the same as the UCC:\n(1) A reply to an offer which purports to be an acceptance but contains additions,\nlimitations or other modifications is a rejection of the offer and constitutes a counter-offer.\n\n(2) However, a reply to an offer which purports to be an acceptance but contains additional\nor different terms which do not materially alter the terms of the offer constitutes an\nacceptance, unless the offeror, without undue delay, objects orally to the discrepancy or\ndispatches a notice to that effect. If he does not so object, the terms of the contract are the\nterms of the offer with the modifications contained in the acceptance.\n\n(3) Additional or different terms relating, among other things, to the price, payment,\nquality and quantity of the goods, place and time of delivery, extent of one party\xe2\x80\x99s liability\nto the other or the settlement of disputes are considered to alter the terms of the offer\nmaterially.\n\nRevocation of Offer\nUnder both common law and the UCC, an offer can be revoked at any time prior to acceptance unless the\nofferor has given the offeree an option (supported by consideration); under the UCC, an offer can be\nrevoked at any time prior to acceptance unless a merchant gives a \xe2\x80\x9cfirm offer\xe2\x80\x9d (for which no\nconsideration is needed). The CISG (Article 17) provides that an offer is revocable before it is accepted\nunless, however, \xe2\x80\x9cit indicates\xe2\x80\xa6that it is irrevocable\xe2\x80\x9d or if the offeree reasonably relied on its irrevocability.\n\nReality of Consent\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n367\n\n\x0cThere is no particular difference between the common law and the UCC on issues of duress,\nmisrepresentation, undue influence, or mistake. As for international sales contracts, the CISG provides\n(Article 4(a)) that it \xe2\x80\x9cgoverns only the formation of the contract of sale and the rights and obligations of\nthe seller and the buyer arising from such a contract and is not concerned with the validity of the contract\nor of any of its provisions.\xe2\x80\x9d\n\nConsideration\nThe UCC\nThe UCC requires no consideration for modification of a sales contract made in good faith; at common\nlaw, consideration is required to modify a contract.\n\n[3]\n\nThe UCC requires no consideration if one party\n\nwants to forgive another\xe2\x80\x99s breach by written waiver or renunciation signed and delivered by the aggrieved\nparty; under common law, consideration is required to discharge a breaching party.\n\n[4]\n\nThe UCC requires\n\nno consideration for a \xe2\x80\x9cfirm offer\xe2\x80\x9d\xe2\x80\x94a writing signed by a merchant promising to hold an offer open for\nsome period of time; at common law an option requires consideration. (Note, however, the person can\ngive an option under either common law or the code.)\n\nUnder the CISG (Article 29), \xe2\x80\x9cA contract may be modified or terminated by the mere\nagreement of the parties.\xe2\x80\x9d No consideration is needed.\n\nForm and Meaning\nRequirement of a Writing\nThe common law has a Statute of Frauds, and so does the UCC. It requires a writing to enforce a contract\nfor the sale of goods worth $500 or more, with some exceptions, as discussed in (Reference mayer_1.0ch13 not found in Book).\n\n[5]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n368\n\n\x0cThe CISG provides (Article 11), \xe2\x80\x9cA contract of sale need not be concluded in or evidenced by\nwriting and is not subject to any other requirement as to form. It may be proved by any\nmeans, including witnesses.\xe2\x80\x9d But Article 29 provides, \xe2\x80\x9cA contract in writing which contains\na provision requiring any modification or termination by agreement to be in writing may\nnot be otherwise modified or terminated by agreement.\xe2\x80\x9d\n\nParol Evidence\nSection 2-202 of the UCC provides pretty much the same as the common law: if the parties have a writing\nintended to be their final agreement, it \xe2\x80\x9cmay not be contradicted by evidence of any prior agreement or of\na contemporaneous oral agreement.\xe2\x80\x9d However, it may be explained by \xe2\x80\x9ccourse of dealing or usage of trade\nor by course of performance\xe2\x80\x9d and \xe2\x80\x9cby evidence of consistent additional terms.\xe2\x80\x9d\nThe CISG provides (Article 8) the following: \xe2\x80\x9cIn determining the intent of a party or the understanding a\nreasonable person would have had, due consideration is to be given to all relevant circumstances of the\ncase including the negotiations, any practices which the parties have established between themselves,\nusages and any subsequent conduct of the parties.\xe2\x80\x9d\n\nK E Y TA K EA WAY\nThe UCC modernizes and simplifies some common-law strictures. Under the UCC,\nthe mirror image rule is abolished: an acceptance may sometimes differ from the\noffer, and the UCC can \xe2\x80\x9cplug\xe2\x80\x9d open terms in many cases. No consideration is\nrequired under the UCC to modify or terminate a contract or for a merchant\xe2\x80\x99s\n\xe2\x80\x9cfirm offer,\xe2\x80\x9d which makes the offer irrevocable according to its terms. The UCC has\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n369\n\n\x0ca Statute of Frauds analogous to the common law, and its parol evidence rule is\nsimilar as well. The CISG compares fairly closely to the UCC.\n\nE XE R C IS ES\n1. Why does the UCC change the common-law mirror image rule, and how?\n2. What is meant by \xe2\x80\x9copen terms,\xe2\x80\x9d and how does the UCC handle them?\n3. The requirement for consideration is relaxed under the UCC compared with\ncommon law. In what circumstances is no consideration necessary under the\nUCC?\n4. On issues so far discussed, is the CISG more aligned with the common law or\nwith the UCC? Explain your answer.\n[1] Uniform Commercial Code, Section 2-305(4).\n[2] This section of the UCC is one of the most confusing and fiercely litigated sections; Professor\nGrant Gilmore once called it a \xe2\x80\x9cmiserable, bungled, patched-up job\xe2\x80\x9d and \xe2\x80\x9carguably the greatest\nstatutory mess of all time.\xe2\x80\x9d Mark E. Roszkowski, \xe2\x80\x9cSymposium on Revised Article 2 of the\nUniform Commercial Code\xe2\x80\x94Section-by-Section Analysis,\xe2\x80\x9d SMU Law Review 54 (Spring 2001):\n927, 932, quoting Professor Grant Gilmore to Professor Robert Summers, Cornell University\nSchool of Law, September 10, 1980, in Teaching Materials on Commercial and Consumer Law,\ned. Richard E. Speidel, Robert S Summers, and James J White, 3rd ed. (St. Paul, MN: West.\n1981), pp. 54\xe2\x80\x9355. In 2003 the UCC revisioners presented an amendment to this section in an\nattempt to fix Section 2-207, but no state has adopted this section\xe2\x80\x99s revision. See Commercial\nLaw, \xe2\x80\x9cUCC Legislative Update,\xe2\x80\x9d March 2, 2010, accessed March 1,\n2011, http://ucclaw.blogspot.com/2010/03/ucc-legislative-update.html.\n[3] Uniform Commercial Code, Section 2-209(1).\n[4] Uniform Commercial Code, Section 1\xe2\x80\x93107.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n370\n\n\x0c[5] Proposed amendments by UCC revisioners presented in 2003 would have raised the amount\nof money\xe2\x80\x94to take into account inflation since the mid-fifties\xe2\x80\x94to $5,000, but no state has yet\nadopted this amendment; Uniform Commercial Code, Section 2-201.\n\n8.4 General Obligations under UCC Article 2\nL EA R N IN G O B JEC T IV ES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n371\n\n\x0c1. Know that the Uniform Commercial Code (UCC) imposes a general obligation to act\nin good faith and that it makes unconscionable contracts or parts of a contract\nunenforceable.\n2. Recognize that though the UCC applies to all sales contracts, merchants have special\nobligations.\n3. See that the UCC is the \xe2\x80\x9cdefault position\xe2\x80\x9d\xe2\x80\x94that within limits, parties are free to put\nanything they want to in their contract.\n\nArticle 2 of the UCC of course has rules governing the obligations of parties specifically as to the offer,\nacceptance, performance of sales contracts, and so on. But it also imposes some general obligations on the\nparties. Two are called out here: one deals with unfair contract terms, and the second with obligations\nimposed on merchants.\n\nObligation of Good-Faith Dealings in General\nUnder the UCC\nSection 1-203 of the UCC provides, \xe2\x80\x9cEvery contract or duty within this Act imposes an obligation of good\nfaith in its performance or enforcement.\xe2\x80\x9d Good faith is defined at Section 2-103(j) as \xe2\x80\x9chonesty in fact and\nthe observance of reasonable commercial standards of fair dealing.\xe2\x80\x9d This is pretty much the same as what\nis held by common law, which \xe2\x80\x9cimposes a duty of good faith and fair dealing upon the parties in\nperforming and enforcing the contract.\xe2\x80\x9d\n\n[1]\n\nThe UCC\xe2\x80\x99s good faith in \xe2\x80\x9cperformance or enforcement\xe2\x80\x9d of the contract is one thing, but what if the terms\nof the contract itself are unfair? Under Section 2-302(1), the courts may tinker with a contract if they\ndetermine that it is particularly unfair. The provision reads as follows: \xe2\x80\x9cIf the court as a matter of law\nfinds the contract or any clause of the contract to have been unconscionable at the time it was made the\ncourt may refuse to enforce the contract, or it may enforce the remainder of the contract without the\nunconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any\nunconscionable result.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n372\n\n\x0cThe court thus has considerable flexibility. It may refuse to enforce the entire contract, strike a particular\nclause or set of clauses, or limit the application of a particular clause or set of clauses.\n\nAnd what does \xe2\x80\x9cunconscionable\xe2\x80\x9d mean? The UCC provides little guidance on this crucial question.\nAccording to Section 2-302(1), the test is \xe2\x80\x9cwhether, in the light of the general commercial background and\nthe commercial needs of the particular trade or case, the clauses involved are so one-sided as to be\nunconscionable under the circumstances existing at the time of the making of the contract.\xe2\x80\xa6The principle\nis one of the prevention of oppression and unfair surprise and not of disturbance of allocation of risks\nbecause of superior bargaining power.\xe2\x80\x9d\n\nThe definition is somewhat circular. For the most part, judges have had to develop the concept with little\nhelp from the statutory language. Unconscionability is much like US Supreme Court Justice Potter\nStewart\xe2\x80\x99s famous statement about obscenity: \xe2\x80\x9cI can\xe2\x80\x99t define it, but I know it when I see it.\xe2\x80\x9d In the leading\ncase, Williams v. Walker-Thomas Furniture Co. ((Reference mayer_1.0-ch12_s05_s03 not found in\nBook), set out in (Reference mayer_1.0-ch12 not found in Book)), Judge J. Skelly Wright attempted to\ndevelop a framework for analysis. He refined the meaning of unconscionability by focusing on \xe2\x80\x9cabsence of\nmeaningful choice\xe2\x80\x9d (often referred to asprocedural unconscionability) and on terms that are\n\xe2\x80\x9cunreasonably favorable\xe2\x80\x9d (commonly referred to assubstantive unconscionability). An example of\nprocedural unconscionability is the salesperson who says, \xe2\x80\x9cDon\xe2\x80\x99t worry about all that little type on\nthe back of this form.\xe2\x80\x9d Substantive unconscionability is the harsh term\xe2\x80\x94the provision that permits the\n\xe2\x80\x9ctaking of a pound of flesh\xe2\x80\x9d if the contract is not honored.\n\nDespite its fuzziness, the concept of unconscionability has had a dramatic impact on American law. In\nmany cases, in fact, the traditional notion of caveat emptor (Latin for \xe2\x80\x9cbuyer beware\xe2\x80\x9d) has changed\nto caveat venditor (\xe2\x80\x9clet the seller beware\xe2\x80\x9d). So important is this provision that courts in recent years have\napplied the doctrine in cases not involving the sale of goods.\nUnder the CISG, Article 7: \xe2\x80\x9cRegard is to be had\xe2\x80\xa6to the observance of good faith in\ninternational trade.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n373\n\n\x0cObligations Owed by Merchants\n\xe2\x80\x9cMerchant\xe2\x80\x9d Sellers\nAlthough the UCC applies to all sales of goods (even when you sell your used car to your neighbor),\nmerchants often have special obligations or are governed by special rules.\n\nAs between Merchants\nThe UCC assumes that merchants should be held to particular standards because they are more\nexperienced and have or should have special knowledge. Rules applicable to professionals ought not apply\nto the casual or inexperienced buyer or seller. For example, we noted previously that the UCC relaxes the\nmirror image rule and provides that as \xe2\x80\x9cbetween merchants\xe2\x80\x9d additional terms in an acceptance become\npart of the contract, and we have discussed the \xe2\x80\x9cten-day-reply doctrine\xe2\x80\x9d that says that, again \xe2\x80\x9cas between\nmerchants,\xe2\x80\x9d a writing signed and sent to the other binds the recipient as an exception to the Statute of\nFrauds.\n\n[2]\n\nThere are other sections of the UCC applicable \xe2\x80\x9cas between merchants,\xe2\x80\x9d too.\n\nArticle 1 of the CISG abolishes any distinction between merchants and nonmerchants:\n\xe2\x80\x9cNeither the nationality of the parties nor the civil or commercial character of the parties\nor of the contract is to be taken into consideration in determining the application of this\nConvention.\xe2\x80\x9d\n\nMerchant to Nonmerchant\nIn addition to duties imposed between merchants, the UCC imposes certain duties on a merchant when\nshe sells to a nonmerchant. A merchant who sells her merchandise makes an important\nimplied warranty of merchantability. That is, she promises that goods sold will be fit for the\npurpose for which such goods are normally intended. A nonmerchant makes no such promise, nor does a\nmerchant who is not selling merchandise\xe2\x80\x94for example, a supermarket selling a display case is not a\n\xe2\x80\x9cmerchant\xe2\x80\x9d in display cases.\nIn Sheeskin v. Giant Foods, Inc., the problem of whether a merchant made an implied warranty of\nmerchantability was nicely presented. Mr. Seigel, the plaintiff, was carrying a six-pack carton of Coca-Cola\nfrom a display bin to his shopping cart when one or more of the bottles exploded. He lost his footing and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n374\n\n\x0cwas injured. When he sued the supermarket and the bottler for breach of the implied warranty of fitness,\nthe defendants denied there had been a sale: he never paid for the soda pop, thus no sale by a merchant\nand thus no warranty. The court said that Mr. Seigel\xe2\x80\x99s act of reaching for the soda to put it in his cart was\na \xe2\x80\x9creasonable manner of acceptance\xe2\x80\x9d (quoting UCC, Section 2-206(1)).\n\n[3]\n\nWho Is a Merchant?\nSection 2-104(1) of the UCC defines a merchant as one \xe2\x80\x9cwho deals in goods of the kind or otherwise by his\noccupation holds himself out as having knowledge or skill peculiar to the practices or goods involved in\nthe transaction.\xe2\x80\x9d A phrase that recurs throughout Article 2\xe2\x80\x94\xe2\x80\x9cbetween merchants\xe2\x80\x9d\xe2\x80\x94refers to any\ntransaction in which both parties are chargeable with the knowledge or skill of merchants.\n\n[4]\n\nNot every\n\nbusinessperson is a merchant with respect to every possible transaction. But a person or institution\nnormally not considered a merchant can be one under Article 2 if he employs an agent or broker who\nholds himself out as having such knowledge or skill. (Thus a university with a purchasing office can be a\nmerchant with respect to transactions handled by that department.)\n\nDetermining whether a particular person operating a business is a merchant under Article 2-104 is a\ncommon problem for the courts.Goldkist, Inc. v. Brownlee, Section 8.5.2 "\xe2\x80\x9cMerchants\xe2\x80\x9d under the UCC",\nshows that making the determination is difficult and contentious, with significant public policy\nimplications.\n\nObligations May Be Determined by Parties\nUnder the UCC\nUnder the UCC, the parties to a contract are free to put into their contract pretty much anything they\nwant. Article 1-102 states that \xe2\x80\x9cthe effect of provisions of this Act may be varied by agreement\xe2\x80\xa6except that\nthe obligations of good faith, diligence, reasonableness and care prescribed by this Act may not be\ndisclaimed by agreement but the parties may by agreement determine the standards by which the\nperformance of such obligations is to be measure if such standards are not manifestly unreasonable.\xe2\x80\x9d\nThus the UCC is the \xe2\x80\x9cdefault\xe2\x80\x9d position: if the parties want the contract to operate in a specific way, they\ncan provide for that. If they don\xe2\x80\x99t put anything in their agreement about some aspect of their contract\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n375\n\n\x0coperation, the UCC applies. For example, if they do not state where \xe2\x80\x9cdelivery\xe2\x80\x9d will occur, the UCC\nprovides that term. (Section 2-308 says it would be at the \xe2\x80\x9cseller\xe2\x80\x99s place of business or if he has none, his\nresidence.\xe2\x80\x9d)\n\nArticle 6 of the CISG similarly gives the parties freedom to contract. It provides, \xe2\x80\x9cThe\nparties may exclude the application of this Convention or\xe2\x80\xa6vary the effect of any of its\nprovisions.\xe2\x80\x9d\n\nK E Y TA K EA WAY\nThe UCC imposes some general obligations on parties to a sales contract. They must act\nin good faith, and unconscionable contracts or terms thereof will not be enforced. The\nUCC applies to any sale of goods, but sometimes special obligations are imposed on\nmerchants. While the UCC imposes various general (and more specific) obligations on\nthe parties, they are free, within limits, to make up their own contract terms and\nobligations; if they do not, the UCC applies. The CISG tends to follow the basic thrust of\nthe UCC.\n\nE XE R C IS ES\n\n1. What does the UCC say about the standard duty parties to a contract owe each\nother?\n2. Why are merchants treated specially by the UCC in some circumstances?\n3. Give an example of a merchant-to-merchant duty imposed by the UCC and of a\nmerchant-to-nonmerchant duty.\n4. What does it mean to say the UCC is the \xe2\x80\x9cdefault\xe2\x80\x9d contract term?\n[1] Restatement (Second) of Contracts, Section 205.\n[2] Uniform Commercial Code, Sections 2-205 and 2A\xe2\x80\x93205.\n[3] Sheeskin v. Giant Food, Inc., 318 A.2d 874 (Md. Ct. App. 1974).\n[4] Uniform Commercial Code, Section 2-104(3).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n376\n\n\x0c8.5 Cases\nMixed Goods and Services Contracts: The \xe2\x80\x9cPredominant Factor\xe2\x80\x9d Test\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n377\n\n\x0cPittsley v. Houser\n\n875 P.2d 232 (Idaho App. 1994)\n\nSwanstrom, J.\n\nIn September of 1988, Jane Pittsley contracted with Hilton Contract Carpet Co. (Hilton) for the\ninstallation of carpet in her home. The total contract price was $4,402 [about $7,900 in 2010 dollars].\nHilton paid the installers $700 to put the carpet in Pittsley\xe2\x80\x99s home. Following installation, Pittsley\ncomplained to Hilton that some seams were visible, that gaps appeared, that the carpet did not lay flat in\nall areas, and that it failed to reach the wall in certain locations. Although Hilton made various attempts to\nfix the installation, by attempting to stretch the carpet and other methods, Pittsley was not satisfied with\nthe work. Eventually, Pittsley refused any further efforts to fix the carpet. Pittsley initially paid Hilton\n$3,500 on the contract, but refused to pay the remaining balance of $902.\n\nPittsley later filed suit, seeking rescission of the contract, return of the $3,500 and incidental damages.\nHilton answered and counterclaimed for the balance remaining on the contract. The matter was heard by\na magistrate sitting without a jury. The magistrate found that there were defects in the installation and\nthat the carpet had been installed in an unworkmanlike manner. The magistrate also found that there was\na lack of evidence on damages. The trial was continued to allow the parties to procure evidence on the\namount of damages incurred by Pittsley. Following this continuance, Pittsley did not introduce any\nfurther evidence of damages, though witnesses for Hilton estimated repair costs at $250.\n\nAlthough Pittsley had asked for rescission of the contract and a refund of her money, the magistrate\ndetermined that rescission, as an equitable remedy, was only available when one party committed a\nbreach so material that it destroyed the entire purpose of the contract. Because the only estimate of\ndamages was for $250, the magistrate ruled rescission would not be a proper remedy. Instead, the\nmagistrate awarded Pittsley $250 damages plus $150 she expended in moving furniture prior to Hilton\xe2\x80\x99s\nattempt to repair the carpet. On the counterclaim, the magistrate awarded Hilton the $902 remaining on\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n378\n\n\x0cthe contract. Additionally, both parties had requested attorney fees in the action. The magistrate\ndetermined that both parties had prevailed and therefore awarded both parties their attorney fees.\n\nFollowing this decision, Pittsley appealed to the district court, claiming that the transaction involved was\ngoverned by the Idaho Uniform Commercial Code (UCC), [Citation]. Pittsley argued that if the UCC had\nbeen properly applied, a different result would have been reached. The district court agreed with Pittsley\xe2\x80\x99s\nargument, reversing and remanding the case to the magistrate to make additional findings of fact and to\napply the UCC to the transaction.\xe2\x80\xa6\n\nHilton now appeals the decision of the district court. Hilton claims that Pittsley failed to allege or argue\nthe UCC in either her pleadings or at trial. Even if application of the UCC was properly raised, Hilton\nargues that there were no defects in the goods that were the subject of the transaction, only in the\ninstallation, making application of the UCC inappropriate.\xe2\x80\xa6\nThe single question upon which this appeal depends is whether the UCC is applicable to the subject\ntransaction. If the underlying transaction involved the sale of \xe2\x80\x9cgoods,\xe2\x80\x9d then the UCC would apply. If the\ntransaction did not involve goods, but rather was for services, then application of the UCC would be\nerroneous.\n\nIdaho Code \xc2\xa7 28\xe2\x80\x932-105(1) defines \xe2\x80\x9cgoods\xe2\x80\x9d as \xe2\x80\x9call things (including specially manufactured goods) which\nare movable at the time of identification to the contract for sale.\xe2\x80\xa6\xe2\x80\x9d Although there is little dispute that\ncarpets are \xe2\x80\x9cgoods,\xe2\x80\x9d the transaction in this case also involved installation, a service. Such hybrid\ntransactions, involving both goods and services, raise difficult questions about the applicability of the\nUCC. Two lines of authority have emerged to deal with such situations.\n\nThe first line of authority, and the majority position, utilizes the \xe2\x80\x9cpredominant factor\xe2\x80\x9d test. The Ninth\nCircuit, applying the Idaho Uniform Commercial Code to the subject transaction, restated the\npredominant factor test as:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n379\n\n\x0cThe test for inclusion or exclusion is not whether they are mixed, but, granting that they are mixed,\nwhether their predominant factor, their thrust, their purpose, reasonably stated, is the rendition of\nservice, with goods incidentally involved (e.g., contract with artist for painting) or is a transaction of sale,\nwith labor incidentally involved (e.g., installation of a water heater in a bathroom).\n\n[Citations]. This test essentially involves consideration of the contract in its entirety, applying the UCC to\nthe entire contract or not at all.\n\nThe second line of authority, which Hilton urges us to adopt, allows the contract to be severed into\ndifferent parts, applying the UCC to the goods involved in the contract, but not to the non-goods involved,\nincluding services as well as other non-goods assets and property. Thus, an action focusing on defects or\nproblems with the goods themselves would be covered by the UCC, while a suit based on the service\nprovided or some other non-goods aspect would not be covered by the UCC.\xe2\x80\xa6\n\nWe believe the predominant factor test is the more prudent rule. Severing contracts into various parts,\nattempting to label each as goods or non-goods and applying different law to each separate part clearly\ncontravenes the UCC\xe2\x80\x99s declared purpose \xe2\x80\x9cto simplify, clarify and modernize the law governing commercial\ntransactions.\xe2\x80\x9d I.C. \xc2\xa7 28\xe2\x80\x931\xe2\x80\x93102(2)(a). As the Supreme Court of Tennessee suggested in [Citation], such a\nrule would, in many contexts, present \xe2\x80\x9cdifficult and in some instances insurmountable problems of proof\nin segregating assets and determining their respective values at the time of the original contract and at the\ntime of resale, in order to apply two different measures of damages.\xe2\x80\x9d\n\nApplying the predominant factor test to the case before us, we conclude that the UCC was applicable to\nthe subject transaction. The record indicates that the contract between the parties called for \xe2\x80\x9c175 yds\nMasterpiece # 2122-Installed\xe2\x80\x9d for a price of $4319.50. There was an additional charge for removing the\nexisting carpet. The record indicates that Hilton paid the installers $700 for the work done in laying\nPittsley\xe2\x80\x99s carpet. It appears that Pittsley entered into this contract for the purpose of obtaining carpet of a\ncertain quality and color. It does not appear that the installation, either who would provide it or the\nnature of the work, was a factor in inducing Pittsley to choose Hilton as the carpet supplier. On these\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n380\n\n\x0cfacts, we conclude that the sale of the carpet was the predominant factor in the contract, with the\ninstallation being merely incidental to the purchase. Therefore, in failing to consider the UCC, the\nmagistrate did not apply the correct legal principles to the facts as found. We must therefore vacate the\njudgment and remand for further findings of fact and application of the UCC to the subject transaction.\n\nC A SE QU ES TIO NS\n1. You may recall in (Reference mayer_1.0-ch15 not found in Book)the discussion of\nthe \xe2\x80\x9csubstantial performance\xe2\x80\x9d doctrine. It says that if a common-law contract is not\ncompletely, but still \xe2\x80\x9csubstantially,\xe2\x80\x9d performed, the nonbreaching party still owes\nsomething on the contract. And it was noted there that under the UCC, there is no\nsuch doctrine. Instead, the \xe2\x80\x9cperfect tender\xe2\x80\x9d rule applies: the goods delivered by the\nseller must be exactly right. Does the distinction between the substantial\nperformance doctrine and the perfect tender rule shed light on what difference\napplying the common law or the UCC would make in this case?\n2. If Pittsley won on remand, what would she get?\n3. In discussing the predominant factor test, the court here quotes from the Ninth\nCircuit, a federal court of appeals. What is a federal court doing making rules for a\nstate court?\n\n\xe2\x80\x9cMerchants\xe2\x80\x9d under the UCC\nGoldkist, Inc. v. Brownlee\n\n355 S.E.2d 773 (Ga. App. 1987)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n381\n\n\x0cBeasley, J.\n\nThe question is whether the two defendant farmers, who as a partnership both grew and sold their crops,\nwere established by the undisputed facts as not being \xe2\x80\x9cmerchants\xe2\x80\x9d as a matter of law, according to the\ndefinition in [Georgia UCC 2-104(1)].\xe2\x80\xa6\n\nAppellees admit that their crops are \xe2\x80\x9cgoods\xe2\x80\x9d as defined in [2-105]. The record establishes the following\nfacts. The partnership had been operating the row crop farming business for 14 years, producing peanuts,\nsoybeans, corn, milo, and wheat on 1,350 acres, and selling the crops.\n\nIt is also established without dispute that Barney Brownlee, whose deposition was taken, was familiar\nwith the marketing procedure of \xe2\x80\x9cbooking\xe2\x80\x9d crops, which sometimes occurred over the phone between the\nfarmer and the buyer, rather than in person, and a written contract would be signed later. He periodically\ncalled plaintiff\xe2\x80\x99s agent to check the price, which fluctuated. If the price met his approval, he sold soybeans.\nAt this time the partnership still had some of its 1982 crop in storage, and the price was rising slowly. Mr.\nBrownlee received a written confirmation in the mail concerning a sale of soybeans and did not contact\nplaintiff to contest it but simply did nothing. In addition to the agricultural business, Brownlee operated a\ngasoline service station\n.\xe2\x80\xa6\n\nIn dispute are the facts with respect to whether or not an oral contract was made between Barney\nBrownlee for the partnership and agent Harrell for the buyer in a July 22 telephone conversation. The\nplaintiff\xe2\x80\x99s evidence was that it occurred and that it was discussed soon thereafter with Brownlee at the\nservice station on two different occasions, when he acknowledged it, albeit reluctantly, because the market\nprice of soybeans had risen. Mr. Brownlee denies booking the soybeans and denies the nature of the\nconversations at his service station with Harrell and the buyer\xe2\x80\x99s manager.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n382\n\n\x0cWhether or not the farmers in this case are \xe2\x80\x9cmerchants\xe2\x80\x9d as a matter of law, which is not before us, the\nevidence does not demand a conclusion that they are outside of that category which is excepted from the\nrequirement of a signed writing to bind a buyer and seller of goods.\xe2\x80\xa6To allow a farmer who deals in crops\nof the kind at issue, or who otherwise comes within the definition of \xe2\x80\x9cmerchant\xe2\x80\x9d in [UCC] 2-104(1), to\nrenege on a confirmed oral booking for the sale of crops, would result in a fraud on the buyer. The farmer\ncould abide by the booking if the price thereafter declined but reject it if the price rose; the buyer, on the\nother hand, would be forced to sell the crop following the booking at its peril, or wait until the farmer\ndecides whether to honor the booking or not.\n\nDefendants\xe2\x80\x99 narrow construction of \xe2\x80\x9cmerchant\xe2\x80\x9d would, given the booking procedure used for the sale of\nfarm products, thus guarantee to the farmers the best of both possible worlds (fulfill booking if price goes\ndown after booking and reject it if price improves) and to the buyers the worst of both possible worlds. On\nthe other hand, construing \xe2\x80\x9cmerchants\xe2\x80\x9d in [UCC] 2-104(1) as not excluding as a matter of law farmers\nsuch as the ones in this case, protects them equally as well as the buyer. If the market price declines after\nthe booking, they are assured of the higher booking price; the buyer cannot renege, as [UCC]2-201(2)\nwould apply.\n\nIn giving this construction to the statute, we are persuaded by [Citation], supra, and the analyses provided\nin the following cases from other states: [Citations]. By the same token, we reject the narrow construction\ngiven in other states\xe2\x80\x99 cases: [Citations]. We believe this is the proper construction to give the two statutes,\n[UCC 2-104(1) and 2-201(2)], as taken together they are thus further branches stemming from the\ncenturies-old simple legal idea pacta servanda sunt\xe2\x80\x94agreements are to be kept. So construed, they evince\nthe legislative intent to enforce the accepted practices of the marketplace among those who frequent it.\n\nJudgment reversed. [Four justices concurred with Justice Beasley].\n\nBenham, J., dissenting.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n383\n\n\x0cBecause I cannot agree with the majority\xe2\x80\x99s conclusion that appellees are merchants, I must respectfully\ndissent.\n\n\xe2\x80\xa6The validity of [plaintiff\xe2\x80\x99s] argument, that sending a confirmation within a reasonable time makes\nenforceable a contract even though the statute of frauds has not been satisfied, rests upon a showing that\nthe contract was \xe2\x80\x9c[b]etween merchants.\xe2\x80\x9d \xe2\x80\x9cBetween merchants\xe2\x80\x9d is statutorily defined in the Uniform\nCommercial Code as meaning \xe2\x80\x9cany transaction with respect to which both parties are chargeable with the\nknowledge or skill of merchants\xe2\x80\x9d [2-104(3)]. \xe2\x80\x9c\xe2\x80\x98Merchant\xe2\x80\x99 means a person [1] who deals in goods of the\nkind or [2] otherwise by his occupation holds himself out as having knowledge or skill peculiar to the\npractices or goods involved in the transaction or [3] to whom such knowledge or skill may be attributed by\nhis employment of an agent or broker or other intermediary who by his occupation holds himself out as\nhaving such knowledge or skill\xe2\x80\x9d [Citation]. Whether [plaintiff] is a merchant is not questioned here; the\nquestion is whether, under the facts in the record, [defendant]/farmers are merchants.\xe2\x80\xa6\n\nThe Official Comment to \xc2\xa7 2-104 of the U.C.C. (codified in Georgia)\xe2\x80\xa6states: \xe2\x80\x9cThis Article assumes that\ntransactions between professionals in a given field require special and clear rules which may not apply to\na casual or inexperienced seller or buyer\xe2\x80\xa6This section lays the foundation of this policy by defining those\nwho are to be regarded as professionals or \xe2\x80\x98merchants\xe2\x80\x99 and by stating when a transaction is deemed to be\n\xe2\x80\x98between merchants.\xe2\x80\x99 The term \xe2\x80\x98merchant\xe2\x80\x99 as defined here roots in the \xe2\x80\x98law merchant\xe2\x80\x99 concept of a\nprofessional in business.\xe2\x80\x9d As noted by the Supreme Court of Kansas in [Citation] (1976): \xe2\x80\x9cThe concept of\nprofessionalism is heavy in determining who is a merchant under the statute. The writers of the official\nUCC comment virtually equate professionals with merchants\xe2\x80\x94the casual or inexperienced buyer or seller\nis not to be held to the standard set for the professional in business. The defined term \xe2\x80\x98between\nmerchants,\xe2\x80\x99 used in the exception proviso to the statute of frauds, contemplates the knowledge and skill of\nprofessionals on each side of the transaction.\xe2\x80\x9d The Supreme Court of Iowa [concurs in cases cited].\nWhere, as here, the undisputed evidence is that the farmer\xe2\x80\x99s sole experience in the marketplace consists of\nselling the crops he has grown, the courts of several of our sister states have concluded that the farmer is\nnot a merchant. [Citations]. Just because appellee Barney Brownlee kept \xe2\x80\x9cconversant with the current\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n384\n\n\x0cprice of [soybeans] and planned to market it to his advantage does not necessarily make him a \xe2\x80\x98merchant.\xe2\x80\x99\nIt is but natural for anyone who desires to sell anything he owns to negotiate and get the best price\nobtainable. If this would make one a \xe2\x80\x98merchant,\xe2\x80\x99 then practically anyone who sold anything would be\ndeemed a merchant, hence would be an exception under the statute[,] and the need for a contract in\nwriting could be eliminated in most any kind of a sale.\xe2\x80\x9d [Citation].\n\nIt is also my opinion that the record does not reflect that appellees \xe2\x80\x9cdealt\xe2\x80\x9d in soybeans, or that through\ntheir occupation, they held themselves out as having knowledge or skill peculiar to the practices or goods\ninvolved in the transaction. See [UCC] 2-104(1). \xe2\x80\x9c[A]lthough a farmer may well possess special knowledge\nor skill with respect to the production of a crop, the term \xe2\x80\x98merchant,\xe2\x80\x99 as used in the Uniform Commercial\nCode, contemplates special knowledge and skill associated with the marketplace. As to the area of farm\ncrops, this special skill or knowledge means, for instance, special skill or knowledge associated with the\noperation of the commodities market. It is inconceivable that the drafters of the Uniform Commercial\nCode intended to place the average farmer, who merely grows his yearly crop and sells it to the local\nelevator, etc., on equal footing with the professional commodities dealer whose sole business is the buying\nand selling of farm commodities\xe2\x80\x9d [Citations]. If one who buys or sells something on an annual basis is a\nmerchant, then the annual purchaser of a new automobile is a merchant who need not sign a contract for\nthe purchase in order for the contract to be enforceable.\xe2\x80\xa6\n\nIf these farmers are not merchants, a contract signed by both parties is necessary for enforcement. If the\nfarmer signs a contract, he is liable for breach of contract if he fails to live up to its terms. If he does not\nsign the contract, he cannot seek enforcement of the terms of the purchaser\xe2\x80\x99s offer to buy.\xe2\x80\xa6\n\nBecause I find no evidence in the record that appellees meet the statutory qualifications as merchants, I\nwould affirm the decision of the trial court. I am authorized to state that [three other justices] join in this\ndissent.\n\nC A SE QU ES TIO NS\n\n1. How is the UCC\xe2\x80\x99s ten-day-reply doctrine in issue here?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n385\n\n\x0c2. Five justices thought the farmers here should be classified as \xe2\x80\x9cmerchants,\xe2\x80\x9d and four\nof them thought otherwise. What argument did the majority have against calling the\nfarmers \xe2\x80\x9cmerchants\xe2\x80\x9d? What argument did the dissent have as to why they should\nnot be called merchants?\n3. Each side marshaled persuasive precedent from other jurisdictions to support its\ncontention. As a matter of public policy, is one argument better than another?\n4. What does the court mean when it says the defendants are not excluded from the\ndefinition of merchants \xe2\x80\x9cas a matter of law\xe2\x80\x9d?\n\nUnconscionability in Finance Lease Contracts\nInfo. Leasing Corp. v. GDR Investments, Inc.\n\n787 N.E.2d 652 (Ohio App. 2003)\n\nGorman, J.\n\nThe plaintiff-appellant, Information Leasing Corporation (\xe2\x80\x9cILC\xe2\x80\x9d), appeals from the order of the trial court\nrendering judgment in favor of the defendants-appellees\xe2\x80\xa6GDR Investments, Inc. [defendant Arora\xe2\x80\x99s\ncorporation], Pinnacle Exxon, and Avtar S. Arora, in an action to recover $15,877.37 on a five-year\ncommercial lease of an Automated Teller Machine (\xe2\x80\x9cATM\xe2\x80\x9d).\xe2\x80\xa6\n\nThis is one of many cases involving ILC that have been recently before this court. ILC is an Ohio\ncorporation wholly owned by the Provident Bank. ILC is in the business of leasing ATMs through a third\nparty, or vendor. In all of these cases, the vendor has been\xe2\x80\xa6Credit Card Center (\xe2\x80\x9cCCC\xe2\x80\x9d). CCC was in the\nbusiness of finding lessees for the machines and then providing the services necessary to operate them,\noffering the lessees attractive commissions. Essentially, CCC would find a customer, usually a small\nbusiness interested in having an ATM available on its premises, arrange for its customer to sign a lease\nwith ILC, and then agree to service the machine, keeping it stocked with cash and paying the customer a\ncertain monthly commission. Usually, as in the case of [defendants], the owner of the business was\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n386\n\n\x0crequired to sign as a personal guarantor of the lease. The twist in this story is that CCC soon went\nbankrupt, leaving its customers stuck with ATMs under the terms of leases with ILC but with no service\nprovider. Rather than seeking to find another company to service the ATMs, many of CCC\xe2\x80\x99s former\ncustomers, like [defendants], simply decided that they no longer wanted the ATMs and were no longer\ngoing to make lease payments to ILC. The terms of each lease, however, prohibited cancellation. The\npertinent section read,\n\nLEASE NON-CANCELABLE AND NO WARRANTY. THIS LEASE CANNOT BE CANCELED BY YOU FOR\nANY REASON, INCLUDING EQUIPMENT FAILURE, LOSS OR DAMAGE. YOU MAY NOT REVOKE\nACCEPTANCE OF THE EQUIPMENT. YOU, NOT WE, SELECTED THE EQUIPMENT AND THE\nVENDOR. WE ARE NOT RESPONSIBLE FOR EQUIPMENT FAILURE OR THE VENDOR\xe2\x80\x99S ACTS. YOU\nARE LEASING THE EQUIPMENT \xe2\x80\x98AS IS\xe2\x80\x99, [sic] AND WE DISCLAIM ALL WARRANTIES, EXPRESS OR\nIMPLIED. WE ARE NOT RESPONSIBLE FOR SERVICE OR REPAIRS.\n\nEither out of a sense of fair play or a further desire to make enforcement of the lease ironclad, ILC put a\nnotice on the top of the lease that stated,\n\nNOTICE: THIS IS A NON-CANCELABLE, BINDING CONTRACT. THIS CONTRACT WAS WRITTEN IN\nPLAIN LANGUAGE FOR YOUR BENEFIT. IT CONTAINS IMPORTANT TERMS AND CONDITIONS\nAND HAS LEGAL AND FINANCIAL CONSEQUENCES TO YOU. PLEASE READ IT CAREFULLY; FEEL\nFREE TO ASK QUESTIONS BEFORE SIGNING BY CALLING THE LEASING COMPANY AT\n\n1-513-\n\n421-9191.\n\nArora, the owner of [defendant corporation], was a resident alien with degrees in commerce and\neconomics from the University of Delhi, India. Arora wished to have an ATM on the premises of his Exxon\nstation in the hope of increasing business. He made the mistake of arranging acquisition of the ATM\nthrough CCC. According to his testimony, a representative of CCC showed up at the station one day and\ngave him \xe2\x80\x9cformality papers\xe2\x80\x9d to sign before the ATM could be delivered. Arora stated that he was busy with\nother customers when the CCC representative asked him to sign the papers. He testified that when he\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n387\n\n\x0cinformed the CCC representative that he needed time to read the documents before signing them, he was\ntold not to worry and\xe2\x80\xa6that the papers did not need his attention and that his signature was a mere\nformality. Arora signed the ILC lease, having never read it.\n\nWithin days, CCC went into bankruptcy. Arora found himself with an ATM that he no longer\nwanted.\xe2\x80\xa6According to his testimony, he tried unsuccessfully to contact ILC to take back the ATM. Soon\nArora suffered a mild heart attack, the gas station went out of business, and the ATM, which had been in\nplace for approximately eighteen days, was left sitting in the garage, no longer in use until ILC came and\nremoved it several months later.\n\nUnfortunately for Arora, the lease also had an acceleration clause that read,\n\nDEFAULT. If you fail to pay us or perform as agreed, we will have the right to (i) terminate this lease, (ii)\nsue you for all past due payment AND ALL FUTURE PAYMENTS UNDER THIS LEASE, plus the Residual\nValue we have placed on the equipment and other charges you owe us, (iii) repossess the equipment at\nyour expense and (iv) exercise any other right or remedy which may be available under applicable law or\nproceed by court act.\n\nThe trial court listened to the evidence in this case, which was awkwardly presented due in large part to\nArora\xe2\x80\x99s decision to act as his own trial counsel. Obviously impressed with Arora\xe2\x80\x99s honesty and\nsympathetic to his situation, the trial court found that Arora owed ILC nothing. In so ruling, the court\nstated that ILC \xe2\x80\x9cha[d] not complied with any of its contractual obligations and that [Arora] appropriately\ncanceled any obligations by him, if there really were any.\xe2\x80\x9d The court also found that ILC, \xe2\x80\x9cif they did have\na contract, failed to mitigate any damages by timely picking up the machine after [Arora] gave them notice\nto pick up the machine.\xe2\x80\x9d\xe2\x80\xa6\n\nILC contends, and we do not disagree, that the lease in question satisfied the definition of a \xe2\x80\x9cfinance\nlease\xe2\x80\x9d under [UCC 2A-407]. A finance lease is considerably different from an ordinary lease in that it adds\na third party, the equipment supplier or manufacturer (in this case, the now defunct CCC). As noted by\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n388\n\n\x0cWhite and Summers, \xe2\x80\x9cIn effect, the finance lessee * * * is relying upon the manufacturer * * * to provide\nthe promised goods and stand by its promises and warranties; the [lessee] does not look to the [lessor] for\nthese. The [lessor] is only a finance lessor and deals largely in paper, rather than goods.\xe2\x80\x9d [Citation].\n\nOne notorious feature of a finance lease is its typically noncancelable nature, which is specifically\nauthorized by statute [UCC 2A-407]. [UCC 2A-407(1)] provides in the case of a finance lease that is not a\nconsumer lease, \xe2\x80\x9c[T]he lessee\xe2\x80\x99s promises under the lease contract become irrevocable and independent\nupon the lessee\xe2\x80\x99s acceptance of the goods.\xe2\x80\x9d The same statutory section also makes clear that the finance\nlease is \xe2\x80\x9cnot subject to cancellation, termination, modification, repudiation, excuse, or substitution\nwithout the consent of the party to whom it runs.\xe2\x80\x9d [Citation]\n\nBecause of their noncancelable nature, finance leases enjoy somewhat of a reputation. The titles of law\nreview articles written about them reveal more than a little cynicism regarding their fairness: [Citations].\n\n\xe2\x80\xa6As described by Professors White and Summers, \xe2\x80\x9cThe parties can draft a lease agreement that carefully\nexcludes warranty and promissory liability of the finance lessor to the lessee, and that sets out what is\nknown in the trade as a \xe2\x80\x98hell or high water clause,\xe2\x80\x99 namely, a clause that requires the lessee to continue to\nmake rent payments to the finance lessor even though the [equipment] is unsuitable, defective, or\ndestroyed.\xe2\x80\x9d\xe2\x80\xa6\xe2\x80\x9cThe lessor\xe2\x80\x99s responsibility is merely to provide the money, not to instruct the lessee like a\nwayward child concerning a suitable purchase * * *. Absent contrary agreement, even if [, for example, a\nfinance-leased] Boeing 747 explodes into small pieces in flight and is completely uninsured, lessee\xe2\x80\x99s\nobligation to pay continues.\xe2\x80\x9d\n\n\xe2\x80\xa6Some people complain about being stuck with the bill; Arora\xe2\x80\x99s complaint was that he was stuck with the\nATM.\xe2\x80\xa6\nTo begin the proper legal analysis, we note first that this was not a \xe2\x80\x9cconsumer lease\xe2\x80\x9d expressly excepted\nfrom [UCC 2A-407]. A \xe2\x80\x9cconsumer lease\xe2\x80\x9d is defined in [UCC 2A-103(e)] as one in which the lessee is \xe2\x80\x9can\nindividual and who takes under the lease primarily for a personal, family, or household purpose.\xe2\x80\x9d This\nwould definitely not apply here, where the ATM was placed on the business premises of the Exxon station,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n389\n\n\x0cand where the lessee was [Arora\xe2\x80\x99s corporation] and not Arora individually. (Arora was liable individually\nas the personal guarantor of [his corporation]\xe2\x80\x99s obligations under the lease.)\xe2\x80\xa6\n\nCertain defenses do remain, however. First, the UCC expressly allows for the application of the doctrine of\nunconscionability to finance leases, both consumer and commercial. [Citation] authorizes the trial court\nto find \xe2\x80\x9cany clause of a lease contract to have been unconscionable at the time it was made * * *.\xe2\x80\x9d If it so\nfinds, the court is given the power to \xe2\x80\x9crefuse to enforce the lease contract, * * * enforce the remainder of\nthe lease contract without the unconscionable clause, or * * * limit the application of the unconscionable\nclause as to avoid any unconscionable result.\xe2\x80\x9d [Citation]\n\nIn this case, the trial court made no findings as to whether the finance lease was unconscionable. The\nprimary purpose of the doctrine of unconscionability is to prevent oppression and unfair surprise.\n[Citation] \xe2\x80\x9cOppression\xe2\x80\x9d refers to substantive unconscionability and arises from overly burdensome or\npunitive terms of a contract, whereas \xe2\x80\x9cunfair surprise\xe2\x80\x9d refers to procedural unconscionability and is\nimplicated in the formation of a contract, when one of the parties is either overborne by a lack of equal\nbargaining power or otherwise unfairly or unjustly drawn into a contract. [Citation]\n\nIt should be pointed that, although harsh, many characteristics of a finance lease are not inherently\nunconscionable and, as we have discussed, are specifically authorized by statute. Simply because a finance\nlease has a \xe2\x80\x9chell or high water clause\xe2\x80\x9d does not make it unconscionable. As noted, a finance lease is a\nseparate animal\xe2\x80\x94it is supposed to secure minimal risk to the lessor. At least one court has rejected the\nargument that an acceleration clause in a commercial finance lease is punitive and unconscionable in the\ncontext of parties of relatively equal bargaining power. See [Citation]\n\nAt the heart of Arora\xe2\x80\x99s defense in this case was his claim that he was misled into signing the finance lease\nby the CCC representative and was unfairly surprised to find himself the unwitting signatory of an\noppressive lease. This is clearly an argument that implicated procedural unconscionability. His claim of\nbeing an unwitting signatory, however, must be carefully balanced against the law in Ohio that places\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n390\n\n\x0cupon a person a duty to read any contract before signing it, a duty that is not excused simply because a\nperson willingly gives into the encouragement to \xe2\x80\x9cjust go ahead and sign.\xe2\x80\x9d See [Citation]\n\nMoreover, we note that courts have also recognized that the lessor may give, through word or conduct, the\nlessee consent to cancel an otherwise noncancelable lease. [UCC 2A-40792)(b)] makes a finance lease \xe2\x80\x9cnot\nsubject to cancellation, termination, modification, repudiation, excuse, or substitution without the\nconsent of the party to whom it runs.\xe2\x80\x9d (Emphasis supplied.) As noted by the court inColonial\nCourt [Citation], the UCC does not say anything with respect to the form or content of the consent.\nThe Colonial Pacific court concluded, therefore, \xe2\x80\x9cthat the consent may be oral and may be established by\nconduct that reasonably manifests an intent. * * * Any manifestations that the obligation of the lessee will\nnot be enforced independently of the obligation that runs to the consenting party is sufficient.\xe2\x80\x9d The\nquestion whether consent has been given to a cancellation is a question of fact for the trier of fact.\n\nWe raise this point because the evidence indicates that there was some communication between Arora\nand ILC before ILC retrieved the ATM. It is unclear whether ILC removed the ATM at Arora\xe2\x80\x99s request, or\nwhether the company was forcibly repossessing the equipment pursuant to the default provision of the\nlease. In view of the murkiness of the testimony, it is unclear when the ATM was taken back and when the\nfinal lease payment was made. One interesting question that arises from ILC\xe2\x80\x99s retrieval of the ATM, not\naddressed in the record, is what ILC did with the equipment afterward. Did ILC warehouse the equipment\nfor the next four and one-half years (conduct that would appear unprofitable and therefore unlikely) or\ndid the company then turn around and lease the ATM to someone else? If there was another lease, was\nILC actually seeking a double recovery on the ATM\xe2\x80\x99s rental value? In this regard, we note that the trial\ncourt ruled that ILC had failed to mitigate its damages, a finding that is not supported by the current\nrecord, but may well prove to be true upon further trial of the matter.\nIn sum, this is a case that requires a much more elaborate presentation of evidence by the parties, and\nmuch more detailed findings of fact and conclusions of law than those actually made by the trial court. We\nsustain ILC\xe2\x80\x99s assignment of error upon the basis that the trial court did not apply the correct legal\nanalysis, and that the evidence of record did not mandate a judgment in Arora\xe2\x80\x99s favor. Because of the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n391\n\n\x0cnumber of outstanding issues and unresolved factual questions, we reverse the trial court\xe2\x80\x99s judgment and\nremand this case for a new trial consistent with the law set forth in this opinion.\n\nJudgment reversed and cause remanded.\n\nC A SE QU ES TIO NS\n1. Why would a finance lease have such an iron-clad, \xe2\x80\x9chell or high water\xe2\x80\x9d\nnoncancellation clause as is apparently common and demonstrated here?\n2. On what basis did the lower court rule in the defendant\xe2\x80\x99s favor?\n3. What is an acceleration clause?\n4. What was Mr. Arora\xe2\x80\x99s main defense? What concern did the court have with it?\n5. The appeals court helpfully suggested several arguments the defendant might make\non remand to be relieved of his contract obligations. What were they?\n\n8.6 Summary and Exercises\nSummary\n\nSales law is a special type of contract law, governed by Article 2 of the Uniform\nCommercial Code (UCC), adopted in every state but Louisiana. Article 2 governs the sale\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n392\n\n\x0cof goods only, defined as things movable at the time of identification to the contract for\nsale. Article 2A, a more recent offering, deals with the leasing of goods, including\nfinance leases and consumer leases. The Convention on Contracts for the International\nSale of Goods (CISG) is an international equivalent of Article 2.\nDifficult questions sometimes arise when the subject of the contract is a hybrid of goods\nand real estate or goods and services. If the seller is called on to sever crops, timber, or\nminerals from the land, or the buyer is required to sever and can do so without material\nharm to the land, then the items are goods subject to Article 2. When the goods are\n\xe2\x80\x9csold\xe2\x80\x9d incidental to a service, the \xe2\x80\x9cpredominant factor\xe2\x80\x9d test is used, but with inconsistent\nresults. For two categories of goods, legislation specifically answers the question:\nfoodstuffs served by a restaurant are goods; blood supplied for transfusions is not.\nAlthough they are kin, in some areas Article 2 differs from the common law. As regards\nmutual assent, the UCC abolishes the mirror image rule; it allows for more\nindefiniteness and open terms. The UCC does away with some requirements for\nconsideration. It sometimes imposes special obligations on merchants (though defining\na merchant is problematic), those who deal in goods of the kind, or who by their\noccupations hold themselves out as experts in the use of the goods as between other\nmerchants and in selling to nonmerchants. Article 2 gives courts greater leeway than\nunder the common law to modify contracts at the request of a party, if a clause is found\nto have been unconscionable at the time made.\n\nE XE R C IS ES\n\n1. Ben owns fifty acres of timberland. He enters into a contract with Bunyan under\nwhich Bunyan is to cut and remove the timber from Ben\xe2\x80\x99s land. Bunyan enters into a\ncontract to sell the logs to Log Cabin, Inc., a homebuilder. Are these two contracts\ngoverned by the UCC? Why?\n2. Clarence agreed to sell his farm to Jud in exchange for five antique cars owned by\nJud. Is this contract governed by the UCC? Why?\n3. Professor Byte enters into a contract to purchase a laptop computer from UltraIntelligence Inc. He also enters into a contract with a graduate student, who is to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n393\n\n\x0cwrite programs that will be run on the computer. Are these two contracts governed\nby the UCC? Why?\n4. Pat had a skin problem and went to Dr. Pore, a dermatologist, for treatment. Dr.\nPore applied a salve obtained from a pharmaceutical supplier, which made the\nproblem worse. Is Dr. Pore liable under Article 2 of the UCC? Why?\n5. Zanae visited the Bonita Burrito restaurant and became seriously ill after eating\ntainted food. She was rushed to a local hospital, where she was given a blood\ntransfusion. Zanae developed hepatitis as a result of the transfusion. When she sued\nthe restaurant and the hospital, claiming remedies under the UCC, both defended\nthe suit by arguing that they were providing services, not goods. Are they correct?\nWhy?\n6. Bill, the owner of Bill\xe2\x80\x99s Used Books, decided to go out of business. He sold two of his\nbookcases to Ned. Ned later discovered that the bookcases were defective and sued\nBill on the theory that, as a merchant, he warranted that the bookcases were of fair,\naverage quality. Will Ned prevail on this theory? Why?\n7. Rufus visited a supermarket to purchase groceries. As he moved past a display of\nsoda pop and perhaps lightly brushed it, a bottle exploded. Rufus sustained injury\nand sued the supermarket, claiming breach of warranty under the UCC. Will Rufus\nwin? Why?\n8. Carpet Mart bought carpet from Collins & Aikman (Defendant) represented to\nbe 100 percent polyester fiber. When Carpet Mart discovered in fact the carpet\npurchased was composed of cheaper, inferior fiber, it sued for compensatory\nand punitive damages. Defendant moved for a stay pending arbitration, pointing\nto the language of its acceptance form: \xe2\x80\x9cThe acceptance of your order is subject\nto all the terms and conditions on the face and reverse side hereof, including\narbitration, all of which are accepted by buyer; it supersedes buyer\xe2\x80\x99s order\nform.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n394\n\n\x0c9. The small print on the reverse side of the form provided, among other things,\nthat all claims arising out of the contract would be submitted to arbitration in\nNew York City. The lower court held that Carpet Mart was not bound by the\narbitration agreement appearing on the back of Collins & Aikman\xe2\x80\x99s\nacknowledgment form, and Defendant appealed. How should the appeals court\nrule?\n10. Plaintiff shipped to Defendant\xe2\x80\x94Pizza Pride Inc. of Jamestown, North Carolina\xe2\x80\x94an\norder of mozzarella cheese totaling $11,000. That same day, Plaintiff mailed\nDefendant an invoice for the order, based on Plaintiff\xe2\x80\x99s understanding that an oral\ncontract existed between the parties whereby Defendant had agreed to pay for the\ncheese. Defendant was engaged in the real estate business at this time and had\nearlier been approached by Pizza Pride Inc. to discuss that company\xe2\x80\x99s real estate\ninvestment potential. Defendant denied ever guaranteeing payment for the cheese\nand raised the UCC\xe2\x80\x99s Statute of Frauds, Section 2-201, as an affirmative defense. The\nPlaintiff contended that because Defendant was in the business of buying and selling\nreal estate, she possessed knowledge or skill peculiar to the practices involved in the\ntransaction here. After hearing the evidence, the court concluded as a matter of law\nthat Defendant did agree to pay for the cheese and was liable to Plaintiff in the\namount of $11,000. Defendant appealed. How should the appeals court rule?\n11. Seller offered to sell to Buyer goods at an agreed price \xe2\x80\x9cto be shipped to Buyer by\nUPS.\xe2\x80\x9d Buyer accepted on a form that included this term: \xe2\x80\x9cgoods to be shipped\nFedEx, Buyer to pay freight.\xe2\x80\x9d Seller then determined not to carry on with the\ncontract as the price of the goods had increased, and Seller asserted that because\nthe acceptance was different from the offer, there was no contract. Is this correct?\n\nS EL F -T E ST QU EST IO N S\n1. Among subjects the UCC does not cover are\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n395\n\n\x0ca. letters of credit\nb. service contracts\nc. sale of goods\nd. bank collections\nWhen a contract is unconscionable, a court may\na. refuse to enforce the contract\nb. strike the unconscionable clause\nc. limit the application of the unconscionable clause\nd. take any of the above approaches\nUnder the UCC, the definition of merchant is limited to\na. manufacturers\nb. retailers\nc. wholesalers\nd. none of the above\nFor the purpose of sales law, goods\na. always include items sold incidental to a service\nb. include things movable at the time of identification to the contract\nc. include blood supplied for transfusions\nd. include all of the above\nArticle 2 differs from the common law of contracts\na. in no substantial way\nb. by disallowing parties to create agreements with open terms\nc. by obligating courts to respect all terms of the contract\nd. by imposing special obligations on merchants\n\nS EL F -T E ST A NSW E R S\n1. a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n396\n\n\x0c2. d\n3. d\n4. b\n5. d\n\nChapter 9\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n397\n\n\x0cTitle and Risk of Loss\nL EA R N IN G O B JEC T IV ES\n\nAfter reading this chapter, you should understand the following:\n1. Why title is important and at what point in the contracting relationship the\nbuyer acquires title\n2. Why risk of loss is important, when risk of loss passes to the buyer, and when\nthe buyer acquires an insurable interest\n3. Under what circumstances the buyer can obtain title when a nonowner sells\nthe goods\n\nParties to a sales contract will usually agree on the obvious details of a sales transaction\xe2\x80\x94the nature of\ngoods, the price, and the delivery time, as discussed in the next chapter. But there are two other issues of\nimportance lurking in the background of every sale:\n\n1.\n\nWhen does the title pass to the buyer? This question arises more in cases involving third parties,\nsuch as creditors and tax collectors. For instance, a creditor of the seller will not be allowed to\ntake possession of goods in the seller\xe2\x80\x99s warehouse if the title has already passed to the buyer.\n\n2. If goods are damaged or destroyed, who must bear the loss? The answer has obvious financial\nsignificance to both parties. If the seller must bear the loss, then in most cases he must pay\ndamages or send the buyer another shipment of goods. A buyer who bears the loss must pay for\nthe goods even though they are unusable. In the absence of a prior agreement, loss can trigger\nlitigation between the parties.\n\n9.1 Transfer of Title\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n398\n\n\x0cL EA R N IN G O B JEC T IV ES\n1. Understand why it is important to know who has title in a sales transaction.\n2. Be able to explain when title shifts.\n3. Understand when a person who has no title can nevertheless pass good title on to a\nbuyer.\n\nWhy It Is Important When Title Shifts\nThere are three reasons why it is important when title shifts from seller to buyer\xe2\x80\x94that is, when the buyer\ngets title.\n\nIt Affects Whether a Sale Has Occurred\nFirst, a sale cannot occur without a shift in title. You will recall that a sale is defined by the Uniform\nCommercial Code (UCC) as a \xe2\x80\x9ctransfer of title from seller to buyer for a price.\xe2\x80\x9d Thus if there is no shift of\ntitle, there is no sale. And there are several consequences to there being no sale, one of which is\xe2\x80\x94\nconcerning a merchant-seller\xe2\x80\x94that no implied warranty of merchantability arises. (Again, as discussed in\nthe previous chapter, an implied warranty provides that when a merchant-seller sells goods, the goods are\nsuitable for the ordinary purpose for which such goods are used.) In a lease, of course, title remains with\nthe lessor.\n\nCreditors\xe2\x80\x99 Rights\nSecond, title is important because it determines whether creditors may take the goods. If Creditor has a\nright to seize Debtor\xe2\x80\x99s goods to satisfy a judgment or because the parties have a security agreement (giving\nCreditor the right to repossess Debtor\xe2\x80\x99s goods), obviously it won\xe2\x80\x99t do at all for Creditor to seize goods\nwhen Debtor doesn\xe2\x80\x99t have title to them\xe2\x80\x94they are somebody else\xe2\x80\x99s goods, and seizing them would be\nconversion, a tort (the civil equivalent of a theft offense).\n\nInsurable Interest\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n399\n\n\x0cThird, title is related to who has an insurable interest. A buyer cannot legally obtain insurance unless\nhe has an insurable interest in the goods. Without an insurable interest, the insurance contract would be\nan illegal gambling contract. For example, if you attempt to take out insurance on a ship with which you\nhave no connection, hoping to recover a large sum if it sinks, the courts will construe the contract as a\nwager you have made with the insurance company that the ship is not seaworthy, and they will refuse to\nenforce it if the ship should sink and you try to collect. Thus this question arises: under the UCC, at what\npoint does the buyer acquire an insurable interest in the goods? Certainly a person has insurable interest\nif she has title, but the UCC allows a person to have insurable interest with less than full title. The\nargument here is often between two insurance companies, eachdenying that its insured had insurable\ninterest as to make it liable.\n\nGoods Identified to the Contract\nThe Identification Issue\nThe UCC at Section 2-401 provides that \xe2\x80\x9ctitle to goods cannot pass under a contract for sale prior to their\nidentification to the contract.\xe2\x80\x9d (In a lease, of course, title to the leased goods does not pass at all, only the\n[1]\n\nright to possession and use for some time in return for consideration. ) So identification to the contract\nhas to happen before title can shift. Identification to the contract here means that the seller in one\nway or another picks the goods to be sold out of the mass of inventory so that they can be delivered or held\nfor the buyer.\n\nArticle 67 of the CISG says the same thing: \xe2\x80\x9c[T]he risk does not pass to the buyer until the\ngoods are clearly identified to the contract, whether by markings on the goods, by shipping\ndocuments, by notice given to the buyer or otherwise.\xe2\x80\x9d\n\nWhen are goods \xe2\x80\x9cidentified\xe2\x80\x9d? There are two possibilities as to when identification happens.\n\nParties May Agree\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n400\n\n\x0cSection 2-501(1) of the UCC says \xe2\x80\x9cidentification can be made at any time and in any manner explicated\nagreed to by the parties.\xe2\x80\x9d\n\nUCC Default Position\nIf the parties do not agree on when identification happens, the UCC default kicks in. Section 2-501(1) of\nthe UCC says identification occurs\n\na.\n\nwhen the contract is made if it is for the sale of goods already existing and identified;\n\nb. if the contract is for the sale of future goods other than those described in paragraph c., when\ngoods are shipped, marked, or otherwise identified by the seller as goods to which the contract\nrefers;\nc.\n\nwhen crops are planted or otherwise become growing crops or the young are conceived if the\ncontract is for the sale of unborn young to be born within twelve months after contract or for the\nsale of corps to be harvested within twelve months or the next normal harvest seasons after\ncontracting, whichever is longer.\n\nThus if Very Fast Food Inc.\xe2\x80\x99s purchasing agent looks at a new type of industrial sponge on Delta Sponge\nMakers\xe2\x80\x99 store shelf for restaurant supplies, points to it, and says, \xe2\x80\x9cI\xe2\x80\x99ll take it,\xe2\x80\x9d identification happens then,\nwhen the contract is made. But if the purchasing agent wants to purchase sponges for her fast-food\nrestaurants, sees a sample on the shelf, and says, \xe2\x80\x9cI want a gross of those\xe2\x80\x9d\xe2\x80\x94they come in boxes of one\nhundred each\xe2\x80\x94identification won\xe2\x80\x99t happen until one or the other of them chooses the gross of boxes of\nsponges out of the warehouse inventory.\n\nWhen Title Shifts\nParties May Agree\nAssuming identification is done, when does title shift? The law begins with the premise that the\nagreement of the parties governs. Section 2-401(1) of the UCC says that, in general, \xe2\x80\x9ctitle to goods passes\nfrom the seller to the buyer in any manner and on any conditions explicitly agreed on by the parties.\xe2\x80\x9d\nMany companies specify in their written agreements at what moment the title will pass; here, for example,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n401\n\n\x0cis a clause that appears in sales contracts of Dow Chemical Company: \xe2\x80\x9cTitle and risk of loss in all goods\nsold hereunder shall pass to Buyer upon Seller\xe2\x80\x99s delivery to carrier at shipping point.\xe2\x80\x9d Thus Dow retains\ntitle to its goods only until it takes them to the carrier for transportation to the buyer.\n\nBecause the UCC\xe2\x80\x99s default position (further discussed later in this chapter) is that title shifts when the\nseller has completed delivery obligations, and because the parties may agree on delivery terms, they also\nmay, by choosing those terms, effectively agree when title shifts (again, they also can agree using any\nother language they want). So it is appropriate to examine some delivery terms at this juncture. There are\nthree possibilities: shipment contracts, destination contracts, and contracts where the goods are not to be\nmoved.\n\nShipment Contracts\nIn a shipment contract, the seller\xe2\x80\x99s obligation is to send the goods to the buyer, but not to a particular\ndestination. The typical choices are set out in the UCC at Section 2-319:\n\xe2\x80\xa2\n\nF.O.B. [place of shipment] (the place from which the goods are to be shipped goes in the brackets,\nas in \xe2\x80\x9cF.O.B. Seattle\xe2\x80\x9d). F.O.B. means \xe2\x80\x9cfree on board\xe2\x80\x9d; the seller\xe2\x80\x99s obligation, according to Section 2504 of the UCC, is to put the goods into the possession of a carrier and make a reasonable contract for\ntheir transportation, to deliver any necessary documents so the buyer can take possession, and\npromptly notify the buyer of the shipment.\n\n\xe2\x80\xa2\n\nF.A.S. [named port] (the name of the seaport from which the ship is carrying the goods goes in the\nbrackets, as in \xe2\x80\x9cF.A.S. Long Beach\xe2\x80\x9d). F.A.S means \xe2\x80\x9cfree alongside ship\xe2\x80\x9d; the seller\xe2\x80\x99s obligation is to at\nhis \xe2\x80\x9cexpense and risk deliver the goods alongside the vessel in the manner usual in that port\xe2\x80\x9d and to\nprovide the buyer with pickup instructions.\n\n\xe2\x80\xa2\n\n[2]\n\nC.I.F. and C. & F. These are actually not abbreviations for delivery terms, but rather they describe\nwho pays insurance and freight. \xe2\x80\x9cC.I.F\xe2\x80\x9d means \xe2\x80\x9ccost, insurance, and freight\xe2\x80\x9d\xe2\x80\x94if this term is used, it\nmeans that the contract price \xe2\x80\x9cincludes in a lump sum the cost of the goods and the insurance and\nfreight to the named destination.\xe2\x80\x9d\nnamed destination.\xe2\x80\x9d\n\n[3]\n\n\xe2\x80\x9cC. & F.\xe2\x80\x9d means that \xe2\x80\x9cthe price so includes cost and freight to the\n\n[4]\n\nDestination Contracts\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n402\n\n\x0cIn a destination contract, the seller\xe2\x80\x99s obligation is to see to it that the goods actually arrive at the\ndestination. Here again, the parties may employ the use of abbreviations that indicate the seller\xe2\x80\x99s duties.\nSee the following from the UCC, Section 2-319:\n\n\xe2\x80\xa2\n\nF.O.B. [destination] means the seller\xe2\x80\x99s obligation is to \xe2\x80\x9cat his own expense and risk transport the goods\nto that place and there tender delivery of them\xe2\x80\x9d with appropriate pickup instructions to the buyer.\n\n\xe2\x80\xa2\n\nEx-ship \xe2\x80\x9cis the reverse of the F.A.S. term.\xe2\x80\x9d\n\n[5]\n\nIt means \xe2\x80\x9cfrom the carrying vessel\xe2\x80\x9d\xe2\x80\x94the seller\xe2\x80\x99s obligation\n\nis to make sure the freight bills are paid and that \xe2\x80\x9cthe goods leave the ship\xe2\x80\x99s tackle or are otherwise\nproperly unloaded.\xe2\x80\x9d\n\xe2\x80\xa2\n\nNo arrival, no sale means the \xe2\x80\x9cseller must properly ship conforming goods and if they arrive by any\nmeans he must tender them on arrival but he assumes no obligation that the goods will arrive unless he\nhas caused the non-arrival.\xe2\x80\x9d\n\n[6]\n\nIf the goods don\xe2\x80\x99t arrive, or if they are damaged or deteriorated through no\n\nfault of the seller, the buyer can either treat the contract as avoided, or pay a reduced amount for the\ndamaged goods, with no further recourse against the seller.\n\n[7]\n\nGoods Not to Be Moved\nIt is not uncommon for contracting parties to sell and buy goods stored in a grain elevator or warehouse\nwithout physical movement of the goods. There are two possibilities:\n\n1.\n\nGoods with documents of title. A first possibility is that the ownership of the goods is manifested by a\ndocument of title\xe2\x80\x94\xe2\x80\x9cbill of lading, dock warrant, dock receipt, warehouse receipt or order for the\ndelivery of goods, and also any other document which in the regular course of business or financing is\ntreated as adequately evidencing that the person in possession of it is entitled to receive, hold and\ndispose of the document and the goods it covers.\xe2\x80\x9d\n\n[8]\n\nIn that case, the UCC, Section 2-401(3)(a), says\n\nthat title passes \xe2\x80\x9cat the time when and the place where\xe2\x80\x9d the documents are delivered to the buyer.\n2. Goods without documents of title. If there is no physical transfer of the goods and no documents to\nexchange, then UCC, Section 2-401(3)(b), provides that \xe2\x80\x9ctitle passes at the time and place of\ncontracting.\xe2\x80\x9d\nHere are examples showing how these concepts work.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n403\n\n\x0cSuppose the contract calls for Delta Sponge Makers to \xe2\x80\x9cship the entire lot of industrial grade Sponge No. 2\nby truck or rail\xe2\x80\x9d and that is all that the contract says about shipment. That\xe2\x80\x99s a \xe2\x80\x9cshipment contract,\xe2\x80\x9d and\nthe UCC, Section 2-401(2)(a), says that title passes to Very Fast Foods at the \xe2\x80\x9ctime and place of\nshipment.\xe2\x80\x9d At the moment that Delta turns over the 144 cartons of 1,000 sponges each to a trucker\xe2\x80\x94\nperhaps Easy Rider Trucking comes to pick them up at Delta\xe2\x80\x99s own factory\xe2\x80\x94title has passed to Very Fast\nFoods.\n\nSuppose the contract calls for Delta to \xe2\x80\x9cdeliver the sponges on June 10 at the Maple Street warehouse of\nVery Fast Foods Inc.\xe2\x80\x9d This is a destination contract, and the seller \xe2\x80\x9ccompletes his performance with\nrespect to the physical delivery of the goods\xe2\x80\x9d when it pulls up to the door of the warehouse and tenders\nthe cartons.\n\n[9]\n\n\xe2\x80\x9cTender\xe2\x80\x9d means that the party\xe2\x80\x94here Delta Sponge Makers\xe2\x80\x94is ready, able, and willing to\n\nperform and has notified its obligor of its readiness. When the driver of the delivery truck knocks on the\nwarehouse door, announces that the gross of industrial grade Sponge No. 2 is ready for unloading, and\nasks where the warehouse foreman wants it, Delta has tendered delivery, and title passes to Very Fast\nFoods.\n\nSuppose Very Fast Foods fears that the price of industrial sponges is about to soar; it wishes to acquire a\nlarge quantity long before it can use them all or even store them all. Delta does not store all of its sponges\nin its own plant, keeping some of them instead at Central Warehousing. Central is a bailee, one who has\nrightful possession but not title. (A parking garage often is a bailee of its customers\xe2\x80\x99 cars; so is a carrier\ncarrying a customer\xe2\x80\x99s goods.) Now assume that Central has issued a warehouse receipt (a document of\ntitle that provides proof of ownership of goods stored in a warehouse) to Delta and that Delta\xe2\x80\x99s contract\nwith Very Fast Foods calls for Delta to deliver \xe2\x80\x9cdocument of title at the office of First Bank\xe2\x80\x9d on a particular\nday. When the goods are not to be physically moved, that title passes to Very Fast Foods \xe2\x80\x9cat the time when\nand the place where\xe2\x80\x9d Delta delivers the document.\n\nSuppose the contract did not specify physical transfer or exchange of documents for the purchase price.\nInstead, it said, \xe2\x80\x9cSeller agrees to sell all sponges stored on the north wall of its Orange Street warehouse,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n404\n\n\x0cnamely, the gross of industrial Sponge No. 2, in cartons marked B300\xe2\x80\x93B444, to Buyer for a total purchase\nprice of $14,000, payable in twelve equal monthly installments, beginning on the first of the month\nbeginning after the signing of this agreement.\xe2\x80\x9d Then title passes at the time and place of contracting\xe2\x80\x94that\nis, when Delta Sponge Makers and Very Fast Foods sign the contract.\n\nSo, as always under the UCC, the parties may agree on the terms they want when title shifts. They can do\nthat directly by just saying when\xe2\x80\x94as in the Dow Chemical example\xe2\x80\x94or they can indirectly agree when\ntitle shifts by stipulating delivery terms: shipment, destination, goods not to be moved. If they don\xe2\x80\x99t\nstipulate, the UCC default kicks in.\n\nUCC Default Provision\nIf the parties do not stipulate by any means when title shifts, Section 2-401(2) of the UCC provides that\n\xe2\x80\x9ctitle passes to the buyer at the time and place at which seller completes his performance with reference to\nthe physical delivery of the goods.\xe2\x80\x9d And if the parties have no term in their contract about delivery, the\nUCC\xe2\x80\x99s default delivery term controls. It says \xe2\x80\x9cthe place for delivery is the seller\xe2\x80\x99s place of business or if he\nhas none his residence,\xe2\x80\x9d and delivery is accomplished at the place when the seller \xe2\x80\x9cput[s] and hold[s]\nconforming goods at the buyer\xe2\x80\x99s disposition and give[s] the buyer any notification reasonably necessary to\nenable him to take delivery.\xe2\x80\x9d\n\n[10]\n\nK E Y TA K EA WAY\nTitle is important for three reasons: it determines whether a sale has occurred, it\ndetermines rights of creditors, and it affects who has an insurable interest. Parties may\nexplicitly agree when title shifts, or they may agree indirectly by settling on delivery\nterms (because absent explicit agreement, delivery controls title passage). Delivery\nterms to choose from include shipment contracts, destination contracts, and delivery\nwithout the goods being moved (with or without documents of title). If nothing is said\nabout when title shifts, and the parties have not indirectly agreed by choosing a delivery\nterm, then title shifts when delivery obligations under the contract are complete, and if\nthere are no delivery terms, delivery happens when the seller makes the goods available\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n405\n\n\x0cat seller\xe2\x80\x99s place of business (or if seller has no place of business, goods will be made\navailable at seller\xe2\x80\x99s residence)\xe2\x80\x94that\xe2\x80\x99s when title shifts.\n\nE XE R C IS ES\n1. Why does it matter who has title?\n2. If the parties do not otherwise agree, when does title shift from seller to buyer?\n3. Why does the question of delivery terms arise in examining when title shifts?\n4. When does title shift for goods stored in a warehouse that are not to be moved?\n[1] Uniform Commercial Code, Section 2A-103(1)(j).\n[2] Uniform Commercial Code, Section 2-319(2).\n[3] Uniform Commercial Code, Section 2-320.\n[4] Uniform Commercial Code, Section 2-320.\n[5] Uniform Commercial Code, Section 2-322.\n[6] Uniform Commercial Code, Section 2-324.\n[7] Uniform Commercial Code, Section 2-613.\n[8] Uniform Commercial Code, Section 1-201(15).\n[9] Uniform Commercial Code, Section 2-401(2)(b).\n[10] Uniform Commercial Code, Sections 2-308 and 2-503.\n\n9.2 Title from Nonowners\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n406\n\n\x0cL EA R N IN G O B JEC T IV E\n1. Understand when and why a nonowner can nevertheless pass title on to a\npurchaser.\n\nThe Problem of Title from Nonowners\nWe have examined when title transfers from buyer to seller, and here the assumption is, of course, that\nseller had good title in the first place. But what title does a purchaser acquire when the seller has no title\nor has at best only a voidable title? This question has often been difficult for courts to resolve. It typically\ninvolves a type of eternal triangle with a three-step sequence of events, as follows (see Figure 9.1 "Sales by\nNonowners"): (1) The nonowner obtains possession, for example, by loan or theft; (2) the nonowner sells\nthe goods to an innocent purchaser for cash; and (3) the nonowner then takes the money and disappears,\ngoes into bankruptcy, or ends up in jail. The result is that two innocent parties battle over the goods, the\nowner usually claiming that the purchaser is guilty of conversion (i.e., the unlawful assumption of\nownership of property belonging to another) and claiming damages or the right to recover the goods.\n\nFigure 9.1 Sales by Nonowners\n\nThe Response to the Problem of Title from Nonowners\nThe Basic Rule\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n407\n\n\x0cTo resolve this dilemma, we begin with a basic policy of jurisprudence: a person cannot transfer better\ntitle than he or she had. (The Uniform Commercial Code [UCC] notes this policy in Sections 2-403, 2A304, and 2A-305.) This policy would apply in a sale-of-goods case in which the nonowner had a void title\nor no title at all. For example, if a nonowner stole the goods from the owner and then sold them to an\ninnocent purchaser, the owner would be entitled to the goods or to damages. Because the thief had no\ntitle, he had no title to transfer to the purchaser. A person cannot get good title to goods from a thief, nor\ndoes a person have to retain physical possession of her goods at all times to retain their ownership\xe2\x80\x94\npeople are expected to leave their cars with a mechanic for repair or to leave their clothing with a dry\ncleaner.\n\nIf thieves could pass on good title to stolen goods, there would be a hugely increased traffic in stolen\nproperty; that would be unacceptable. In such a case, the owner can get her property back from whomever\nthe thief sold it to in an action called replevin (an action to recover personal property unlawfully taken).\nOn the other hand, when a buyer in good faith buys goods from an apparently reputable seller, she\nreasonably expects to get good title, and that expectation cannot be dashed with impunity without faith in\nthe market being undermined. Therefore, as between two innocent parties, sometimes the original owner\ndoes lose, on the theory that (1) that person is better able to avoid the problem than the downstream\nbuyer, who had absolutely no control over the situation, and (2) faith in commercial transactions would be\nundermined by allowing original owners to claw back their property under all circumstances.\n\nSo the basic legal policy that a person cannot pass on better title than he had is subject to a number of\nexceptions. In Chapter 15 "Holder in Due Course and Defenses", for instance, we discuss how certain\npurchasers of commercial paper (\xe2\x80\x9cholders in due course\xe2\x80\x9d) will obtain greater rights than the sellers\npossessed. And in Chapter 19 "Secured Transactions and Suretyship", we examine how a buyer in the\nordinary course of business is allowed to purchase goods free of security interests that the seller has given\nto creditors. Likewise, the law governing the sale of goods contains exceptions to the basic legal policy.\nThese usually fall within one of two categories: sellers with voidable title and entrustment.\n\nThe Exceptions\nAs noted, there are exceptions to the law governing the sale of goods.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n408\n\n\x0cSellers with a Voidable Title\nUnder the UCC, a person with a voidable title has the power to transfer title to a good-faith purchaser for\nvalue (see Figure 9.2 "Voidable Title"). The UCC defines good faith as \xe2\x80\x9chonesty in fact in the conduct or\ntransaction concerned.\xe2\x80\x9d\n\n[1]\n\nA \xe2\x80\x9cpurchaser\xe2\x80\x9d is not restricted to one who pays cash; any taking that creates an\n\ninterest in property, whether by mortgage, pledge, lien, or even gift, is a purchase for purposes of the UCC.\nAnd \xe2\x80\x9cvalue\xe2\x80\x9d is not limited to cash or goods; a person gives value if he gives any consideration sufficient to\nsupport a simple contract, including a binding commitment to extend credit and security for a preexisting\nclaim. Recall from (Reference mayer_1.0-ch09 not found in Book) that a \xe2\x80\x9cvoidable\xe2\x80\x9d title is one that, for\npolicy reasons, the courts will cancel on application of one who is aggrieved. These reasons include fraud,\nundue influence, mistake, and lack of capacity to contract. When a person has a voidable title, title can be\ntaken away from her, but if it is not, she can transfer better title than she has to a good-faith purchaser for\nvalue. (See Section 9.4.2 "Defrauding Buyer Sells to Good-Faith Purchaser for Value" at the end of this\nchapter.)\n\nRita, sixteen years old, sells a video game to her neighbor Annie, who plans to give the game to her\nnephew. Since Rita is a minor, she could rescind the contract; that is, the title that Annie gets is voidable:\nit is subject to be avoided by Rita\xe2\x80\x99s rescission. But Rita does not rescind. Then Annie discovers that her\nnephew already has that video game, so she sells it instead to an office colleague, Donald. He has had no\nnotice that Annie bought the game from a minor and has only a voidable title. He pays cash. Should Rita\xe2\x80\x94\nthe minor\xe2\x80\x94subsequently decide she wants the game back, it would be too late: Annie has transferred good\ntitle to Donald even though Annie\xe2\x80\x99s title was voidable.\n\nFigure 9.2 Voidable Title\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n409\n\n\x0cSuppose Rita was an adult and Annie paid her with a check that later bounced, but Annie sold the game to\nDonald before the check bounced. Does Donald still have good title? The UCC says he does, and it\nidentifies three other situations in which the good-faith purchaser is protected: (1) when the original\ntransferor was deceived about the identity of the purchaser to whom he sold the goods, who then transfers\nto a good-faith purchaser; (2) when the original transferor was supposed to but did not receive cash from\nthe intermediate purchaser; and (3) when \xe2\x80\x9cthe delivery was procured through fraud punishable as\nlarcenous under the criminal law.\xe2\x80\x9d\n\n[2]\n\nThis last situation may be illustrated as follows: Dimension LLC leased a Volkswagen to DK Inc. The\nagreement specified that DK could use the Volkswagen solely for business and commercial purposes and\ncould not sell it. Six months later, the owner of DK, Darrell Kempf, representing that the Volkswagen was\npart of DK\xe2\x80\x99s used-car inventory, sold it to Edward Seabold. Kempf embezzled the proceeds from the sale\nof the car and disappeared. When DK defaulted on its payments for the Volkswagen, Dimension\nattempted to repossess it. Dimension discovered that Kempf had executed a release of interest on the car\xe2\x80\x99s\ntitle by forging the signature of Dimension\xe2\x80\x99s manager. The Washington Court of Appeals, applying the\nUCC, held that Mr. Seabold should keep the car. The car was not stolen from Dimension; instead, by\nleasing the vehicle to DK, Dimension transferred possession of the car to DK voluntarily, and because\n[3]\n\nSeabold was a good-faith purchaser, he won.\n\nEntrustment\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n410\n\n\x0cA merchant who deals in particular goods has the power to transfer all rights of one who entrusts to him\ngoods of the kind to a \xe2\x80\x9cbuyer in the ordinary course of business\xe2\x80\x9d (see Figure 9.3 "Entrustment").\n\n[4]\n\nThe\n\nUCC defines such a buyer as a person who buys goods in an ordinary transaction from a person in the\nbusiness of selling that type of goods, as long as the buyer purchases in \xe2\x80\x9cgood faith and without knowledge\nthat the sale to him is in violation of the ownership rights or security interest of a third party in the\ngoods.\xe2\x80\x9d\n\n[5]\n\nBess takes a pearl necklace, a family heirloom, to Wellborn\xe2\x80\x99s Jewelers for cleaning; as\n\nthe entrustor, she has entrusted the necklace to an entrustee. The owner of Wellborn\xe2\x80\x99s\xe2\x80\x94perhaps by\nmistake\xe2\x80\x94sells it to Clara, a buyer, in the ordinary course of business. Bess cannot take the necklace back\nfrom Clara, although she has a cause of action against Wellborn\xe2\x80\x99s for conversion. As between the two\ninnocent parties, Bess and Clara (owner and purchaser), the latter prevails. Notice that the UCC only says\nthat the entrustee can pass whatever title the entrustor had to a good-faith purchaser, not necessarily\ngood title. If Bess\xe2\x80\x99s cleaning woman borrowed the necklace, soiled it, and took it to Wellborn\xe2\x80\x99s, which then\nsold it to Clara, Bess could get it back because the cleaning woman had no title to transfer to the entrustee,\nWellborn\xe2\x80\x99s.\n\nFigure 9.3 Entrustment\n\nEntrustment is based on the general principle of estoppel: \xe2\x80\x9cA rightful owner may be estopped by his own\nacts from asserting his title. If he has invested another with the usual evidence of title, or an apparent\nauthority to dispose of it, he will not be allowed to make claim against an innocent purchaser dealing on\nthe faith of such apparent ownership.\xe2\x80\x9d\n\n[6]\n\nK E Y TA K EA WAY\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n411\n\n\x0cThe general rule\xe2\x80\x94for obvious reasons\xe2\x80\x94is that nobody can pass on better title to goods\nthan he or she has: a thief cannot pass on good title to stolen goods to anybody. But in\nbalancing that policy against the reasonable expectations of good-faith buyers that they\nwill get title, the UCC has made some exceptions. A person with voidable title can pass\non good title to a good-faith purchaser, and a merchant who has been entrusted with\ngoods can pass on title of the entrustor to a good-faith purchaser.\n\nE XE R C IS ES\n1. Why is it the universal rule that good title to goods cannot be had from a thief?\n2. What is the \xe2\x80\x9cvoidable title\xe2\x80\x9d exception to the universal rule? Why is the exception\nmade?\n3. What is the \xe2\x80\x9centrusting\xe2\x80\x9d exception to the general rule?\n[1] Uniform Commercial Code, Section 1-201(19).\n[2] Uniform Commercial Code, Sections 2-403(1), 2-403(1), 2A-304, and 2A-305.\n[3] Dimension Funding, L.L.C. v. D.K. Associates, Inc., 191 P.3d 923 (Wash. App. 2008).\n[4] Uniform Commercial Code, Sections 2-403(2), 2A-304(2), and 2A-305(2).\n[5] Uniform Commercial Code, Section 1-201(9).\n[6] Zendman v. Harry Winston, Inc., 111 N.E. 2d 871 (N.Y. 1953).\n\n9.3 Risk of Loss\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n412\n\n\x0cL EA R N IN G O B JEC T IV ES\n1. Understand why who has the risk of loss is important.\n2. Know how parties may agree on when the risk of loss shifts.\n3. Know when the risk of loss shifts if there is no breach, and if there is a breach.\n4. Recognize what \xe2\x80\x9cinsurable interest\xe2\x80\x9d is, why it is important, and how it\nattaches.\n\nWhy Risk of Loss Is Important\n\xe2\x80\x9cRisk of loss\xe2\x80\x9d means who has to pay\xe2\x80\x94who bears the risk\xe2\x80\x94if the goods are lost or destroyed without the\nfault of either party. It is obvious why this issue is important: Buyer contracts to purchase a new car for\n$35,000. While the car is in transit to Buyer, it is destroyed in a landslide. Who takes the $35,000 hit?\n\nThe CISG, Article 66, provides as follows: \xe2\x80\x9cLoss of or damage to the goods after the risk has\npassed to the buyer does not discharge him from his obligation to pay the price, unless the\nloss or damage is due to an act or omission of the seller.\xe2\x80\x9d\n\nWhen Risk of Loss Passes\nThe Parties May Agree\nJust as title passes in accordance with the parties\xe2\x80\x99 agreement, so too can the parties fix the risk of loss on\none or the other. They may even devise a formula to divide the risk between themselves.\n\n[1]\n\nCommon terms by which parties set out their delivery obligations that then affect when title shifts (F.O.B.,\nF.A.S., ex-ship, and so on) were discussed earlier in this chapter. Similarly, parties may use common\nterms to set out which party has the risk of loss; these situation arise with trial sales. That is, sometimes\nthe seller will permit the buyer to return the goods even though the seller had conformed to the contract.\nWhen the goods are intended primarily for the buyer\xe2\x80\x99s use, the transaction is said to be \xe2\x80\x9csale on approval.\xe2\x80\x9d\nWhen they are intended primarily for resale, the transaction is said to be \xe2\x80\x9csale or return.\xe2\x80\x9d When the\n\xe2\x80\x9cbuyer\xe2\x80\x9d is really only a sales agent for the \xe2\x80\x9cseller,\xe2\x80\x9d it is a consignment sale.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n413\n\n\x0cSale on Approval\nUnder a sale-on-approval contract, risk of loss (and title) remains with the seller until the buyer\naccepts, and the buyer\xe2\x80\x99s trial use of the goods does not in itself constitute acceptance. If the buyer decides\nto return the goods, the seller bears the risk and expense of return, but a merchant buyer must follow any\nreasonable instructions from the seller. Very Fast Foods asks Delta for some sample sponges to test on\napproval; Delta sends a box of one hundred sponges. Very Fast plans to try them for a week, but before\nthat, through no fault of Very Fast, the sponges are destroyed in a fire. Delta bears the loss.\n\n[2]\n\nSale or Return\nThe buyer might take the goods with the expectation of reselling them\xe2\x80\x94as would a women\xe2\x80\x99s wear shop\nbuy new spring fashions, expecting to sell them. But if the shop doesn\xe2\x80\x99t sell them before summer wear is\nin vogue, it could arrange with the seller to return them for credit. In contrast to sale-on-approval\ncontracts, sale-or-return contracts have risk of loss (and title too) passing to the buyer, and the buyer\nbears the risk and expense of returning the goods.\n\nOccasionally the question arises whether the buyer\xe2\x80\x99s other creditors may claim the goods when the sales\ncontract lets the buyer retain some rights to return the goods. The answer seems straightforward: in a\nsale-on-approval contract, where title remains with the seller until acceptance, the buyer does not own the\ngoods\xe2\x80\x94hence they cannot be seized by his creditors\xe2\x80\x94unless he accepts them, whereas they are the buyer\xe2\x80\x99s\ngoods (subject to his right to return them) in a sale-or-return contract and may be taken by creditors if\nthey are in his possession.\n\nConsignment Sales\nIn a consignment situation, the seller is a bailee and an agent for the owner who sells the goods for the\nowner and takes a commission. Under the Uniform Commercial Code (UCC), this is considered a sale or\nreturn, thus the consignee (at whose place the goods are displayed for sale to customers) is considered a\nbuyer and has the risk of loss and title.\n\n[3]\n\nThe consignee\xe2\x80\x99s creditors can take the goods; that is, unless the\n\nparties comply \xe2\x80\x9cwith an applicable law providing for a consignor\xe2\x80\x99s interest or the like to be evidenced by a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n414\n\n\x0csign, or where it is established that the person conducting the business is generally known by his creditors\nto be substantially engaged in selling the goods of others\xe2\x80\x9d (or complies with secured transactions\nrequirements under Article 9, discussed in a later chapter).\n\n[4]\n\nThe UCC Default Position\nIf the parties fail to specify how the risk of loss is to be allocated or apportioned, the UCC again supplies\nthe answers. A generally applicable rule, though not explicitly stated, is that risk of loss passes when the\nseller has completed obligations under the contract. Notice this is not the same as when title passes: title\npasses when seller has completed delivery obligations under the contract, risk of loss passes\nwhen all obligations are completed. (Thus a buyer could get good title to nonconforming goods, which\nmight be better for the buyer than not getting title to them: if the seller goes bankrupt, at least the buyer\nhas something of value.)\n\nRisk of Loss in Absence of a Breach\nIf the goods are conforming, then risk of loss would indeed pass when delivery obligations are complete,\njust as with title. And the analysis here would be the same as we looked at in examining shift of title.\n\nA shipment contract. The contract requires Delta to ship the sponges by carrier but does not require it\nto deliver them to a particular destination. In this situation, risk of loss passes to Very Fast Foods when\nthe goods are delivered to the carrier.\n\nThe CISG\xe2\x80\x94pretty much like the UCC\xe2\x80\x94provides as follows (Article 67):\n\nIf the contract of sale involves carriage of the goods and the seller is not bound to hand\nthem over at a particular place, the risk passes to the buyer when the goods are handed\nover to the first carrier for transmission to the buyer in accordance with the contract of\nsale. If the seller is bound to hand the goods over to a carrier at a particular place, the risk\ndoes not pass to the buyer until the goods are handed over to the carrier at that place.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n415\n\n\x0cA destination contract. If the destination contract agreement calls for Delta to deliver the sponges by\ncarrier to a particular location, Very Fast Foods assumes the risk of loss only when Delta\xe2\x80\x99s carrier tenders\nthem at the specified place.\n\nThe CISG provides for basically the same thing (Article 69): \xe2\x80\x9cIf the contract is for\nsomething other than shipment, the risk passes to the buyer when he takes over the goods\nor, if he does not do so in due time, from the time when the goods are placed at his disposal\nand he commits a breach of contract by failing to take delivery.\xe2\x80\x9d\n\nGoods not to be moved. If Delta sells sponges that are stored at Central Warehousing to Very Fast\nFoods, and the sponges are not to be moved, Section 2-509(2) of the UCC sets forth three possibilities for\ntransfer of the risk of loss:\n\n1.\n\nThe buyer receives a negotiable document of title covering the goods. A document of title is negotiable\nif by its terms goods are to be delivered to the bearer of the document or to the order of a named\nperson.\n\n2. The bailee acknowledges the buyer\xe2\x80\x99s right to take possession of the goods. Delta signs the contract for\nthe sale of sponges and calls Central to inform it that a buyer has purchased 144 cartons and to ask it\nto set aside all cartons on the north wall for that purpose. Central does so, sending notice to Very Fast\nFoods that the goods are available. Very Fast Foods assumes risk of loss upon receipt of the notice.\n3. When the seller gives the buyer a nonnegotiable document of title or a written direction to the bailee\nto deliver the goods and the buyer has had a reasonable time to present the document or direction.\n\nAll other cases. In any case that does not fit within the rules just described, the risk of loss passes to the\nbuyer only when the buyer actually receives the goods. Cases that come within this section generally\ninvolve a buyer who is taking physical delivery from the seller\xe2\x80\x99s premises. A merchant who sells on those\nterms can be expected to insure his interest in any goods that remain under his control. The buyer is\nunlikely to insure goods not in his possession. The Ramos case (Section 9.4.3 "Risk of Loss, Seller a\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n416\n\n\x0cMerchant" in this chapter) demonstrates how this risk-of-loss provision applies when a customer pays for\nmerchandise but never actually receives his purchase because of a mishap.\n\nRisk of Loss Where Breach Occurs\nThe general rule for risk of loss was set out as this: risk of loss shifts when seller has completed obligations\nunder the contract. We said if the goods are conforming, the only obligation left is delivery, so then risk of\nloss would shift upon delivery. But if the goods are nonconforming, then the rule would say the risk\ndoesn\xe2\x80\x99t shift. And that\xe2\x80\x99s correct, though it\xe2\x80\x99s subject to one wrinkle having to do with insurance. Let\xe2\x80\x99s\nexamine the two possible circumstances: breach by seller and breach by buyer.\nFirst, suppose the seller breaches the contract by proffering nonconforming goods, and the\nbuyer rejects them\xe2\x80\x94never takes them at all. Then the goods are lost or damaged. Under Section 2-510(1)\nof the UCC, the loss falls on seller and remains there until seller cures the breach or until buyer accepts\ndespite the breach. Suppose Delta is obligated to deliver a gross of industrial No. 2 sponges; instead it\ntenders only one hundred cartons or delivers a gross of industrial No. 3 sponges. The risk of loss falls on\nDelta because Delta has not completed its obligation under the contract and Very Fast Foods doesn\xe2\x80\x99t have\npossession of the goods. Or suppose Delta has breached the contract by tendering to Very Fast Foods a\ndefective document of title. Delta cures the defect and gives the new document of title to Very Fast Foods,\nbut before it does so the sponges are stolen. Delta is responsible for the loss.\nNow suppose that a seller breaches the contract by proffering nonconforming goods and that the buyer,\nnot having discovered the nonconformity, accepts them\xe2\x80\x94the nonconforming goods are in the buyer\xe2\x80\x99s\nhands. The buyer has a right to revoke acceptance, but before the defective goods are returned to the\nseller, they are destroyed while in the buyer\xe2\x80\x99s possession. The seller breached, but here\xe2\x80\x99s the wrinkle: the\nUCC says that the seller bears the loss only to the extent of any deficiency in the buyer\xe2\x80\x99s insurance\ncoverage.\n\n[5]\n\nVery Fast Foods had taken delivery of the sponges and only a few days later discovered that\n\nthe sponges did not conform to the contract. Very Fast has the right to revoke and announces its intention\nto do so. A day later its warehouse burns down and the sponges are destroyed. It then discovers that its\ninsurance was not adequate to cover all the sponges. Who stands the loss? The seller does, again, to the\nextent of any deficiency in the buyer\xe2\x80\x99s insurance coverage.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n417\n\n\x0cSecond, what if the buyer breaches the contract? Here\xe2\x80\x99s the scenario: Suppose Very Fast Foods calls two\ndays before the sponges identified to the contract are to be delivered by Delta and says, \xe2\x80\x9cDon\xe2\x80\x99t bother; we\nno longer have a need for them.\xe2\x80\x9d Subsequently, while the lawyers are arguing, Delta\xe2\x80\x99s warehouse burns\ndown and the sponges are destroyed. Under the rules, risk of loss does not pass to the buyer until the\nseller has delivered, which has not occurred in this case. Nevertheless, responsibility for the loss here has\npassed to Very Fast Foods, to the extent that the seller\xe2\x80\x99s insurance does not cover it. Section 2-510(3) of\nthe UCC permits the seller to treat the risk of loss as resting on the buyer for a \xe2\x80\x9ccommercially reasonable\ntime\xe2\x80\x9d when the buyer repudiates the contract before risk of loss has passed to him. This transfer of the\nrisk can take place only when the goods are identified to the contract. The theory is that if the buyer had\ntaken the goods as per the contract, the goods would not have been in the warehouse and thus would not\nhave been burned up.\n\nInsurable Interest\nWhy It Matters\nWe noted at the start of this chapter that who has title is important for several reasons, one of which is\nbecause it affects who has an insurable interest. (You can\xe2\x80\x99t take out insurance in something you have no\ninterest in: if you have no title, you may not have an insurable interest.) And it was noted that the rules on\nrisk of loss are affected by insurance. (The theory is that a businessperson is likely to have insurance,\nwhich is a cost of business, and if she has insurance and also has possession of goods\xe2\x80\x94even\nnonconforming ones\xe2\x80\x94it is reasonable to charge her insurance with loss of the goods; thus she will have\ncause to take care of them in her possession, else her insurance rates increase.) So in commercial\ntransactions insurance is important, and when goods are lost or destroyed, the frequent argument is\nbetween the buyer\xe2\x80\x99s and the seller\xe2\x80\x99s insurance companies, neither of which wants to be responsible. They\nwant to deny that their insured had an insurable interest. Thus it becomes important who has an\ninsurable interest.\n\nInsurable Interest of the Buyer\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n418\n\n\x0cIt is not necessary for the buyer to go all the way to having title in order for him to have an insurable\ninterest. The buyer obtains a \xe2\x80\x9cspecial property and insurable interest in goods by identification of existing\ngoods as goods to which the contract refers.\xe2\x80\x9d\n\n[6]\n\nWe already discussed how \xe2\x80\x9cidentification\xe2\x80\x9d of the goods can\n\noccur. The parties can do it by branding, marking, tagging, or segregating them\xe2\x80\x94and they can do it at any\ntime. We also set out the rules for when goods will be considered identified to the contract under the UCC\nif the parties don\xe2\x80\x99t do it themselves (Section 9.1.2 "Goods Identified to the Contract").\n\nInsurable Interest of the Seller\nAs long as the seller retains title to or any security interest in the goods, he has an insurable interest.\n\nOther Rights of the Buyer\nThe buyer\xe2\x80\x99s \xe2\x80\x9cspecial property\xe2\x80\x9d interest that arises upon identification of goods gives the buyer rights other\nthan that to insure the goods. For example, under Section 2-502 of the UCC, the buyer who has paid for\nunshipped goods may take them from a seller who becomes insolvent within ten days after receipt of the\nwhole payment or the first installment payment. Similarly, a buyer who has not yet taken delivery may sue\na third party who has in some manner damaged the property.\n\nK E Y TA K EA WAY\nKnowing who has the risk of loss in a contract for the sale of goods is important for\nobvious reasons: it is not uncommon for goods to be lost or stolen between the\ntime they leave the seller\xe2\x80\x99s possession and before the buyer gets them. The\nparties are certainly free to agree on when the risk of loss shifts; if they do not, the\nUCC says it shifts when the seller has completed obligations under the contract.\nThus if there is no breach, the risk of loss shifts upon delivery. If there is a breach,\nthe UCC places the risk of loss on the breaching party, with this caveat: where the\nnonbreaching party is in control of the goods, the UCC places the risk of loss on\nthat party to the extent of her insurance coverage. So if there is a breach by the\nseller (delivery of nonconforming goods), the risk of loss never shifts except if the\nbuyer has taken possession of the nonconforming goods; in that case, the buyer\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n419\n\n\x0cdoes have the risk of loss insofar as her insurance covers the loss. If the buyer\nbreaches by repudiating before the risk of loss passes to him (by the goods\xe2\x80\x99\ndelivery), the UCC permits the seller to treat the risk of loss as resting on the buyer\nfor a commercially reasonable time as to goods identified to the contract.\nInsurable interest becomes important when goods suffer a casualty loss because\xe2\x80\x94\namong other reasons\xe2\x80\x94often neither the seller\xe2\x80\x99s nor the buyer\xe2\x80\x99s insurance\ncompany wants its insured to have an interest in the goods: each side denies it.\nThe seller retains an insurable interest if he has title to or any security interest in\nthe goods, and the buyer obtains an insurable interest by identification of existing\ngoods as goods to which the contract refers. A person has an insurable interest in\nany property owned or in the person\xe2\x80\x99s possession.\n\nE XE R C IS ES\n1. Which is more important in determining who has the risk of loss, the\nagreement of the parties or the UCC\xe2\x80\x99s default provisions?\n2. When does the risk of loss shift to the buyer if the parties have no agreement\non the issue?\n3. Why does the UCC impose the risk of loss to the extent of his insurance on a\nnonbreaching party if that party has control of the goods?\n4. Why can a person not take out insurance for goods in which the person has no\ninterest? How does a seller retain an insurable interest? When does the buyer\nget an insurable interest?\n[1] Uniform Commercial Code, Section 2-303.\n[2] Uniform Commercial Code, Section 2-327(1)(a).\n[3] Uniform Commercial Code, Section 2-326(3).\n[4] Uniform Commerical Code, Section 2-326.\n[5] Uniform Commercial Code, Section 2-510(2).\n[6] Uniform Commercial Code, Section 2-501(1).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n420\n\n\x0c9.4 Cases\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n421\n\n\x0cTransfer of Title: Destination Contracts\nSam and Mac, Inc. v. Treat\n\n783 N.E.2d 760 (Ind. App. 2003)\n\nAnthony L. Gruda and Sharon R. Gruda (the \xe2\x80\x9cGrudas\xe2\x80\x9d) owned and operated Gruda Enterprises, Inc.\n(Gruda Enterprises), which in turn operated The Kitchen Works, a kitchen supply business. On March 5,\n1998, Gruda Enterprises contracted to sell a set of kitchen cabinets to Sam and Mac, Inc. [SMI], a\ncommercial construction and contracting corporation. Gruda Enterprises was also to deliver and install\nthe cabinets. Because it did not have the cabinets in stock, Gruda Enterprises ordered them from a\nmanufacturer. On March 14, 1998, nine days after placing the order, SMI pre-paid Gruda Enterprises for\nthe cabinet order.\n\nOn May 14, 1998, prior to delivery and installation of the cabinets, the Grudas ceased operation of Gruda\nEnterprises and filed for personal bankruptcy. Gruda Enterprises did not file for bankruptcy and was not\ndissolved. Instead, the Grudas\xe2\x80\x99 stock in Gruda Enterprises became part of their bankruptcy estate.\xe2\x80\xa6When\nno cabinets were delivered or installed, and the Grudas ceased operation of Gruda Enterprises, SMI asked\nTreat, who was the landlord of Gruda Enterprises, to open the business premises and permit SMI to\nremove cabinets from the property. Treat declined, stating that he feared he would incur liability to Gruda\nEnterprises if he started giving away its inventory. Treat and other secured creditors sued Gruda\nEnterprises, which owed them money. [Summary judgment was for Treat, SMI appeals.]\n\nSMI contends that there was a completed sale between SMI, as the buyer, and Gruda Enterprises, as the\nseller. Specifically, SMI maintains that title to the cabinets under [UCC] 2-401(3)(b) passed to SMI when\nthe contract for sale was [made].\xe2\x80\xa6Therefore, SMI argues that the trial court improperly granted summary\njudgment in favor of Treat because [SMI] held title and, thus, a possessory interest in the cabinets.\xe2\x80\xa6\n[T]he contract is governed by the\xe2\x80\xa6Indiana Uniform Commercial Code (UCC). 2-401 establishes the point\nin time at which title passes from seller to buyer. Specifically, 2-401(2) provides, in pertinent part, that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n422\n\n\x0cunless explicitly agreed, title passes to the buyer at the time and place at which the seller completes his\nperformance with respect to the physical delivery of goods.\xe2\x80\xa6\n\nMoreover, the record indicates that SMI and Gruda Enterprises did not have an explicit agreement to pass\ntitle at any other time, or at any time prior to actual delivery of the cabinets. SMI argues that title passed\nto it under 2-401(3)(b) [\xe2\x80\x9cwhere delivery is to be made without moving the goods,\xe2\x80\xa6if the goods are at the\ntime of contacting already identified and no documents are to be delivered, title passes at the time and\nplace of contacting.\xe2\x80\x9d].\xe2\x80\xa6However, the record reflects that SMI admitted that the terms of the contract\nrequired Gruda Enterprises to not only order the cabinets, but to deliver and install them at the location\nspecified by SMI, i.e. the house that SMI was building. 2-403(3) applies to purchases of goods where\ndelivery is to be made without moving the goods. SMI argues that since the cabinets were identified at the\ntime of contracting and no documents needed delivery, title passed at the time and place of contracting.\xe2\x80\xa6\n\n[T]itle to goods cannot pass under a contract for sale prior to their identification in the contract. See 2401(1). This does not mean that title passes when the goods are identified. It only means that\nidentification is merely the earliest possible opportunity for title to pass.\xe2\x80\xa6[I]dentification does not, in and\nof itself, confer either ownership or possessory rights in the goods. [UCC] 2-401(2)(b) states that \xe2\x80\x9c[i]f the\ncontract requires delivery at destination, title passes on tender there.\xe2\x80\x9d In the present case, tender did not\noccur when Gruda Enterprises called SMI to notify it that the cabinets were in and ready to be delivered\nand installed. SMI requested that the cabinets remain at the warehouse until the house it was building\nwas ready for the cabinets to be installed.\xe2\x80\xa6[W]e find that SMI and Gruda Enterprises agreed to a\ndestination point, i.e. the house that SMI was building. Accordingly, we find that 2-401(2)(b) is also\napplicable. The title to the cabinets did not pass to SMI because the cabinets were not delivered and\ninstalled at the agreed upon destination. Therefore, we conclude that SMI does not have a possessory\ninterest in the cabinets.\n\nBased on the foregoing, we conclude that the trial court properly granted summary judgment in favor of\nTreat.\xe2\x80\xa6Affirmed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n423\n\n\x0cC A SE QU ES TIO NS\n1. One argument made by the plaintiff was that because the plaintiff had paid for the\ngoods and they had been identified to the contract, title passed to the plaintiff. Why\ndid the court disagree with this contention?\n2. When would title to the cabinets have shifted to the plaintiff?\n3. This is footnote 2 (it was not included in the parts of the case set out above):\n\xe2\x80\x9cWe note that Treat owned Kitchen Wholesalers, Inc., from approximately 1987\nto approximately June 20, 1996. On or about June 20, 1996, Kitchen\nWholesalers, Inc. sold its assets, inventory, equipment, and business to Gruda\nEnterprises. The Grudas executed an Agreement for Sale of Assets, Lease, and\nSecurity Agreement, as well as a Promissory Note in which they agreed to pay\n$45,000 for the assets, inventory, equipment, and business, and to pay monthly\nrent of $1,500 for the premises where the business was located, and secured\ntheir obligations with inventory, equipment, and proceeds therefrom, of the\nbusiness which they were purchasing. Treat filed and perfected a security\ninterest in the accounts receivable, inventory, and equipment of The Kitchen\nWorks on August 28, 1998. The Grudas currently owe Treat $61,794.99.\xe2\x80\x9d\nThis means that when the Grudas failed to pay Treat, he had a right to repossess\nall assets belonging to them, including the cabinets\xe2\x80\x94Treat was a creditor of the\nGrudas. SMI, of course, contended it had title to the cabinets. Based on the\ncourt\xe2\x80\x99s analysis, who is going to get the cabinets?\n\nDefrauding Buyer Sells to Good-Faith Purchaser for Value\nMarlow v. Conley\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n424\n\n\x0c787 N.E.2d 490, (Ind. App. 2003)\n\nDonald E. Marlow appeals the trial court\xe2\x80\x99s judgment in favor of Robert L. Medley and Linda L. Medley\n(collectively, the \xe2\x80\x9cMedleys\xe2\x80\x9d) on Marlow\xe2\x80\x99s complaint for replevin. Marlow raises [this issue],\xe2\x80\xa6whether the\nMedleys obtained good title to a truck pursuant to Indiana UCC 2-403(1). We affirm.\n\nThe relevant facts follow. On May 21, 2000, Robert Medley attended a car show in Indianapolis.\nHenderson Conley attended the same car show and was trying to sell a 1932 Ford Truck (\xe2\x80\x9cTruck\xe2\x80\x9d). Conley\ntold Robert that he operated a \xe2\x80\x9cbuy here, pay here car lot,\xe2\x80\x9d and Robert saw that the Truck had a dealer\nlicense plate. Robert purchased the Truck for $7,500.00 as a gift for Linda. Conley gave Robert the\nTruck\xe2\x80\x99s certificate of title, which listed the owner as Donald Marlow. When Robert questioned Conley\nabout the owner of the Truck, Conley responded that Marlow had signed the title as part of a deal Conley\nhad made with him. After purchasing the Truck, Robert applied to the Bureau of Motor Vehicles for a\ncertificate of title in Linda\xe2\x80\x99s name.\n\nOn December 18, 2000, Marlow filed a complaint against Conley and the Medleys.\xe2\x80\xa6At the bench trial,\nMarlow testified that he had met Conley at a car show in Indianapolis on May 19, 2000, and Conley had\ntold him that Conley owed a \xe2\x80\x9ccar lot\xe2\x80\x9d on the west side of Indianapolis. Marlow also testified that Conley\ncame to his house that night, but he \xe2\x80\x9cdidn\xe2\x80\x99t let him in.\xe2\x80\x9d Rather, Marlow testified that Conley \xe2\x80\x9c[came] over\n[his] fence\xe2\x80\xa6a big high fence.\xe2\x80\x9d According to Marlow, Conley asked him to invest in Conley\xe2\x80\x99s business that\nnight. Marlow gave Conley $500.00. Marlow testified that Conley came back the next day and Marlow\ngave him an additional $4,000.00. Marlow then testified that Conley stole the certificate of title for the\nTruck from Marlow\xe2\x80\x99s house and stole the Truck from his garage. According to Marlow, he told Conley\nlater in the day to bring his Truck back and Conley told him that it had caught on fire. Marlow testified\nthat he then called the police. However, in the May 30, 2000 police report, which was admitted into\nevidence at trial, the police officer noted the following:\nThe deal was [Conley] gets $4500.00, plus an orange \xe2\x80\xb232 Ford truck. In return, [Marlow] would get a \xe2\x80\xb294\nFord flatbed dump truck and an \xe2\x80\xb289 Ford Bronco. [Marlow] stated that he has not received the vehicles\nand that [Conley] keeps delaying getting the vehicles for him. [Conley] gave [Marlow] several titles of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n425\n\n\x0cvehicles which are believed to be junk. [Conley] told [Marlow] that he has a car lot at 16th and Lafayette\nRoad.\n\n[The trial court determined that Marlow bought the truck from Conley, paying Conley $4500 plus a Ford\nflatbed truck and Ford Bronco.]\n\xe2\x80\xa6\n\nThe issue is whether the Medleys obtained good title to the Truck pursuant to Indiana UCC 2-403(1)\n[voidable title passed on to good-faith purchaser]. We first note that UCC 2-401(2) provides that \xe2\x80\x9c[u]nless\notherwise explicitly agreed, title passes to the buyer at the time and place at which the seller completes his\nperformance with reference to the physical delivery of the goods.\xe2\x80\xa6\xe2\x80\x9d Further, 2-403(1) provides as follows:\n\xe2\x80\x9cA purchaser of goods acquires all title which his transferor had or had power to transfer.\xe2\x80\xa6A person with\nvoidable title has power to transfer a good title to a good faith purchaser for value. When goods have been\ndelivered under a transaction of purchase, the purchaser has such power even though:\xe2\x80\xa6(d) the delivery\nwas procured through fraud punishable as theft under the criminal law.\xe2\x80\x9d\n\nThus, Conley, as purchaser of the goods, acquired all title to the Truck that Marlow, as transferor, had or\nhad power to transfer. Additionally, even if Conley had \xe2\x80\x9cvoidable title,\xe2\x80\x9d he had the power to transfer good\ntitle to the Medleys if they were \xe2\x80\x9cgood faith purchasers for value.\xe2\x80\x9d Consequently, we must determine\nwhether Conley had voidable title and, if so, whether the Medleys were good faith purchasers for value.\n\nA. Voidable Title\nWe first determine whether Conley had voidable title to the Truck.\xe2\x80\xa6[T]he UCC does not define \xe2\x80\x9cvoidable\ntitle.\xe2\x80\x9d However, we have held that Indiana\xe2\x80\x99s UCC 2-403 is consistent with Indiana\xe2\x80\x99s common law, which\nprovided that \xe2\x80\x9clegal title passes to a defrauding buyer. This title is not void; it is voidable, which means\nthat when title gets into the hands of a bona fide purchaser for value then he will prevail over the\ndefrauded seller.\xe2\x80\x9d [Citation] Thus, a \xe2\x80\x9cdefrauding buyer\xe2\x80\x9d obtains voidable title. However, a thief obtains\nvoid title. See, e.g., [Citation] holding that a renter who stole a motor home had void title, not voidable\ntitle, and could not convey good title).\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n426\n\n\x0cHere, Marlow argues that Conley stole the Truck and forged his name on the certificate of title. However,\nthe trial court was presented with conflicting evidence regarding whether Conley stole the Truck and the\ncertificate of title or whether Conley and Marlow had a business deal and Conley failed to comply with the\nagreement. The trial court found that:\n\nEvidence presented concerning [Marlow\xe2\x80\x99s] complaint to the Indianapolis Police Department on May 30,\n2000 casts doubt on the credibility of [Marlow\xe2\x80\x99s] trial testimony as the report states the truck and title\nwere obtained by Conley in exchange for a 1994 Ford Flatbed Dump Truck and a 1989 Ford Bronco plus\nthe payment of $4500.00 by [Marlow]. Apparently, [Marlow] was complaining to the police concerning\nConley\xe2\x80\x99s failure to deliver the two Ford vehicles.\n\n\xe2\x80\xa6The trial court did not find Marlow\xe2\x80\x99s testimony regarding the theft of the Truck and the certificate of\ntitle to be credible.\xe2\x80\xa6[B]ased upon the trial court\xe2\x80\x99s findings of fact, we must assume that the police report\naccurately describes the circumstances under which Conley obtained possession of the Truck and its\nsigned certificate of title. Consequently, we assume that Marlow gave Conley $4,500.00 and the Truck in\nexchange for two other vehicles. Although Conley gave Marlow the certificates of title for the two vehicles,\nhe never delivered the vehicles.\n\nConley\xe2\x80\x99s title is voidable if \xe2\x80\x9cthe delivery was procured through fraud punishable as theft under the\ncriminal law\xe2\x80\x9d under 2-403(1)(d).\xe2\x80\xa6Assuming that Conley knew that he would not deliver the two vehicles\nto Marlow, the delivery of the Truck to Conley was procured through fraud punishable as theft.\nConsequently, Marlow was defrauded, and Conley obtained voidable title to the Truck.\xe2\x80\xa6\n\nB. Good Faith Purchasers for Value\nHaving determined that Conley obtained voidable title to the Truck, we must now determine whether the\nMedleys were good faith purchasers for value. Marlow does not dispute that the Medleys were purchasers\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n427\n\n\x0cfor value. Rather, Marlow questions their \xe2\x80\x9cgood faith\xe2\x80\x9d because they purchased the Truck from someone\nother than the person listed on the Truck\xe2\x80\x99s certificate of title. [UCC 1-201919] defines good faith as\n\xe2\x80\x9chonesty in fact in the conduct or transaction concerned.\xe2\x80\x9d Marlow argues that Robert did not purchase the\nTruck in good faith because, although Robert purchased the vehicle from Conley, he was aware that the\ncertificate of title was signed by Marlow.\n\n\xe2\x80\xa6Here, the sole evidence presented by Marlow regarding the Medleys\xe2\x80\x99 lack of good faith is the fact that\nthe certificate of title provided by Conley was signed by Marlow. Robert testified that he thought Conley\nwas a licensed dealer and operated a \xe2\x80\x9cbuy here, pay here\xe2\x80\x9d car lot. The Truck had a dealer license plate.\nRobert questioned Conley about the certificate of title. Conley explained that Marlow had signed the title\nas part of a deal Conley had made with him. Robert also testified that he had previously purchased\nvehicles at car shows and had previously purchased a vehicle from a dealer where the certificate of title\nhad the previous owner\xe2\x80\x99s name on it.\xe2\x80\xa6\n\nThe Medleys\xe2\x80\x99 failure to demand a certificate of title complying with [the Indiana licensing statute] does\nnot affect their status as good faith purchasers in this case.\xe2\x80\xa6The statute does not void transactions that\nviolate the statute. [Citations] Although the failure to comply with [the licensing statute] may, combined\nwith other suspicious circumstances, raise questions about a purchaser\xe2\x80\x99s good faith, we find no such\ncircumstances here. Consequently, the Medleys were good faith purchasers for value.\xe2\x80\xa6\n\nLastly, Marlow also argues that the Medleys violated [licensing statutes] by providing false information to\nthe Bureau of Motor Vehicles because the Medleys allegedly listed the seller of the Truck as Marlow rather\nthan Conley. We noted above that legal title to a vehicle is governed by the sales provisions of the UCC\nrather than the Indiana Certificate of Title Act. Thus, although false statements to the Bureau of Motor\nVehicles under Ind.Code \xc2\xa7 9-18-2-2 could result in prosecution for perjury, such false statements do not\naffect legal title to the vehicle.\nIn summary, we conclude that, as a defrauding buyer, Conley possessed voidable title and transferred\ngood title to the Medleys as good faith purchasers for value.\xe2\x80\xa6Thus, legal title to the Truck passed to the\nMedleys at the time Conley delivered the Truck to them. See UCC 2-401(2) (\xe2\x80\x9c[T]itle passes to the buyer at\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n428\n\n\x0cthe time and place at which the seller completes his performance with reference to the physical delivery of\nthe goods.\xe2\x80\xa6\xe2\x80\x9d). This result is consistent with the policy behind 2-403.\n\nSection 2-403 was intended to determine the priorities between the two innocent parties: (1) the original\nowner who parts with his goods through fraudulent conduct of another and (2) an innocent third party\nwho gives value for the goods to the perpetrator of the fraud without knowledge of the fraud. By favoring\nthe innocent third party, the Uniform Commercial Code endeavors to promote the flow of commerce by\nplacing the burden of ascertaining and preventing fraudulent transactions on the one in the best position\nto prevent them, the original seller. The policy behind the UCC is to favor the Medleys because, as\nbetween the Medleys and Marlow, Marlow was in the best position to prevent the fraudulent transaction.\n\nFor the foregoing reasons, we affirm the trial court\xe2\x80\x99s judgment for the Medleys. Affirmed.\n\nC A SE QU ES TIO NS\n1. The court determined Marlow was defrauded by Conley. How did Conley defraud\nMarlow?\n2. What is the rationale, here expressed, for the UCC\xe2\x80\x99s provision that a defrauding\npurchaser (Conley) can pass on title to a good-faith purchaser for value?\n3. Why did Marlow think the Medleys should not be considered good-faith\npurchasers?\n4. Why would the UCC prevail over the state\xe2\x80\x99s certificate of title act?\n\nRisk of Loss, Seller a Merchant\nRamos v. Wheel Sports Center\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n429\n\n\x0c409 N.Y.S.2d 505 (N.Y. Civ. Ct. 1978)\n\nMercorella, J.\n\nIn this non-jury action plaintiff/purchaser is seeking to recover from defendant/vendor the sum of $893\n[about $3,200 in 2010 dollars] representing the payment made by plaintiff for a motorcycle.\n\nThe parties entered into a sales contract wherein defendant agreed to deliver a motorcycle to plaintiff by\nJune 30, 1978, for the agreed price of $893. The motorcycle was subsequently stolen by looters during the\ninfamous power blackout of July 11, 1977.\n\nIt is uncontroverted that plaintiff paid for the motorcycle in full; was given the papers necessary for\nregistration and insurance and did in fact register the cycle and secure liability insurance prior to the loss\nalthough license plates were never affixed to the vehicle. It is also conceded that the loss occurred without\nany negligence on defendant\xe2\x80\x99s part.\n\nPlaintiff testified that defendant\xe2\x80\x99s salesman was informed that plaintiff was leaving on vacation and\nplaintiff would come for the cycle when he returned. He further testified that he never saw or rode the\nvehicle. From the evidence adduced at trial it is apparent that plaintiff never exercised dominion or\ncontrol over the vehicle.\n\nDefendant\xe2\x80\x99s president testified that he had no knowledge of what transpired between his salesman and\nplaintiff nor why the cycle was not taken prior to its loss.\n\nThe sole issue presented to the Court is which party, under the facts disclosed, bears the risk of loss?\nIt is the opinion of this Court that defendant must bear the risk of loss under the provisions of Section 2509(3) of the Uniform Commercial Code.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n430\n\n\x0cThis section provides that \xe2\x80\x9c\xe2\x80\xa6the risk of loss passes to the buyer on his receipt of the goods if the seller is a\nmerchant.\xe2\x80\xa6\xe2\x80\x9d Section 2-103(1)(c) states that receipt of goods means taking physical possession of them.\n[Authors\xe2\x80\x99 note: UCC revisions have changed the rule so that risk of loss passes to the buyer on his receipt\nof the goods irrespective of whether the seller is a merchant or not. It is still 2-509(3), however.]\n\nThe provision tends more strongly to hold risk of loss on the seller than did the former Uniform Sales Act.\nWhether the contract involves delivery at the seller\xe2\x80\x99s place of business or at the situs of the goods, a\nmerchant seller cannot transfer risk of loss and it remains on him until actual receipt by the buyer, even\nthough full payment has been made and the buyer notified that the goods are at his disposal. The\nunderlying theory is that a merchant who is to make physical delivery at his own place continues\nmeanwhile to control the goods and can be expected to insure his interest in them.\n\nThe Court is also of the opinion that no bailee/bailor relationship, constructive or otherwise, existed\nbetween the parties.\n\nAccordingly, let judgment be entered in favor of plaintiff for the sum of $893, together with interest, costs\nand disbursements.\n\nC A SE QU ES TIO NS\n1. What caused the loss here, through no fault of either party?\n2. What is the rationale for holding the merchant-seller liable in this circumstance?\n3. Suppose instead that Ramos had purchased the motorcycle at a garage sale from an\nacquaintance and the same loss occurred. Who would bear the risk then?\n\n9.5 Summary and Exercises\nSummary\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n431\n\n\x0cTwo significant questions lurk in the background of any sale: (1) when does title pass? and (2) who must\nbear the risk of loss if the goods are destroyed or damaged through no fault of either party?\n\nIn general, title passes when the buyer and the seller agree that it passes. If the buyer and the seller fail to\nspecify the time at which title passes, Article 2 lays down four rules: (1) under a shipment contract, title\npasses when the seller places the goods with the carrier; (2) under a destination contract, title passes\nwhen the goods are tendered at the place of delivery; (3) under a contract calling for delivery of\ndocuments of title, title passes when the seller tenders documents of title, even if the goods are not\nphysically moved; and (4) when no physical delivery or exchange of documents is called for, title passes\nwhen the contract is signed.\n\nThe buyer and the seller may also specify who must bear the risk of loss. But if they do not, Article 2 sets\nout these four rules: (1) when the seller must ship by carrier but not to any particular destination, risk\npasses to the buyer when the seller delivers the goods to the carrier; (2) when the goods must be\ntransported to a particular destination, risk passes when the carrier tenders them at that destination; (3)\nif the goods are held by a bailee who has issued a negotiable document of title, risk passes when the buyer\nreceives the document; (4) in other cases, risk of loss turns on whether the seller is a merchant. If he is a\nmerchant, risk passes when the buyer receives the goods; if he is not a merchant, risk passes when the\nseller tenders the goods. These rules are modified when either of the parties breaches the contract. In\ngeneral, unless the breach is cured, the risk of uninsured losses lies on the party who breached.\n\nEither party may insure the goods if it has an insurable interest in them. The buyer has an insurable\ninterest in goods identified to the contract\xe2\x80\x94for example, by marking them in some manner. The seller has\nan insurable interest as long as he retains title or a security interest.\n\nIn fixing passage of title and risk of loss, the parties often use shorthand terminology whose meaning\nmust be mastered to make sense of the contract. These terms include F.O.B.; F.A.S.; ex-ship; C.I.F.; C.F.;\nno arrival, no sale; sale on approval; and sale or return. Use of these terms in a contract can have a\nsignificant effect on title and risk of loss.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n432\n\n\x0cSometimes goods are sold by nonowners. A person with voidable title has the power to transfer title to a\ngood-faith purchaser for value. A merchant who deals in particular goods has the power to transfer all\nrights of one who entrusts to him goods of the kind. And a rightful owner may be estopped by his own acts\nfrom asserting title against an innocent purchaser.\n\nE XE R C IS ES\n1. Betty from Baltimore contracts to purchase one hundred purple llama\nfigurines from Sam of Syracuse. Sam is to send the goods by carrier and is not\nrequired to deliver them to Betty\xe2\x80\x99s Boutique, their destination. He ships them\nby train, which unfortunately crashes in Delaware. All the figurines are\ndestroyed. Whose loss is it? Why?\n2. In Exercise 1, assume that the train did not crash but that Sam\xe2\x80\x99s creditors\nattempted to seize the goods before their arrival. May the creditors do so?\nWhy?\n3. Hattie\xe2\x80\x99s Head Shop signed a written agreement with the Tangerine Computer\nCompany to supply a Marilyn, a supercomputer with bubble memory, to total\nup its orders and pay its foreign agents. The contract provided that the\ncomputer was to be specially built and that Tangerine would deliver it by\ncarrier to Hattie\xe2\x80\x99s ready to install no later than June 1. Tangerine engineers\nworked feverishly to comply with the contract terms. On May 25, the\ncomputer stood gleaming in Tangerine\xe2\x80\x99s shipping department. That night,\nbefore the trucks could depart, a tornado struck the factory and destroyed the\ncomputer intended for Hattie\xe2\x80\x99s. Whose loss is it? Why?\n4. In Exercise 3, assume that the tornado did not strike but that Tangerine\xe2\x80\x99s\ncreditors attempted to seize the computer. May they? Why?\n5. On February 18, Clancy, who was in debt, took his stereo to Lucy\xe2\x80\x99s repair\nshop. Because Lucy and Clancy were old friends, Lucy didn\xe2\x80\x99t give him a receipt.\nOn February 19, hounded by creditors, Clancy sold the stereo on credit to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n433\n\n\x0cGrover, who was to pick it up on February 21 at Lucy\xe2\x80\x99s, pay Lucy the repair bill,\nand pay the balance of the purchase price to Clancy. Who is entitled to the\nradio if, on February 20, Clancy\xe2\x80\x99s creditor appears with the sheriff to seize the\nstereo from Lucy? Why?\n6. Assume in Exercise 5 that, instead of the attempted seizure of the stereo by\nthe creditor, Lucy\xe2\x80\x99s shop and the stereo are destroyed by fire on February 20.\nMust Grover still pay Clancy for the stereo? Why?\n7. Cleo\xe2\x80\x99s Close-Outs, a wholesaler of discounted merchandise, offered Randy\xe2\x80\x99s\nRetailers a chance to buy all the contents of a shipment of bathtub toys just\nreceived. Cleo estimated that she had between five hundred and six hundred\nrubber ducks and wrote on October 21 offering them to Randy for only one\ndollar each if Randy would pick them up at Cleo\xe2\x80\x99s. Randy received the letter in\nthe mail the next day and mailed his acceptance immediately. In the wee\nhours of the following morning, October 23, a fire consumed Cleo\xe2\x80\x99s\nwarehouse, melting the ducks into an uneven soup. Assuming that Cleo was a\nmerchant, who bears the loss? Why?\n8. Plaintiff, a manufacturer of men\xe2\x80\x99s clothing in Los Angeles, contracted to sell a\nvariety of clothing items to Defendant, Harrison\xe2\x80\x99s clothing store in Westport,\nConnecticut, \xe2\x80\x9cF.O.B. Los Angeles.\xe2\x80\x9d Plaintiff delivered the goods to Trucking\nCompany and received a bill of lading. When the goods arrived at Defendant\xe2\x80\x99s\nstore about two weeks later, Mrs. Harrison, Defendant\xe2\x80\x99s wife, who was in\ncharge of the store at the time, requested the truck driver to deliver the goods\ninside the door of the shop. The driver refused and ultimately drove away. The\ngoods were lost. Defendant refused to pay for the goods and raised as a\ndefense that \xe2\x80\x9cthe Plaintiff refused to deliver the merchandise into the\nDefendant\xe2\x80\x99s place of business.\xe2\x80\x9d Who wins and why? [1]\n9. Jackson owned a number of guns and asked his friend Willard, who ran a\ncountry store, if Willard would let Jackson display the guns in the store for sale\non consignment. Willard would get some compensation for his trouble.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n434\n\n\x0cWillard agreed. Subsequently Willard\xe2\x80\x99s creditors seized assets of the store,\nincluding the guns. Jackson protested that they were his guns, not Willard\xe2\x80\x99s,\nand that the latter\xe2\x80\x99s creditors should keep their hands off them. Given no\nother facts, who wins?\n10. Plaintiff advertised his car for sale. Roberts stopped by to look at it. He took it\nfor a short test drive, returned to Plaintiff\xe2\x80\x99s house, and said, \xe2\x80\x9cI like it, but my\nwife needs to look at it before I buy it. I\xe2\x80\x99ll be back in less than half an hour.\xe2\x80\x9d\nRoberts took the car and never returned. Plaintiff called the police, who later\nfound the car in a neighboring state. Defendant had bought it from Roberts,\nwho had presented him with forged registration papers. Plaintiff then sued\nDefendant to get the car back. Who wins?\n\nS EL F -T E ST QU EST IO N S\n1. In a sale-on-approval contract\na. the goods are intended primarily for the buyer\xe2\x80\x99s use\nb. the goods are intended primarily for resale\nc. the risk of loss is on the buyer\nd. the buyer obtains title upon receipt of the goods\nAs a general rule\na. goods cannot be sold by persons with voidable title\nb. a rightful owner cannot be estopped from asserting title against an\ninnocent purchaser\nc. a merchant cannot transfer the rights of a person who entrusts\ngoods to him\nd. a person with voidable title has the power to transfer title to a\ngood-faith purchaser for value\nIn general, title passes\na. to a buyer when the contract is signed\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n435\n\n\x0cb. when the buyer and the seller agree that it passes\nc. to a buyer when the seller receives payment for goods\nd. under none of the above conditions\nWhen a destination contract does not specify when title is to pass, it\npasses\na. when the goods are shipped\nb. when the contract is signed\nc. when the buyer pays for the goods\nd. when the seller tenders delivery\nIn a C.I.F. contract\na. the seller must obtain insurance\nb. the buyer must obtain insurance\nc. the seller has fewer duties than with a C.F. contract\nd. title passes to the buyer when the seller tenders delivery\n\nS EL F -T E ST A NSW E R S\n1. a\n2. d\n3. b\n4. d\n5. a\n[1] Ninth Street East, Ltd. v. Harrison, 259 A.2d 772 (Conn. 1968).\n\nChapter 10\nPerformance and Remedies\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n436\n\n\x0cL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. What performance is expected of the seller in a sales contract\n2. What performance is expected of the buyer in a sales contract\n3. What rights and duties the buyer has if there is a nonconforming delivery\n4. How, in general, the UCC approaches remedies\n5. What the seller\xe2\x80\x99s remedies are for breach by the buyer\n6. What the buyer\xe2\x80\x99s remedies are for breach by the seller\n7. What excuses the UCC provides for nonperformance\n\nIn Part II, we examined contract performance and remedies under common law. In this chapter, we\nexamine performance and remedies under Article 2, the law of sales, of the Uniform Commercial Code\n(UCC). In the next chapter, we cover special remedies for those damaged or injured by defective products.\nThe parties often set out in their contracts the details of performance. These include price terms and\nterms of delivery\xe2\x80\x94where the goods are to be delivered, when, and how. If the parties fail to list these\nterms, the rules studied in this chapter will determine the parties\xe2\x80\x99 obligations: the parties may agree; if\nthey do not, the UCC rules kick in as the default. In any event, the parties have an obligation to act in good\nfaith.\n\n10.1 Performance by the Seller\nL EA R N IN G O B JEC T IV E\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n437\n\n\x0c1. Understand what is meant when it is said the seller has a duty to \xe2\x80\x9cmake a\ntimely delivery of conforming goods.\xe2\x80\x9d\n\nThe Seller\xe2\x80\x99s Duty in General\nThe general duty of the seller is this: to make a timely delivery of conforming goods.\n\n[1]\n\nThe CISG, Article 30, says, \xe2\x80\x9cThe seller must deliver the goods, hand over any documents\nrelating to them and transfer the property in the goods, as required by the contract and\nthis Convention.\xe2\x80\x9d\n\nAnalysis of the Seller\xe2\x80\x99s Duty\nTiming\nBy agreement or stipulation, the parties may fix the time when delivery is to be made by including\nstatements in contracts such as \xe2\x80\x9cDelivery is due on or before July 8\xe2\x80\x9d or \xe2\x80\x9cThe first of 12 installments is due\non or before July 8.\xe2\x80\x9d Both statements are clear.\n\nIf the parties do not stipulate in their contract when delivery is to occur, the UCC fills the gap. Section 2309 of the UCC says, \xe2\x80\x9cThe time for shipment or any other action under a contract if not provided for in\nthis Article or agreed upon shall be a reasonable time.\xe2\x80\x9d And what is a \xe2\x80\x9creasonable time\xe2\x80\x9d is addressed by\ncomment 1 to this section:\n\nIt thus turns on the criteria as to \xe2\x80\x9creasonable time\xe2\x80\x9d and on good faith and commercial standards set forth\nin Sections 1-202, 1-203 and 2-103. It\xe2\x80\xa6depends on what constitutes acceptable commercial conduct in\nview of the nature, purposes and circumstances of the action to be taken.\n\nThe CISG (Article 33) provides as follows:\n\nThe seller must deliver the goods\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n438\n\n\x0c(a) if a date is fixed by or determinable from the contract, on that date;\n\n(b) if a period of time is fixed by or determinable from the contract, at any time within that\nperiod unless circumstances indicate that the buyer is to choose a date; or\n\n(c) in any other case, within a reasonable time after the conclusion of the contract.\n\nDelivery\nThe parties may agree as to how delivery shall be accomplished; if they do not, the UCC fills the gap.\n\nThe CISG (Article 31) says this:\n\nIf the seller is not bound to deliver the goods at any other particular place, his obligation to\ndeliver consists\n\n(a) if the contract of sale involves carriage of the goods\xe2\x80\x94in handing the goods over to the\nfirst carrier for transmission to the buyer;\n\n(b) if, in cases not within the preceding subparagraph\xe2\x80\xa6in placing the goods at the buyer\xe2\x80\x99s\ndisposal at that place [where the goods are];\n\n(c) in other cases\xe2\x80\x94in placing the goods at the buyer\xe2\x80\x99s disposal at the place where the seller\nhad his place of business at the time of the conclusion of the contract.\n\nBy Agreement\nThe parties may use any language they want to agree on delivery terms.\n\nIf There Is No Agreement\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n439\n\n\x0cIf the parties do not stipulate delivery terms or if their agreement is incomplete or merely formulaic, the\nUCC describes the seller\xe2\x80\x99s obligations or gives meaning to the formulaic language. (Because form\ncontracts are prevalent, formulaic language is customary.) You recall the discussion in Chapter 9 "Title\nand Risk of Loss" about when title shifts: we said title shifts when the seller has completed delivery\nobligations under the contract, and we ran through how those obligations are usually expressed. A quick\nreview here is appropriate.\n\nThe contract may be either a shipment contract, a destination contract, or a contract where the goods are\nnot to be moved (being held by a bailee). In any case, unless otherwise agreed, the delivery must be at a\nreasonable time and the tender (the offer to make delivery) must be kept open for a reasonable time; the\nbuyer must furnish facilities \xe2\x80\x9creasonably suited to the receipt of the goods.\xe2\x80\x9d\n\n[2]\n\nIn a shipment contract, the seller has four duties: (1) to deliver the goods to a carrier; (2) to deliver the\ngoods with a reasonable contract for their transportation; (3) to deliver them with proper documentation\nfor the buyer; and (4) to promptly notify the buyer of the shipment (UCC, Section 2-504). The contract\nmay set out the seller\xe2\x80\x99s duties using customary abbreviations, and the UCC interprets those: \xe2\x80\x9cF.O.B [insert\nplace where goods are to be shipped from]\xe2\x80\x9d means \xe2\x80\x9cfree on board\xe2\x80\x9d\xe2\x80\x94the seller must see to it that the goods\nare loaded on the vehicle of conveyance at the place of shipment. \xe2\x80\x9cF.A.S. [port of shipment inserted here]\xe2\x80\x9d\nmeans the seller must see to it that the goods are placed along the ship on the dock ready to be loaded\n(Section 2-319). Price terms include \xe2\x80\x9cC.I.F.,\xe2\x80\x9d which means the sale price includes the cost of the goods,\ninsurance, and freight charges, and \xe2\x80\x9cC. & F.,\xe2\x80\x9d which means the sales price includes the cost of the goods at\na cheaper unit price and freight but not insurance.\n\n[3]\n\nIf it is clear from the contract that the seller is\n\nsupposed to ship the goods (i.e., the buyer is not going to the seller\xe2\x80\x99s place to get them) but not clear\nwhether it is a shipment or a destination contract, the UCC presumes it is a shipment contract.\n\n[4]\n\nIf it is a destination contract, the seller has two duties: to get the goods to the destination at the buyer\xe2\x80\x99s\ndisposal and to provide appropriate documents of delivery.\n\n[5]\n\nThe contract language could be \xe2\x80\x9cF.O.B.\n\n[place of destination inserted here],\xe2\x80\x9d which obligates the seller to deliver to that specific location; \xe2\x80\x9cexship,\xe2\x80\x9d which obligates the seller to unload the goods from the vehicle of transportation at the agreed\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n440\n\n\x0clocation (e.g., load the goods onto the dock); or it could be \xe2\x80\x9cno arrival, no sale,\xe2\x80\x9d where the seller is not\nliable for failure of the goods to arrive, unless she caused it.\n\n[6]\n\nIf the goods are in the possession of a bailee and are not to be moved\xe2\x80\x94and the parties don\xe2\x80\x99t stipulate\notherwise\xe2\x80\x94the UCC, Section 2-503 says delivery is accomplished when the seller gives the buyer a\nnegotiable document of title, or if none, when the bailee acknowledges the buyer\xe2\x80\x99s right to take the goods.\n\nIf nothing at all is said about delivery, the place for delivery is the seller\xe2\x80\x99s place of business or his\n[7]\n\nresidence if he has no place of business.\n\nConforming Goods\nAs always, the parties may put into the contract whatever they want about the goods as delivered. If they\ndon\xe2\x80\x99t, the UCC fills the gaps.\n\nBy Agreement\nThe parties may agree on what \xe2\x80\x9cconforming goods\xe2\x80\x9d means. An order will specify \xe2\x80\x9clarge grade A eggs,\xe2\x80\x9d and\nthat means something in the trade. Or an order might specify \xe2\x80\x9c20 gross 100-count boxes No. 8 \xc3\x97 3/8 \xc3\x97 32\nPhillips flathead machine screws.\xe2\x80\x9d That is a screw with a designated diameter, length, number of threads\nper inch, and with a unique, cruciform head insert to take a particular kind of driver. The buyer might, for\nexample, agree to purchase \xe2\x80\x9cseconds,\xe2\x80\x9d which are goods with some flaw, such as clothes with seams not\nsewed quite straight or foodstuffs past their pull date. The parties may also agree in the contract what\nhappens if nonconforming goods are delivered, as we\xe2\x80\x99ll see later in this chapter.\n\nIf There Is No Agreement\nIf nothing is said in the contract about what quality of goods conform to the contract, then the UCC\ndefault rule kicks in. The seller is to make a perfect tender: what is delivered must in every respect\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n441\n\n\x0cconform to the contract.\n\n[8]\n\nAnd if what is delivered doesn\xe2\x80\x99t conform to the contract, the buyer is not\n\nobligated to accept the goods.\n\nThe CISG has no perfect tender rule. Article 46 provides this:\n\nIf the goods do not conform with the contract, the buyer may require delivery of substitute\ngoods only if the lack of conformity constitutes a fundamental breach of contract and a\nrequest for substitute goods is made either in conjunction with notice given under article\n39 or within a reasonable time thereafter. If the goods do not conform with the contract,\nthe buyer may require the seller to remedy the lack of conformity by repair, unless this is\nunreasonable having regard to all the circumstances. A request for repair must be made\neither in conjunction with notice given under article 39 or within a reasonable time\nthereafter.\n\nInstallment Contracts\nUnless otherwise agreed, all goods should be delivered at one time, and no payment is due until tender.\nBut where circumstances permit either party to make or demand delivery in lots, Section 2-307 of the\nUCC permits the seller to demand payment for each lot if it is feasible to apportion the price. What if the\ncontract calls for delivery in installment, and one installment is defective\xe2\x80\x94is that a material breach of the\nwhole contract? No. Section 2-612 of the UCC says this:\n\n(2) The buyer may reject any installment which is non-conforming if the non-conformity substantially\nimpairs the value of that installment and cannot be cured or if the non-conformity is a defect in the\nrequired documents; but if the non-conformity does not fall within subsection (3) and the seller gives\nadequate assurance of its cure the buyer must accept that installment.\n(3) Whenever non-conformity or default with respect to one or more installments substantially impairs\nthe value of the whole contract there is a breach of the whole.\n\nCure for Improper Delivery\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n442\n\n\x0cFailure to make a perfect tender, unless otherwise agreed, is a material breach of the sales contract.\nHowever, before the defaulting seller is in complete default, she has a right to cure. Here\xe2\x80\x99s what the UCC\nsays in Section 2-508:\n\n(1) Where any tender or delivery by the seller is rejected because non-conforming and the time for\nperformance has not yet expired, the seller may seasonably notify the buyer of his intention to cure and\nmay then within the contract time make a conforming delivery.\n\n(2) Where the buyer rejects a non-conforming tender which the seller had reasonable grounds to believe\nwould be acceptable with or without money allowance the seller may if he seasonably notifies the buyer\nhave a further reasonable time to substitute a conforming tender.\n\nBuyer orders Santa Claus candles deliverable November 5; on October 25 the goods are delivered, but\nthey\xe2\x80\x99re not right: they\xe2\x80\x99re Christmasangel candles instead. But the seller still has eleven days to cure, and\nthe buyer must allow that. Buyer places an order exactly the same as the first order, and the order arrives\non November 5 in the original manufacturer\xe2\x80\x99s packaging, but they\xe2\x80\x99re not right. \xe2\x80\x9cWell,\xe2\x80\x9d says the seller, \xe2\x80\x9cI\nthought they\xe2\x80\x99d be OK right out of the package. I\xe2\x80\x99ll get the correct ones to you right away.\xe2\x80\x9d And the buyer\nwould have a duty to allow that, if \xe2\x80\x9cright away\xe2\x80\x9d is a \xe2\x80\x9cfurther reasonable time.\xe2\x80\x9d\n\nArticle 48 of the CISG says this:\nThe seller may, even after the date for delivery, remedy at his own expense any failure to\nperform his obligations, if he can do so without unreasonable delay and without causing\nthe buyer unreasonable inconvenience or uncertainty of reimbursement by the seller of\nexpenses advanced by the buyer. However, the buyer retains any right to claim damages as\nprovided for in this Convention. If the seller requests the buyer to make known whether he\nwill accept performance and the buyer does not comply with the request within a\nreasonable time, the seller may perform within the time indicated in his request. The buyer\nmay not, during that period of time, resort to any remedy which is inconsistent with\nperformance by the seller.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n443\n\n\x0cSo, again, the seller\xe2\x80\x99s duty is to make a timely delivery of conforming goods. Let\xe2\x80\x99s take a look now at the\nbuyer\xe2\x80\x99s duties.\n\nK E Y TA K EA WAY\nThe seller\xe2\x80\x99s obligation under the UCC is to make a timely delivery of conforming\ngoods. For each element of the duty\xe2\x80\x94timely, delivery, conforming goods\xe2\x80\x94the\nparties may agree in their contract. If they do not, the UCC fills in default rules.\n\nE XE R C IS ES\n1. If the parties do not specify a time for delivery, what is the UCC\xe2\x80\x99s default\nposition?\n2. What are the seller\xe2\x80\x99s obligations in an F.O.B. shipment contract? In an F.O.B.\ndestination contract?\n3. Compare the UCC\xe2\x80\x99s perfect tender rule to the common-law substantial\nperformance doctrine.\n[1] Uniform Commercial Code, Sections 2-301and 2-309.\n[2] Uniform Commercial Code, Section 2-503.\n[3] Uniform Commercial Code, Section 2-320.\n[4] Uniform Commercial Code, Section 2-503(5).\n[5] Uniform Commercial Code, Section 2-503.\n[6] Uniform Commercial Code, Sections 2-319, 2-322, and 2-324.\n[7] Uniform Commercial Code, Section 2-308.\n[8] Uniform Commercial Code, Section 2-601.\n\n10.2 Performance by Buyer\nL EA R N IN G O B JEC T IV ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n444\n\n\x0c1. Understand what the general duties of the buyer are.\n2. Recognize what rights the buyer has if the seller tenders a nonconforming\ndelivery.\n\nGeneral Duties of Buyer\nThe general duty of the buyer is this: inspection, acceptance, and payment.\n\n[1]\n\nBut the buyer\xe2\x80\x99s duty does\n\nnot arise unless the seller tenders delivery.\n\nInspection\nUnder Sections 2-513(1) and (2) of the Uniform Commercial Code (UCC), the buyer has a qualified right\nto inspect goods. That means the buyer must be given the chance to look over the goods to determine\nwhether they conform to the contract. If they do not, he may properly reject the goods and refuse to pay.\nThe right to inspect is subject to three exceptions:\n\n1.\n\nThe buyer waives the right. If the parties agree that payment must be made before inspection,\nthen the buyer must pay (unless the nonconformity is obvious without inspection). Payment\nunder these circumstances does not constitute acceptance, and the buyer does not lose the right to\ninspect and reject later.\n\n2. The delivery is to be made C.O.D. (cash on delivery).\n3. Payment is to be made against documents of title.\n\nIf the buyer fails to inspect, or fails to discover a defect that an inspection would have revealed, he cannot\nlater revoke his acceptance, subject to some exceptions.\n\nAcceptance\nAcceptance is clear enough: it means the buyer takes the goods. But the buyer\xe2\x80\x99s options on\nimproper delivery need to be examined, because that\xe2\x80\x99s often a problem area.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n445\n\n\x0cThe buyer may accept goods by words, silence, or action. Section 2-606(1) of the UCC defines\nacceptance as occurring in any one of three circumstances:\n\n1. Words. The buyer, after a reasonable opportunity to inspect, tells the seller either that\nthe goods conform or that he will keep them despite any nonconformity.\n2. Silence. The buyer fails to reject, after a reasonable opportunity to inspect.\n3. Action. The buyer does anything that is inconsistent with the seller\xe2\x80\x99s ownership, such as\nusing the goods (with some exceptions) or selling the goods to someone else.\n\nOnce the buyer accepts, she is obligated to pay at the contract rate and loses the right to reject\nthe goods. [2] She is stuck, subject to some exceptions.\n\nPayment\nThe parties may specify in their contract what payment means and when it is to be made. If they don\xe2\x80\x99t,\n[3]\n\nthe UCC controls the transaction.\n\nA Buyer\xe2\x80\x99s Right on Nonconforming Delivery\nObviously if the delivery is defective, the disappointed buyer does not have to accept the goods: the buyer\nmay (a) reject the whole, (b) accept the whole, or (c) accept any commercial unit and reject the rest (2601, 2A-509), or (d)\xe2\x80\x94in two situations\xe2\x80\x94revoke an acceptance already made.\n\nRejection and a Buyer\xe2\x80\x99s Duties after Rejection\nUnder UCC, Section 2-601(a), rejection is allowed if the seller fails to make a perfect tender. The rejection\nmust be made within a reasonable time after delivery or tender. Once it is made, the buyer may not act as\nthe owner of the goods. If he has taken possession of the goods before he rejects them, he must hold them\nwith reasonable care to permit the seller to remove them. If the buyer is a merchant, then the buyer has a\nspecial duty to follow reasonable instructions from the seller for disposing of the rejected goods; if no\ninstructions are forthcoming and the goods are perishable, then he must try to sell the goods for the\nseller\xe2\x80\x99s account and is entitled to a commission for his efforts. Whether or not he is a merchant, a buyer\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n446\n\n\x0cmay store the goods, reship them to the seller, or resell them\xe2\x80\x94and charge the seller for his services\xe2\x80\x94if the\nseller fails to send instructions on the goods\xe2\x80\x99 disposition. Such storage, reshipping, and reselling are not\nacceptance or conversion by the buyer.\n\nAcceptance of a Nonconforming Delivery\nThe buyer need not reject a nonconforming delivery. She may accept it with or without allowance for the\nnonconformity.\n\nAcceptance of Part of a Nonconforming Delivery\nThe buyer may accept any commercial unit and reject the rest if she wants to. A commercial unit means\n\xe2\x80\x9csuch a unit of goods as by commercial usage is a single whole for purposes of sale and division of which\nmaterially impairs its character or value on the market or in use. A commercial unit may be a single article\n(as a machine), a set of articles (as a suite of furniture or an assortment of sizes), a quantity (as a bale,\ngross, or carload), or any other unit treated in use or in the relevant market as a single whole.\xe2\x80\x9d\n\n[4]\n\nInstallment Sales\nA contract for an installment sale complicates the answer to the question, \xe2\x80\x9cWhat right does the buyer have\nto accept or reject when the seller fails to deliver properly?\xe2\x80\x9d (An installment contract is one calling for\ndelivery of goods in separate lots with separate acceptance for each delivery.) The general answer is found\nin the UCC at Section 2-612, which permits the buyer to reject any nonconforming installment if the\nnonconformity cannot be cured if it substantially impairs the value of that particular installment.\nHowever, the seller may avoid rejection by giving the buyer adequate assurances that he will cure the\ndefect, unless the particular defect substantially impairs the value of the whole contract.\n\nSuppose the Corner Gas Station contracts to buy 12,000 gallons of regular gasoline from Gasoline Seller,\ndeliverable in twelve monthly installments of 1,000 gallons on the first of each month, with a set price\npayable three days after delivery. In the third month, Seller is short and can deliver only 500 gallons\nimmediately and will not have the second 500 gallons until midmonth. May Corner Gas reject this tender?\nThe answer depends on the circumstances. The nonconformity clearly cannot be cured, since the contract\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n447\n\n\x0ccalls for the full 1,000 on a particular day. But the failure to make full delivery does not necessarily impair\nthe value of that installment; for example, Corner Gas may know that it will not use up the 500 gallons\nuntil midmonth. However, if the failure will leave Corner Gas short before midmonth and unable to buy\nfrom another supplier unless it agrees to take a full 1,000 (more than it could hold at once if it also took\nSeller\xe2\x80\x99s 500 gallons), then Corner Gas is entitled to reject Seller\xe2\x80\x99s tender.\n\nIs Corner Gas entitled to reject the entire contract on the grounds that the failure to deliver impairs the\nvalue of the contract as a whole? Again, the answer depends on whether the impairment was substantial.\nSuppose other suppliers are willing to sell only if Corner Gas agrees to buy for a year. If Corner Gas\nneeded the extra gasoline right away, the contract would have been breached as whole, and Corner Gas\nwould be justified in rejecting all further attempted tenders of delivery from Seller. Likewise, if the spot\nprice of gasoline were rising so that month-to-month purchases from other suppliers might cost it more\nthan the original agreed price with Seller, Corner Gas would be justified in rejecting further deliveries\nfrom Seller and fixing its costs with a supply contract from someone else. Of course, Corner Gas would\nhave a claim against Seller for the difference between the original contract price and what it had to pay\nanother supplier in a rising market (as you\xe2\x80\x99ll see later in this chapter).\n\nRevocation\nA revocation of acceptance means that although the buyer has accepted and exercised ownership of the\ngoods, he can return the goods and get his money back. There are two circumstances in which the buyer\ncan revoke an acceptance if the nonconformity \xe2\x80\x9csubstantially impairs its value to him\xe2\x80\x9d:\n\na.\n\n[5]\n\nif the buyer reasonably thought the nonconformity would be cured and it is not within a\nreasonable time; or\n\nb. if the acceptance was due to a latent defect that could not reasonably have been discovered before\nacceptance.\nConsider two examples illustrated in the next paragraph. The first deals with point a (buyer thought\nnonconformity would be cured and it was not within a reasonable time), and the second gets to point b\n(latent defect).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n448\n\n\x0cIn August 1983, the Borsages purchased a furnished mobile home on the salesperson\xe2\x80\x99s assertion that it\nwas \xe2\x80\x9cthe Cadillac of mobile homes.\xe2\x80\x9d But when they moved in, the Borsages discovered defects: water\nleaks, loose moldings, a warped dishwasher door, a warped bathroom door, holes in walls, defective\nheating and cooling systems, cabinets with chips and holes, furniture that fell apart, mold and mildew in\nsome rooms, a closet that leaked rainwater, and defective doors and windows. They had not seen these\ndefects at the time of purchase because they looked at the mobile home at night and there were no lights\non in it. The Borsages immediately complained. Repairmen came by but left, only promising to return\nagain. Others did an inadequate repair job by cutting a hole in the bottom of the home and taping up the\nhole with masking tape that soon failed, causing the underside of the home to pooch out. Yet more\nrepairmen came by but made things worse by inadvertently poking a hole in the septic line and failing to\nfix it, resulting in a permanent stench. More repairmen came by, but they simply left a new dishwasher\ndoor and countertop at the home, saying they didn\xe2\x80\x99t have time to make the repairs. In June 1984, the\nBorsages provided the seller a long list of uncorrected problems; in October they stopped making\npayments. Nothing happened. In March 1986\xe2\x80\x94thirty-one months after buying the mobile home\xe2\x80\x94they\ntold the seller to pick up the mobile home: they revoked their acceptance and sued for the purchase price.\nThe defendant seller argued that the Borsages\xe2\x80\x99 failure to move out of the house for so long constituted\nacceptance. But they were repeatedly assured the problems would be fixed, and moreover they had no\nplace else to live, and no property to put another mobile home on if they abandoned the one they had. The\ncourt had no problem validating the Borsages\xe2\x80\x99 revocation of acceptance, under the section noted earlier, if\nthey ever had accepted it. The seller might have a right to some rental value, though.\n\n[6]\n\nIn April 1976, Clarence Miller ordered a new 1976 Dodge Royal Monaco station wagon from plaintiff\nColonial Dodge. The car included a heavy-duty trailer package with wide tires. The evening of the day the\nMillers picked up the new car, Mrs. Miller noticed that there was no spare tire. The following morning, the\ndefendant notified the plaintiff that he insisted on a spare tire, but when he was told there were no spare\ntires available (because of a labor strike), Mr. Miller told the plaintiff\xe2\x80\x99s salesman that he would stop\npayment on the check he\xe2\x80\x99d given them and that the car could be picked up in front of his house. He parked\nit there, where it remained until the temporary registration sticker expired and it was towed by the police\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n449\n\n\x0cto an impound yard. Plaintiff sued for the purchase price, asserting that the missing spare tire did not\n\xe2\x80\x9csubstantially impair the value of the goods to the buyer.\xe2\x80\x9d On appeal to the Michigan Supreme Court, the\nplaintiff lost. \xe2\x80\x9cIn this case the defendant\xe2\x80\x99s concern with safety is evidenced by the fact that he ordered the\nspecial package which included spare tires. The defendant\xe2\x80\x99s occupation demanded that he travel\nextensively, sometimes in excess of 150 miles per day on Detroit freeways, often in the early morning\nhours.\xe2\x80\xa6He was afraid of a tire going flat\xe2\x80\xa6at 3 a.m. Without a spare, he would be helpless until morning\nbusiness hours. The dangers attendant upon a stranded motorist are common knowledge, and Mr.\nMiller\xe2\x80\x99s fears are not unreasonable.\xe2\x80\x9d The court observed that although he had accepted the car before he\ndiscovered the nonconformity, that did not preclude revocation: the spare was under a fastened panel,\nconcealed from view.\n\n[7]\n\nK E Y TA K EA WAY\nThe duty of the buyer in a sales contract is to inspect, accept, and pay. Failure to\ndiscover a defect that an inspection would have revealed is a waiver of right to\ncomplain. Normally the goods are conforming and the buyer accepts them, but\nupon discovery of a defect the buyer may reject the whole nonconforming\ndelivery, part of it (the buyer has some duties if she has possession of the rejected\ngoods), or in some cases reject one installment of an installment sale or, if one\ndefective installment is serious enough to vitiate the whole contract, the buyer\nmay consider the contract terminated. If goods have been accepted because the\nseller promised to fix defects or because the defects were latent, then the buyer\nmay revoke the acceptance where the nonconformity substantially impairs the\nvalue of the contract to the buyer.\n\nE XE R C IS ES\n1. If a buyer takes possession of goods and shortly thereafter discovers they are\nnonconforming, what duty does the nonmerchant buyer have with respect to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n450\n\n\x0cthe goods? What duty does the merchant buyer have with respect to the\ngoods?\n2. What is the difference between rejection and revocation?\n3. Under what circumstances will a defective installment allow the buyer to\nreject that installment? Under what circumstances would a defective\ninstallment allow the buyer to terminate the contract?\n[1] Uniform Commercial Code, Sections 2-301 and 2-513.\n[2] Uniform Commercial Code, Section 2-607.\n[3] Uniform Commercial Code, Sections 2-511 and 2-512.\n[4] Uniform Commercial Code, Sections 2-105 and 2A103(1).\n[5] Uniform Commercial Code, Section 2-608.\n[6] North River Homes, Inc., v. Borsage, Mississippi (1992).\n[7] Colonial Dodge v. Miller, 362 N.W.2d 704 (Mich. 1984).\n\n10.3 Remedies\nL EA R N IN G O B JEC T IV ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n451\n\n\x0c1. Understand what purpose remedies serve under the UCC.\n2. Be able to see when the parties\xe2\x80\x99 agreements as to limited remedies fail under\nthe UCC.\n3. Recognize what the seller\xe2\x80\x99s remedies are.\n4. Recognize what the buyer\xe2\x80\x99s remedies are.\n\nRemedies in General\nGeneral Policy\nThe general policy of the Uniform Commercial Code (UCC) is to put the aggrieved party in a good position\nas if the other party had fully performed\xe2\x80\x94as if there had been a timely delivery of conforming goods. The\nUCC provisions are to be read liberally to achieve that result if possible. Thus the seller has a number of\npotential remedies when the buyer breaches, and likewise the buyer has a number of remedies when the\nseller breaches.\n\nThe CISG provides, at Article 74:\nDamages for breach of contract by one party consist of a sum equal to the loss, including\nloss of profit, suffered by the other party as a consequence of the breach. Such damages\nmay not exceed the loss which the party in breach foresaw or ought to have foreseen at the\ntime of the conclusion of the contract, in the light of the facts and matters of which he then\nknew or ought to have known, as a possible consequence of the breach of contract.\n\nSpecifying Remedies\nWe have emphasized how the UCC allows people to make almost any contract they want (as long as it\xe2\x80\x99s\nnot unconscionable). Just as the parties may specify details of performance in the contract, so they may\nprovide for and limit remedies in the event of breach.\n\n[1]\n\nThe following would be a typical limitation of\n\nremedy: \xe2\x80\x9cSeller\xe2\x80\x99s sole obligation in the event goods are deemed defective by the seller is to replace a like\nquantity of nondefective goods.\xe2\x80\x9d A remedy is optional unless it is expressly agreed that it is the exclusive\nremedy.\n\n[2]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n452\n\n\x0cBut the parties are not free to eliminate all remedies. As the UCC comment to this provision puts it, \xe2\x80\x9cIf the\nparties intend to conclude a contract for sale within this Article they must accept the legal consequence\nthat there be at least a fair quantum of remedy for breach of the obligations or duties outlined in the\ncontract.\xe2\x80\x9d In particular, the UCC lists three exemptions from the general rule that the parties are free to\nmake their contract up any way they want as regards remedies:\n\n1.\n\nWhen the circumstances cause the agreed-to remedy to fail or be ineffective, the default UCC\nremedy regime works instead.\n\n[3]\n\n2. Consequential damages may be limited or excluded unless the limitation or exclusion is\nunconscionable. Limitation of consequential damages for injury to the person in the case of\nconsumer goods is prima facie unconscionable, but limitation of damages where the loss is\ncommercial is not.\n\n[4]\n\n3. The parties may agree to liquidated damages: \xe2\x80\x9cDamages for breach by either party may be\nliquidated in the agreement but only at an amount which is reasonable in the light of the\nanticipated or actual harm caused by the breach, the difficulties of proof of loss, and the\ninconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing\nunreasonably large liquidated damages is void as a penalty.\xe2\x80\x9d\n\n[5]\n\nThe Code\xe2\x80\x99s equivalent position\n\non leases is interestingly slightly different. UCC 2A-504(1) says damages may be liquidated \xe2\x80\x9cbut\nonly at an amount or by a formula that is reasonable in light of the then anticipated harm caused\xe2\x80\x9d\nby the breach. It leaves out anything about difficulties of proof or inconvenience of obtaining\nanother adequate remedy.\n\nStatute of Limitations\nThe UCC statute of limitations for breach of any sales contract is four years. The parties may \xe2\x80\x9creduce the\nperiod of limitation to not less than one year but may not extend it.\xe2\x80\x9d\n\n[6]\n\nArticle 2A-506(1) is similar, but\n\nomits the prohibition against extending the limitation. Article 2-725(2) goes on: \xe2\x80\x9cA cause of action accrues\nwhen the breach occurs, regardless of the aggrieved party\xe2\x80\x99s lack of knowledge of the breach. A breach of\nwarranty occurs when tender of delivery is made, except that where a warranty explicitly extends to future\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n453\n\n\x0cperformance of the goods and discovery of the breach must await the time of such performance the cause\nof action accrues when the breach is or should have been discovered.\xe2\x80\x9d\nArticle 2A-506(2) is similar to 2-725(2).\n\nSeller\xe2\x80\x99s Remedies\nArticle 2 in General\nArticle 2-703 of the UCC lists the four things the buyer can do by way of default, and it lists\xe2\x80\x94here slightly\nparaphrased\xe2\x80\x94the seller\xe2\x80\x99s remedies (2A-523(1) is similar for leases):\n\nWhere the buyer wrongfully rejects or revokes acceptance of goods or fails to make a payment due on or\nbefore delivery or repudiates with respect to a part or the whole, then with respect to any goods directly\naffected and, if the breach is of the whole contract, then also with respect to the whole undelivered\nbalance, the aggrieved seller may:\n\n(1) withhold delivery of such goods;\n(2) stop delivery by any bailee;\n(3) identify to the contract conforming goods not already identified;\n(4) reclaim the goods on the buyer\xe2\x80\x99s insolvency;\n(5) resell and recover damages;\n(6) recover damages for non-acceptance or repudiation;\n(7) or in a proper case recover the price;\n(8) cancel.\n\nItems (1)\xe2\x80\x93(4) address the seller\xe2\x80\x99s rights to deal with the goods; items (5)\xe2\x80\x93(7) deal with the seller\xe2\x80\x99s rights\nas regards the price, and item (8) deals with the continued existence of the contract.\n\nThe CISG\xe2\x80\x99s take is similar. Article 61 and following state,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n454\n\n\x0cIf the buyer fails to perform any of his obligations under the contract or this Convention,\nthe seller may:\xe2\x80\xa6(a) require the buyer to pay the price. (b) Fix an additional period of time\nof reasonable length for performance by the buyer of his obligations; unless the seller has\nreceived notice from the buyer that he will not perform within the period so fixed, the\nseller may not, during that period, resort to any remedy for breach of contract. (c) Declare\nthe contract avoided if the failure by the buyer to perform any of his obligations under the\ncontract or this Convention amounts to a fundamental breach of contract or if the buyer\ndoes not, within the additional period of time fixed by the seller [above], perform his\nobligation to pay the price or take delivery of the goods, or if he declares that he will not do\nso within the period so fixed. (d) The seller also has the right to damages.\n\nTo illustrate the UCC\xe2\x80\x99s remedy provision, in this and the following section, we assume these facts:\nHoward, of Los Angeles, enters into a contract to sell and ship one hundred prints of a Pieter Bruegel\npainting, plus the original, to Bunker in Dallas. Twenty-five prints have already been delivered to Bunker,\nanother twenty-five are en route (having been shipped by common carrier), another twenty-five are\nfinished but haven\xe2\x80\x99t yet been shipped, and the final twenty-five are still in production. The original is\nhanging on the wall in Howard\xe2\x80\x99s living room. We will take up the seller\xe2\x80\x99s remedies if the buyer breaches\nand if the buyer is insolvent.\n\nRemedies on Breach\nBunker, the buyer, breaches the contract. He sends Howard an e-mail stating that he won\xe2\x80\x99t buy and will\nreject the goods if delivery is attempted. Howard has the following cumulative remedies; election is not\nrequired.\n\nWithhold Further Delivery\nHoward may refuse to send the third batch of twenty-five prints that are awaiting shipment.\n\nStop Delivery\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n455\n\n\x0cHoward may also stop the shipment. If Bunker is insolvent, and Howard discovers it, Howard would be\npermitted to stop any shipment in the possession of a carrier or bailee. If Bunker is not insolvent, the UCC\npermits Howard to stop delivery only of carload, truckload, planeload, or larger shipment. The reason for\nlimiting the right to bulk shipments in the case of noninsolvency is that stopping delivery burdens the\ncarrier and requiring a truck, say, to stop and the driver to find a small part of the contents could pose a\nsizeable burden.\n\nIdentify to the Contract Goods in Possession\nHoward could \xe2\x80\x9cidentify to the contract\xe2\x80\x9d the twenty-five prints in his possession. Section 2-704(1) of the\nUCC permits the seller to denote conforming goods that were not originally specified as the exact objects\nof the contract, if they are under his control or in his possession at the time of the breach. Assume that\nHoward had five hundred prints of the Bruegel painting. The contract did not state which one hundred of\nthose prints he was obligated to sell, but once Bunker breached, Howard could declare that those\nparticular prints were the ones contemplated by the contract. He has this right whether or not the\nidentified goods could be resold. Moreover, Howard may complete production of the twenty-five\nunfinished prints and identify them to the contract, too, if in his \xe2\x80\x9creasonable commercial judgment\xe2\x80\x9d he\ncould better avoid loss\xe2\x80\x94for example, by reselling them. If continued production would be expensive and\nthe chances of resale slight, the seller should cease manufacture and resell for scrap or salvage value.\n\nResell\nHoward could resell the seventy-five prints still in his possession as well as the original. As long as he\nproceeds in good faith and in a commercially reasonable manner, per Section 2-706(2) and Section 2A527(3), he is entitled to recover the difference between the resale price and the contract price, plus\nincidental damages (but less any expenses saved, like shipping expenses). \xe2\x80\x9cIncidental damages\xe2\x80\x9d include\nany reasonable charges or expenses incurred because, for example, delivery had to be stopped, new\ntransportation arranged, storage provided for, and resale commissions agreed on.\n\nThe seller may resell the goods in virtually any way he desires as long as he acts reasonably. He may resell\nthem through a public or private sale. If the resale is public\xe2\x80\x94at auction\xe2\x80\x94only identified goods can be sold,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n456\n\n\x0cunless there is a market for a public sale of futures in the goods (as there is in agricultural commodities,\nfor example). In a public resale, the seller must give the buyer notice unless the goods are perishable or\nthreaten to decline in value speedily. The goods must be available for inspection before the resale, and the\nbuyer must be allowed to bid or buy.\n\nThe seller may sell the goods item by item or as a unit. Although the goods must relate to the contract, it is\nnot necessary for any or all of them to have exited or to have been identified at the time of breach.\nThe seller does not owe the buyer anything if resale or re-lease results in a profit for the buyer.\n\n[7]\n\nRecover Damages\nThe seller may recover damages equal to the difference between the market price (measured at the time\nand place for tender of delivery) and the unpaid contract price, plus incidental damages, but less any\nexpenses saved because of the buyer\xe2\x80\x99s breach. Suppose Howard\xe2\x80\x99s contract price was $100 per print plus\n$10,000 for the original and that the market price on the day Howard was to deliver the seventy-five\nprints was $75 (plus $8,000 for the original). Suppose too that the shipping costs (including insurance)\nthat Howard saved when Bunker repudiated were $2,000 and that to resell them Howard would have to\nspend another $750. His damages, then, would be calculated as follows: original contract price ($17,500)\nless market price ($13,625) = $3,875 less $2,000 in saved expenses = $1,875 plus $750 in additional\nexpenses = $2,625 net damages recoverable by Howard, the seller.\n\nThe CISG puts it similarly in Article 75: \xe2\x80\x9cIf the contract is avoided and if, in a reasonable\nmanner and within a reasonable time after avoidance, the buyer has bought goods in\nreplacement or the seller has resold the goods, the party claiming damages may recover\nthe difference between the contract price and the price in the substitute transaction as well\nas any further damages recoverable.\xe2\x80\x9d\n\nIf the formula would not put the seller in as good a position as performance under the contract, then the\nmeasure of damages is lost profits\xe2\x80\x94that is, the profit that Howard would have made had Bunker taken the\noriginal painting and prints at the contract price (again, deducting expenses saved and adding additional\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n457\n\n\x0cexpenses incurred, as well as giving credit for proceeds of any resale).\n\n[8]\n\nThis provision becomes especially\n\nimportant for so-called lost volume sellers. Howard may be able to sell the remaining seventy-five prints\neasily and at the same price that Bunker had agreed to pay. Then why isn\xe2\x80\x99t Howard whole? The reason is\nthat the second buyer was not a substitute buyer but an additional one; that is, Howard would have made\nthat sale even if Bunker had not reneged on the contract. So Howard is still short a sale and is out a profit\nthat he would have made had Bunker honored the contract.\n\nRecover the Price\nHoward\xe2\x80\x94the seller\xe2\x80\x94could recover from Bunker for the price of the twenty-five prints that Bunker holds.\nOr suppose they had agreed to a shipment contract, so that the risk of loss passed to Bunker when\nHoward placed the other prints with the trucker and that the truck crashed en route and the cargo\ndestroyed. Howard could recover the price. Or suppose there were no market for the remaining seventyfive prints and the original. Howard could identify these prints to the contract and recover the contract\nprice. If Howard did resell some prints, the proceeds of the sale would have to be credited to Bunker\xe2\x80\x99s\naccount and deducted from any judgment. Unless sold, the prints must be held for Bunker and given to\nhim upon his payment of the judgment.\n\nCancel the Contract\nWhen Bunker repudiated, Howard could declare the contract cancelled. This would also apply if a buyer\nfails to make a payment due on or before delivery. Cancellation entitles the nonbreaching party to any\nremedies for the breach of the whole contract or for any unperformed balance. That is what happens when\nHoward recovers damages, lost profits, or the price.\n\n[9]\n\nAgain, the CISG is similar. Article 64 provides that the seller may declare the contract\navoided \xe2\x80\x9cif the failure by the buyer to perform any of his obligations under the contract or\nthis Convention amounts to a fundamental breach of contract; or if the buyer does not,\nwithin the additional period of time fixed by the seller perform his obligation to pay the\nprice or take delivery of the goods, or if he declares that he will not do so within the period\nso fixed.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n458\n\n\x0cNote again that these UCC remedies are cumulative. That is, Howard could withhold future\ndelivery and stop delivery en route, and identify to the contract goods in his\npossession, and resell, and recover damages, and cancel.\n\nRemedies on Insolvency\nThe remedies apply when the buyer breaches the contract. In addition to those remedies, the seller has\nremedies when he learns that the buyer is insolvent, even if the buyer has not breached. Insolvency\nresults, for example, when the buyer has \xe2\x80\x9cceased to pay his debts in the ordinary course of business,\xe2\x80\x9d or\nthe buyer \xe2\x80\x9ccannot pay his debts as they become due.\xe2\x80\x9d\n\n[10]\n\nUpon learning of Bunker\xe2\x80\x99s insolvency, Howard could refuse to deliver the remaining prints, unless Bunker\npays cash not only for the remaining prints but for those already delivered. If Howard learned of Bunker\xe2\x80\x99s\ninsolvency within ten days of delivering the first twenty-five prints, he could make a demand to reclaim\nthem. If within three months prior to delivery, Bunker had falsely represented that he was solvent, the\nten-day limitation would not cut off Howard\xe2\x80\x99s right to reclaim. If he does seek to reclaim, Howard will lose\nthe right to any other remedy with respect to those particular items. However, Howard cannot reclaim\ngoods already purchased from Bunker by a customer in the ordinary course of business. The customer\n[11]\n\ndoes not risk losing her print purchased several weeks before Bunker has become insolvent.\n\nIn the lease situation, of course, the goods belong to the lessor\xe2\x80\x94the lessor has title to them\xe2\x80\x94so the lessor\ncan repossess them if the lessee defaults.\n\n[12]\n\nBuyer\xe2\x80\x99s Remedies\nIn this section, let us assume that Howard, rather than Bunker, breaches, and all other circumstances are\nthe same. That is, Howard had delivered twenty-five prints, twenty-five more were en route, the original\npainting hung in Howard\xe2\x80\x99s living room, another twenty-five prints were in Howard\xe2\x80\x99s factory, and the final\ntwenty-five prints were in production.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n459\n\n\x0cIn General\nThe buyer can do the following three things by way of defaulting: repudiate the contract, fail to deliver the\ngoods, or deliver or tender nonconforming goods. Section 2-711 of the UCC provides the following\nremedies for the buyer:\n\nWhere the seller fails to make delivery or repudiates, or the buyer rightfully rejects or justifiably revokes,\nthen with respect to any goods involved, and with respect to the whole if the breach goes to the whole\ncontract, the buyer may\n\n(1) cancel the contract, and\n(2) recover as much of the price as has been paid; and\n(3) \xe2\x80\x9ccover\xe2\x80\x9d and get damages; and\n(4) recover damages for nondelivery.\nWhere the seller fails to deliver or repudiates, the buyer may also:\n(5) if the goods have been identified recover them; or\n(6) in a proper case obtain specific performance or\n(7) replevy the goods.\nOn rightful rejection or justifiable revocation of acceptance, a buyer:\n(8) has a security interest in goods in his possession or control for any payments made on their price and\nany expenses reasonably incurred in their inspection, receipt, transportation, care and custody and may\nhold such goods and resell them in like manner as an aggrieved seller.\nIf the buyer has accepted non-conforming goods and notified seller of the non-conformity, buyer can\n(9) recover damages for the breach;\n\n[13]\n\nand in addition the buyer may\n(10) recover incidental damages and\n(11) recover consequential damages.\n\n[14]\n\nThus the buyer\xe2\x80\x99s remedies can be divided into two general categories: (1) remedies for goods that the\nbuyer does not receive or accept, when he has justifiably revoked acceptance or when the seller\nrepudiates, and (2) remedies for goods accepted.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n460\n\n\x0cThe CISG provides similar remedies at Articles 45\xe2\x80\x9351:\nIf the seller fails to perform any of his obligations under the contract, buyer may (1)\ndeclare the contract avoided if the seller\xe2\x80\x99s breach is fundamental; or (2) require\nperformance by the seller of his obligations unless the buyer has resorted to a remedy\nwhich is inconsistent with this requirement; (3) require delivery of substitute goods if the\nnon-conformity constitutes a fundamental breach of contract; (4) may require the seller to\nremedy the lack of conformity by repair, unless this is unreasonable having regard to all\nthe circumstances; (5) may fix an additional period of time of reasonable length for\nperformance by the seller of his obligations and unless the buyer has received notice from\nthe seller that he will not perform within the period so fixed, the buyer may not, during\nthat period, resort to any remedy for breach of contract; (6) in case of non-conforming\ndelivery, reduce the price in the same proportion as the value that the goods actually\ndelivered had at the time of the delivery bears to the value that conforming goods would\nhave had at that time.\n\nGoods Not Received\nThe UCC sets out buyer\xe2\x80\x99s remedies if goods are not received or if they are rightfully rejected or acceptance\nis rightfully revoked.\n\nCancel\nIf the buyer has not yet received or accepted the goods (or has justifiably rejected or revoked acceptance\nbecause of their nonconformity), he may cancel the contract and\xe2\x80\x94after giving notice of his cancellation\xe2\x80\x94\nhe is excused from further performance.\n\n[15]\n\nRecover the Price\nWhether or not the buyer cancels, he is entitled to recover the price paid above the value of what was\naccepted.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n461\n\n\x0cCover\nIn the example case, Bunker\xe2\x80\x94the buyer\xe2\x80\x94may \xe2\x80\x9ccover\xe2\x80\x9d and have damages: he may make a good-faith,\nreasonable purchase of substitute goods. He may then recover damages from the seller for the difference\nbetween the cost of cover and the contract price. This is the buyer\xe2\x80\x99s equivalent of the seller\xe2\x80\x99s right to resell.\nThus Bunker could try to purchase seventy-five additional prints of the Bruegel from some other\nmanufacturer. But his failure or inability to do so does not bar him from any other remedy open to him.\n\nSue for Damages for Nondelivery\nBunker could sue for damages for nondelivery. Under Section 2-713 of the UCC, the measure of damages\nis the difference between the market price at the time when the buyer learned of the breach and the\ncontract price (plus incidental damages, less expenses saved). Suppose Bunker could have bought\nseventy-five prints for $125 on the day Howard called to say he would not be sending the rest of the order.\nBunker would be entitled to $1,875\xe2\x80\x94the market price ($9,375) less the contract price ($7,500). This\nremedy is available even if he did not in fact purchase the substitute prints. Suppose that at the time of\nbreach, the original painting was worth $15,000 (Howard having just sold it to someone else at that\nprice). Bunker would be entitled to an additional $5,000, which would be the difference between his\ncontract price and the market price.\n\nFor leases, the UCC, Section 2A-519(1), provides the following: \xe2\x80\x9cthe measure of damages for non-delivery\nor repudiation by the lessor or for rejection or revocation of acceptance by the lessee is the present value,\nas of the date of the default, of the then market rent minus the present value as of the same date of the\noriginal rent, computed for the remaining lease term of the original lease agreement, together with\nincidental and consequential damages, less expenses saved in consequence of the lessor\xe2\x80\x99s default.\xe2\x80\x9d\n\nRecover the Goods\nIf the goods are unique\xe2\x80\x94as in the case of the original Bruegel\xe2\x80\x94Bunker is entitled to specific\nperformance\xe2\x80\x94that is, recovery of the painting. This section is designed to give the buyer rights\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n462\n\n\x0ccomparable to the seller\xe2\x80\x99s right to the price and modifies the old common-law requirement that courts will\nnot order specific performance except for unique goods. It permits specific performance \xe2\x80\x9cin other proper\ncircumstances,\xe2\x80\x9d and these might include particular goods contemplated under output or requirements\ncontracts or those peculiarly available from one market source.\n\n[16]\n\nEven if the goods are not unique, the buyer is entitled to replevy them if they are identified to the contract\nand after good-faith effort he cannot recover them. Replevin is the name of an ancient common-law\naction for recovering goods that have been unlawfully taken; in effect it is not different from specific\nperformance, and the UCC makes no particular distinction between them in Section 2-716. Section 2A-521\nholds the same for leases. In our case, Bunker could replevy the twenty-five prints identified and held by\nHoward.\n\nBunker also has the right to recover the goods should it turn out that Howard is insolvent. Under UCC,\nSection 2-502, if Howard were to become insolvent within ten days of the day on which Bunker pays the\nfirst installment of the price due, Bunker would be entitled to recover the original and the prints, as long\nas he tendered any unpaid portion of the price.\n\nFor security interest in goods rightfully rejected, if the buyer rightly rejects nonconforming goods or\nrevokes acceptance, he is entitled to a security interest in any goods in his possession. In other words,\nBunker need not return the twenty-five prints he has already received unless Howard reimburses him for\nany payments made and for any expenses reasonably incurred in their inspection, receipt, transportation,\ncare, and custody. If Howard refuses to reimburse him, Bunker may resell the goods and take from the\nproceeds the amount to which he is entitled.\n\n[17]\n\nGoods Accepted\nThe buyer does not have to reject nonconforming goods. She may accept them anyway or may effectively\naccept them because the time for revocation has expired. In such a case, the buyer is entitled to remedies\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n463\n\n\x0cas long as she notifies the seller of the breach within a reasonable time.\n\n[18]\n\nIn our example, Bunker can\n\nreceive three types of damages, all of which are outlined here.\n\nCompensatory Damages\nBunker may recover damages for any losses that in the ordinary course of events stem from the seller\xe2\x80\x99s\nbreach. Suppose Howard had used inferior paper that was difficult to detect, and within several weeks of\nacceptance the prints deteriorated. Bunker is entitled to be reimbursed for the price he paid.\n\nConsequential Damages\nBunker is also entitled to consequential damages.\n\n[19]\n\nThese are losses resulting from general or particular\n\nrequirements of the buyer\xe2\x80\x99s needs, which the seller had reason to know and which the buyer could not\nreasonably prevent by cover or otherwise. Suppose Bunker is about to make a deal to resell the twenty-five\nprints that he has accepted, only to discover that Howard used inferior ink that faded quickly. Howard\nknew that Bunker was in the business of retailing prints and therefore he knew or should have known that\none requirement of the goods was that they be printed in long-lasting ink. Because Bunker will lose the\nresale, he is entitled to the profits he would have made. (If Howard had not wished to take the risk of\npaying for consequential damages, he could have negotiated a provision limiting or excluding this\nremedy.) The buyer has the burden or proving consequential damages, but the UCC does not require\nmathematical precision. Suppose customers come to Bunker\xe2\x80\x99s gallery and sneer at the faded colors. If he\ncan show that he would have sold the prints were it not for the fading ink (perhaps by showing that he had\nsold Bruegels in the past), he would be entitled to recover a reasonable estimate of his lost profits.\nIn De La Hoya v. Slim\xe2\x80\x99s Gun Shop the plaintiff purchased a handgun from the defendant, a properly\nlicensed dealer. While the plaintiff was using it for target shooting, he was questioned by a police officer,\nwho traced the serial number of the weapon and determined that\xe2\x80\x94unknown to either the plaintiff or the\ndefendant\xe2\x80\x94it had been stolen. The plaintiff was arrested for possession of stolen property and incurred,\nin 2010 dollars, $3,000 in attorney fees to extricate himself from the criminal charges. He sued the\ndefendant for breach of the implied warranty of title and was awarded the amount of the attorney fees as\nconsequential damages. On appeal the California court held it foreseeable that the plaintiff would get\narrested for possessing a stolen gun, and \xe2\x80\x9conce the foreseeability of the arrest is established, a natural and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n464\n\n\x0cusual consequence is that the [plaintiff] would incur attorney\xe2\x80\x99s fee.\xe2\x80\x9d\n\n[20]\n\nCompare with In re Stem in the\n\nexercises later in this chapter.\n\nIncidental Damages\nSection 2-715 of the UCC allows incidental damages, which are \xe2\x80\x9cdamages resulting from the seller\xe2\x80\x99s\nbreach including expenses reasonably incurred in inspection, receipt, transportation and care and custody\nof goods rightfully rejected, any commercially reasonable charges, expenses or commissions in connection\nwith effecting cover and any other reasonable expense incident to the delay or other breach.\xe2\x80\x9d Section 2A520(1) of the UCC is similar for leases.\n\nK E Y TA K EA WAY\nParties to a contract for the sale of goods may specify what the remedies will be in\ncase of breach. They may limit or exclude remedies, but the UCC insists that there\nbe some remedies; if the parties agree to liquidated damages, the amount set\ncannot be a penalty.\nIf the parties do not agree to different remedies for the seller in case the buyer\ndefaults, the UCC sets out remedies. As to the seller\xe2\x80\x99s obligation, he may cancel\nthe contract. As to the goods, he may withhold or stop delivery, identify\nconforming goods to the contract, or reclaim goods upon the buyer\xe2\x80\x99s insolvency.\nAs to money, he may resell and recover damages or lost profits and recover the\nprice. Unless they are inconsistent, these remedies are cumulative. The point of\nthe range of remedies is, as much as possible, to put the nonbreaching seller in the\nposition she would have been in had there been no breach. The aggrieved lessor is\nentitled to similar remedies as the seller.\nThe UCC also provides a full panoply of remedies available to a buyer if the seller\nfails to deliver goods or if the buyer rightfully rejects them or revokes her\nacceptance. As to the buyer\xe2\x80\x99s obligations, she may cancel the contract. As to the\ngoods, she may claim a security interest in those rightfully rejected, recover goods\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n465\n\n\x0cidentified if the seller is insolvent, or replevy or seek specific performance to get\ngoods wrongfully withheld. As to money, she may recover payments made or\ncover and recover damages for nondelivery. If the buyer accepts nonconforming\ngoods, she is entitled to damages for breach of warranty. These remedies are\ncumulative, so the aggrieved buyer may pursue any of them, unless the remedies\nare mutually exclusive. The Article on leases provides basically the same remedies\nfor the aggrieved lessee (UCC 2A 520\xe2\x80\x93523).\n\nE XE R C IS ES\n1. What are the four things a breaching seller could do to cause the buyer grief,\ncommercially speaking?\n2. If the buyer breaches, what rights does the seller have in regard to the goods?\n3. In regard to the money owed to her?\n4. In regard to the continued existence of the contract?\n5. What are the four things a breaching buyer could do to cause the seller grief,\ncommercially speaking?\n6. If the seller breaches, what rights does the buyer have in regard to the goods?\n7. In regard to the money owed to him?\n8. In regard to the continued existence of the contract?\n[1] Uniform Commercial Code, Sections 2-719(1) and 2A-503(1).\n[2] Uniform Commercial Code, Sections 2-719(1)(b) and 2A-503(2).\n[3] Uniform Commercial Code, Sections 2-719(2) and 2A-503(2).\n[4] Uniform Commercial Code, Sections 2-719(3) and 2A-503(2).\n[5] Uniform Commercial Code, Section 2-718.\n[6] Uniform Commercial Code, Section 2-725.\n[7] Uniform Commercial Code, Sections 2-706 and 2A-527.\n[8] Uniform Commercial Code, Section 2-708(2); Section 2A-528(2) is similar.\n[9] Uniform Commercial Code, Sections 2-703(f) and 2A-524(1)(a).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n466\n\n\x0c[10] Uniform Commercial Code, Section 1-201(23).\n[11] Uniform Commercial Code, Section 2-702 (3).\n[12] Uniform Commercial Code, Section 2A-525(2).\n[13] Uniform Commercial Code, Section 2-714.\n[14] Uniform Commercial Code, Section 2-715.\n[15] Uniform Commercial Code, Sections 2-711(1), 2-106, 2A-508(1)(a), and 2A-505(1).\n[16] Uniform Commercial Code, Sections 2-716(1) and 2A-521(1).\n[17] Uniform Commercial Code, Sections 2-711(3), 2-706, 2A-508(5), and 2A-527(5).\n[18] Uniform Commercial Code, Sections 2-714(1) and 2A-519(3).\n[19] Uniform Commercial Code, Sections 2-714(3), 2-715, and 2A-519(3).\n[20] De La Hoya v. Slim\xe2\x80\x99s Gun Shop, 146 Cal. Rptr. 68 (Super. 1978).\n\n10.4 Excuses for Nonperformance\nL EA R N IN G O B JEC T IV ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n467\n\n\x0c1. Recognize how parties are discharged if the goods are destroyed.\n2. Determine what defenses are valid when it becomes very difficult or impossible to\nperform.\n3. Understand the UCC\xe2\x80\x99s position on the right to adequate assurances and anticipatory\nrepudiation.\n\nIn contracts for the sale of goods, as in common law, things can go wrong. What then?\n\nCasualty to Identified Goods\nAs always, the parties may agree what happens if the goods are destroyed before delivery. The default is\nSections 2-613 and 2A-221(a) of the Uniform Commercial Code (UCC). The UCC says that \xe2\x80\x9cwhere the\ncontract requires for its performance goods identified when the contract is made, and the goods suffer\ncasualty without fault of either party before the risk of loss passes to the buyer,\xe2\x80\xa6then (a) if the loss is total\nthe contract is avoided; and (b) if the loss is partial the buyer may nevertheless accept them with due\nallowance for the goods\xe2\x80\x99 defects.\xe2\x80\x9d Thus if Howard ships the original Bruegel to Bunker but the painting is\ndestroyed, through no fault of either party, before delivery occurs, the parties are discharged. If the frame\nis damaged, Bunker could, if he wants, take the painting anyway, but at a discount.\n\nThe UCC\xe2\x80\x99s Take on Issues Affecting \xe2\x80\x9cImpossibility\xe2\x80\x9d\nAlthough this matter was touched on in , it is appropriate to mention briefly again the UCC\xe2\x80\x99s treatment of\nvariations on the theme of \xe2\x80\x9cimpossibility.\xe2\x80\x9d\n\nImpracticability\nSections 2-614(1) and 2A-404(1) of the UCC require reasonable substitution for berthing, loading, and\nunloading facilities that become unavailable. They also require reasonable substitution for transportation\nand delivery systems that become \xe2\x80\x9ccommercially impracticable\xe2\x80\x9d; if a practical alternative exists,\n\xe2\x80\x9cperformance must be tendered and accepted.\xe2\x80\x9d If Howard agreed to send the prints by rail, but a critical\nrailroad bridge is unusable and no trains can run, delivery by truck would be required.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n468\n\n\x0cSection 2-615 of the UCC says that the failure to deliver goods is not a breach of the seller\xe2\x80\x99s duty \xe2\x80\x9cif\nperformance as agreed has become impracticable by the occurrence of a contingency the non-occurrence\nof which was a basic assumption on which the contract was made or by compliance in good faith with any\napplicable foreign or domestic government regulation or order whether or not it later proves to be\ninvalid.\xe2\x80\x9d Section 2A-405(b) of the UCC is similar for leases.\n\nThe CISG provides something similar at Article 79: \xe2\x80\x9cA party is not liable for a failure to\nperform any of his obligations if he proves that the failure was due to an impediment\nbeyond his control and that he could not reasonably be expected to have taken the\nimpediment into account at the time of the conclusion of the contract or to have avoided or\novercome it or its consequences.\xe2\x80\x9d\n\nRight to Adequate Assurances of Performance\nSection 2-609, Comment 1, of the UCC observes that \xe2\x80\x9cthe essential purpose of a contract\xe2\x80\xa6is actual\nperformance [but] a continuing sense of reliance and security that the promised performance will be\nforthcoming when due is an important feature of the bargain.\xe2\x80\x9d Thus the UCC says that if one party has\n\xe2\x80\x9creasonable grounds for insecurity arise\xe2\x80\xa6either party may in writing demand adequate assurance and\nuntil he receives such assurance may if commercially reasonable suspend [his own] performance[.]\xe2\x80\x9d\n\nThe CISG has a similar take at Article 71: \xe2\x80\x9cA party may suspend the performance of his\nobligations if, after the conclusion of the contract, it becomes apparent that the other party\nwill not perform a substantial part of his obligations. A party suspending performance,\nwhether before or after dispatch of the goods, must immediately give notice of the\nsuspension to the other party and must continue with performance if the other party\nprovides adequate assurance of his performance.\xe2\x80\x9d\n\nAnticipatory Repudiation\nObviously if a person repudiates the contract it\xe2\x80\x99s clear she will not perform, but what if she repudiates\nbefore time for performance is due? Does the other side have to wait until nonperformance actually\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n469\n\n\x0chappens, or can he sue in anticipation of the other\xe2\x80\x99s default? Sections 2-610 and 2A-402 of the UCC say\nthe aggrieved party can do either: wait for performance or \xe2\x80\x9cresort to any remedy for breach.\xe2\x80\x9d Under the\nUCC, Sections 2-611 and 2A-403, the one who has anticipatorily repudiated can \xe2\x80\x9cretract his repudiation\nunless the aggrieved party has since the repudiation cancelled or materially changed his position[.]\xe2\x80\x9d\nSuppose that Howard has cause to suspect that if he does deliver the goods, Bunker won\xe2\x80\x99t pay. Howard\nmay write to Bunker and demand\xe2\x80\x94not request\xe2\x80\x94assurances of adequate performance. If such assurances\nare not adequately forthcoming, Howard may assume that Bunker has repudiated the contract and have\nremedies.\n\nArticle 72 of the CISG is pretty much the same: \xe2\x80\x9cIf prior to the date for performance of the\ncontract it is clear that one of the parties will commit a fundamental breach of contract, the\nother party may declare the contract avoided.\xe2\x80\x9d\n\nK E Y TA K EA WAY\nIf, through no fault of either party, the goods are destroyed before the risk of loss has\npassed from the seller to the buyer, the parties are both discharged. If the expected\nmeans of performance is impossible, but an alternative is available, the alternative must\nbe utilized. If performance becomes impracticable because of an unexpected\ncontingency, failure to deliver the goods is excused. But a party who has concerns\nwhether the other side will perform is entitled to adequate assurances of performance;\nif they are not forthcoming, the worried party may suspend performance. Where a party\nrepudiates a contract before performance is due, the other side may sue immediately\n(anticipatory repudiation) or may wait until the time performance comes due and then\nsue.\n\nE XE R C IS ES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n470\n\n\x0c1. Suppose Plaintiff sues Defendant for breach of contract, and Defendant successfully\nraises an excuse for nonperformance. What liability does Defendant have now?\n2. The contract read that the goods would be \xe2\x80\x9cshipped F.O.B. Seattle, by Burlington\nNorthern Rail to the buyer in Vancouver, B.C.\xe2\x80\x9d Due to heavy rain and mudslides, the\nrail line between Seattle and points north was impassable. Buyer insists Seller is\nobligated to send the goods by motor truck; Seller insists her performance has\nbecome impossible or at least that shipment must await the rail-line clearance. Who\nis correct? Explain.\n3. Buyer manufactured ceramic insulators and ordered the dies into which the liquid\nceramic would be poured for hardening and finishing from Seller, to be delivered\nApril 15. The first test batch of a dozen dies arrived on February 15; these dies were\ndefective. Buyer wrote inquiring whether the defects could be remedied in time for\nthe final delivery. Seller responded, \xe2\x80\x9cWe are working to address the problems here.\xe2\x80\x9d\nBuyer again inquired; Seller responded, \xe2\x80\x9cAs I said, we are working on the problems.\xe2\x80\x9d\nBuyer fretted that the deadline\xe2\x80\x94two months in the future\xe2\x80\x94would not be met.\nWhat remedy, if any, does Buyer have now?\n\n10.5 Cases\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n471\n\n\x0cLimitations of Remedy Results in No Remedy\nHartzell v. Justus Co., Inc.\n\n693 F.2d 770 (8th Cir. S.D. 1982)\n\nArnold, J.\n\nThis is a diversity case arising out of the purchase by Dr. Allan Hartzell of Sioux Falls, South Dakota, of a\nlog home construction kit manufactured by the defendant Justus Homes. Dr. Hartzell purchased the\npackage in 1977 for $38,622 [about $135,000 in 2010 dollars] from Del Carter, who was Justus Homes\xe2\x80\x99\ndealer for the Sioux Falls area. He also hired Carter\xe2\x80\x99s construction company, Natural Wood Homes, to\nbuild the house. Hartzell, who testified that the home eventually cost about $150,000, was dissatisfied\nwith the house in many respects. His chief complaints were that knotholes in the walls and ceiling leaked\nrain profusely, and that the home was not weather tight because flashings were not included in the roofing\nmaterials and because the timbers were not kiln-dried and therefore shrank. He also complained that an\nundersized support beam, which eventually cracked, was included in the package. This latter defect was\nalleged to have resulted in cracks in the floor and inside doors that would not close. Hartzell further\nalleged that these structural defects were only partially remediable, and that the fair market value of the\nhouse was reduced even after all practicable repairs had been made. Alleging breach of implied and\nexpress warranties and negligence, he sought damages for this loss in value and for the cost of repairs.\nAfter a two-day trial, the jury returned a plaintiff\xe2\x80\x99s verdict for $34,794.67.\n\nJustus Homes contends the District Court erred in failing to instruct the jury on a limitation-of-remedies\nclause contained in its contract with the plaintiff. The defendants rely on Clause 10c of the contract, which\nsays Justus will repair or replace defective materials, and Clause 10d, which states that this limited\nrepair or replacement clause is the exclusive remedy available against Justus [emphasis added]. These\nagreements, Justus asserts, are valid under the Uniform Commercial Code 2-719(1). Section 2-719(1)\nstates:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n472\n\n\x0c(1) Subject to the provisions of subsections (2) and (3) of this section and of \xc2\xa7 57A-2-718 on liquidation\nand limitation of damages,\n\n(a) The agreement may provide for remedies in addition to or in substitution for those provided in this\nchapter and may limit or alter the measure of damages recoverable under this chapter, as by limiting the\nbuyer\xe2\x80\x99s remedies to return of the goods and repayment of the price or to repair and replacement of\nnonconforming goods or parts; and\n\n(b) Resort to a remedy as provided is optional unless the remedy is expressly agreed to be exclusive, in\nwhich case it is the sole remedy.\n\nSubsection (1) of section 2-719 is qualified by subsection (2): \xe2\x80\x9cWhere circumstances cause an exclusive or\nlimited remedy to fail of its essential purpose, remedy may be had as provided in this title.\xe2\x80\x9d\xe2\x80\xa6\n\nThe jury\xe2\x80\x99s verdict for the plaintiff in an amount almost exactly equal to the plaintiff\xe2\x80\x99s evidence of cost of\nrepairs plus diminution in market value means it must have found that the structural defects were not\nentirely remediable. Such a finding necessarily means that the limited warranty failed of its essential\npurpose.\n\nTwo of our recent cases support this conclusion. In Soo Line R.R. v. Fruehauf Corp., 547 F.2d 1365 (8th\nCir.1977), the defendant claimed, relying on a limitation-of-remedies clause similar to the one involved\nhere, that the plaintiff\xe2\x80\x99s damages should be limited to the reasonable cost of repairing the railroad cars\nthat plaintiff had bought from defendant. The jury verdict included, among other things, an award for the\ndifference between the value of the cars as actually manufactured, and what they would have been worth if\nthey had measured up to the defendant\xe2\x80\x99s representations. This Court affirmed the verdict for the larger\namount. We held, construing the Minnesota U.C.C., which is identical to \xc2\xa7 2-719 as adopted in South\nDakota, that the limitation-of-remedies clause was ineffective because the remedy as thus limited failed of\nits essential purpose. The defendant, though called upon to make the necessary repairs, had refused to do\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n473\n\n\x0cso, and the repairs as performed by the plaintiff itself \xe2\x80\x9cdid not fully restore the cars to totally acceptable\noperating conditions.\xe2\x80\x9d\n\nHere, Justus Homes attempted to help with the necessary repairs, which is more than Fruehauf did in\nthe Soo Line case, but after the repairs had been completed the house was still, according to the jury\nverdict, not what Justus had promised it would be. The purpose of a remedy is to give to a buyer what the\nseller promised him\xe2\x80\x94that is, a house that did not leak. If repairs alone do not achieve that end, then to\nlimit the buyer\xe2\x80\x99s remedy to repair would cause that remedy to fail of its essential purpose.\xe2\x80\xa6\n\nAn analogous case is Select Pork, Inc. v. Babcock Swine, Inc.[Citation], applying \xc2\xa7 2-719 as adopted in\nIowa. The defendant had promised to deliver to plaintiff certain extraordinary pigs known as Midwestern\nGilts and Meatline Boars. Instead, only ordinary pigs were delivered. Plaintiff sued for breach of warranty,\nand defendant claimed that its damages, if any, should be limited to a return of the purchase price by an\nexpress clause to that effect in the contract. The District Court held that the clause was unenforceable\nbecause it was unconscionable, see \xc2\xa7 2-719(3), and because it failed of its essential purpose. We\naffirmed,\xe2\x80\xa6\xe2\x80\x9cHaving failed to deliver the highly-touted special pigs, defendants may not now assert a\nfavorable clause to limit their liability.\xe2\x80\x9d So here, where the house sold was found by the jury to fall short of\nthe seller\xe2\x80\x99s promises, and where repairs could not make it right, defendant\xe2\x80\x99s liability cannot be limited to\nthe cost of repairs. If the repairs had been adequate to restore the house to its promised condition, and if\nDr. Hartzell had claimed additional consequential damages, for example, water damage to a rug from the\nleaky roof, the limitation-of-remedies clause would have been effective. But that is not this case.\n\nThere was no double recovery here: the verdict was not for cost of repair plus the entire decrease in\nmarket value, but rather for cost of repair plus the decrease in market value that still existed after all the\nrepairs had been completed.\n\n[T]he evidence in the record all demonstrate[s] that the repair or replacement clause was a failure under\nthe circumstances of this case. Some of the house\xe2\x80\x99s many problems simply could not be remedied by\nrepair or replacement. The clause having failed of its essential purpose, that is, effective enjoyment of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n474\n\n\x0cimplied and express warranties, the plaintiff was entitled, under UCC \xc2\xa7 2-719(2), to any of the buyer\xe2\x80\x99s\nremedies provided by the Code. Among these remedies are consequential damages as provided in \xc2\xa7\xc2\xa7 2-714\nand 2-715(2).\xe2\x80\xa6\n\nThe judgment is affirmed.\n\nC A SE QU ES TIO NS\n1. What did the seller here limit itself to do in case of defects? What was the\nlimitation of remedy?\n2. Did Justus Homes disclaim implied and expressed warranties with its contract\nlanguage regarding limitation of remedies?\n3. Was the essential purpose of the limitation of remedy to protect the party\nbenefiting from it\xe2\x80\x94here, the seller of the log home kit\xe2\x80\x94or was the essential\npurpose of the limitation of remedy, as the court said, \xe2\x80\x9ceffective enjoyment of\nimplied and expressed warranties\xe2\x80\x9d?\n4. In a part of the opinion excised, the court wrote, \xe2\x80\x9cA finding of\nunconscionability is, as a matter of logic, simply unnecessary in cases where \xc2\xa7\n2-719(2) applies.\xe2\x80\x9d Would it be easier simply to say that the limitation of\nliability here was unconscionable?\n\nCure for Improper Delivery\nWilson v. Scampoli\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n475\n\n\x0c228 A.2d 848 (D.C. App. 1967)\n\nMyers, J.\n\nThis is an appeal from an order of the trial court granting rescission of a sales contract for a color\ntelevision set and directing the return of the purchase price plus interest and costs.\n\nAppellee [Mrs. Kolley\xe2\x80\x99s father] purchased the set in question on November 4, 1965, paying the total\npurchase price in cash. The transaction was evidenced by a sales ticket showing the price paid and\nguaranteeing ninety days\xe2\x80\x99 free service and replacement of any defective tube and parts for a period of one\nyear. Two days after purchase the set was delivered and uncrated, the antennae adjusted and the set\nplugged into an electrical outlet to \xe2\x80\x9ccook out.\xe2\x80\x9d When the set was turned on however, it did not function\nproperly, the picture having a reddish tinge. Appellant\xe2\x80\x99s delivery man advised the buyer\xe2\x80\x99s daughter, Mrs.\nKolley, that it was not his duty to tune in or adjust the color but that a service representative would shortly\ncall at her house for that purpose. After the departure of the delivery men, Mrs. Kolley unplugged the set\nand did not use it.\n\nOn November 8, 1965, a service representative arrived, and after spending an hour in an effort to\neliminate the red cast from the picture advised Mrs. Kolley that he would have to remove the chassis from\nthe cabinet and take it to the shop as he could not determine the cause of the difficulty from his\nexamination at the house. He also made a written memorandum of his service call, noting that the\ntelevision \xe2\x80\x98\\\xe2\x80\x9dNeeds Shop Work (Red Screen).\xe2\x80\x9d Mrs. Kolley refused to allow the chassis to be removed,\nasserting she did not want a \xe2\x80\x98repaired\xe2\x80\x99 set but another \xe2\x80\x98brand new\xe2\x80\x99 set. Later she demanded the return of\nthe purchase price, although retaining the set. Appellant refused to refund the purchase price, but\nrenewed his offer to adjust, repair, or, if the set could not be made to function properly, to replace it.\nUltimately, appellee instituted this suit against appellant seeking a refund of the purchase price. After a\ntrial, the court ruled that \xe2\x80\x9cunder the facts and circumstances the complaint is justified. Under the equity\npowers of the Court I will order the parties put back in their original status, let the $675 [about $4500 in\n2010 dollars] be returned, and the set returned to the defendant.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n476\n\n\x0cAppellant does not contest the jurisdiction of the trial court to order rescission in a proper case, but\ncontends the trial judge erred in holding that rescission here was appropriate. He argues that he was\nalways willing to comply with the terms of the sale either by correcting the malfunction by minor repairs\nor, in the event the set could not be made thereby properly operative, by replacement; that as he was\ndenied the opportunity to try to correct the difficulty, he did not breach the contract of sale or any\nwarranty thereunder, expressed or implied.\n\n[The District of Columbia UCC 2-508] provides:\n\n(1) Where any tender or delivery by the seller is rejected because non-conforming and the time for\nperformance has not yet expired, the seller may seasonably notify the buyer of his intention to cure and\nmay then within the contract time make a conforming delivery.\n\n(2) Where the buyer rejects a nonconforming tender which the seller had reasonable grounds to believe\nwould be acceptable with or without money allowance the seller may if he seasonably notifies the buyer\nhave a further reasonable time to substitute a conforming tender.\n\xe2\x80\xa6\n\nRemoval of a television chassis for a short period of time in order to determine the cause of color\nmalfunction and ascertain the extent of adjustment or correction needed to effect full operational\nefficiency presents no great inconvenience to the buyer. In the instant case, appellant\xe2\x80\x99s expert witness\ntestified that this was not infrequently necessary with new televisions. Should the set be defective in\nworkmanship or parts, the loss would be upon the manufacturer who warranted it free from mechanical\ndefect. Here the adamant refusal of Mrs. Kolley, acting on behalf of appellee, to allow inspection essential\nto the determination of the cause of the excessive red tinge to the picture defeated any effort by the seller\nto provide timely repair or even replacement of the set if the difficulty could not be corrected. The cause of\nthe defect might have been minor and easily adjusted or it may have been substantial and required\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n477\n\n\x0creplacement by another new set\xe2\x80\x94but the seller was never given an adequate opportunity to make a\ndetermination.\n\nWe do not hold that appellant has no liability to appellee, but as he was denied access and a reasonable\nopportunity to repair, appellee has not shown a breach of warranty entitling him either to a brand new set\nor to rescission. We therefore reverse the judgment of the trial court granting rescission and directing the\nreturn of the purchase price of the set.\n\nReversed.\n\nC A SE QU ES TIO NS\n1. Why did the seller \xe2\x80\x9chave reasonable grounds to believe [the television] would\nbe acceptable\xe2\x80\x9d?\n2. What did Mrs. Kolley want?\n3. Does this case require a buyer to accept patchwork goods or substantially\nrepaired articles in lieu of flawless merchandise?\n\nSeller\xe2\x80\x99s Remedies When Buyer Defaults\nSantos v. DeBellis\n\n901 N.Y.S.2d 457 (N.Y. Sup.App. 2010)\n\nMolia, J.\n\nOn March 1, 2008 and March 11, 2008, plaintiff made payments to defendant of $3,000 each, in\nconnection with the purchase of a mobile home located in Fort Pierce, Florida. Thereafter, on March 13,\n2008, plaintiff and defendant signed an agreement which had been prepared by defendant. The\nagreement described the subject property by its location, recorded the fact that plaintiff had paid\ndefendant deposits totaling $6,000, set forth a closing date of March 25, 2008, and specified that \xe2\x80\x9cthe\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n478\n\n\x0cremaining $27,000.00\xe2\x80\x9d was payable at closing to defendant by a guaranteed financial instrument.\nPlaintiff never paid the outstanding balance and brought this action to recover the $6,000 deposit she\npaid to defendant. Following a nonjury trial, judgment was awarded in favor of defendant dismissing the\ncomplaint.\n\nBecause the sale of a mobile home constitutes a contract for the sale of goods rather than of real property\n[Citations], the parties\xe2\x80\x99 agreement was governed by the Uniform Commercial Code. The agreement, which\nwas made after plaintiff had made the two $3,000 \xe2\x80\x9cdeposit\xe2\x80\x9d payments, constituted a memorandum in\nconfirmation of an oral agreement and, even though it omitted some terms, was sufficient to satisfy the\nstatute of frauds [Citations].\n\nSection 2-718 of the Uniform Commercial Code specifies that in the absence of a contractual provision\nwith respect to the liquidation or limitation of damages and the return of deposits,\n\n(2) Where the seller justifiably withholds delivery of goods because of the buyer\xe2\x80\x99s breach, the buyer is\nentitled to restitution of any amount by which the sum of his payments exceeds\xe2\x80\xa6\n\n(b) [in the absence of contractually fixed terms] twenty per cent of the value of the total performance for\nwhich the buyer is obligated under the contract or $500, whichever is smaller.\n\n(3) The buyer\xe2\x80\x99s right to restitution under subsection (2) is subject to offset to the extent that the seller\nestablishes\n\n(a) a right to recover damages under the provisions of this Article other than subsection (1), and\n\n(b) the amount or value of any benefits received by the buyer directly or indirectly by reason of the\ncontract.\nHere, notwithstanding the fact that plaintiff, as buyer, had breached the contract, defendant failed to\ndemonstrate any damages resulting therefrom; nor did defendant establish that plaintiff had received any\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n479\n\n\x0cbenefits directly or indirectly by reason of the parties\xe2\x80\x99 agreement (seeUCC 2-718[3]). Therefore, pursuant\nto UCC 2-718(2), plaintiff was entitled to the return of all but $500 of her deposit.\n\nThe order of the District Court dismissing the complaint is accordingly reversed, and judgment is awarded\nto plaintiff in the principal sum of $5,500.\n\nC A SE QU ES TIO NS\n1. If the plaintiff had been a dealer in mobile homes and the unit here had been\npart of his inventory, he would be entitled to claim lost profits on the sale of\none unit. Here, apparently, the plaintiff seller was a private party. Why was he\nnot entitled to any damages greater than $500?\n2. New York adopted the UCC in 1964. Five hundred dollars in 1964 would be\nworth about $3,500 in 2010. Why isn\xe2\x80\x99t the change in the dollar\xe2\x80\x99s value\nrecognized here?\n\nBuyer\xe2\x80\x99s Remedies When Seller Breaches\n[Note: this case is slightly edited by the authors.]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n480\n\n\x0cFurlong v. Alpha Chi Omega Sorority\n\n657 N.E.2d 866 (Ohio Mun. 1993)\n\nBachman, J.\n\nIn late September through mid-October 1992, plaintiff Johnathan James Furlong (\xe2\x80\x9cFurlong\xe2\x80\x9d) contacted\ndefendant Alpha Chi Omega Sorority (\xe2\x80\x9cAXO\xe2\x80\x9d), by phoning the chairperson of its social committee, Emily\nLieberman (\xe2\x80\x9cEmily\xe2\x80\x9d), between a dozen and a dozen and a half times.\n\nUltimately (about the first week in October), Furlong received Emily\xe2\x80\x99s order for one hundred sixty-eight\nimprinted sweaters at $21.50 each (plus one free sweater) for delivery on Friday, October 23, 1992, so as\nto arrive in time for AXO\xe2\x80\x99s Midnight Masquerade III on the evening of Saturday, October 24, 1992.\n\nThe price was to be $3,612, [about $5600 in 2010 dollars] payable as follows: $2,000 down payment\nwhen the contract was made, and $1,612 balance when the sweaters were delivered.\n\nAn oral contract for the sale of goods (the imprinted sweaters) was made between Furlong and AXO, at a\ndefinite price and with specified dates for payment and for delivery.\n\nAt some point in those phone calls with Furlong, Emily said that the sweaters were to be custom designed\nwith the following specified design: namely, with three colors (hunter green letters on top of maroon\nletters outlined in navy blue, and hunter green masks). Furlong promised to have them so imprinted (by a\nthird party whom he would select).\xe2\x80\xa6Thereafter, he delivered to Emily an Ohio Wesleyan sweater with\nmaroon letters to show her the maroon color.\xe2\x80\xa6Additionally, he faxed to Emily a two-page description of\nthe sweaters, which not only included the designs for the fronts and the backs of the sweaters, but also\nincluded arrows showing where each of the three colors would go (hunter green letters on top of maroon\nletters outlined in navy blue, and hunter green masks).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n481\n\n\x0cFurlong and Emily created an express warranty by each of the above three statutory means: namely, by\naffirmation of fact (his initial phone calls); by sample (the maroon sweater) by description (the fax).This\nexpress warranty became part of the contract. Each of the three methods of showing the express warranty\nwas not in conflict with the other two methods, and thus they are consistent and cumulative, and\nconstitute the warranty. [2-317]\n\nThe design was a \xe2\x80\x9cdickered\xe2\x80\x9d aspect of the individual bargain and went clearly to the essence of that. Thus,\nthe express warranty was that the sweaters would be in accordance with the above design (including types\nof colors for the letters and the mask, and the number of colors for the same). Further, the express\nwarranty became part of the contract.\n\nOn October 13, 1992, AXO mailed Furlong a $2,000 check for the down payment; he deposited it in his\nbank account on October 16, 1992. Thereafter, as discussed below, Furlong had the sweaters imprinted\n(on Thursday, October 22) and delivered to AXO (on Friday, October 23). Upon receipt of the delivery,\nAXO gave a check to Furlong\xe2\x80\x99s agent in the amount of $1,612 for the balance of the purchase price.\nHowever, later on that day, AXO inspected the sweaters, discovered the design changes (mentioned\nbelow), caused AXO\xe2\x80\x99s bank to stop payment on the check, and stated AXO\xe2\x80\x99s objections in a phone call\nwith Furlong. AXO has never paid Furlong that balance on the purchase price.\n\nFurlong\xe2\x80\x99s obligation as the seller was to transfer and deliver the goods in accordance with the contract.\nAXO\xe2\x80\x99s obligation was to accept and pay in accordance with that contract. [2-301] We will now discuss\nwhether it legally did so.\n\nFurlong was a jobber for Argento Bros., Inc. (\xe2\x80\x9cArgento\xe2\x80\x9d) and had Argento print the sweaters. In doing so,\nFurlong worked with Argento\xe2\x80\x99s artists. Early in the morning of Thursday (October 22, 1992), the artist(s)\nbegan to prepare the art work and recommended changes to the design. Furlong authorized the artist(s)\nto change the design without the knowledge or consent of AXO. Argento spent about eight hours printing\nthe sweaters all day Thursday. Furlong did not phone AXO about the changes until the next day, Friday\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n482\n\n\x0c(October 23), after the sweaters were printed with those changes. Here are the five design changes that he\nmade:\n\n\xe2\x80\xa2\n\nThe first change was to delete the agreed-upon outline for the letters (namely, the navy blue\noutline).\n\n\xe2\x80\xa2\n\nThe second change was to reduce the agreed-upon number of colors for the fronts and the backs\n(from three colors per side to two colors per side).\n\n\xe2\x80\xa2\n\nThe third change was to alter one of the agreed-upon colors (from maroon to red).\n\n\xe2\x80\xa2\n\nThe fourth change was to alter the agreed-upon scheme of colors for the letters on the fronts and\nthe backs (namely, both sides were to have the same two colors of maroon and hunter green;\nwhereas in fact the backs had neither of those colors, and instead had a navy blue color for the\nletters).\n\n\xe2\x80\xa2\n\nThe fifth change was to alter the agreed-upon color of the masks (from hunter green to maroon\xe2\x80\x94\nactually red).\n\nThe court specifically finds that the color was red (actually, scarlet) and was not maroon (like the marooncolored letters on the Ohio Wesleyan sweater).\n\nThe sweaters did not conform to the contract (specifically, the express warranty in the contract). Thus (in\nthe words of the statute), the sweaters did \xe2\x80\x9cfail in any respect to conform to the contract.\xe2\x80\x9d Actually, the\nsweaters failed in at least five respects. [2-601] Further, not only did they \xe2\x80\x9cfail in any respect,\xe2\x80\x9d they failed\nin a substantial respect. In either event, they were a nonconforming tender of goods. [2-601]\n\nOn Friday morning (October 23), Furlong picked up the five to six boxes of sweaters from Argento and\nhad a friend deliver them from Columbus to Bowling Green. The boxes arrived at the AXO house around\nmidday. Sometime thereafter on the same day, Emily inspected one of them and screamed her dismay\nupon discovering that the sweaters were not what AXO had ordered.\nThe court rejects Furlong\xe2\x80\x99s assertion that he did all that he could do under the circumstances. The obvious\nanswer is that he did not do enough. He should have gotten AXO\xe2\x80\x99s prior consent to the changes. He could\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n483\n\n\x0chave done this by providing for more lead time-between the time that Argento prepared the art work and\nthe time that it printed the sweaters. Instead, he had both done at the same time (Thursday morning).\n\nFinally, and alternatively, plaintiff should have entered into a contract that gave him discretion to make\ndesign changes without AXO\xe2\x80\x99s consent. We must remember that \xe2\x80\x9cthese sweaters,\xe2\x80\x9d as Furlong himself\nadmits (and describes), were to be \xe2\x80\x9ccustom-designed\xe2\x80\x9d for AXO. Thus, they were to be printed according to\nAXO\xe2\x80\x99s specifications, and not according to Furlong\xe2\x80\x99s discretion.\n\nNext, Furlong asserts that AXO\xe2\x80\x94after learning of the changes\xe2\x80\x94should have agreed to his offer of\ncompromise: namely, that he would reduce the unit price of the sweaters in exchange for AXO\xe2\x80\x99s keeping\nthem and paying the reduced price. Also, Furlong asserts that AXO should have communicated his\ncompromise offer to AXO\xe2\x80\x99s members and pledges. In both respects, the court disagrees: Although the law\nallowed AXO to do so, it did not require AXO to do. Instead, AXO did exactly what the law allowed: AXO\nrejected the nconforming goods in whole.\n\nAbout 4:00 p.m. on the same day that the sweaters arrived at the AXO house (Friday, October 23), Amy\xe2\x80\x94\nas the AXO president\xe2\x80\x94phoned Furlong. She said that the sweaters were not what AXO had ordered. She\nstated the specifics as to why the sweaters were not as ordered. She offered to return the sweaters to him,\nbut he said \xe2\x80\x9cNo.\xe2\x80\x9d AXO still has possession or custody of the boxes of sweaters.\n[The UCC] provides: \xe2\x80\x9cRejection of goods must be within a reasonable time after their delivery * * *. It is\nineffective unless the buyer seasonably notifies the seller.\xe2\x80\x9d [2-602] AXO did what this statute requires.\n\nThat statute further provides: \xe2\x80\x9c[I]f the buyer has before rejection taken physical possession of goods * * *,\nhe is under a duty after rejection to hold them with reasonable care at the seller\xe2\x80\x99s disposition for a time\nsufficient to permit the seller to remove them[.]\xe2\x80\x9d [2-602(2)(b)] AXO has done this, too. From the above, it\nis seen that AXO legally rejected the sweaters on the same day that AXO received physical possession of\nthem.\nThe court disagrees with Furlong\xe2\x80\x99s assertion that AXO accepted the sweaters. He is confusing a layman\xe2\x80\x99s\nunderstanding of the term accept(\xe2\x80\x9cto receive a thing [with a consenting mind]),\xe2\x80\x9d Webster\xe2\x80\x99s Collegiate\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n484\n\n\x0cDictionary (5 Ed.1947), at 6, with the statutory meaning of the term. The mere fact that AXO took physical\npossession of the sweaters does not, by itself, mean that AXO legally \xe2\x80\x9caccepted\xe2\x80\x9d them.\n\nIn regard to\xe2\x80\xa6seller\xe2\x80\x99s remedies, Furlong has no legal remedies because AXO did not breach the contract.\nThus, he is not entitled to an award for the $1,612 balance that he claims is due on the contract price.\n\nAs concluded above, AXO rightfully rejected the sweaters, after having paid part of the purchase price:\nnamely, $2,000. AXO is entitled to cancel the contract and to recover the partial payment of the purchase\nprice. [2-606]\n\nAlso, as concluded above, AXO still has rightful possession or control of the sweaters. AXO has a security\ninterest in the sweaters in its possession or control for the part payment made on the purchase price\xe2\x80\x94but\nwhen reimbursed for that part payment AXO must return the sweaters to Furlong.\n\nThe court will prepare, file, and serve a judgment entry as follows: dismissing with prejudice Furlong\xe2\x80\x99s\nclaim against all defendants; dismissing with prejudice Emily Lieberman\xe2\x80\x99s and Amy Altomondo\xe2\x80\x99s\ncounterclaims against Furlong; granting AXO\xe2\x80\x99s counterclaim (for $2,000, plus ten percent per annum\npostjudgment interest and costs).\n\nFurther, that entry will order AXO\xe2\x80\x99s attorney (Mr. Reddin) to retain possession of the sweaters either until\nfurther court order or until AXO\xe2\x80\x99s judgment is satisfied in full (whereupon he shall surrender the sweaters\nto Furlong if Furlong picks them up within thirty days thereafter, or, if Furlong does not, he may then\ndispose of them as abandoned property without any liability).\n\nJudgment accordingly.\n\nC A SE QU ES TIO NS\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n485\n\n\x0c1. Surely the plaintiff could not have thought that the radically altered design\nwould be acceptable for the young women\xe2\x80\x99s masquerade ball. On what basis\ndid he think he would be entitled to the full payment contracted for?\n2. Whether Amy Altomondo knew it or not, she did what the UCC says a buyer\nshould do when nonconforming goods are delivered. What are those steps?\n3. What does it mean that AXO has a security interest in the sweaters? Security\nfor what?\n\n10.6 Summary and Exercises\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n486\n\n\x0cSummary\nAs with most of the Uniform Commercial Code (UCC), the parties may specify the terms of their\nperformance. Only if they fail to do so does Article 2 (and 2A) provide the terms for them. The seller\xe2\x80\x99s\nduty is to make a timely delivery of conforming goods. In the absence of agreement, the time for delivery\nis a reasonable one, and the place of delivery is the seller\xe2\x80\x99s place of business. All goods must be tendered\nin a single delivery, unless circumstances permit either party the right to make or demand delivery in lots.\n\nIf the seller ships nonconforming goods but has time to meet his contractual obligations or if he\nreasonably believed the goods would be suitable, he may notify the buyer of his intention to cure, and if he\ndoes so in a timely manner the buyer must pay.\n\nThe buyer\xe2\x80\x99s general obligation is to inspect, accept, and pay. If an inspection reveals that the goods are\nnonconforming, the buyer may reject them; if he has accepted because defects were latent or because he\nreceived assurances that the defects would be cured, and they are not, the buyer may revoke his\nacceptance. He then has some duties concerning the goods in his possession. The buyer must pay for any\nconforming goods; payment may be in any manner consistent with current business customs. Payment is\ndue at the time and place at which the buyer will ultimately receive the goods.\n\nThe general policy of the UCC is to put an aggrieved party in as good a position as she would have been\nhad the other party fully performed. The parties may specify or limit certain remedies, but they may not\neliminate all remedies for a breach. However, if circumstances make an agreed-on remedy inadequate,\nthen the UCC\xe2\x80\x99s other remedies apply; parties may not unconscionably limit consequential damages; they\nmay agree to liquidated damages, but not to unreasonable penalties.\n\nIn general, the seller may pursue the following remedies: withhold further delivery, stop delivery, identify\nto the contract goods in her possession, resell the goods, recover damages or the price, or cancel the\ncontract. In addition, when it becomes apparent that the buyer is insolvent, the seller may, within certain\ntime periods, refuse to deliver the remaining goods or reclaim goods already delivered.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n487\n\n\x0cThe buyer, in general, has remedies. For goods not yet received, she may cancel the contract; recover the\nprice paid; cover the goods and recover damages for the difference in price; or recover the specific goods if\nthey are unique or in \xe2\x80\x9cother proper circumstances.\xe2\x80\x9d For goods received and accepted, the buyer may\nrecover ordinary damages for losses that stem from the breach and consequential damages if the seller\nknew of the buyer\xe2\x80\x99s particular needs and the buyer could not reasonably cover.\n\nThe UCC provides some excuses for nonperformance: casualty of the goods, through no fault of either\nparty; the nonhappening of presupposed conditions that were a basic assumption of the contract;\nsubstituted performance if the agreed-on methods of performance become impracticable; right to\nadequate assurances of performance when reasonable grounds for insecurity of performance arise;\nanticipatory repudiation and resort to any remedy, before time for performance is due, is allowed if either\nparty indicates an unwillingness to perform.\n\nE XE R C IS ES\n1. Anne contracted to sell one hundred cans of yellow tennis balls to Chris,\nwith a delivery to be made by June 15.\na. On June 8, Anne delivered one hundred cans of white tennis balls,\nwhich were rejected by Chris. What course of action would you\nrecommend for Anne, and why?\nb. Assume Ann had delivered the one hundred cans of white balls on\nJune 15; these were rejected by Chris. Under what circumstances\nmight Anne be allowed additional time to perform the contract?\nc. If the contract did not specify delivery, when must Anne deliver the\ntennis balls?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n488\n\n\x0ca. When Anne delivers the tennis balls, does Chris have a right to\ninspect them? If Chris accepts the white tennis balls, may the\nacceptance be revoked?\nb. Assume Chris decided she could use twenty-five cans of the white\nballs. Could she accept twenty-five cans and reject the rest?\nc. Suppose Anne delivered white tennis balls because a fire at her\nwarehouse destroyed her entire stock of yellow balls. Does the fire\ndischarge Anne\xe2\x80\x99s contractual duties?\nd. If Chris rejected the white tennis balls and Anne refused to deliver\nyellow ones, may Chris recover damages? If so, how would they be\ncalculated?\nIn 1961, Dorothy and John Wilson purchased a painting from Hammer\nGalleries titled Femme Debout. It cost $11,000 (about $78,000 in 2010\ndollars) and came with this promise: \xe2\x80\x9cThe authenticity of this picture is\nguaranteed.\xe2\x80\x9d In 1984, an expert deemed the painting a fake. The district\ncourt held that the Wilsons\xe2\x80\x99 suit for breach of warranty, filed in February\n1987\xe2\x80\x94twenty-one years after its purchase\xe2\x80\x94was barred by the UCC\xe2\x80\x99s fouryear statute of limitations. The Wilsons argued, however, that the Code\xe2\x80\x99s\nexception to the four-year rule applied: [1] \xe2\x80\x9cA breach of warranty occurs\nwhen tender of delivery is made, except where a warranty explicitly\nextends to future performance and discovery must await the time of such\nperformance the cause of action accrues when the breach is or should have\nbeen discovered.\xe2\x80\x9d\nThey said the painting \xe2\x80\x9cperformed\xe2\x80\x9d by being an authentic Vuillard\xe2\x80\x94a\nFrench artist\xe2\x80\x94and that the warranty of authenticity not only guaranteed\nthe present \xe2\x80\x9cbeing\xe2\x80\x9d of the painting but also extended, as required by 2725(2), to the future existence as a Vuillard. Therefore, they contended,\nexplicit words warranting future performance would be superfluous: a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n489\n\n\x0cwarranty that promises authenticity \xe2\x80\x9cnow and at all times in the future\xe2\x80\x9d\nwould be redundant. How should the court rule?\nSpeedi Lubrication Centers Inc. and Atlas Match Corp. entered into a\ncontract that provided for Speedi to buy 400,000 advertising matchbooks\nfrom Atlas, to be paid for within thirty days of delivery of each shipment.\nOrders for such matches required artwork, artists\xe2\x80\x99 commissions, and\nprinting plates. Atlas sent twenty-two cases of matches to Speedi with an\ninvoice showing $2,100 owed. Almost ninety days later, Speedi sent Atlas a\ncheck for $1,000, received the same day Atlas sent Speedi a letter declaring\nSpeedi to be in material breach of the contract. A second check for $1,100\nwas later received; it bounced but was later replaced by a cashier\xe2\x80\x99s check.\nThe contract provided that an untimely payment was a breach, and it\nincluded these provisions related to liquidated damages:\nAtlas shall have the right to recover from Purchaser the price of all\nmatchbooks and packaging delivered and/or identified to this agreement at\nthe time of Purchaser\xe2\x80\x99s breach hereof and shall be additionally entitled to\nrecover fifty percent (50%) of the contract price of matchbooks and/or\npackaging ordered hereby, but not delivered or identified to this\nAgreement at the time of Purchaser\xe2\x80\x99s breach. Purchaser agrees that the\npercentage as specified hereinabove\xe2\x80\xa6will be reasonable and just\ncompensation for such breach, and Purchaser hereby promises to pay such\nsum as liquidated damages, not as penalty in the event of any such breach.\nOn appeal, Speedi complained that the liquidated damages clause was a\npenalty. Is the matter settled by the contract saying the liquidated damages\nare reasonable? On what criteria would a court determine whether\nliquidated damages are reasonable?\nMrs. Kaiden made a $5,000 deposit on the purchase of new 1973 Rolls-Royce\nautomobile. Lee Oldsmobile, the seller, confirmed the request by transmitting a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n490\n\n\x0cregular order form, which Mrs. Kaiden signed and returned. The price was\n$29,500.00 [about $150,000 in 2010 dollars]. Some of the correspondence and a\nnotation on Mrs. Kaiden\xe2\x80\x99s check indicated that delivery was expected in\nNovember. The order form, however, specified no delivery date. Further, it\ncontained a disclaimer of liability for delay in delivery beyond the dealer\xe2\x80\x99s control,\nand it provided that the dealer had the right, upon failure of the purchaser to\naccept delivery, to retain as liquidated damages any cash deposit made. On\nNovember 21, 1973, Mrs. Kaiden notified Lee by telephone that she had\npurchased another Rolls-Royce elsewhere. She told the salesman to cancel her\norder. On November 29, Lee Oldsmobile notified Mrs. Kaiden that the car was\nready for delivery. She refused delivery and demanded the return of her deposit.\nThe dealer refused. In January 1974, the dealer\xe2\x80\x94without notice to the Kaidens\xe2\x80\x94\nsold the Rolls-Royce to another purchaser for $26,495. Mrs. Kaiden sued Lee\nOldsmobile for the $5,000 deposit. The dealer carefully itemized its losses on the\nKaiden deal\xe2\x80\x94$5080.07. On what basis did the court dismiss the liquidated\ndamages clause? What is the consequence of the dealer\xe2\x80\x99s failure to give notice of\nthe private sale under UCC, Section 2-706(3)?\nHemming saw an advertisement for a Cadillac convertible once owned by the\nfamous early rock \xe2\x80\x99n\xe2\x80\x99 roll singer Elvis Presley. He contracted to buy it from Whitney\nfor $350,000 and sent Whitney $10,000 as a deposit. But, after some delay,\nWhitney returned the $10,000 and informed Hemming that the car had been sold\nto another purchaser. What remedy does Hemming have?\nMurrey manufactured and sold pool tables. He was approached by Madsen,\nwho had an idea for a kind of electronic pool table that would light up and make\nsounds like a pinball machine. Madsen made a $70,000 deposit on an order for\none hundred tables but then encountered difficulties and notified Murrey that he\nwould be unable to accept delivery of the tables. Murrey broke the tables up,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n491\n\n\x0csalvaging materials worth about $15,000 and using the rest for firewood. The\nevidence was that the tables, if completed by Murrey, could have been sold for\n$45,000 as regular pool tables. Madsen gets his deposit back less expenses\nincurred by Murrey. But what principle affects Murrey\xe2\x80\x99s measure of damages, his\nright to claim expenses incurred?\nIn January 1992, Joseph Perna bought an eleven-year-old Oldsmobile at a New\nYork City police auction sale for $1,800 plus towing fees. It had been impounded\nby the police for nonpayment of parking tickets. The bill of sale from the police to\nPerna contained this language: \xe2\x80\x9csubject to the terms and conditions of any and all\nchattel mortgages, rental agreements, liens, conditional bills of sale, and\nencumbrances that may be on the motor vehicle of the [its original owner].\xe2\x80\x9d\nAbout a year later Perna sold the car to a coworker, Elio Marino, for $1,200.\nMarino repaired and improved the car by replacing the radiator, a gasket, and\ndoor locks. Ten months after his father bought the car, Marino\xe2\x80\x99s son was stopped\nby police and arrested for driving a stolen vehicle; Mario paid $600 to a lawyer to\nget that matter resolved, and he never got the car back from the police. Is Perna\nliable to Marino for the value of the car? Is Perna liable for the consequential\ndamages\xe2\x80\x94the attorney\xe2\x80\x99s fees? The relevant UCC sections are 2-312(2) and 2-714.\nWilliam Stem bought a used BMW from Gary Braden for $6,600 on Braden\xe2\x80\x99s\nassertion that as far as he knew the car had not been wrecked and it was in good\ncondition. Less than a week later Stem discovered a disconnected plug; when\nconnected the oil-sensor warning light glowed. Mechanics informed Stem that the\ncar was made up of the front end of a 1979 BMW and the rear end of a 1975\nBMW, and the front half had 100,000 more miles on it than Stem thought. Six\nweeks after he purchased the car, Stem wrote Braden a letter that he refused the\ncar and intended to rescind the sale. Braden did not accept return of the car or\nrefund the money, and Braden continued to drive it for seven months and nearly\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n492\n\n\x0c9,000 miles before suing. He had no other car and needed to transport his child.\nThese issues were before the Alabama Supreme Court, construing UCC, Section 2608: did Stem\xe2\x80\x99s use of the car, notwithstanding his letter of rescission, constitute\nsuch use of it as to be an acceptance? And if not, does Stem owe Braden anything\nfor its use?\nDonnelly ordered a leather motorcycle jacket from Leathers Inc. The jacket\nwas specially designed according to Donnelly\xe2\x80\x99s instructions: it had a unique collar,\nvarious chromed studs throughout, and buckles, and he required an unusually\nlarge size. The coat cost $6,000. Donnelly paid $1,200 as a deposit, but after\nproduction was nearly complete, he telephoned Leathers Inc. and repudiated the\ncontract. What should Leathers do now?\n\nS EL F -T E ST QU EST IO N S\n1. In the absence of agreement, the place of delivery is\na. the buyer\xe2\x80\x99s place of business\nb. the seller\xe2\x80\x99s place of business\nc. either the buyer\xe2\x80\x99s place of business or the buyer\xe2\x80\x99s residence\nd. any of the above\nThe UCC\xe2\x80\x99s statute of limitations is\na. two years\nb. three years\nc. four years\nd. none of the above\n\nUnder the UCC, if the buyer breaches, the seller can\na. withhold further delivery\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n493\n\n\x0cb. resell the goods still in the seller\xe2\x80\x99s possession\nc. recover damages\nd. do all of the above\nIf the seller breaches, the buyer can generally\na. recover the goods, even when the goods have not been identified\nto the contract and the seller is not insolvent\nb. purchase substitute goods and recover their cost\nc. purchase substitute goods and recover the difference between\ntheir cost and the contract price\nd. recover punitive damages\nFollowing a seller\xe2\x80\x99s breach, the buyer can recover the price paid\na. if the buyer cancels the contract\nb. only for goods the buyer has accepted\nc. for all the goods the buyer was to have received, whether or not\nthey were accepted\nd. under none of the above conditions\ne.\n\nS EL F -T E ST A NSW E R S\n\n1. b\n2. c\n3. d\n4. c\n5. d\n[1] Uniform Commercial Code, Section 2-725(2).\n\nChapter 11\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n494\n\n\x0cProducts Liability\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. How products-liability law allocates the costs of a consumer society\n2. How warranty theory works in products liability, and what its limitations are\n3. How negligence theory works, and what its problems are\n4. How strict liability theory works, and what its limitations are\n5. What efforts are made to reform products-liability law, and why\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n495\n\n\x0c11.1 Introduction: Why Products-Liability Law Is\nImportant\nL EA R N IN G O B JEC T IV ES\n1. Understand why products-liability law underwent a revolution in the\ntwentieth century.\n2. Recognize that courts play a vital role in policing the free enterprise system by\nadjudicating how the true costs of modern consumer culture are allocated.\n3. Know the names of the modern causes of action for products-liability cases.\n\nIn previous chapters, we discussed remedies generally. In this chapter, we focus specifically on remedies\navailable when a defective product causes personal injury or other damages. Products liability describes a\ntype of claim, not a separate theory of liability. Products liability has strong emotional overtones\xe2\x80\x94ranging\nfrom the prolitigation position of consumer advocates to the conservative perspective of the\nmanufacturers.\n\nHistory of Products-Liability Law\nThe theory of caveat emptor\xe2\x80\x94let the buyer beware\xe2\x80\x94that pretty much governed consumer law from the\nearly eighteenth century until the early twentieth century made some sense. A horse-drawn buggy is a\nfairly simple device: its workings are apparent; a person of average experience in the 1870s would know\nwhether it was constructed well and made of the proper woods. Most foodstuffs 150 years ago were grown\nat home and \xe2\x80\x9cput up\xe2\x80\x9d in the home kitchen or bought in bulk from a local grocer, subject to inspection and\nsampling; people made home remedies for coughs and colds and made many of their own clothes. Houses\nand furnishings were built of wood, stone, glass, and plaster\xe2\x80\x94familiar substances. Entertainment was a\nbook or a piano. The state of technology was such that the things consumed were, for the most part,\ncomprehensible and\xe2\x80\x94very important\xe2\x80\x94mostly locally made, which meant that the consumer who suffered\ndamages from a defective product could confront the product\xe2\x80\x99s maker directly. Local reputation is a\npowerful influence on behavior.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n496\n\n\x0cThe free enterprise system confers great benefits, and no one can deny that: materialistically, compare the\nimage sketched in the previous paragraph with circumstances today. But those benefits come with a cost,\nand the fundamental political issue always is who has to pay. Consider the following famous passage from\nUpton Sinclair\xe2\x80\x99s great novel The Jungle. It appeared in 1906. He wrote it to inspire labor reform; to his\ndismay, the public outrage focused instead on consumer protection reform. Here is his description of the\nsausage-making process in a big Chicago meatpacking plant:\n\nThere was never the least attention paid to what was cut up for sausage; there would come all the way\nback from Europe old sausage that had been rejected, and that was moldy and white\xe2\x80\x94it would be dosed\nwith borax and glycerin, and dumped into the hoppers, and made over again for home consumption.\nThere would be meat that had tumbled out on the floor, in the dirt and sawdust, where the workers had\ntramped and spit uncounted billions of consumption germs. There would be meat stored in great piles in\nrooms; and the water from leaky roofs would drip over it, and thousands of rats would race about on it. It\nwas too dark in these storage places to see well, but a man could run his hand over these piles of meat and\nsweep off handfuls of the dried dung of rats. These rats were nuisances, and the packers would put\npoisoned bread out for them; they would die, and then rats, bread, and meat would go into the hoppers\ntogether. This is no fairy story and no joke; the meat would be shoveled into carts, and the man who did\nthe shoveling would not trouble to lift out a rat even when he saw one\xe2\x80\x94there were things that went into\nthe sausage in comparison with which a poisoned rat was a tidbit. There was no place for the men to wash\ntheir hands before they ate their dinner, and so they made a practice of washing them in the water that\nwas to be ladled into the sausage. There were the butt-ends of smoked meat, and the scraps of corned\nbeef, and all the odds and ends of the waste of the plants, that would be dumped into old barrels in the\ncellar and left there.\n\nUnder the system of rigid economy which the packers enforced, there were some jobs that it only paid to\ndo once in a long time, and among these was the cleaning out of the waste barrels. Every spring they did\nit; and in the barrels would be dirt and rust and old nails and stale water\xe2\x80\x94and cartload after cartload of it\nwould be taken up and dumped into the hoppers with fresh meat, and sent out to the public\xe2\x80\x99s breakfast.\nSome of it they would make into \xe2\x80\x9csmoked\xe2\x80\x9d sausage\xe2\x80\x94but as the smoking took time, and was therefore\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n497\n\n\x0cexpensive, they would call upon their chemistry department, and preserve it with borax and color it with\ngelatin to make it brown. All of their sausage came out of the same bowl, but when they came to wrap it\nthey would stamp some of it \xe2\x80\x9cspecial,\xe2\x80\x9d and for this they would charge two cents more a pound.\n\n[1]\n\nIt became clear from Sinclair\xe2\x80\x99s expos\xc3\xa9 that associated with the marvels of then-modern meatpacking and\ndistribution methods was food poisoning: a true cost became apparent. When the true cost of some\nmoney-making enterprise (e.g., cigarettes) becomes inescapably apparent, there are two possibilities.\nFirst, the legislature can in some way mandate that the manufacturer itself pay the cost; with the\nmeatpacking plants, that would be the imposition of sanitary food-processing standards. Typically,\nCongress creates an administrative agency and gives the agency some marching orders, and then the\nagency crafts regulations dictating as many industry-wide reform measures as are politically possible.\nSecond, the people who incur damages from the product (1) suffer and die or (2) access the machinery of\nthe legal system and sue the manufacturer. If plaintiffs win enough lawsuits, the manufacturer\xe2\x80\x99s insurance\ncompany raises rates, forcing reform (as with high-powered muscle cars in the 1970s); the business goes\nbankrupt; or the legislature is pressured to act, either for the consumer or for the manufacturer.\n\nIf the industry has enough clout to blunt\xe2\x80\x94by various means\xe2\x80\x94a robust proconsumer legislative response\nso that government regulation is too lax to prevent harm, recourse is had through the legal system. Thus\nfor all the talk about the need for tort reform (discussed later in this chapter), the courts play a vital role in\npolicing the free enterprise system by adjudicating how the true costs of modern consumer culture are\nallocated.\n\nObviously the situation has improved enormously in a century, but one does not have to look very far to\nfind terrible problems today. Consider the following, which occurred in 2009\xe2\x80\x9310:\n\n\xe2\x80\xa2\n\nIn the United States, Toyota recalled 412,000 passenger cars, mostly the Avalon model, for\nsteering problems that reportedly led to three accidents.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n498\n\n\x0c\xe2\x80\xa2\n\nPortable baby recliners that are supposed to help fussy babies sleep better were recalled after the\ndeath of an infant: the Consumer Product Safety Commission announced the recall of 30,000\nNap Nanny recliners made by Baby Matters of Berwyn, Pennsylvania.\n\n\xe2\x80\xa2\n\nMore than 70,000 children and teens go to the emergency room each year for injuries and\ncomplications from medical devices. Contact lenses are the leading culprit, the first detailed\nnational estimate suggests.\n\n\xe2\x80\xa2\n\nSmith and Noble recalled 1.3 million Roman shades and roller shades after a child was nearly\nstrangled: the Consumer Product Safety Commission says a five-year-old boy in Tacoma,\nWashington, was entangled in the cord of a roller shade in May 2009.\n\n\xe2\x80\xa2\n\n[2]\n\nThe Consumer Product Safety Commission reported that 4,521 people were killed in the United\nStates in consumer-product-related incidences in 2009, and millions of people visited hospital\nemergency rooms from consumer-product-related injuries.\n\n\xe2\x80\xa2\n\n[3]\n\nReports about the possibility that cell-phone use causes brain cancer continue to be hotly\ndebated. Critics suggest that the studies minimizing the risk were paid for by cell-phone\nmanufacturers.\n\n[4]\n\nProducts liability can also be a life-or-death matter from the manufacturer\xe2\x80\x99s perspective. In 2009,\nBloomberg BusinessWeek reported that the costs of product safety for manufacturing firms can be\nenormous: \xe2\x80\x9cPeanut Corp., based in Lynchberg, Va., has been driven into bankruptcy since health officials\nlinked tainted peanuts to more than 600 illnesses and nine deaths. Mattel said the first of several toy\nrecalls it announced in 2007 cut its quarterly operating income by $30 million. Earlier this decade, Ford\n[5]\n\nMotor spent roughly $3 billion replacing 10.6 million potentially defective Firestone tires.\xe2\x80\x9d Businesses\ncomplain, with good reason, about the expenses associated with products-liability problems.\n\nCurrent State of the Law\nAlthough the debate has been heated and at times simplistic, the problem of products liability is complex\nand most of us regard it with a high degree of ambivalence. We are all consumers, after all, who profit\ngreatly from living in an industrial society. In this chapter, we examine the legal theories that underlie\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n499\n\n\x0cproducts-liability cases that developed rapidly in the twentieth century to address the problems of\nproduct-caused damages and injuries in an industrial society.\nIn the typical products-liability case, three legal theories are asserted\xe2\x80\x94a contract theory and two tort\ntheories. The contract theory is warranty, governed by the UCC, and the two tort theories are\nnegligence and strict products liability, governed by the common law. See .\n\nFigure 11.1 Major Products Liability Theories\n\nK E Y TA K EA WAY\nAs products became increasingly sophisticated and potentially dangerous in the\ntwentieth century, and as the separation between production and consumption\nwidened, products liability became a very important issue for both consumers and\nmanufacturers. Millions of people every year are adversely affected by defective\nproducts, and manufacturers and sellers pay huge amounts for products-liability\ninsurance and damages. The law has responded with causes of action that provide\na means for recovery for products-liability damages.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n500\n\n\x0cE XE R C IS ES\n1. How does the separation of production from consumption affect productsliability issues?\n2. What other changes in production and consumption have caused the need for\nthe development of products-liability law?\n3. How can it be said that courts adjudicate the allocation of the costs of a\nconsumer-oriented economy?\n[1] Upton Sinclair, The Jungle (New York: Signet Classic, 1963), 136.\n[2] FindLaw, AP reports, http://news.findlaw.com/legalnews/us/pl.\n[3] US Consumer Product Safety Commission, 2009 Report to the President and the Congress,\naccessed March 1, 2011,http://www.cpsc.gov/cpscpub/pubs/reports/2009rpt.pdf.\n[4] Matt Hamblen, \xe2\x80\x9cNew Study Warns of Cell Phone Dangers,\xe2\x80\x9dComputerworld US, August 9,\n2009, accessed March 1, 2011,http://news.techworld.com/personal-tech/3200539/new-studywarns-of-cell-phone-dangers.\n[5] Michael Orey, \xe2\x80\x9cTaking on Toy Safety,\xe2\x80\x9d BusinessWeek, March 6, 2009, accessed March 1,\n2011,http://www.businessweek.com/managing/content/mar2009/ca2009036_271002.htm.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n501\n\n\x0c11.2 Warranties\nL EA R N IN G O B JEC T IV ES\n1. Recognize a UCC express warranty and how it is created.\n2. Understand what is meant under the UCC by implied warranties, and know the main\ntypes of implied warranties: merchantability, fitness for a particular purpose, and\ntitle.\n3. Know that there are other warranties: against infringement and as may arise from\nusage of the trade.\n4. See that there are difficulties with warranty theory as a cause of action for products\nliability; a federal law has addressed some of these.\n\nThe UCC governs express warranties and various implied warranties, and for many years it was the only\nstatutory control on the use and meanings of warranties. In 1975, after years of debate, Congress passed\nand President Gerald Ford signed into law the Magnuson-Moss Act, which imposes certain requirements\non manufacturers and others who warrant their goods. We will examine both the UCC and the MagnusonMoss Act.\n\nTypes of Warranties\nExpress Warranties\nAn express warranty is created whenever the seller affirms that the product will perform in a certain\nmanner. Formal words such as \xe2\x80\x9cwarrant\xe2\x80\x9d or \xe2\x80\x9cguarantee\xe2\x80\x9d are not necessary. A seller may create an express\nwarranty as part of the basis for the bargain of sale by means of (1) an affirmation of a fact or promise\nrelating to the goods, (2) a description of the goods, or (3) a sample or model. Any of these will create an\nexpress warranty that the goods will conform to the fact, promise, description, sample, or model. Thus a\nseller who states that \xe2\x80\x9cthe use of rustproof linings in the cans would prevent discoloration and\nadulteration of the Perform solution\xe2\x80\x9d has given an express warranty, whether he realized it or\nnot.\n\n[1]\n\nClaims of breach of express warranty are, at base, claims of misrepresentation.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n502\n\n\x0cBut the courts will not hold a manufacturer to every statement that could conceivably be interpreted to be\nan express warranty. Manufacturers and sellers constantly \xe2\x80\x9cpuff\xe2\x80\x9d their products, and the law is content to\nlet them inhabit that gray area without having to make good on every claim. UCC 2-313(2) says that \xe2\x80\x9can\naffirmation merely of the value of the goods or a statement purporting to be merely the seller\xe2\x80\x99s opinion or\ncommendation of the goods does not create a warranty.\xe2\x80\x9d Facts do.\n\nIt is not always easy, however, to determine the line between an express warranty and a piece of puffery. A\nsalesperson who says that a strawberry huller is \xe2\x80\x9cgreat\xe2\x80\x9d has probably puffed, not warranted, when it turns\nout that strawberries run through the huller look like victims of a massacre. But consider the classic cases\nof the defective used car and the faulty bull. In the former, the salesperson said the car was in \xe2\x80\x9cA-1 shape\xe2\x80\x9d\nand \xe2\x80\x9cmechanically perfect.\xe2\x80\x9d In the latter, the seller said not only that the bull calf would \xe2\x80\x9cput the buyer on\nthe map\xe2\x80\x9d but that \xe2\x80\x9chis father was the greatest living dairy bull.\xe2\x80\x9d The car, carrying the buyer\xe2\x80\x99s sevenmonth-old child, broke down while the buyer was en route to visit her husband in the army during World\nWar II. The court said that the salesperson had made an express warranty.\n\n[2]\n\nThe bull calf turned out to be\n\nsterile, putting the farmer on the judicial rather than the dairy map. The court said the seller\xe2\x80\x99s spiel was\ntrade talk, not a warranty that the bull would impregnate cows.\n\n[3]\n\nIs there any qualitative difference between these decisions, other than the quarter century that separates\nthem and the different courts that rendered them? Perhaps the most that can be said is that the more\nspecific and measurable the statement\xe2\x80\x99s standards, the more likely it is that a court will hold the seller to a\nwarranty, and that a written statement is easier to construe as a warranty than an oral one. It is also\npossible that courts look, if only subliminally, at how reasonable the buyer was in relying on the\nstatement, although this ought not to be a strict test. A buyer may be unreasonable in expecting a car to\nget 100 miles to the gallon, but if that is what the seller promised, that ought to be an enforceable\nwarranty.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n503\n\n\x0cThe CISG (Article 35) provides, \xe2\x80\x9cThe seller must deliver goods which are of the quantity,\nquality and description required by the contract and which are contained or packaged in\nthe manner required by the contract. [And the] goods must possess the qualities of goods\nwhich the seller has held out to the buyer as a sample or model.\xe2\x80\x9d\n\nImplied Warranties\nExpress warranties are those over which the parties dickered\xe2\x80\x94or could have. Express warranties go to the\nessence of the bargain. An implied warranty, by contrast, is one that circumstances alone, not specific\nlanguage, compel reading into the sale. In short, an implied warranty is one created by law, acting from an\nimpulse of common sense.\n\nImplied Warranty of Merchantability\nSection 2-314 of the UCC lays down the fundamental rule that goods carry\nan implied warranty of merchantability if sold by a merchant-seller. What is merchantability? Section 2314(2) of the UCC says that merchantable goods are those that conform at least to the following six\ncharacteristics:\n\n1.\n\nPass without objection in the trade under the contract description\n\n2. In the case of fungible goods, are of fair average quality within the description\n3. Are fit for the ordinary purposes for which such goods are used\n4. Run, within the variations permitted by the agreement, of even kind, quality, and quantity within\neach unit and among all units involved\n5.\n\nAre adequately contained, packaged, and labeled as the agreement may require\n\n6. Conform to the promise or affirmations of fact made on the container or label if any\n\nFor the purposes of Section 2-314(2)(c) of the UCC, selling and serving food or drink for consumption on\nor off the premises is a sale subject to the implied warranty of merchantability\xe2\x80\x94the food must be \xe2\x80\x9cfit for\nthe ordinary purposes\xe2\x80\x9d to which it is put. The problem is common: you bite into a cherry pit in the cherryvanilla ice cream, or you choke on the clam shells in the chowder. Is such food fit for the ordinary\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n504\n\n\x0cpurposes to which it is put? There are two schools of thought. One asks whether the food was natural as\nprepared. This view adopts the seller\xe2\x80\x99s perspective. The other asks what the consumer\xe2\x80\x99s reasonable\nexpectation was.\n\nThe first test is sometimes said to be the \xe2\x80\x9cnatural-foreign\xe2\x80\x9d test. If the substance in the soup is natural to\nthe substance\xe2\x80\x94as bones are to fish\xe2\x80\x94then the food is fit for consumption. The second test, relying on\nreasonable expectations, tends to be the more commonly used test.\n\nThe Convention provides (Article 35) that \xe2\x80\x9cunless otherwise agreed, the goods sold are fit\nfor the purposes for which goods of the same description would ordinarily be used.\xe2\x80\x9d\n\nFitness for a Particular Purpose\nSection 2-315 of the UCC creates another implied warranty. Whenever a seller, at the time she contracts to\nmake a sale, knows or has reason to know that the buyer is relying on the seller\xe2\x80\x99s skill or judgment to\nselect a product that is suitable for the particular purpose the buyer has in mind for the goods to be sold,\nthere is an implied warranty that the goods are fit for that purpose. For example, you go to a hardware\nstore and tell the salesclerk that you need a paint that will dry overnight because you are painting your\nfront door and a rainstorm is predicted for the next day. The clerk gives you a slow-drying oil-based paint\nthat takes two days to dry. The store has breached an\nimplied warranty of fitness for particular purpose.\n\nNote the distinction between \xe2\x80\x9cparticular\xe2\x80\x9d and \xe2\x80\x9cordinary\xe2\x80\x9d purposes. Paint is made to color and when dry to\nprotect a surface. That is its ordinary purpose, and had you said only that you wished to buy paint, no\nimplied warranty of fitness would have been breached. It is only because you had a particular purpose in\nmind that the implied warranty arose. Suppose you had found a can of paint in a general store and told\nthe same tale, but the proprietor had said, \xe2\x80\x9cI don\xe2\x80\x99t know enough about that paint to tell you anything\nbeyond what\xe2\x80\x99s on the label; help yourself.\xe2\x80\x9d Not every seller has the requisite degree of skill and knowledge\nabout every product he sells to give rise to an implied warranty. Ultimately, each case turns on its\nparticular circumstances:\xe2\x80\x9cThe Convention provides (Article 35): [The goods must be] fit for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n505\n\n\x0cany particular purpose expressly or impliedly made known to the seller at the time of the\nconclusion of the contract, except where the circumstances show that the buyer did not\nrely, or that it was unreasonable for him to rely, on the seller\xe2\x80\x99s skill and judgment.\xe2\x80\x9d\n\nOther Warranties\nArticle 2 contains other warranty provisions, though these are not related specifically to products liability.\nThus, under UCC, Section 2-312, unless explicitly excluded, the seller warrants he is conveyinggood\ntitle that is rightfully his and that the goods are transferred free of any security interest or other lien or\nencumbrance. In some cases (e.g., a police auction of bicycles picked up around campus and never\nclaimed), the buyer should know that the seller does not claim title in himself, nor that title will\nnecessarily be good against a third party, and so subsection (2) excludes warranties in these\ncircumstances. But the circumstances must be so obvious that no reasonable person would suppose\notherwise.\n\nIn Menzel v. List, an art gallery sold a painting by Marc Chagall that it purchased in Paris.\n\n[4]\n\nThe painting\n\nhad been stolen by the Germans when the original owner was forced to flee Belgium in the 1930s. Now in\nthe United States, the original owner discovered that a new owner had the painting and successfully sued\nfor its return. The customer then sued the gallery, claiming that it had breached the implied warranty of\ntitle when it sold the painting. The court agreed and awarded damages equal to the appreciated value of\nthe painting. A good-faith purchaser who must surrender stolen goods to their true owner has a claim for\nbreach of the implied warranty of title against the person from whom he bought the goods.\n\nA second implied warranty, related to title, is that the merchant-seller warrants the goods are free of any\nrightful claim by a third personthat the seller has infringed his rights (e.g., that a gallery has not infringed\na copyright by selling a reproduction). This provision only applies to a seller who regularly deals in goods\nof the kind in question. If you find an old print in your grandmother\xe2\x80\x99s attic, you do not warrant when you\nsell it to a neighbor that it is free of any valid infringement claims.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n506\n\n\x0cA third implied warranty in this context involves the course of dealing or usage of trade. Section 2-314(3)\nof the UCC says that unless modified or excluded implied warranties may arise from a course of dealing or\nusage of trade. If a certain way of doing business is understood, it is not necessary for the seller to state\nexplicitly that he will abide by the custom; it will be implied. A typical example is the obligation of a dog\ndealer to provide pedigree papers to prove the dog\xe2\x80\x99s lineage conforms to the contract.\n\nProblems with Warranty Theory\nIn General\nIt may seem that a person asserting a claim for breach of warranty will have a good chance of success\nunder an express warranty or implied warranty theory of merchantability or fitness for a particular\npurpose. In practice, though, claimants are in many cases denied recovery. Here are four general\nproblems:\n\n\xe2\x80\xa2\n\nThe claimant must prove that there was a sale.\n\n\xe2\x80\xa2\n\nThe sale was of goods rather than real estate or services.\n\n\xe2\x80\xa2\n\nThe action must be brought within the four-year statute of limitations under Article 2-725, when\nthe tender of delivery is made, not when the plaintiff discovers the defect.\n\n\xe2\x80\xa2\n\nUnder UCC, Section 2-607(3)(a) and Section 2A-516(3)(a), which covers leases, the claimant who\nfails to give notice of breach within a reasonable time of having accepted the goods will see the\nsuit dismissed, and few consumers know enough to do so, except when making a complaint about\na purchase of spoiled milk or about paint that wouldn\xe2\x80\x99t dry.\n\nIn addition to these general problems, the claimant faces additional difficulties stemming directly from\nwarranty theory, which we take up later in this chapter.\n\nExclusion or Modification of Warranties\nThe UCC permits sellers to exclude or disclaim warranties in whole or in part. That\xe2\x80\x99s reasonable, given\nthat the discussion here is about contract, and parties are free to make such contracts as they see fit. But a\nnumber of difficulties can arise.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n507\n\n\x0cExclusion of Express Warranties\nThe simplest way for the seller to exclude express warranties is not to give them. To be sure, Section 2316(1) of the UCC forbids courts from giving operation to words in fine print that negate or limit express\nwarranties if doing so would unreasonably conflict with express warranties stated in the main body of the\ncontract\xe2\x80\x94as, for example, would a blanket statement that \xe2\x80\x9cthis contract excludes all warranties express or\nimplied.\xe2\x80\x9d The purpose of the UCC provision is to prevent customers from being surprised by unbargainedfor language.\n\nExclusion of Implied Warranties in General\nImplied warranties can be excluded easily enough also, by describing the product with language such as\n\xe2\x80\x9cas is\xe2\x80\x9d or \xe2\x80\x9cwith all faults.\xe2\x80\x9d Nor is exclusion simply a function of what the seller says. The buyer who has\neither examined or refused to examine the goods before entering into the contract may not assert an\nimplied warranty concerning defects an inspection would have revealed.\nThe Convention provides a similar rule regarding a buyer\xe2\x80\x99s rights when he has failed to\ninspect the goods (Article 35): \xe2\x80\x9cThe seller is not liable\xe2\x80\xa6for any lack of conformity of the\ngoods if at the time of the conclusion of the contract the buyer knew or could not have been\nunaware of such lack of conformity.\xe2\x80\x9d\n\nImplied Warranty of Merchantability\nSection 2-316(2) of the UCC permits the seller to disclaim or modify the implied warranty of\nmerchantability, as long as the statement actually mentions \xe2\x80\x9cmerchantability\xe2\x80\x9d and, if it is written, is\n\xe2\x80\x9cconspicuous.\xe2\x80\x9d Note that the disclaimer need not be in writing, and\xe2\x80\x94again\xe2\x80\x94all implied warranties can be\nexcluded as noted.\n\nImplied Warranty of Fitness\nSection 2-316(2) of the UCC permits the seller also to disclaim or modify an implied warranty of fitness.\nThis disclaimer or modification must be in writing, however, and must be conspicuous. It need not\nmention fitness explicitly; general language will do. The following sentence, for example, is sufficient to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n508\n\n\x0cexclude all implied warranties of fitness: \xe2\x80\x9cThere are no warranties that extend beyond the description on\nthe face of this contract.\xe2\x80\x9d\n\nHere is a standard disclaimer clause found in a Dow Chemical Company agreement: \xe2\x80\x9cSeller warrants that\nthe goods supplied here shall conform to the description stated on the front side hereof, that it will convey\ngood title, and that such goods shall be delivered free from any lawful security interest, lien, or\nencumbrance. SELLER MAKES NO WARRANTY OF MERCHANTABILITY OR FITNESS FOR A\nPARTICULAR USE. NOR IS THERE ANY OTHER EXPRESS OR IMPLIED WARRANTY.\xe2\x80\x9d\n\nConflict between Express and Implied Warranties\nExpress and implied warranties and their exclusion or limitation can often conflict. Section 2-317 of the\nUCC provides certain rules for deciding which should prevail. In general, all warranties are to be\nconstrued as consistent with each other and as cumulative. When that assumption is unreasonable, the\nparties\xe2\x80\x99 intention governs the interpretation, according to the following rules: (a) exact or technical\nspecifications displace an inconsistent sample or model or general language of description; (b) a sample\nfrom an existing bulk displaces inconsistent general language of description; (c) express warranties\ndisplace inconsistent implied warranties other than an implied warranty of fitness for a particular\npurpose. Any inconsistency among warranties must always be resolved in favor of the implied warranty of\nfitness for a particular purpose. This doesn\xe2\x80\x99t mean that warranty cannot be limited or excluded altogether.\nThe parties may do so. But in cases of doubt whether it or some other language applies, the implied\nwarranty of fitness will have a superior claim.\n\nThe Magnuson-Moss Act and Phantom Warranties\nAfter years of debate over extending federal law to regulate warranties, Congress enacted the MagnusonMoss Federal Trade Commission Warranty Improvement Act (more commonly referred to as the\nMagnuson-Moss Act) and President Ford signed it in 1975. The act was designed to clear up confusing and\nmisleading warranties, where\xe2\x80\x94as Senator Magnuson put it in introducing the bill\xe2\x80\x94\xe2\x80\x9cpurchasers of\nconsumer products discover that their warranty may cover a 25-cent part but not the $100 labor charge or\nthat there is full coverage on a piano so long as it is shipped at the purchaser\xe2\x80\x99s expense to the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n509\n\n\x0cfactory.\xe2\x80\xa6There is a growing need to generate consumer understanding by clearly and conspicuously\ndisclosing the terms and conditions of the warranty and by telling the consumer what to do if his\nguaranteed product becomes defective or malfunctions.\xe2\x80\x9d The Magnuson-Moss Act only applies to\nconsumer products (for household and domestic uses); commercial purchasers are presumed to be\nknowledgeable enough not to need these protections, to be able to hire lawyers, and to be able to include\nthe cost of product failures into the prices they charge.\n\nThe act has several provisions to meet these consumer concerns; it regulates the content of warranties and\nthe means of disclosing those contents. The act gives the Federal Trade Commission (FTC) the authority\nto promulgate detailed regulations to interpret and enforce it. Under FTC regulations, any written\nwarranty for a product costing a consumer more than ten dollars must disclose in a single document and\nin readily understandable language the following nine items of information:\n\n1.\n\nThe identity of the persons covered by the warranty, whether it is limited to the original purchaser\nor fewer than all who might come to own it during the warranty period.\n\n2. A clear description of the products, parts, characteristics, components, or properties covered, and\nwhere necessary for clarity, a description of what is excluded.\n3. A statement of what the warrantor will do if the product fails to conform to the warranty,\nincluding items or services the warranty will pay for and, if necessary for clarity, what it will not\npay for.\n4. A statement of when the warranty period starts and when it expires.\n5.\n\nA step-by-step explanation of what the consumer must do to realize on the warranty, including\nthe names and addresses of those to whom the product must be brought.\n\n6. Instructions on how the consumer can be availed of any informal dispute resolution mechanism\nestablished by the warranty.\n7.\n\nAny limitations on the duration of implied warranties\xe2\x80\x94since some states do not permit such\nlimitations, the warranty must contain a statement that any limitations may not apply to the\nparticular consumer.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n510\n\n\x0c8. Any limitations or exclusions on relief, such as consequential damages\xe2\x80\x94as above, the warranty\nmust explain that some states do not allow such limitations.\n9. The following statement: \xe2\x80\x9cThis warranty gives you specific legal rights, and you may also have\nother rights which vary from state to state.\xe2\x80\x9d\n\nIn addition to these requirements, the act requires that the warranty be labeled either a full or limited\nwarranty. A full warranty means (1) the defective product or part will be fixed or replaced for free,\nincluding removal and reinstallation; (2) it will be fixed within a reasonable time; (3) the consumer need\nnot do anything unreasonable (like shipping the piano to the factory) to get warranty service; (4) the\nwarranty is good for anyone who owns the product during the period of the warranty; (5) the consumer\ngets money back or a new product if the item cannot be fixed within a reasonable number of attempts. But\nthe full warranty may not cover the whole product: it may cover only the hard drive in the computer, for\nexample; it must state what parts are included and excluded. A limited warranty is less inclusive. It\nmay cover only parts, not labor; it may require the consumer to bring the product to the store for service;\nit may impose a handling charge; it may cover only the first purchaser. Both full and limited warranties\nmay exclude consequential damages.\n\nDisclosure of the warranty provisions prior to sale is required by FTC regulations; this can be done in a\nnumber of ways. The text of the warranty can be attached to the product or placed in close conjunction to\nit. It can be maintained in a binder kept in each department or otherwise easily accessible to the\nconsumer. Either the binders must be in plain sight or signs must be posted to call the prospective buyer\xe2\x80\x99s\nattention to them. A notice containing the text of the warranty can be posted, or the warranty itself can be\nprinted on the product\xe2\x80\x99s package or container.\n\nPhantom warranties are addressed by the Magnuson-Moss Act. As we have seen, the UCC permits the\nseller to disclaim implied warranties. This authority often led sellers to give what were called phantom\nwarranties\xe2\x80\x94that is, the express warranty contained disclaimers of implied warranties, thus leaving the\nconsumer with fewer rights than if no express warranty had been given at all. In the words of the\nlegislative report of the act, \xe2\x80\x9cThe bold print giveth, and the fine print taketh away.\xe2\x80\x9d The act abolished\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n511\n\n\x0cthese phantom warranties by providing that if the seller gives a written warranty, whether express or\nimplied, he cannot disclaim or modify implied warranties. However, a seller who gives a limited warranty\ncan limit implied warranties to the duration of the limited warranty, if the duration is reasonable.\n\nA seller\xe2\x80\x99s ability to disclaim implied warranties is also limited by state law in two ways. First, by\namendment to the UCC or by separate legislation, some states prohibit disclaimers whenever consumer\nproducts are sold.\n\n[5]\n\nSecond, the UCC at 2-302 provides that unconscionable contracts or clauses will not\n\nbe enforced. UCC 2-719(3) provides that limitation of damages for personal injury in the sale of\n\xe2\x80\x9cconsumer goods is prima facie unconscionable, but limitation of damages where the loss is commercial is\nnot.\xe2\x80\x9d (Unconscionability was discussed in (Reference mayer_1.0-ch12 not found in Book).)\n\nA first problem with warranty theory, then, is that it\xe2\x80\x99s possible to disclaim or limit the warranty. The worst\nabuses of manipulative and tricky warranties are eliminated by the Magnuson-Moss Act, but there are\nseveral other reasons that warranty theory is not the panacea for claimants who have suffered damages or\ninjuries as a result of defective products.\n\nPrivity\nA second problem with warranty law (after exclusion and modification of warranties) is that of privity.\nPrivity is the legal term for the direct connection between the seller and buyer, the two contracting parties.\nFor decades, the doctrine of privity has held that one person can sue another only if they are in privity.\nThat worked well in the days when most commerce was local and the connection between seller and buyer\nwas immediate. But in a modern industrial (or postindustrial) economy, the product is transported\nthrough a much larger distribution system, as depicted in Figure 11.2 "Chain of Distribution". Two\nquestions arise: (1) Is the manufacturer or wholesaler (as opposed to the retailer) liable to the buyer under\nwarranty theory? and (2) May the buyer\xe2\x80\x99s family or friends assert warranty rights?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n512\n\n\x0cFigure 11.2 Chain of Distribution\n\nHorizontal Privity\nSuppose Carl Consumer buys a new lamp for his family\xe2\x80\x99s living room. The lamp is defective: Carl gets a\nserious electrical shock when he turns it on. Certainly Carl would be covered by the implied warranty of\nmerchantability: he\xe2\x80\x99s in direct privity with the seller. But what if Carl\xe2\x80\x99s spouse Carlene is injured? She\ndidn\xe2\x80\x99t buy the lamp; is she covered? Or suppose Carl\xe2\x80\x99s friend David, visiting for an afternoon, gets zapped.\nIs David covered? This gets to horizontal privity, noncontracting parties who suffer damages from\ndefective goods, such as nonbuyer users, consumers, and bystanders. Horizontal privity determines to\nwhose benefit the warranty \xe2\x80\x9cflows\xe2\x80\x9d\xe2\x80\x94who can sue for its breach. In one of its rare instances of\nnonuniformity, the UCC does not dictate the result. It gives the states three choices, labeled in Section 2318 as Alternatives A, B, and C.\n\nAlternative A says that a seller\xe2\x80\x99s warranty extends \xe2\x80\x9cto any natural person who is in the family or\nhousehold of his buyer or who is a guest in his home\xe2\x80\x9d provided (1) it is reasonable to expect the person\nsuffering damages to use, consume, or be affected by the goods and (2) the warranty extends only to\ndamages for personal injury.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n513\n\n\x0cAlternative B \xe2\x80\x9cextends to any natural person who may reasonably be expected to use, consume, or be\naffected by the goods, and who is injured in person by breach of the warranty.\xe2\x80\x9d It is less restrictive than\nthe first alternative: it extends protection to people beyond those in the buyer\xe2\x80\x99s home. For example, what\nif Carl took the lamp to a neighbor\xe2\x80\x99s house to illuminate a poker table: under Alternative B, anybody at the\nneighbor\xe2\x80\x99s house who suffered injury would be covered by the warranty. But this alternative does not\nextend protection to organizations; \xe2\x80\x9cnatural person\xe2\x80\x9d means a human being.\n\nAlternative C is the same as B except that it applies not only to any \xe2\x80\x9cnatural person\xe2\x80\x9d but \xe2\x80\x9cto any person\nwho is injured by breach of the warranty.\xe2\x80\x9d This is the most far-reaching alternative because it provides\nredress for damage to property as well as for personal injury, and it extends protection to corporations\nand other institutional buyers.\n\nOne may incidentally note that having three different alternatives for when third-party nonpurchasers can\nsue a seller or manufacturer for breach of warranty gives rise to unintended consequences. First, different\noutcomes are produced among jurisdictions, including variations in the common law. Second, the great\npurpose of the Uniform Commercial Code in promoting national uniformity is undermined. Third, battles\nover choice of law\xe2\x80\x94where to file the lawsuit\xe2\x80\x94are generated.\n\n, Section 2A-216, provides basically the same alternatives as applicable to the leasing of goods.\n\nVertical Privity\nThe traditional rule was that remote selling parties were not liable: lack of privity was a defense by the\nmanufacturer or wholesaler to a suit by a buyer with whom these entities did not themselves contract. The\nbuyer could recover damages from the retailer but not from the original manufacturer, who after all made\nthe product and who might be much more financially able to honor the warranty. The UCC takes no\nposition here, but over the last fifty years the judicial trend has been to abolish\nthis vertical privity requirement. (See Figure 11.2 "Chain of Distribution"; the entities in the\ndistribution chain are those in vertical privity to the buyer.) It began in 1958, when the Michigan Supreme\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n514\n\n\x0cCourt overturned the old theory in an opinion written by Justice John D. Voelker (who also wrote the\nnovel Anatomy of a Murder, under the pen name Robert Traver).\n\n[6]\n\nContributory Negligence, Comparative Negligence, and Assumption of Risk\nAfter disclaimers and privity issues are resolved, other possible impediments facing the plaintiff in a\nproducts-liability warranty case are issues of assumption of the risk, contributory negligence, and\ncomparative negligence (discussed in Chapter 7 "Introduction to Tort Law" on torts).\n\nCourts uniformly hold that assumption of risk is a defense for sellers against a claim of breach of\nwarranty, while there is a split of authority over whether comparative and contributory negligence are\ndefenses. However, the courts\xe2\x80\x99 use of this terminology is often conflicting and confusing. The ultimate\nquestion is really one of causation: was the seller\xe2\x80\x99s breach of the warranty the cause of the plaintiff\xe2\x80\x99s\ndamages?\n\nThe UCC is not markedly helpful in clearing away the confusion caused by years of discussion of\nassumption of risk and contributory negligence. Section 2-715(2)(b) of the UCC says that among the forms\nof consequential damage for which recovery can be sought is \xe2\x80\x9cinjury to person or\nproperty proximately resulting from any breach of warranty\xe2\x80\x9d (emphasis added). But \xe2\x80\x9cproximately\xe2\x80\x9d is a\ntroublesome word. Indeed, ultimately it is a circular word: it means nothing more than that the defendant\nmust have been a direct enough cause of the damages that the courts will impose liability. Comment 5 to\nthis section says, \xe2\x80\x9cWhere the injury involved follows the use of goods without discovery of the defect\ncausing the damage, the question of \xe2\x80\x98proximate\xe2\x80\x99 turns on whether it was reasonable for the buyer to use\nthe goods without such inspection as would have revealed the defects. If it was not reasonable for him to\ndo so, or if he did in fact discover the defect prior to his use, the injury would not proximately result from\nthe breach of warranty.\xe2\x80\x9d\n\nObviously if a sky diver buys a parachute and then discovers a few holes in it, his family would not likely\nprevail in court when they sued to recover for his death because the parachute failed to function after he\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n515\n\n\x0cjumped at 5,000 feet. But the general notion that it must have been reasonable for a buyer to use goods\nwithout inspection can make a warranty case difficult to prove.\n\nK E Y TA K EA WAY\nA first basis of recovery in products-liability theory is breach of warranty. There are two\ntypes of warranties: express and implied. Under the implied category are three major\nsubtypes: the implied warranty of merchantability (only given by merchants), the implied\nwarranty of fitness for a particular purpose, and the implied warranty of title. There are\na number of problems with the use of warranty theory: there must have been a sale of\nthe goods; the plaintiff must bring the action within the statute of limitations; and the\nplaintiff must notify the seller within a reasonable time. The seller may\xe2\x80\x94within the\nconstraints of the Magnuson-Moss Act\xe2\x80\x94limit or exclude express warranties or limit or\nexclude implied warranties. Privity, or lack of it, between buyer and seller has been\nsignificantly eroded as a limitation in warranty theory, but lack of privity may still affect\nthe plaintiff\xe2\x80\x99s recovery; the plaintiff\xe2\x80\x99s assumption of the risk in using defective goods\nmay preclude recovery.\n\n1 . E XE R C IS ES\n2. What are the two main types of warranties and the important subtypes?\n3. Who can make each type of warranty?\n4. What general problems does a plaintiff have in bringing a products-liability warranty\ncase?\n5. What problems are presented concerning exclusion or manipulative express\nwarranties, and how does the Magnuson-Moss Act address them?\n6. How are implied warranties excluded?\n7. What is the problem of lack of privity, and how does modern law deal with it?\n[1] Rhodes Pharmacal Co. v. Continental Can Co., 219 N.E.2d 726 (Ill. 1976).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n516\n\n\x0c[2] Wat Henry Pontiac Co. v. Bradley, 210 P.2d 348 (Okla. 1949).\n[3] Frederickson v. Hackney, 198 N.W. 806 (Minn. 1924).\n[4] Menzel v. List, 246 N.E.2d 742 (N.Y. 1969).\n[5] A number of states have special laws that limit the use of the UCC implied warranty\ndisclaimer rules in consumer sales. Some of these appear in amendments to the UCC and others\nare in separate statutes. The broadest approach is that of the nine states that prohibit the\ndisclaimer of implied warranties in consumer sales (Massachusetts, Connecticut, Maine,\nVermont, Maryland, the District of Columbia, West Virginia, Kansas, Mississippi, and, with\nrespect to personal injuries only, Alabama). There is a difference in these states whether the\nrules apply to manufacturers as well as retailers.\n[6] Spence v. Three Rivers Builders & Masonry Supply, Inc., 90 N.W.2d 873 (Mich. 1958).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n517\n\n\x0c11.3 Negligence\nL EA R N IN G O B JEC T IV ES\n1. Recognize how the tort theory of negligence may be of use in products-liability\nsuits.\n2. Understand why negligence is often not a satisfactory cause of action in such\nsuits: proof of it may be difficult, and there are powerful defenses to claims of\nnegligence.\n\nNegligence is the second theory raised in the typical products-liability case. It is a tort theory (as\ncompared to breach of warranty, which is of course a contract theory), and it does have this advantage\nover warranty theory: privity is never relevant. A pedestrian is struck in an intersection by a car whose\nbrakes were defectively manufactured. Under no circumstances would breach of warranty be a useful\ncause of action for the pedestrian\xe2\x80\x94there is no privity at all. Negligence is considered in detail in the on\ntorts; it basically means lack of due care.\n\nTypical Negligence Claims: Design Defects and Inadequate Warnings\nNegligence theory in products liability is most useful in two types of cases: defective design and defective\nwarnings.\n\nDesign Defects\nManufacturers can be, and often are, held liable for injuries caused by products that were defectively\ndesigned. The question is whether the designer used reasonable care in designing a product reasonably\nsafe for its foreseeable use. The concern over reasonableness and standards of care are elements of\nnegligence theory.\nDefective-design cases can pose severe problems for manufacturing and safety engineers. More safety\nmeans more cost. Designs altered to improve safety may impair functionality and make the product less\ndesirable to consumers. At what point safety comes into reasonable balance with performance, cost, and\ndesirability (see ) is impossible to forecast accurately, though some factors can be taken into account. For\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n518\n\n\x0cexample, if other manufacturers are marketing comparable products whose design are intrinsically safer,\nthe less-safe products are likely to lose a test of reasonableness in court.\n\nFigure 11.3 The Reasonable Design Balance\n\nWarning Defects\nWe noted that a product may be defective if the manufacturer failed to warn the user of potential dangers.\nWhether a warning should have been affixed is often a question of what is reasonably foreseeable, and the\nfailure to affix a warning will be treated as negligence. The manufacturer of a weed killer with poisonous\ningredients is certainly acting negligently when it fails to warn the consumer that the contents are\npotentially lethal.\n\nThe law governing the necessity to warn and the adequacy of warnings is complex. What is reasonable\nturns on the degree to which a product is likely to be misused and, as the disturbing Laaperi case ()\nillustrates, whether the hazard is obvious.\n\nProblems with Negligence Theory\nNegligence is an ancient cause of action and, as was discussed in the torts chapter, it carries with it a\nnumber of well-developed defenses. Two categories may be mentioned: common-law defenses and\npreemption.\n\nCommon-Law Defenses against Negligence\nAmong the problems confronting a plaintiff with a claim of negligence in productsliability suits (again, these concepts are discussed in the torts chapter) are the following:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n519\n\n\x0c\xe2\x80\xa2\n\nProving negligence at all: just because a product is defective does not necessarily\nprove the manufacturer breached a duty of care.\n\n\xe2\x80\xa2\n\nProximate cause: even if there was some negligence, the plaintiff must prove her\ndamages flowed proximately from that negligence.\n\n\xe2\x80\xa2\n\nContributory and comparative negligence: the plaintiff\xe2\x80\x99s own actions contributed\nto the damages.\n\n\xe2\x80\xa2\n\nSubsequent alteration of the product: generally the manufacturer will not be\nliable if the product has been changed.\n\n\xe2\x80\xa2\n\nMisuse or abuse of the product: using a lawn mower to trim a hedge or taking too\nmuch of a drug are examples.\n\n\xe2\x80\xa2\n\nAssumption of the risk: knowingly using the product in a risky way.\n\nPreemption\nPreemption (or \xe2\x80\x9cpre-emption\xe2\x80\x9d) is illustrated by this problem: suppose there is a federal standard\nconcerning the product, and the defendant manufacturer meets it, but the standard is not really very\nprotective. (It is not uncommon, of course, for federal standard makers of all types to be significantly\ninfluenced by lobbyists for the industries being regulated by the standards.) Is it enough for the\nmanufacturer to point to its satisfaction of the standard so that such satisfaction preempts (takes over)\nany common-law negligence claim? \xe2\x80\x9cWe built the machine to federal standards: we can\xe2\x80\x99t be liable. Our\ncompliance with the federal safety standard is an affirmative defense.\xe2\x80\x9d\n\nPreemption is typically raised as a defense in suits about (1) cigarettes, (2) FDA-approved medical devices,\n(3) motor-boat propellers, (4) pesticides, and (5) motor vehicles. This is a complex area of law. Questions\ninevitably arise as to whether there was federal preemption, express or implied. Sometimes courts find\npreemption and the consumer loses; sometimes the courts don\xe2\x80\x99t find preemption and the case goes\nforward. According to one lawyer who works in this field, there has been \xe2\x80\x9cincreasing pressure on both the\nregulatory and congressional fronts to preempt state laws.\xe2\x80\x9d That is, the usual defendants (manufacturers)\npush Congress and the regulatory agencies to state explicitly in the law that the federal standards preempt\nand defeat state law.\n\n[1]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n520\n\n\x0cK E Y TA K EA WAY\nNegligence is a second possible cause of action for products-liability claimants. A\nmain advantage is that no issues of privity are relevant, but there are often\nproblems of proof; there are a number of robust common-law defenses, and\nfederal preemption is a recurring concern for plaintiffs\xe2\x80\x99 lawyers.\n\nE XE R C IS ES\n1. What two types of products-liability cases are most often brought under\nnegligence?\n2. How could it be said that merely because a person suffers injury as the result\nof a defective product, proof of negligence is not necessarily made?\n3. What is \xe2\x80\x9cpreemption\xe2\x80\x9d and how is it used as a sword to defeat productsliability plaintiffs?\n[1] C. Richard Newsome and Andrew F. Knopf, \xe2\x80\x9cFederal Preemption: Products Lawyers\nBeware,\xe2\x80\x9d Florida Justice Association Journal, July 27, 2007, accessed March 1,\n2011, http://www.newsomelaw.com/resources/articles/federal-preemption-products-lawyersbeware.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n521\n\n\x0c11.4 Strict Liability in Tort\nL EA R N IN G O B JEC T IV ES\n1. Know what \xe2\x80\x9cstrict products liability\xe2\x80\x9d means and how it differs from the other two\nproducts-liability theories.\n2. Understand the basic requirements to prove strict products liability.\n3. See what obstacles to recovery remain with this doctrine.\n\nThe warranties grounded in the Uniform Commercial Code (UCC) are often ineffective in assuring\nrecovery for a plaintiff\xe2\x80\x99s injuries. The notice requirements and the ability of a seller to disclaim the\nwarranties remain bothersome problems, as does the privity requirement in those states that continue to\nadhere to it.\n\nNegligence as a products-liability theory obviates any privity problems, but negligence comes with a\nnumber of familiar defenses and with the problems of preemption.\n\nTo overcome the obstacles, judges have gone beyond the commercial statutes and the ancient concepts of\nnegligence. They have fashioned a tort theory of products liability based on the principle of strict\nproducts liability. One court expressed the rationale for the development of the concept as follows:\n\xe2\x80\x9cThe rule of strict liability for defective products is an example of necessary paternalism judicially shifting\nrisk of loss by application of tort doctrine because [the UCC] scheme fails to adequately cover the\nsituation. Judicial paternalism is to loss shifting what garlic is to a stew\xe2\x80\x94sometimes necessary to give full\nflavor to statutory law, always distinctly noticeable in its result, overwhelmingly counterproductive if\nexcessive, and never an end in itself.\xe2\x80\x9d\n\n[1]\n\nPaternalism or not, strict liability has become a very important\n\nlegal theory in products-liability cases.\n\nStrict Liability Defined\nThe formulation of strict liability that most courts use is Section 402A of the Restatement of Torts\n(Second), set out here in full:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n522\n\n\x0c(1) One who sells any product in a defective condition unreasonably dangerous to the user or consumer or\nto his property is subject to liability for physical harm thereby caused to the ultimate user or consumer, or\nto his property, if\n\n(a) the seller is engaged in the business of selling such a product, and\n\n(b) it is expected to and does reach the user or consumer without substantial change in the condition in\nwhich it is sold.\n\n(2) This rule applies even though\n\n(a) the seller has exercised all possible care in the preparation and sale of his product, and\n\n(b) the user or consumer has not bought the product from or entered into any contractual relation with\nthe seller.\n\nSection 402A of the Restatement avoids the warranty booby traps. It states a rule of law not governed by\nthe UCC, so limitations and exclusions in warranties will not apply to a suit based on the Restatement\ntheory. And the consumer is under no obligation to give notice to the seller within a reasonable time of\nany injuries. Privity is not a requirement; the language of the Restatement says it applies to \xe2\x80\x9cthe user or\nconsumer,\xe2\x80\x9d but courts have readily found that bystanders in various situations are entitled to bring\nactions under Restatement, Section 402A. The formulation of strict liability, though, is limited to physical\nharm. Many courts have held that a person who suffers economic loss must resort to warranty law.\nStrict liability avoids some negligence traps, too. No proof of negligence is required. See .\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n523\n\n\x0cFigure 11.4 Major Difference between Warranty and Strict Liability\n\nSection 402A Elements\nProduct in a Defective Condition\nSales of goods but not sales of services are covered under the Restatement, Section 402A. Furthermore,\nthe plaintiff will not prevail if the product was safe for normal handling and consumption when sold. A\nglass soda bottle that is properly capped is not in a defective condition merely because it can be broken if\nthe consumer should happen to drop it, making the jagged glass dangerous. Chocolate candy bars are not\ndefective merely because you can become ill by eating too many of them at once. On the other hand, a\nseller would be liable for a product defectively packaged, so that it could explode or deteriorate and\nchange its chemical composition. A product can also be in a defective condition if there is danger that\ncould come from an anticipated wrongful use, such as a drug that is safe only when taken in limited doses.\nUnder those circumstances, failure to place an adequate dosage warning on the container makes the\nproduct defective.\n\nThe plaintiff bears the burden of proving that the product is in a defective condition, and this burden can\nbe difficult to meet. Many products are the result of complex feats of engineering. Expert witnesses are\nnecessary to prove that the products were defectively manufactured, and these are not always easy to\ncome by. This difficulty of proof is one reason why many cases raise the failure to warn as the dispositive\nissue, since in the right case that issue is far easier to prove. The Anderson case (detailed in the exercises\nat the end of this chapter) demonstrates that the plaintiff cannot prevail under strict liability merely\nbecause he was injured. It is not the fact of injury that is dispositive but the defective condition of the\nproduct.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n524\n\n\x0cUnreasonably Dangerous\nThe product must be not merely dangerous but unreasonably dangerous. Most products have\ncharacteristics that make them dangerous in certain circumstances. As the Restatement commentators\nnote, \xe2\x80\x9cGood whiskey is not unreasonably dangerous merely because it will make some people drunk, and\nis especially dangerous to alcoholics; but bad whiskey, containing a dangerous amount of fuel oil, is\nunreasonably dangerous.\xe2\x80\xa6Good butter is not unreasonably dangerous merely because, if such be the case,\nit deposits cholesterol in the arteries and leads to heart attacks; but bad butter, contaminated with\npoisonous fish oil, is unreasonably dangerous.\xe2\x80\x9d\n\n[2]\n\nUnder Section 402A, \xe2\x80\x9cthe article sold must be\n\ndangerous to an extent beyond that which would be contemplated by the ordinary consumer who\npurchases it, with the ordinary knowledge common to the community as to its characteristics. \xe2\x80\x9d\n\nEven high risks of danger are not necessarily unreasonable. Some products are unavoidably unsafe; rabies\nvaccines, for example, can cause dreadful side effects. But the disease itself, almost always fatal, is worse.\nA product is unavoidably unsafe when it cannot be made safe for its intended purpose given the present\nstate of human knowledge. Because important benefits may flow from the product\xe2\x80\x99s use, its producer or\nseller ought not to be held liable for its danger.\n\nHowever, the failure to warn a potential user of possible hazards can make a product defective under\nRestatement, Section 402A, whether unreasonably dangerous or even unavoidably unsafe. The dairy\nfarmer need not warn those with common allergies to eggs, because it will be presumed that the person\nwith an allergic reaction to common foodstuffs will be aware of them. But when the product contains an\ningredient that could cause toxic effects in a substantial number of people and its danger is not widely\nknown (or if known, is not an ingredient that would commonly be supposed to be in the product), the lack\nof a warning could make the product unreasonably dangerous within the meaning of Restatement, Section\n402A. Many of the suits brought by asbestos workers charged exactly this point; \xe2\x80\x9cThe utility of an\ninsulation product containing asbestos may outweigh the known or foreseeable risk to the insulation\nworkers and thus justify its marketing. The product could still be unreasonably dangerous, however, if\nunaccompanied by adequate warnings. An insulation worker, no less than any other product user, has a\nright to decide whether to expose himself to the risk.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\n[3]\n\nThis rule of law came to haunt the Manville\nSaylor.org\n525\n\n\x0cCorporation: it was so burdened with lawsuits, brought and likely to be brought for its sale of asbestos\xe2\x80\x94a\nknown carcinogen\xe2\x80\x94that it declared bankruptcy in 1982 and shucked its liability.\n\n[4]\n\nEngaged in the Business of Selling\nRestatement, Section 402A(1)(a), limits liability to sellers \xe2\x80\x9cengaged in the business of selling such a\nproduct.\xe2\x80\x9d The rule is intended to apply to people and entities engaged in business, not to casual one-time\nsellers. The business need not be solely in the defective product; a movie theater that sells popcorn with a\nrazor blade inside is no less liable than a grocery store that does so. But strict liability under this rule does\nnot attach to a private individual who sells his own automobile. In this sense, Restatement, Section 402A,\nis analogous to the UCC\xe2\x80\x99s limitation of the warranty of merchantability to the merchant.\nThe requirement that the defendant be in the business of selling gets to the rationale for the whole\nconcept of strict products liability: businesses should shoulder the cost of injuries because they are in the\nbest position to spread the risk and distribute the expense among the public. This same policy has been\nthe rationale for holding bailors and lessors liable for defective equipment just as if they had been\n[5]\n\nsellers.\n\nReaches the User without Change in Condition\nRestatement, Section 402A(1)(b), limits strict liability to those defective products that are expected to and\ndo reach the user or consumer without substantial change in the condition in which the products are sold.\nA product that is safe when delivered cannot subject the seller to liability if it is subsequently mishandled\nor changed. The seller, however, must anticipate in appropriate cases that the product will be stored;\nfaulty packaging or sterilization may be the grounds for liability if the product deteriorates before being\nused.\n\nLiability Despite Exercise of All Due Care\nStrict liability applies under the Restatement rule even though \xe2\x80\x9cthe seller has exercised all possible care in\nthe preparation and sale of his product.\xe2\x80\x9d This is the crux of \xe2\x80\x9cstrict liability\xe2\x80\x9d and distinguishes it from the\nconventional theory of negligence. It does not matter how reasonably the seller acted or how exemplary is\na manufacturer\xe2\x80\x99s quality control system\xe2\x80\x94what matters is whether the product was defective and the user\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n526\n\n\x0cinjured as a result. Suppose an automated bottle factory manufactures 1,000 bottles per hour under\nexacting standards, with a rigorous and costly quality-control program designed to weed out any bottles\nshowing even an infinitesimal amount of stress. The plant is \xe2\x80\x9cstate of the art,\xe2\x80\x9d and its computerized\nquality-control operation is the best in the world. It regularly detects the one out of every 10,000 bottles\nthat analysis has shown will be defective. Despite this intense effort, it proves impossible to weed out\nevery defective bottle; one out of one million, say, will still escape detection. Assume that a bottle, filled\nwith soda, finds its way into a consumer\xe2\x80\x99s home, explodes when handled, sends glass shards into his eye,\nand blinds him. Under negligence, the bottler has no liability; under strict liability, the bottler will be\nliable to the consumer.\n\nLiability without Contractual Relation\nUnder Restatement, Section 402A(2)(b), strict liability applies even though the user has not purchased\nthe product from the seller nor has the user entered into any contractual relation with the seller. In short,\nprivity is abolished and the injured user may use the theory of strict liability against manufacturers and\nwholesalers as well as retailers. Here, however, the courts have varied in their approaches; the trend has\nbeen to allow bystanders recovery. The Restatement explicitly leaves open the question of the bystander\xe2\x80\x99s\nright to recover under strict liability.\n\nProblems with Strict Liability\nStrict liability is liability without proof of negligence and without privity. It would seem that strict liability\nis the \xe2\x80\x9choly grail\xe2\x80\x9d of products-liability lawyers: the complete answer. Well, no, it\xe2\x80\x99s not the holy grail. It is\ncertainly true that 402A abolishes the contractual problems of warranty. Restatement, Section 402A,\nComment m, says,\n\nThe rule stated in this Section is not governed by the provisions of the Uniform Commercial Code, as to\nwarranties; and it is not affected by limitations on the scope and content of warranties, or by limitation to\n\xe2\x80\x9cbuyer\xe2\x80\x9d and \xe2\x80\x9cseller\xe2\x80\x9d in those statutes. Nor is the consumer required to give notice to the seller of his injury\nwithin a reasonable time after it occurs, as provided by the Uniform Act. The consumer\xe2\x80\x99s cause of action\ndoes not depend upon the validity of his contract with the person from whom he acquires the product, and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n527\n\n\x0cit is not affected by any disclaimer or other agreement, whether it be between the seller and his immediate\nbuyer, or attached to and accompanying the product into the consumer\xe2\x80\x99s hands. In short, \xe2\x80\x9cwarranty\xe2\x80\x9d must\nbe given a new and different meaning if it is used in connection with this Section. It is much simpler to\nregard the liability here stated as merely one of strict liability in tort.\n\nInherent in the Restatement\xe2\x80\x99s language is the obvious point that if the product has been altered, losses\ncaused by injury are not the manufacturer\xe2\x80\x99s liability. Beyond that there are still some limitations to strict\nliability.\n\nDisclaimers\nComment m specifically says the cause of action under Restatement, Section 402A, is not\naffected by disclaimer. But in nonconsumer cases, courts have allowed clear and specific\ndisclaimers. In 1969, the Ninth Circuit observed: \xe2\x80\x9cIn Kaiser Steel Corp. the [California Supreme\nCourt] court upheld the dismissal of a strict liability action when the parties, dealing from\npositions of relatively equal economic strength, contracted in a commercial setting to limit the\ndefendant\xe2\x80\x99s liability. The court went on to hold that in this situation the strict liability cause of\naction does not apply at all. In reaching this conclusion, the court inKaiser reasoned that strict\nliability \xe2\x80\x98is designed to encompass situations in which the principles of sales warranties serve\ntheir purpose \xe2\x80\x9cfitfully at best.\xe2\x80\x9d\xe2\x80\x99 [Citation]\xe2\x80\x9d It concluded that in such commercial settings the\nUCC principles work well and \xe2\x80\x9cto apply the tort doctrines of products liability will displace the\nstatutory law rather than bring out its full flavor.\xe2\x80\x9d [6]\n\nPlaintiff\xe2\x80\x99s Conduct\nConduct by the plaintiff herself may defeat recovery in two circumstances.\n\nAssumption of Risk\nCourts have allowed the defense of assumption of the risk in strict products-liability cases. A plaintiff\nassumes the risk of injury, thus establishing defense to claim of strict products liability, when he is aware\nthe product is defective, knows the defect makes the product unreasonably dangerous, has reasonable\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n528\n\n\x0copportunity to elect whether to expose himself to the danger, and nevertheless proceeds to make use of\nthe product. The rule makes sense.\n\nMisuse or Abuse of the Product\nWhere the plaintiff does not know a use of the product is dangerous but nevertheless uses for an incorrect\npurpose, a defense arises, but only if such misuse was not foreseeable. If it was, the manufacturer should\nwarn against that misuse. In Eastman v. Stanley Works, a carpenter used a framing hammer to drive\nmasonry nails; the claw of the hammer broke off, striking him in the eye.\n\n[7]\n\nHe sued. The court held that\n\nwhile a defense does exist \xe2\x80\x9cwhere the product is used in a capacity which is unforeseeable by the\nmanufacturer and completely incompatible with the product\xe2\x80\x99s design\xe2\x80\xa6misuse of a product suggests a use\nwhich was unanticipated or unexpected by the product manufacturer, or unforeseeable and unanticipated\n[but] it was not the case that reasonable minds could only conclude that appellee misused the [hammer].\nThough the plaintiff\xe2\x80\x99s use of the hammer might have been unreasonable, unreasonable use is not a\ndefense to a strict product-liability action or to a negligence action.\xe2\x80\x9d\n\nLimited Remedy\nThe Restatement says recovery under strict liability is limited to \xe2\x80\x9cphysical harm thereby caused to the\nultimate user or consumer, or to his property,\xe2\x80\x9d but not other losses and not economic losses. In Atlas Air\nv. General Electric, a New York court held that the \xe2\x80\x9ceconomic loss rule\xe2\x80\x9d (no recovery for economic losses)\nbarred strict products-liability and negligence claims by the purchaser of a used airplane against the\nairplane engine manufacturer for damage to the plane caused by an emergency landing necessitated by\nengine failure, where the purchaser merely alleged economic losses with respect to the plane itself, and\nnot damages for personal injury (recovery for damage to the engine was allowed).\n\n[8]\n\nBut there are exceptions. In Duffin v. Idaho Crop Imp. Ass\xe2\x80\x99n, the court recognized that a party generally\nowes no duty to exercise due care to avoid purely economic loss, but if there is a \xe2\x80\x9cspecial relationship\xe2\x80\x9d\nbetween the parties such that it would be equitable to impose such a duty, the duty will be imposed.\n\n[9]\n\n\xe2\x80\x9cIn\n\nother words, there is an extremely limited group of cases where the law of negligence extends its\nprotections to a party\xe2\x80\x99s economic interest.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n529\n\n\x0cThe Third Restatement\nThe law develops. What seemed fitting in 1964 when the Restatement (Second) announced the state of the\ncommon-law rules for strict liability in Section 402A seemed, by 1997, not to be tracking common law\nentirely closely. The American Law Institute came out with the Restatement (Third) in that year. The\nRestatement changes some things. Most notably it abolishes the \xe2\x80\x9cunreasonably dangerous\xe2\x80\x9d test and\nsubstitutes a \xe2\x80\x9crisk-utility test.\xe2\x80\x9d That is, a product is not defective unless its riskiness outweighs its utility.\nMore important, the Restatement (Third), Section 2, now requires the plaintiff to provide a reasonable\nalternative design to the product in question. In advancing a reasonable alternative design, the plaintiff is\nnot required to offer a prototype product. The plaintiff must only show that the proposed alternative\ndesign exists and is superior to the product in question. The Restatement (Third) also makes it more\ndifficult for plaintiffs to sue drug companies successfully. One legal scholar commented as follows on the\nRestatement (Third):\n\nThe provisions of the Third Restatement, if implemented by the courts, will establish a degree of fairness\nin the products liability arena. If courts adopt the Third Restatement\xe2\x80\x99s elimination of the \xe2\x80\x9cconsumer\nexpectations test,\xe2\x80\x9d this change alone will strip juries of the ability to render decisions based on potentially\nsubjective, capricious and unscientific opinions that a particular product design is unduly dangerous\nbased on its performance in a single incident. More important, plaintiffs will be required to propose a\nreasonable alternative design to the product in question. Such a requirement will force plaintiffs to prove\nthat a better product design exists other than in the unproven and untested domain of their experts\xe2\x80\x99\n[10]\n\nimaginations.\n\nOf course some people put more faith in juries than is evident here. The new Restatement has been\nadopted by a few jurisdictions and some cases the adopting jurisdictions incorporate some of its ideas, but\ncourts appear reluctant to abandon familiar precedent.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n530\n\n\x0cK E Y TA K EA WAY\nBecause the doctrines of breach of warranty and negligence did not provide adequate\nrelief to those suffering damages or injuries in products-liability cases, beginning in the\n1960s courts developed a new tort theory: strict products liability, restated in the\nSecond Restatement, section 402A. Basically the doctrine says that if goods sold are\nunreasonably dangerous or defective, the merchant-seller will be liable for the\nimmediate property loss and personal injuries caused thereby. But there remain\nobstacles to recovery even under this expanded concept of liability: disclaimers of\nliability have not completely been dismissed, the plaintiff\xe2\x80\x99s conduct or changes to the\ngoods may limit recovery, and\xe2\x80\x94with some exceptions\xe2\x80\x94the remedies available are\nlimited to personal injury (and damage to the goods themselves); economic loss is not\nrecoverable. Almost forty years of experience with the Second Restatement\xe2\x80\x99s section on\nstrict liability has seen changes in the law, and the Third Restatement introduces those,\nbut it has not been widely accepted yet.\n\nE XE R C IS ES\n1. What was perceived to be inadequate about warranty and negligence theories that\nnecessitated the development of strict liability?\n2. Briefly describe the doctrine.\n3. What defects in goods render their sellers strictly liable?\n4. Who counts as a liable seller?\n5. What obstacles does a plaintiff have to overcome here, and what limitations are\nthere to recovery?\n[1] Kaiser Steel Corp. v. Westinghouse Electric Corp., 127 Cal. Rptr. 838 (Cal. 1976).\n[2] Restatement (Second) of Contracts, Section 402A(i).\n[3] Borel v. Fibreboard Paper Products Corp., 493 F.Zd 1076 (5th Cir. 1973).\n[4] In re Johns-Manville Corp., 36 R.R. 727 (So. Dist. N.Y. 1984).\n[5] Martin v. Ryder Rental, Inc., 353 A.2d 581 (Del. 1976).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n531\n\n\x0c[6] Idaho Power Co. v. Westinghouse Electric Corp., 596 F.2d 924, 9CA (1979).\n[7] Eastman v. Stanley Works, 907 N.E.2d 768 (Ohio App. 2009).\n[8] Atlas Air v. General Electric, 16 A.D.3d 444 (N.Y.A.D. 2005).\n[9] Duffin v. Idaho Crop Imp. Ass\xe2\x80\x99n, 895 P.2d 1195 (Idaho 1995).\n[10] Quinlivan Wexler LLP, \xe2\x80\x9cThe 3rd Restatement of Torts\xe2\x80\x94Shaping the Future of Products\nLiability Law,\xe2\x80\x9d June 1, 1999, accessed March 1,\n2011,http://library.findlaw.com/1999/Jun/1/127691.html.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n532\n\n\x0c11.5 Tort Reform\nL EA R N IN G O B JEC T IV ES\n1. See why tort reform is advocated, why it is opposed, and what interests take\neach side.\n2. Understand some of the significant state reforms in the last two decades.\n3. Know what federal reforms have been instituted.\n\nThe Cry for Reform\nIn 1988, The Conference Board published a study that resulted from a survey of more than 500 chief\nexecutive officers from large and small companies regarding the effects of products liability on their firms.\nThe study concluded that US companies are less competitive in international business because of these\neffects and that products-liability laws must be reformed. The reform effort has been under way ever\nsince, with varying degrees of alarms and finger-pointing as to who is to blame for the \xe2\x80\x9ctort crisis,\xe2\x80\x9d if there\neven is one. Business and professional groups beat the drums for tort reform as a means to guarantee\n\xe2\x80\x9cfairness\xe2\x80\x9d in the courts as well as spur US economic competitiveness in a global marketplace, while\nplaintiffs\xe2\x80\x99 attorneys and consumer advocates claim that businesses simply want to externalize costs by\ndenying recovery to victims of greed and carelessness.\n\nEach side vilifies the other in very unseemly language: probusiness advocates call consumer-oriented\nstates \xe2\x80\x9cjudicial hell-holes\xe2\x80\x9d and complain of \xe2\x80\x9cwell-orchestrated campaign[s] by tort lawyer lobbyists and\nallies to undo years of tort reform at the state level,\xe2\x80\x9d\n\n[1]\n\nwhile pro-plaintiff interests claim that there is\n\n[2]\n\n\xe2\x80\x9cscant evidence\xe2\x80\x9d of any tort abuse. It would be more amusing if it were not so shrill and partisan.\nPerhaps the most one can say with any certainty is that peoples\xe2\x80\x99 perception of reality is highly colored by\ntheir self-interest. In any event, there have been reforms (or, as the detractors say, \xe2\x80\x9cdeforms\xe2\x80\x9d).\n\nState Reforms\nProdded by astute lobbying by manufacturing and other business trade associations, state legislatures responded to\nthe cries of manufacturers about the hardships that the judicial transformation of the products-liability lawsuit\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n533\n\n\x0costensibly worked on them. Most state legislatures have enacted at least one of some three dozen \xe2\x80\x9creform\xe2\x80\x9d proposal\npressed on them over the last two decades. Some of these measures do little more than affirm and clarify case law.\nAmong the most that have passed in several states are outlined in the next sections.\n\nStatutes of Repose\nPerhaps nothing so frightens the manufacturer as the occasional reports of cases involving products that\nwere fifty or sixty years old or more at the time they injured the plaintiff. Many states have addressed this\nproblem by enacting the so-called statute of repose. This statute establishes a time period, generally\nranging from six to twelve years; the manufacturer is not liable for injuries caused by the product after\nthis time has passed.\n\nState-of-the-Art Defense\nSeveral states have enacted laws that prevent advances in technology from being held against the\nmanufacturer. The fear is that a plaintiff will convince a jury a product was defective because it did not use\ntechnology that was later available. Manufacturers have often failed to adopt new advances in technology\nfor fear that the change will be held against them in a products-liability suit. These new statutes declare\nthat a manufacturer has a valid defense if it would have been technologically impossible to have used the\nnew and safer technology at the time the product was manufactured.\n\nFailure to Warn\nSince it is often easier to prove that an injury resulted because the manufacturer failed to warn against a\ncertain use than it is to prove an injury was caused by a defective design, manufacturers are subjected to a\nconsiderable degree of hindsight. Some of the state statutes limit the degree to which the failure to warn\ncan be used to connect the product and the injury. For example, the manufacturer has a valid defense if it\nwould have been impossible to foresee that the consumer might misuse the product in a certain way.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n534\n\n\x0cComparative Fault for Consumer Misuse\nContributory negligence is generally not a defense in a strict liability action, while assumption of risk is. In\nstates that have enacted so-called comparative fault statutes, the user\xe2\x80\x99s damages are pegged to the\npercentage of responsibility for the injury that the defendant bears. Thus if the consumer\xe2\x80\x99s misuse of the\nproduct is assessed as having been 20 percent responsible for the accident (or for the extent of the\ninjuries), the consumer is entitled to only 80 percent of damages, the amount for which the defendant\nmanufacturer is responsible.\n\nCriminal Penalties\nNot all state reform is favorable to manufacturers. Under the California Corporate Criminal Liability Act,\nwhich took effect twenty years ago, companies and managers must notify a state regulatory agency if they\nknow that a product they are selling in California has a safety defect, and the same rule applies under\ncertain federal standards, as Toyota executives were informed by their lawyers following alarms about\nsudden acceleration in some Toyota automobiles. Failure to provide notice may result in corporate and\nindividual criminal liability.\n\nFederal Reform\nPiecemeal reform of products-liability law in each state has contributed to the basic lack of uniformity\nfrom state to state, giving it a crazy-quilt effect. In the nineteenth century, this might have made little\ndifference, but today most manufacturers sell in the national market and are subjected to the varying\nrequirements of the law in every state. For years there has been talk in and out of Congress of enacting a\nfederal products-liability law that would include reforms adopted in many states, as discussed earlier. So\nfar, these efforts have been without much success.\n\nCongressional tort legislation is not the only possible federal action to cope with products-related injuries.\nIn 1972, Congress created the Consumer Product Safety Commission (CPSC) and gave the commission\nbroad power to act to prevent unsafe consumer products. The CPSC can issue mandatory safety standards\ngoverning design, construction, contents, performance, packaging, and labeling of more than 10,000\nconsumer products. It can recall unsafe products, recover costs on behalf of injured consumers, prosecute\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n535\n\n\x0cthose who violate standards, and require manufacturers to issue warnings on hazardous products. It also\nregulates four federal laws previously administered by other departments: the Flammable Fabrics Act, the\nHazardous Substances Act, the Poison Prevention Packaging Act, and the Refrigerator Safety Act. In its\nearly years, the CPSC issued standards for bicycles, power mowers, television sets, architectural glass,\nextension cords, book matches, pool slides, and space heaters. But the list of products is long, and the\nCPSC\xe2\x80\x99s record is mixed: it has come under fire for being short on regulation and for taking too long to\npromulgate the relatively few safety standards it has issued in a decade.\n\nK E Y TA K EA WAY\nBusiness advocates claim the American tort system\xe2\x80\x94products-liability law\nincluded\xe2\x80\x94is broken and corrupted by grasping plaintiffs\xe2\x80\x99 lawyers; plaintiffs\xe2\x80\x99\nlawyers say businesses are greedy and careless and need to be smacked into\nrecognition of its responsibilities to be more careful. The debate rages on, decade\nafter decade. But there have been some reforms at the state level, and at the\nfederal level the Consumer Product Safety Act sets out standards for safe products\nand requires recalls for defective ones. It is regularly castigated for (1) being\nofficious and meddling or (2) being too timid.\n\nE XE R C IS ES\n1. Why is it so difficult to determine if there really is a \xe2\x80\x9ctort crisis\xe2\x80\x9d in the United\nStates?\n2. What reforms have been made to state tort law?\n3. What federal legislation affects consumer safety?\n[1] American Tort Reform Association website, accessed March 1, 2011,http://www.atra.org.\n[2] http://www.shragerlaw.com/html/legal_rights.html.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n536\n\n\x0c11.6 Cases\nImplied Warranty of Merchantability and the Requirement of a \xe2\x80\x9cSale\xe2\x80\x9d\nSheeskin v. Giant Food, Inc.\n\n318 A.2d 874 (Md. App. 1974)\n\nDavidson, J.\n\nEvery Friday for over two years Nathan Seigel, age 73, shopped with his wife at a Giant Food Store. This\ncomplex products liability case is before us because on one of these Fridays, 23 October 1970, Mr. Seigel\nwas carrying a six-pack carton of Coca-Cola from a display bin at the Giant to a shopping cart when one or\nmore of the bottles exploded. Mr. Seigel lost his footing, fell to the floor and was injured.\n\nIn the Circuit Court for Montgomery County, Mr. Seigel sued both the Giant Food, Inc., and the\nWashington Coca-Cola Bottling Company, Inc., for damages resulting from their alleged negligence and\nbreach of an implied warranty. At the conclusion of the trial Judge Walter H. Moorman directed a verdict\nin favor of each defendant.\xe2\x80\xa6\n\nIn an action based on breach of warranty it is necessary for the plaintiff to show the existence of the\nwarranty, the fact that the warranty was broken and that the breach of warranty was the proximate cause\nof the loss sustained. [UCC] 2-314.\xe2\x80\xa6The retailer, Giant Food, Inc., contends that appellant failed to prove\nthat an implied warranty existed between himself and the retailer because he failed to prove that there\nwas a sale by the retailer to him or a contract of sale between the two. The retailer maintains that there\nwas no sale or contract of sale because at the time the bottles exploded Mr. Seigel had not yet paid for\nthem. We do not agree.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n537\n\n\x0c[UCC] 2-314(1) states in pertinent part:\n\nUnless excluded or modified, a warranty that the goods shall be merchantable is implied in a contract\nfor their sale if the seller is a merchant with respect to goods of that kind.\n\n[1]\n\n(emphasis added)\n\nThus, in order for the implied warranties of 2-314 to be applicable there must be a \xe2\x80\x9ccontract for sale.\xe2\x80\x9d In\nMaryland it has been recognized that neither a completed \xe2\x80\x98sale\xe2\x80\x99 nor a fully executed contract for sale is\nrequired. It is enough that there be in existence an executory contract for sale.\xe2\x80\xa6\n\nHere, the plaintiff has the burden of showing the existence of the warranty by establishing that at the time\nthe bottles exploded there was a contract for their sale existing between himself and the Giant. [Citation]\nMr. Titus, the manager of the Giant, testified that the retailer is a \xe2\x80\x9cself-service\xe2\x80\x9d store in which \xe2\x80\x9cthe only\nway a customer can buy anything is to select it himself and take it to the checkout counter.\xe2\x80\x9d He stated that\nthere are occasions when a customer may select an item in the store and then change his mind and put the\nitem back. There was no evidence to show that the retailer ever refused to sell an item to a customer once\nit had been selected by him or that the retailer did not consider himself bound to sell an item to the\ncustomer after the item had been selected. Finally, Mr. Titus said that an employee of Giant placed the\nsix-pack of Coca-Cola selected by Mr. Seigel on the shelf with the purchase price already stamped upon it.\nMr. Seigel testified that he picked up the six-pack with the intent to purchase it.\n\nWe think that there is sufficient evidence to show that the retailer\xe2\x80\x99s act of placing the bottles upon the\nshelf with the price stamped upon the six-pack in which they were contained manifested an intent to offer\nthem for sale, the terms of the offer being that it would pass title to the goods when Mr. Seigel presented\nthem at the check-out counter and paid the stated price in cash. We also think that the evidence is\nsufficient to show that Mr. Seigel\xe2\x80\x99s act of taking physical possession of the goods with the intent to\npurchase them manifested an intent to accept the offer and a promise to take them to the checkout\ncounter and pay for them there.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n538\n\n\x0c[UCC] 2-206 provides in pertinent part:\n\n(1) Unless otherwise unambiguously indicated by the language or circumstances\n\n(a) An offer to make a contract shall be construed as inviting acceptance in any manner and by any\nmedium reasonable in the circumstances.\xe2\x80\xa6\n\nThe Official Comment 1 to this section states:\n\nAny reasonable manner of acceptance is intended to be regarded as available unless the offeror has made\nquite clear that it will not be acceptable.\n\nIn our view the manner by which acceptance was to be accomplished in the transaction herein involved\nwas not indicated by either language or circumstances. The seller did not make it clear that acceptance\ncould not be accomplished by a promise rather than an act. Thus it is equally reasonable under the terms\nof this specific offer that acceptance could be accomplished in any of three ways: 1) by the act of delivering\nthe goods to the check-out counter and paying for them; 2) by the promise to pay for the goods as\nevidenced by their physical delivery to the check-out counter; and 3) by the promise to deliver the goods\nto the check-out counter and to pay for them there as evidenced by taking physical possession of the goods\nby their removal from the shelf.\n\nThe fact that customers, having once selected goods with the intent to purchase them, are permitted by\nthe seller to return them to the shelves does not preclude the possibility that a selection of the goods, as\nevidenced by taking physical possession of them, could constitute a reasonable mode of acceptance.\nSection 2-106(3) provides:\n\n\xe2\x80\x9cTermination\xe2\x80\x9d occurs when either party pursuant to a power created by agreement or law puts an end to\nthe contract otherwise then for its breach. On \xe2\x80\x9ctermination\xe2\x80\x9d all obligations which are still executory on\nboth sides are discharged but any right based on prior breach or performance survives.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n539\n\n\x0cHere the evidence that the retailer permits the customer to \xe2\x80\x9cchange his mind\xe2\x80\x9d indicates only an\nagreement between the parties to permit the consumer to end his contract with the retailer irrespective of\na breach of the agreement by the retailer. It does not indicate that an agreement does not exist prior to the\nexercise of this option by the consumer.\xe2\x80\xa6\n\nHere Mr. Seigel testified that all of the circumstances surrounding his selection of the bottles were\nnormal; that the carton in which the bottles came was not defective; that in lifting the carton from the\nshelf and moving it toward his basket the bottles neither touched nor were touched by anything other than\nhis hand; that they exploded almost instantaneously after he removed them from the shelf; and that as a\nresult of the explosion he fell injuring himself. It is obvious that Coca-Cola bottles which would break\nunder normal handling are not fit for the ordinary use for which they were intended and that the\nrelinquishment of physical control of such a defective bottle to a consumer constitutes a breach of\nwarranty. Thus the evidence was sufficient to show that when the bottles left the retailer\xe2\x80\x99s control they did\nnot conform to the representations of the warranty of merchantability, and that this breach of the\nwarranty was the cause of the loss sustained.\xe2\x80\xa6\n\n[Judgment in favor of Giant Foods is reversed and the case remanded for a new trial. Judgment in favor of\nthe bottler is affirmed because the plaintiff failed to prove that the bottles were defective when they were\ndelivered to the retailer.]\n\nC A SE QU ES TIO NS\n1. What warranty did the plaintiff complain was breached here?\n2. By displaying the soda pop, the store made an offer to its customers. How did the\ncourt say such offers might be accepted?\n3. Why did the court get into the discussion about \xe2\x80\x9ctermination\xe2\x80\x9d of the contract?\n4. What is the controlling rule of law applied in this case?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n540\n\n\x0cStrict Liability and Bystanders\nEmbs v. Pepsi-Cola Bottling Co. of Lexington, Kentucky, Inc.\n\n528 S.W.2d 703 (Ky. 1975)\n\nJukowsky, J.\n\nOn the afternoon of July 25, 1970 plaintiff-appellant entered the self-service retail store operated by the\ndefendant-appellee, Stamper\xe2\x80\x99s Cash Market, Inc., for the purpose of \xe2\x80\x9cbuying soft drinks for the kids.\xe2\x80\x9d She\nwent to an upright soft drink cooler, removed five bottles and placed them in a carton. Unnoticed by her, a\ncarton of Seven-Up was sitting on the floor at the edge of the produce counter about one foot from where\nshe was standing. As she turned away from the cooler she heard an explosion that sounded \xe2\x80\x9clike a\nshotgun.\xe2\x80\x9d When she looked down she saw a gash in her leg, pop on her leg, green pieces of a bottle on the\nfloor and the Seven-Up carton in the midst of the debris. She did not kick or otherwise come into contact\nwith the carton of Seven-Up prior to the explosion. Her son, who was with her, recognized the green\npieces of glass as part of a Seven-Up bottle.\n\nShe was immediately taken to the hospital by Mrs. Stamper, a managing agent of the store. Mrs. Stamper\ntold her that a Seven-Up bottle had exploded and that several bottles had exploded that week. Before\nleaving the store Mrs. Stamper instructed one of her children to clean up the mess. Apparently, all of the\nphysical evidence went out with the trash. The location of the Seven-Up carton immediately before the\nexplosion was not a place where such items were ordinarily kept.\xe2\x80\xa6\n\nWhen she rested her case, the defendants-appellees moved for a directed verdict in their favor. The trial\ncourt granted the motion on the grounds that the doctrine of strict product liability in tort does not extend\nbeyond users and consumers and that the evidence was insufficient to permit an inference by a reasonably\nprudent man that the bottle was defective or if it was, when it became so.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n541\n\n\x0cIn [Citation] we adopted the view of strict product liability in tort expressed in Section 402 A of the\nAmerican Law Institute\xe2\x80\x99s Restatement of Torts 2d.\n\n402 A. Special Liability of Seller of Product for Physical Harm to\nUser or Consumer\n(1) One who sells any product in a defective condition unreasonably dangerous to the user or to his\nproperty is subject to liability for physical harm thereby caused to the ultimate user or consumer, or to his\nproperty, if\n\n(a) the seller is engaged in the business of selling such a product, and\n\n(b) it is expected to and does reach the user or consumer without substantial change in the condition in\nwhich it was sold.\n\n(2) The rule stated in Subsection (1) applies although\n\n(a) the seller has exercised all possible care in the preparation and sale of his product, and\n\n(b) the user or consumer has not bought the product from or entered into any contractual relation with\nthe seller.\n\nComment f on that section makes it abundantly clear that this rule applies to any person engaged in the\nbusiness of supplying products for use or consumption, including any manufacturer of such a product and\nany wholesale or retail dealer or distributor.\n\nComment c points out that on whatever theory, the justification for the rule has been said to be that the\nseller, by marketing his product for use and consumption, has undertaken and assumed a special\nresponsibility toward any member of the consuming public who may be injured by it; that the public has\nthe right to and does expect that reputable sellers will stand behind their goods; that public policy\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n542\n\n\x0cdemands that the burden of accidental injuries caused by products intended for consumption be placed\nupon those who market them, and be treated as a cost of production against which liability insurance can\nbe obtained; and that the consumer of such products is entitled to the maximum of protection at the\nhands of someone, and the proper persons to afford it are those who market the products.\n\nThe caveat to the section provides that the Institute expresses no opinion as to whether the rule may not\napply to harm to persons other than users or consumers. Comment on caveat o states the Institute\nexpresses neither approval nor disapproval of expansion of the rule to permit recovery by casual\nbystanders and others who may come in contact with the product, and admits there may be no essential\nreason why such plaintiffs should not be brought within the scope of protection afforded, other than they\ndo not have the same reasons for expecting such protection as the consumer who buys a marketed\nproduct, and that the social pressure which has been largely responsible for the development of the rule\nhas been a consumer\xe2\x80\x99s pressure, and there is not the same demand for the protection of casual\nstrangers.\xe2\x80\xa6\n\nThe caveat articulates the essential point: Once strict liability is accepted, bystander recovery is fait\naccompli.\n\nOur expressed public policy will be furthered if we minimize the risk of personal injury and property\ndamage by charging the costs of injuries against the manufacturer who can procure liability insurance and\ndistribute its expense among the public as a cost of doing business; and since the risk of harm from\ndefective products exists for mere bystanders and passersby as well as for the purchaser or user, there is\nno substantial reason for protecting one class of persons and not the other. The same policy requires us to\nmaximize protection for the injured third party and promote the public interest in discouraging the\nmarketing of products having defects that are a menace to the public by imposing strict liability upon\nretailers and wholesalers in the distributive chain responsible for marketing the defective product which\ninjures the bystander. The imposition of strict liability places no unreasonable burden upon sellers\nbecause they can adjust the cost of insurance protection among themselves in the course of their\ncontinuing business relationship.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n543\n\n\x0cWe must not shirk from extending the rule to the manufacturer for fear that the retailer or middleman\nwill be impaled on the sword of liability without regard to fault. Their liability was already established\nunder Section 402 A of the Restatement of Torts 2d. As a matter of public policy the retailer or\nmiddleman as well as the manufacturer should be liable since the loss for injuries resulting from defective\nproducts should be placed on those members of the marketing chain best able to pay the loss, who can\nthen distribute such risk among themselves by means of insurance and indemnity agreements.\n[Citation]\xe2\x80\xa6\n\nThe result which we reach does not give the bystander a \xe2\x80\x9cfree ride.\xe2\x80\x9d When products and consumers are\nconsidered in the aggregate, bystanders, as a class, purchase most of the same products to which they are\nexposed as bystanders. Thus, as a class, they indirectly subsidize the liability of the manufacturer,\nmiddleman and retailer and in this sense do pay for the insurance policy tied to the product.\xe2\x80\xa6\nFor the sake of clarity we restate the extension of the rule. The protections of Section 402 A of the\nRestatement of Torts 2d extend to bystanders whose injury from the defective product is reasonably\nforeseeable.\xe2\x80\xa6\n\nThe judgment is reversed and the cause is remanded to the Clark Circuit Court for further proceedings\nconsistent herewith.\n\nStephenson, J. (dissenting):\n\nI respectfully dissent from the majority opinion to the extent that it subjects the seller to liability. Every\nrule of law in my mind should have a rational basis. I see none here.\nLiability of the seller to the user, or consumer, is based upon warranty. Restatement, Second, Torts s\n403A. To extend this liability to injuries suffered by a bystander is to depart from any reasonable basis\nand impose liability by judicial fiat upon an otherwise innocent defendant. I do not believe that the\nexpression in the majority opinion which justifies this rule for the reason that the seller may procure\nliability insurance protection is a valid legal basis for imposing liability without fault. I respectfully\ndissent.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n544\n\n\x0cC A SE QU ES TIO NS\n1. Why didn\xe2\x80\x99t the plaintiff here use warranty as a theory of recovery, as Mr. Seigel did\nin the previous case?\n2. The court offers a rationale for the doctrine of strict products liability. What is it?\n3. Restatement, Section 402A, by its terms extends protection \xe2\x80\x9cto the ultimate user or\nconsumer,\xe2\x80\x9d but Mrs. Embs [plaintiff-appellant] was not that. What rationale did the\ncourt give for expanding the protection here?\n4. Among the entities in the vertical distribution chain\xe2\x80\x94manufacturer, wholesaler,\nretailer\xe2\x80\x94who is liable under this doctrine?\n5. What argument did Judge Stephenson have in dissent? Is it a good one?\n6. What is the controlling rule of law developed in this case?\n\nFailure to Warn\nLaaperi v. Sears, Roebuck & Co., Inc.\n\n787 F.2d 726 C.A.1 (Mass. 1986)\n\nCampbell, J.\n\nIn March 1976, plaintiff Albin Laaperi purchased a smoke detector from Sears. The detector,\nmanufactured by the Pittway Corporation, was designed to be powered by AC (electrical) current. Laaperi\ninstalled the detector himself in one of the two upstairs bedrooms in his home.\n\nEarly in the morning of December 27, 1976, a fire broke out in the Laaperi home. The three boys in one of\nthe upstairs bedrooms were killed in the blaze. Laaperi\xe2\x80\x99s 13-year-old daughter Janet, who was sleeping in\nthe other upstairs bedroom, received burns over 12 percent of her body and was hospitalized for three\nweeks.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n545\n\n\x0cThe uncontroverted testimony at trial was that the smoke detector did not sound an alarm on the night of\nthe fire. The cause of the fire was later found to be a short circuit in an electrical cord that was located in a\ncedar closet in the boys\xe2\x80\x99 bedroom. The Laaperi home had two separate electrical circuits in the upstairs\nbedrooms: one which provided electricity to the outlets and one which powered the lighting fixtures. The\nsmoke detector had been connected to the outlet circuit, which was the circuit that shorted and cut off.\nBecause the circuit was shorted, the AC-operated smoke detector received no power on the night of the\nfire. Therefore, although the detector itself was in no sense defective (indeed, after the fire the charred\ndetector was tested and found to be operable), no alarm sounded.\n\nLaaperi brought this diversity action against defendants Sears and Pittway, asserting negligent design,\nnegligent manufacture, breach of warranty, and negligent failure to warn of inherent dangers. The parties\nagreed that the applicable law is that of Massachusetts. Before the claims went to the jury, verdicts were\ndirected in favor of defendants on all theories of liability other than failure to warn.\xe2\x80\xa6\n\nLaaperi\xe2\x80\x99s claim under the failure to warn theory was that he was unaware of the danger that the very short\ncircuit which might ignite a fire in his home could, at the same time, incapacitate the smoke detector. He\ncontended that had he been warned of this danger, he would have purchased a battery-powered smoke\ndetector as a back-up or taken some other precaution, such as wiring the detector to a circuit of its own, in\norder better to protect his family in the event of an electrical fire.\n\nThe jury returned verdicts in favor of Laaperi in all four actions on the failure to warn claim. The jury\nassessed damages in the amount of $350,000 [$1,050,000, or about $3,400,000 in 2010 dollars] each of\nthe three actions brought on behalf of the deceased sons, and $750,000 [about $2,500,000 in 2010\ndollars] in the action brought on behalf of Janet Laaperi. The defendants\xe2\x80\x99 motions for directed verdict and\njudgment notwithstanding the verdict were denied, and defendants appealed.\n\nDefendants ask us to declare that the risk that an electrical fire could incapacitate an AC-powered smoke\ndetector is so obvious that the average consumer would not benefit from a warning. This is not a trivial\nargument; in earlier\xe2\x80\x94some might say sounder\xe2\x80\x94days, we might have accepted it.\xe2\x80\xa6 Our sense of the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n546\n\n\x0ccurrent state of the tort law in Massachusetts and most other jurisdictions, however, leads us to conclude\nthat, today, the matter before us poses a jury question; that \xe2\x80\x9cobviousness\xe2\x80\x9d in a situation such as this would\nbe treated by the Massachusetts courts as presenting a question of fact, not of law. To be sure, it would be\nobvious to anyone that an electrical outage would cause this smoke detector to fail. But the average\npurchaser might not comprehend the specific danger that a fire-causing electrical problem can\nsimultaneously knock out the circuit into which a smoke detector is wired, causing the detector to fail at\nthe very moment it is needed. Thus, while the failure of a detector to function as the result of an electrical\nmalfunction due, say, to a broken power line or a neighborhood power outage would, we think, be obvious\nas a matter of law, the failure that occurred here, being associated with the very risk\xe2\x80\x94fire\xe2\x80\x94for which the\ndevice was purchased, was not, or so a jury could find.\xe2\x80\xa6\n\nFinally, defendants contend that the award of $750,000 [$2.5 million in 2010 dollars] in damages to\nJanet Laaperi was excessive, and should have been overturned by the district court.\xe2\x80\xa6\n\nJanet Laaperi testified that on the night of the fire, she woke up and smelled smoke. She woke her friend\nwho was sleeping in her room, and they climbed out to the icy roof of the house. Her father grabbed her\nfrom the roof and took her down a ladder. She was taken to the hospital. Although she was in \xe2\x80\x9cmild\ndistress,\xe2\x80\x9d she was found to be \xe2\x80\x9calert, awake, [and] cooperative.\xe2\x80\x9d Her chest was clear. She was diagnosed as\nhaving first and second degree burns of her right calf, both buttocks and heels, and her left lower back, or\napproximately 12 percent of her total body area. She also suffered from a burn of her tracheobronchial\nmucosa (i.e., the lining of her airway) due to smoke inhalation, and multiple superficial lacerations on her\nright hand.\n\nThe jury undoubtedly, and understandably, felt a great deal of sympathy for a young girl who, at the age of\n13, lost three brothers in a tragic fire. But by law the jury was only permitted to compensate her for those\ndamages associated with her own injuries. Her injuries included fright and pain at the time of and after\nthe fire, a three-week hospital stay, some minor discomfort for several weeks after discharge, and a\npermanent scar on her lower back. Plaintiff has pointed to no cases, and we have discovered none, in\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n547\n\n\x0cwhich such a large verdict was sustained for such relatively minor injuries, involving no continuing\ndisability.\n\nThe judgments in favor of Albin Laaperi in his capacity as administrator of the estates of his three sons are\naffirmed. In the action on behalf of Janet Laaperi, the verdict of the jury is set aside, the judgment of the\ndistrict court vacated, and the cause remanded to that court for a new trial limited to the issue of\ndamages.\n\nC A SE QU ES TIO NS\n1. The \xe2\x80\x9cC.A. 1\xe2\x80\x9d under the title of the case means it is a US Court of Appeals case from\nthe First Circuit in Massachusetts. Why is this case in federal court?\n2. Why does the court talk about its \xe2\x80\x9csense of the current state of tort law in\nMassachusetts\xe2\x80\x9d and how this case \xe2\x80\x9cwould be treated by the Massachusetts courts,\xe2\x80\x9d\nas if it were not in the state at all but somehow outside?\n3. What rule of law is in play here as to the defendants\xe2\x80\x99 liability?\n4. This is a tragic case\xe2\x80\x94three boys died in a house fire. Speaking dispassionately\xe2\x80\x94if\nnot heartlessly\xe2\x80\x94though, did the fire actually cost Mr. Laaperi, or did he lose $3.4\nmillion (in 2010 dollars) as the result of his sons\xe2\x80\x99 deaths? Does it make sense that he\nshould become a millionaire as a result? Who ends up paying this amount? (The\nlawyers\xe2\x80\x99 fees probably took about half.)\n5. Is it likely that smoke-alarm manufactures and sellers changed the instructions as a\nresult of this case?\n[1] Uniform Commercial Code, Section 2-316.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n548\n\n\x0c11.7 Summary and Exercises\nSummary\nProducts liability describes a type of claim\xe2\x80\x94for injury caused by a defective product\xe2\x80\x94and not a separate\ntheory of liability. In the typical case, three legal doctrines may be asserted: (1) warranty, (2) negligence,\nand (3) strict liability.\n\nIf a seller asserts that a product will perform in a certain manner or has certain characteristics, he has\ngiven an express warranty, and he will be held liable for damages if the warranty is breached\xe2\x80\x94that is, if\nthe goods do not live up to the warranty. Not every conceivable claim is an express warranty; the courts\npermit a certain degree of \xe2\x80\x9cpuffing.\xe2\x80\x9d\n\nAn implied warranty is one created by law. Goods sold by a merchant-seller carry an implied warranty of\nmerchantability, meaning that they must possess certain characteristics, such as being of average quality\nfor the type described and being fit for the ordinary purposes for which they are intended.\nAn implied warranty of fitness for a particular purpose is created whenever a seller knows or has reason to\nknow that the buyer is relying on the seller\xe2\x80\x99s knowledge and skill to select a product for the buyer\xe2\x80\x99s\nparticular purposes.\n\nUnder UCC Article 2, the seller also warrants that he is conveying good title and that the goods are free of\nany rightful claim by a third person.\n\nUCC Article 2 permits sellers to exclude or disclaim warranties in whole or in part. Thus a seller may\nexclude express warranties. He may also disclaim many implied warranties\xe2\x80\x94for example, by noting that\nthe sale is \xe2\x80\x9cas is.\xe2\x80\x9d The Magnuson-Moss Act sets out certain types of information that must be included in\nany written warranty. The act requires the manufacturer or seller to label the warranty as either \xe2\x80\x9cfull\xe2\x80\x9d or\n\xe2\x80\x9climited\xe2\x80\x9d depending on what types of defects are covered and what the customer must do to obtain repair\nor replacement. The act also abolishes \xe2\x80\x9cphantom warranties.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n549\n\n\x0cPrivity once stood as a bar to recovery in suits brought by those one or more steps removed in the\ndistribution chain from the party who breached a warranty. But the nearly universal trend in the state\ncourts has been to abolish privity as a defense.\n\nBecause various impediments stand in the way of warranty suits, courts have adopted a tort theory of\nstrict liability, under which a seller is liable for injuries resulting from the sale of any product in a\ndefective condition if it is unreasonably dangerous to the user or consumer. Typical issues in strict liability\ncases are these: Is the defendant a seller engaged in the business of selling? Was the product sold in a\ndefective condition? Was it unreasonably dangerous, either on its face or because of a failure to warn? Did\nthe product reach the consumer in an unchanged condition? Strict liability applies regardless of how\ncareful the seller was and regardless of his lack of contractual relation with the consumer or user.\n\nManufacturers can also be held liable for negligence\xe2\x80\x94most often for faulty design of products and\ninadequate warnings about the hazards of using the product.\n\nThe products-liability revolution prompted many state legislatures to enact certain laws limiting to some\ndegree the manufacturer\xe2\x80\x99s responsibility for defective products. These laws include statutes of repose and\nprovide a number of other defenses.\xe2\x80\x99\n\nE XE R C IS ES\n1. Ralph\xe2\x80\x99s Hardware updated its accounting system and agreed to purchase a\ncomputer system from a manufacturer, Bits and Bytes (BB). During contract\nnegotiations, BB\xe2\x80\x99s sales representative promised that the system was \xe2\x80\x9cA-1\xe2\x80\x9d and\n\xe2\x80\x9cperfect.\xe2\x80\x9d However, the written contract, which the parties later signed, disclaimed\nall warranties, express and implied. After installation the computer produced only\nrandom numbers and letters, rather than the desired accounting information. Is BB\nliable for breaching an express warranty? Why?\n2. Kate owned a small grocery store. One day John went to the store and purchased a\ncan of chip dip that was, unknown to Kate or John, adulterated. John became\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n550\n\n\x0cseriously ill after eating the dip and sued Kate for damages on the grounds that she\nbreached an implied warranty of merchantability. Is Kate liable? Why?\n3. Carrie visited a neighborhood store to purchase some ham, which a salesperson cut\nby machine in the store. The next day she made a ham sandwich. In eating the\nsandwich, Carrie bit into a piece of cartilage in the ham. As a result, Carrie lost a\ntooth, had to undergo root canal treatments, and must now wear a full-coverage\ncrown to replace the tooth. Is the store liable for the damage? Why?\n4. Clarence, a business executive, decided to hold a garage sale. At the sale, his\nneighbor Betty mentioned to Clarence that she was the catcher on her city-league\nbaseball team and was having trouble catching knuckleball pitches, which required a\nspecial catcher\xe2\x80\x99s mitt. Clarence pulled an old mitt from a pile of items that were on\nsale and said, \xe2\x80\x9cHere, try this.\xe2\x80\x9d Betty purchased the mitt but discovered during her\nnext game that it didn\xe2\x80\x99t work. Has Clarence breached an express or implied\nwarranty? Why?\n5. Sarah purchased several elegant picture frames to hang in her dorm room. She also\npurchased a package of self-sticking hangers. Late one evening, while Sarah was\nstudying business law in the library, the hangers came loose and her frames came\ncrashing to the floor. After Sarah returned to her room and discovered the rubble,\nshe examined the box in which the hangers were packaged and found the following\nlanguage: \xe2\x80\x9cThere are no warranties except for the description on this package and\nspecifically there is NO IMPLIED WARRANTY OF MERCHANTABILITY.\xe2\x80\x9d Assuming the\nhangers are not of fair, average, ordinary quality, would the hanger company be\nliable for breaching an implied warranty of merchantability? Why?\n6. A thirteen-year-old boy received a Golfing Gizmo\xe2\x80\x94a device for training novice\ngolfers\xe2\x80\x94as a gift from his mother. The label on the shipping carton and the cover of\nthe instruction booklet urged players to \xe2\x80\x9cdrive the ball with full power\xe2\x80\x9d and further\nstated: \xe2\x80\x9cCOMPLETELY SAFE BALL WILL NOT HIT PLAYER.\xe2\x80\x9d But while using the device,\nthe boy was hit in the eye by the ball. Should lack of privity be a defense to the\nmanufacturer? The manufacturer argued that the Gizmo was a \xe2\x80\x9ccompletely safe\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n551\n\n\x0ctraining device only when the ball is hit squarely, and\xe2\x80\x94the defendant argued\xe2\x80\x94\nplaintiffs could not reasonably expect the Gizmo to be \xe2\x80\x9ccompletely safe\xe2\x80\x9d under all\ncircumstances, particularly those in which the player hits beneath the ball. What\nlegal argument is this, and is it valid?\n7. A bank repossessed a boat and sold it to Donald. During the negotiations with\nDonald, Donald stated that he wanted to use the boat for charter service in Florida.\nThe bank officers handling the sale made no representations concerning the boat\nduring negotiations. Donald later discovered that the boat was defective and sued\nthe bank for breach of warranty. Is the bank liable? Why?\n8. Tom Anderson, the produce manager at the Thriftway Market in Pasco, Washington,\nremoved a box of bananas from the top of a stack of produce. When he reached for\na lug of radishes that had been under the bananas, a six-inch spider\xe2\x80\x94Heteropoda\nvenatoria, commonly called a banana spider\xe2\x80\x94leaped from some wet burlap onto his\nleft hand and bit him. Nine months later he died of heart failure. His wife brought an\naction against Associated Grocers, parent company of Thriftway Market, on theories\nof (1) strict products liability under Restatement, Section 402(a); (2) breach of the\nimplied warranty of merchantability; and (3) negligence. The trial court ruled against\nthe plaintiff on all three theories. Was that a correct ruling? Explain.\n9. A broken water pipe flooded a switchboard at RCA\xe2\x80\x99s office. The flood tripped the\nswitchboard circuit breakers and deactivated the air-conditioning system. Three\nemployees were assigned to fix it: an electrical technician with twelve years on-thejob training, a licensed electrician, and an electrical engineer with twenty years of\nexperience who had studied power engineering in college. They switched on one of\nthe circuit breakers, although the engineer said he knew that one was supposed to\ntest the operation of a wet switchboard before putting it back into use. There was a\n\xe2\x80\x9csnap\xe2\x80\x9d and everyone ran from the room up the stairs and a \xe2\x80\x9cbig ball of fire\xe2\x80\x9d came\nafter them up the stairs. The plaintiffs argued that the manufacturer of the circuit\nbreaker had been negligent in failing to give RCA adequate warnings about the\ncircuit breakers. How should the court rule, and on what theory should it rule?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n552\n\n\x0c10. Plaintiff\xe2\x80\x99s business was to convert vans to RVs, and for this purpose it had used a 3M\nadhesive to laminate carpeting to the van walls. This adhesive, however, failed to\nhold the fabric in place in hot weather, so Plaintiff approached Northern Adhesive\nCo., a manufacturer of adhesives, to find a better one. Plaintiff told Northern why it\nwanted the adhesive, and Northern\xe2\x80\x94Defendant\xe2\x80\x94sent several samples to Plaintiff\nto experiment with. Northern told Plaintiff that one of the adhesives, Adhesive\n7448, was \xe2\x80\x9ca match\xe2\x80\x9d for the 3M product that previously failed. Plaintiff tested the\nsamples in a cool plant and determined that Adhesive 7448 was better than the 3M\nproduct. Defendant had said nothing except that \xe2\x80\x9cwhat they would ship would be\nlike the sample. It would be the same chemistry.\xe2\x80\x9d Plaintiff used the adhesive during\nthe fall and winter; by spring complaints of delamination came in: Adhesive 7448\nfailed just as the 3M product had. Over 500 vans had to be repaired. How should the\ncourt rule on Plaintiff\xe2\x80\x99s claims of breach of (1) express warranty, (2) implied\nwarranty of merchantability, and (3) implied warranty of fitness for a particular\npurpose?\n\nS EL F -T E ST QU EST IO N S\n1. In a products-liability case\na. only tort theories are typically asserted\nb. both tort and contract theories are typically asserted\nc. strict liability is asserted only when negligence is not asserted\nd. breach of warranty is not asserted along with strict liability\nAn implied warranty of merchantability\na. is created by an express warranty\nb. is created by law\nc. is impossible for a seller to disclaim\nd. can be disclaimed by a seller only if the disclaimer is in writing\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n553\n\n\x0cA possible defense to breach of warranty is\na. lack of privity\nb. absence of an express warranty\nc. disclaimer of implied warranties\nd. all of the above\nUnder the strict liability rule in Restatement, Section 402A, the seller is liable for\nall injuries resulting from a product\na. even though all possible care has been exercised\nb. regardless of the lack of a contract with the user\nc. in both of the above situations\nd. in none of the above situations\nAn individual selling her car could be liable\na. for breaching the implied warranty of merchantability\nb. under the strict liability theory\nc. for breaching the implied warranty of fitness\nd. under two of the above\n\nS EL F -T E ST A NSW E R S\n1. b\n2. b\n3. d\n4. c\n5. d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n554\n\n\x0cChapter 12\nBailments and the Storage, Shipment, and\nLeasing of Goods\nL EA R N IN G O B JEC T IV ES\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\x94\narise\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n555\n\n\x0c12.1 Introduction to Bailment Law\nL EA R N IN G O B JEC T IV ES\n1. 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.\n\nFinally, we turn to the legal relationships that buyers and sellers have with warehousers and carriers\xe2\x80\x94the\nparties responsible for physically transferring goods from seller to buyer. This topic introduces a new\nbranch of law\xe2\x80\x94that of bailments; we\xe2\x80\x99ll examine it before turning directly to warehousers and carriers.\n\nOverview of Bailments\nA bailment is the relationship established when someone entrusts his property temporarily to someone\nelse without intending to give up title. Although bailment has often been said to arise only through a\ncontract, the modern definition does not require that there be an agreement. One widely quoted definition\nholds that a bailment is \xe2\x80\x9cthe rightful possession of goods by one who is not the owner. It is the element of\nlawful possession, however created, and the duty to account for the thing as the property of another, that\ncreates the bailment, regardless of whether such possession is based upon contract in the ordinary sense\nor not.\xe2\x80\x9d\n\n[1]\n\nThe word bailment derives from a Latin verb, bajulare, meaning \xe2\x80\x9cto bear a burden,\xe2\x80\x9d and then from\nFrench, bailler, which means \xe2\x80\x9cto deliver\xe2\x80\x9d (i.e., into the hands or possession of someone). The one who\nbails out a boat, filling a bucket and emptying it overboard, is a water-bearer. The one who bails someone\nout of jail takes on the burden of ensuring that the one sprung appears in court to stand trial; he also takes\non the risk of loss of bond money if the jailed party does not appear in court. The one who is\na bailee takes on the burden of being responsible to return the goods to their owner.\n\nThe law of bailments is important to virtually everyone in modern society: anyone who has ever delivered\na car to a parking lot attendant, checked a coat in a restaurant, deposited property in a safe-deposit box,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n556\n\n\x0crented tools, or taken items clothes or appliance in to a shop for repair. In commercial transactions,\nbailment law governs the responsibilities of warehousers and the carriers, such as UPS and FedEx, that\nare critical links in the movement of goods from manufacturer to the consumer. Bailment law is an\nadmixture of common law (property and tort), state statutory law (in the Uniform Commercial Code;\nUCC), federal statutory law, and\xe2\x80\x94for international issues\xe2\x80\x94treaty.\n\n[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 possession\nand must return the identical object. In most cases the distinction is clear, but difficult borderline cases\ncan arise. Consider the sad case of the leased cows: Carpenter v. Griffen (N.Y. 1841). Carpenter leased a\nfarm for five years to Spencer. The lease included thirty cows. At the end of the term, Spencer was to give\nCarpenter, the owner, \xe2\x80\x9ccows of equal age and quality.\xe2\x80\x9d Unfortunately, Spencer fell into hard times and\nhad to borrow money from one Griffin. When the time came to pay the debt, Spencer had no money, so\nGriffin went to court to levy against the cows (i.e., he sought a court order giving him the cows in lieu of\nthe money owed). Needless to say, this threatened transfer of the cows upset Carpenter, who went to court\nto stop Griffin 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 which\ncase Spencer would own the cows and Griffin could levy against them. The court ruled that title had\npassed to Spencer\xe2\x80\x94the cows were his. Why? The court reasoned that Spencer was not obligated to return\nthe identical cows to Carpenter, hence Spencer was not a bailee.\n\n[3]\n\nSection 2-304(1) of the UCC confirms\n\nthis position, declaring that whenever the price of a sale is payable in goods, each party is a seller of the\ngoods that he is to transfer.\n\nNote the implications that flow from calling this transaction a sale. Creditors of the purchaser can seize\nthe goods. The risk of loss is on the purchaser. The seller cannot recover the goods (to make up for the\nbuyer\xe2\x80\x99s failure to pay him) or sell them to a third party.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n557\n\n\x0cFungible Goods\nFungible goods (goods that are identical, like grain in a silo) present an especially troublesome problem.\nIn many instances the goods of several owners are mingled, and the identical items are not intended to be\nreturned. For example, the operator of a grain elevator agrees to return an equal quantity of like-quality\ngrain but not the actual kernels deposited there. Following the rule in Carpenter\xe2\x80\x99s cow case, this might\nseem to be a sale, but it is not. Under the UCC, Section 2-207, the depositors of fungible goods are\n\xe2\x80\x9ctenants in common\xe2\x80\x9d of the goods; in other words, the goods are owned by all. This distinction between a\nsale and a bailment is important. When there is a loss through natural causes\xe2\x80\x94for example, if the grain\nelevator burns\xe2\x80\x94the depositors must share the loss on a pro rata basis (meaning that no single depositor is\nentitled to take all his grain out; if 20 percent of the grain was destroyed, then each depositor can take out\nno more than 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 For the\nmost part, this definition is clear (and note that it does not dictate that a bailment be created by contract).\nBailment law applies to the delivery of goods\xe2\x80\x94that is, to the delivery personal property. Personal property\nis usually defined as anything that can be owned other than real estate. As we have just seen in comparing\nbailments to sales, the definition implies a duty to return the identical goods when the bailment ends.\n\nBut one word in the definition is both critical and troublesome: possession. Possession requires both a\nphysical 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 obviously\nwithin the physical control of the garage. But in some instances, physical control is difficult to\nconceptualize. For example, you can rent a safe-deposit box in a bank to store valuable papers, stock\ncertificates, jewelry, and the like. The box is usually housed in the bank\xe2\x80\x99s vault. To gain access, you sign a\nregister and insert your key after a bank employee inserts the bank\xe2\x80\x99s key. You may then inspect, add to, or\nremove contents of the box in the privacy of a small room maintained in the vault for the purpose.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n558\n\n\x0cBecause the bank cannot gain access to the box without your key and does not know what is in the box, it\nmight be said to have no physical control. Nevertheless, the rental of a safe-deposit box is a bailment. In\nso holding, a New York court pointed out that if the bank was not in possession of the box renter\xe2\x80\x99s\nproperty \xe2\x80\x9cit is difficult to know who was. Certainly [the renter] was not, because she could not obtain\naccess to the 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 own key;\nthus absolutely controlling [her] access to that which she had deposited within the safe. The vault was the\n[company\xe2\x80\x99s] and was in its custody, and its contents were under the same conditions.\xe2\x80\x9d\n\n[4]\n\nStatutes in some\n\nstates, however, provide that the relationship is not a bailment but that of a landlord and tenant, and\nmany 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, to exercise\ncontrol over them. This mental condition is difficult to prove; it almost always turns on the specific\ncircumstances and, as a fact question, is left to the jury to determine. To illustrate the difficulty, suppose\nthat one crisp fall day, Mimi goes to Sally Jane\xe2\x80\x99s Boutique to try on a jacket. The sales clerk hands Mimi a\njacket and watches while Mimi takes off her coat and places it on a nearby table. A few minutes later,\nwhen Mimi is finished inspecting herself in the mirror, she goes to retrieve her coat, only to discover it is\nmissing. Who is responsible for the loss? The answer depends on whether the store is a bailee. In some\nsense the boutique had physical control, but did it intend to exercise that control? In a leading case, the\ncourt held that it did, even though no one said anything about guarding the coat, because a store invites\nits patrons to come 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 the\nsalesperson, the store must exercise some care in its safekeeping.\n\n[5]\n\nNow suppose that when Mimi walked in, the salesperson told her to look around, to try on some clothes,\nand to put her coat on the table. When the salesperson was finished with her present customer, she said,\nshe would be glad to help Mimi. So Mimi tried on a jacket and minutes later discovered her coat gone. Is\nthis a bailment? Many courts, including the New York courts, would say no. The difference? The\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n559\n\n\x0csalesperson was helping another customer. Therefore, Mimi had a better opportunity to watch over her\nown coat and knew that the salesperson would not be looking out for it. This is a subtle distinction, but it\nhas been sufficient in many cases to change the ruling.\n\n[6]\n\nQuestions of intent and control frequently arise in parking lot cases. As someone once said, \xe2\x80\x9cThe key to\nthe problem is the key itself.\xe2\x80\x9d The key is symbolic of possession and intent to possess. If you give the\nattendant your key, you are a bailor and he (or the company he works for) is the bailee. If you do not give\nhim the key, no bailment arises. Many parking lot cases do not fall neatly within this rule, however.\nEspecially common are cases involving self-service airport parking lots. The customer drives through a\ngate, takes a ticket dispensed by a machine, parks his car, locks it, and takes his key. When he leaves, he\nretrieves the car himself and pays at an exit gate. As a general rule, no bailment is created under these\ncircumstances. The lot operator does not accept the vehicle nor intend to watch over it as bailee. In effect,\nthe operator is simply renting out space.\n\n[7]\n\nBut a slight change of facts can alter this legal conclusion.\n\nSuppose, for instance, that the lot had an attendant at the single point of entrance and exit, that the\nattendant jotted 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 been held to\nadd up to an intention to exercise custody and control over the cars in the lot, and hence to have created a\n[8]\n\nbailment.\n\nFor a bailment to exist, the bailee must know or have reason to know that the property exists. When\nproperty is hidden within the main object entrusted to the bailee, lack of notice can defeat the bailment in\nthe hidden property. For instance, a parking lot is not responsible for the disappearance of valuable golf\nclubs stored in the trunk of a car, nor is a dance hall cloak room responsible for the disappearance of a fur\nwrap inside a coat, if they did not know of their existence.\n\n[9]\n\nThis result is usually justified by observing\n\nthat when a person is unaware that goods exist or does not know their value, it is inequitable to hold him\nresponsible for their loss since he cannot take steps to prevent it. This rule has been criticized: trunks are\nmeant to hold things, and if the car was within the garage\xe2\x80\x99s control, surely its contents were too. Some\ncourts soften the impact of the rule by holding that a bailee is responsible for goods that he might\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n560\n\n\x0creasonably expect to be present, like gloves in a coat checked at a restaurant or ordinary baggage in a car\nchecked at a hotel.\n\nK E Y TA K EA WAY\nA bailment arises when one person (a bailee) rightfully holds property belonging\nto another (a bailor). The law of bailments addresses the critical links in the\nmovement of goods from the manufacturer to the end user in a consumer society:\nto the storage and transportation of goods. Bailments only apply to personal\nproperty; a bailment requires that the bailor deliver physical control of the goods\nto the bailee, who has an intention to possess the goods and a duty to return\nthem.\n\nE XE R C IS ES\n1. Dennis takes his Mercedes to have the GPS system repaired. In the trunk of\nhis car is a briefcase containing $5,000 in cash. Is the cash bailed goods?\n2. Marilyn wraps up ten family-heirloom crystal goblets, packages them carefully\nin a cardboard box, and drops the box off at the local UPS store. Are the\ngoblets bailed goods?\n3. Bob agrees to help his friend Roger build a deck at Roger\xe2\x80\x99s house. Bob leaves\nsome of his tools\xe2\x80\x94without Bob\xe2\x80\x99s noticing\xe2\x80\x94around the corner of the garage at\nthe foot of a rhododendron bush. The tools are partly hidden. Are they bailed\ngoods?\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\nCommon Law,\xe2\x80\x9d accessed March 1,\n2011,http://www.globusz.com/ebooks/CommonLaw/00000015.htm.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n561\n\n\x0c[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.\n1968).\n[9] Samples v. Geary, 292 S.W. 1066 (Mo. App. 1927).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n562\n\n\x0c12.2 Liability of the Parties to a Bailment\nL EA R N IN G O B JEC T IV ES\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\non such disclaimers.\n3. Understand what duty and liability the bailor has.\n4. Know other rights and duties that arise in a bailment.\n5. Understand the extent to which innkeepers\xe2\x80\x94hotel and motels\xe2\x80\x94are liable for their\nguests\xe2\x80\x99 property.\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 bailee\xe2\x80\x99s time\nfor possession of them is over, and he is presumed liable if the goods are not returned. But that a bailee\nhas accepted delivery of goods does not mean that he is responsible for their safekeeping no matter what.\nThe law of bailments does not apply a standard of absolute liability: the bailee is not an insurer of the\ngoods\xe2\x80\x99 safety; her liability depends on the circumstances.\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 the\ncircumstances.\xe2\x80\x9d The question becomes whether the bailee exercised such care. If she did, she is not liable\nfor the loss.\n\nBenefit-of-the-Bargain Rule\nMost courts use a complex (some say annoying) tripartite division of responsibility. If the bailment is for\nthe sole benefit of the owner (the bailor), the bailee is answerable only for gross neglect or fraud: the duty\nof care is slight. For example, imagine that your car breaks down on a dark night and you beg a passing\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n563\n\n\x0cmotorist to tow it to a gas station; or you ask your neighbor if you can store your utility trailer in her\ngarage.\n\nOn the other hand, if the goods are entrusted to the bailee for his sole benefit, then he owes the bailor\nextraordinary care. For example, imagine that your neighbor asks you to let him borrow your car to go to\nthe grocery store downtown because his car is in the shop; or a friend asks if she can borrow your party\ncanopy.\n\nIf the bailment is for the mutual benefit of bailee and bailor, then the ordinary negligence standard of care\nwill govern. For example, imagine you park your car in a commercial parking lot, or you take your suit\njacket to a dry cleaner (see ).\n\nFigure 12.1 Duty of Care\n\nOne problem with using the majority approach is the inherent ambiguity in the standards of care. What\nconstitutes \xe2\x80\x9cgross\xe2\x80\x9d negligence as opposed to \xe2\x80\x9cordinary\xe2\x80\x9d negligence? The degree-of-care approach is\nfurther complicated by the tendency of the courts to take into account the value of the goods; the lesser\nthe value of the goods, the lesser the obligation of the bailee to watch out for them. To some degree, this\napproach makes sense, because it obviously behooves a person guarding diamonds to take greater\nprecautions against theft than one holding three paperback books. But the value of the goods ought not to\nbe the whole story: some goods obviously have great value to the owner, regardless of any lack of intrinsic\nvalue.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n564\n\n\x0cAnother problem in using the majority approach to the standard of care is determining whether or not a\nbenefit has been conferred on the bailee when the bailor did not expressly agree to pay compensation. For\nexample, a bank gives its customers free access to safe-deposit boxes. Is the bank a \xe2\x80\x9cgratuitous bailee\xe2\x80\x9d that\nowes its bailor only a slight degree of care, or has it made the boxes available as a commercial matter to\nhold onto its customers? Some courts cling to one theory, some to the other, suggesting the difficulty with\nthe tripartite division of the standard of care. However, in many cases, whatever the formal theory, the\ncourts look to the actual benefits to be derived. Thus when a customer comes to an automobile showroom\nand leaves her car in the lot while she test-drives the new car, most courts would hold that two bailments\nfor mutual benefit 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 defendant\nbailee\xe2\x80\x99s failure to exercise due care. However, the bailor establishes a prima facie (\xe2\x80\x9cat first sight\xe2\x80\x9d\xe2\x80\x94on first\nappearance, but subject to further investigation) case by showing that he delivered the goods into the\nbailee\xe2\x80\x99s hands and that the bailee did not return them or returned them damaged. At that point, a\npresumption of negligence arises, and to avoid liability the defendant must rebut that presumption by\nshowing affirmatively that he was not negligent. The reason for this rule is that the bailee usually has a\nmuch better opportunity to explain why the goods were not returned or were returned damaged. To put\nthis burden on the bailor might make 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 of law on\nthe 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 he has a\nduty to inform the bailee of known defects and to make a reasonable inspection for other defects. Suppose\nthe Tranquil Chemical Manufacturing Company produces an insecticide that it wants the Plattsville\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n565\n\n\x0cChemical Storage Company to keep in tanks until it is sold. One of the batches is defectively acidic and\noozes out of the tanks. This acidity could have been discovered through a routine inspection, but Tranquil\nneglects to inspect the batch. The tanks leak and the chemical builds up on the floor until it explodes.\nSince Tranquil, the bailor, received a benefit from the storage, it had a duty to warn Plattsville, and its\nfailure to do so makes it liable for all damages caused by the explosion.\n\nIf the bailor does not receive any benefit, however, then his only duty is to inform the bailee of known\ndefects. Your neighbor asks to borrow your car. You have a duty to tell her that the brakes are weak, but\nyou do not need to inspect the car beforehand for unknown defects.\n\nOther Types of Liability\nThe theory of products liability discussed in 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, damage can\nbe done equally by sellers or lessors of equipment. A rented car can inflict substantial injury no less than a\npurchased one.\n\nIn several states, when an automobile owner (bailor) lends a vehicle to a friend (bailee) who causes an\naccident, the owner is liable to third persons injured in the accident. This liability is discussed in , which\ncovers agency law.\n\nDisclaimers of Liability\nBailee\xe2\x80\x99s Disclaimer\nBailees frequently attempt to disclaim their liability for loss or damage. But courts often refuse to honor\nthe 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 posted\nnotices and receipts disclaiming or limiting liability must set forth clearly and legibly the legal effects\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n566\n\n\x0cintended. Most American courts follow the rule that the defendant bailee must show that the bailor in fact\nknew about the disclaimer. Language printed on the back side of a receipt will not do.\n\nPublic Policy Exception\nEven if the bailor reads the disclaimer, some courts will nevertheless hold the bailee liable on public policy\ngrounds, especially when the bailee is a \xe2\x80\x9cbusiness bailee,\xe2\x80\x9d such as a warehouse or carrier. Indeed, to the\nextent that a business bailee attempts to totally disclaim liability, he will probably fail in every American\njurisdiction. But the Restatement (Second) of Contracts, Section 195(2)(b), does not go quite this far for\nmost nonbusiness bailees. They may disclaim liability as long as the disclaimer is read and does not\nrelieve the bailee from wanton carelessness.\n\nBailor\xe2\x80\x99s Disclaimer\nBailors most frequently attempt to disclaim liability in rental situations. For example, in Zimmer v.\nMitchell and Ness, the plaintiff went to the defendant\xe2\x80\x99s rental shop at the Camelback ski area to rent skis,\nboots, and poles.\n\n[1]\n\nHe signed a rental agreement before accepting the ski equipment. He was a lessee and\n\na bailee. Later, while descending the beginners\xe2\x80\x99 slope, he fell. The bindings on his skis did not release,\nthereby causing him to sustain numerous injuries. The plaintiff sued the defendant and Camelback Ski\nCorporation, alleging negligence, violation of Section 402A of the Restatement (Second) of Torts, and\nbreach of warranty. 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 signing the\nagreement but generally denied that it released the defendant from liability. The defendant won on\nsummary judgment.\n\nOn appeal, the Pennsylvania Supreme Court held for the defendant and set out the law: \xe2\x80\x9cThe test for\ndetermining the validity of exculpatory clauses, admittedly not favored in the law, is set out in [Citation].\nThe contract must not contravene any policy of the law. It must be a contract between individuals relating\nto their private affairs. Each party must be a free bargaining agent, not simply one drawn into an adhesion\ncontract, with no recourse but to reject the entire transaction.\xe2\x80\xa6We must construe the agreement strictly\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n567\n\n\x0cand against the party asserting it [and], the agreement must spell out the intent of the parties with the\nutmost particularity.\xe2\x80\x9d The court here 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 entitled to\ncompensation. Remember, however, that not every bailment is necessarily for compensation. The difficult\nquestion is whether the bailee is entitled to compensation when nothing explicit has been said about\nincidental expenses he has incurred to care for the bailed property\xe2\x80\x94as, for example, if he were to repair a\npiece of machinery to keep it running. No firm rule can be given. Perhaps the best generalization that can\nbe made is that, in the absence of an express agreement, ordinary repairs fall to the bailee to pay, but\nextraordinary repairs are the bailor\xe2\x80\x99s responsibility. An express agreement between the parties detailing\nthe responsibilities would 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 someone\nhas over the property of another. It is akin, in effect, to a security interest. A common type is the\nmechanic\xe2\x80\x99s lien (\xe2\x80\x9cmechanic\xe2\x80\x9d here means one who works with his hands). For example, a carpenter\nbuilds a room on your house and you fail to pay him; he can secure a lien on your house, meaning that he\nhas a property interest in the house and can start foreclosure proceedings if you still fail to pay. Similarly,\na bailee is said to have a lien on the bailed property in his possession and need not redeliver it to the bailor\nuntil he has been paid. Try to take your car out of a parking lot without paying and see what happens. The\nattendant\xe2\x80\x99s refusal to give you the car is entirely lawful under a common-law rule now more than a\ncentury and a half old. As the rule is usually stated, the common law confers the lien on the bailee if he has\nadded value to the property through his labor, skill, or materials. But that statement of the rule is\nsomewhat deceptive, 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 better way of\nstating the rule is this: a lien is created when the bailee performs some special benefit to the goods (e.g.,\npreserving them or repairing them).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n568\n\n\x0cMany states have enacted statutes governing various types of liens. In many instances, these have\nbroadened the bailee\xe2\x80\x99s common-law rights. This book discusses two types of liens in great detail: the liens\nof warehousemen and those of common carriers. Recall that a leasecreates a type of bailment: the lessor is\nthe bailor and the lessee is the bailee. This book references the UCC\xe2\x80\x99s take on leasing in its discussion of\nthe sale of goods.\n\n[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 or taken\nby a third party, but he must account in turn to the bailor. A delivery service is carrying parcels\xe2\x80\x94bailed\ngoods entrusted to the trucker for delivery\xe2\x80\x94when the truck is struck from behind and blows up. The\ncarrier may sue the third person who caused the accident and recover for the total loss, including the\nvalue of the packages. The bailor may also recover for damages to the parcels, but not if the bailee has\nalready recovered a judgment. Suppose the bailee has sued and lost. Does the bailor have a right to sue\nindependently on the same grounds? Ordinarily, the principle of res judicata would prevent a second suit,\nbut if the bailor did not know of and cooperate in the bailee\xe2\x80\x99s suit, he probably has the right to proceed on\nhis 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 conditions that\nprevailed in medieval England, where brigands and bandits roamed the countryside and the innkeeper\nhimself might not have been above stealing from his guests. The innkeeper\xe2\x80\x99s liability extended not merely\nto loss of goods through negligence. His was an insurer\xe2\x80\x99s liability, extending to any loss, no matter how\noccasioned, and even to losses that occurred in the guest\xe2\x80\x99s room, a place where the guest had the primary\nright of possession. The only exception was for losses due to the guest\xe2\x80\x99s own negligence.\n\nMost states have enacted statutes providing exceptions to this extraordinarily broad common-law duty.\nTypically, the statutes exempt the hotel keeper from insurer\xe2\x80\x99s liability if the hotelier furnishes a safe in\nwhich the guests can leave their jewels, money, and other valuables and if a notice is posted a notice\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n569\n\n\x0cadvising the guests of the safe\xe2\x80\x99s availability. The hotelier might face liability for valuables lost or stolen\nfrom the safe but not from the rooms.\n\nK E Y TA K EA WAY\nIf the bailee fails to redeliver the goods to the bailor, a presumption of negligence arises,\nbut the bailee can rebut the presumption by showing that she exercised appropriate\ncare. What is \xe2\x80\x9cappropriate care\xe2\x80\x9d depends on the test used in the jurisdiction: some\ncourts use the \xe2\x80\x9cordinary care under the circumstances,\xe2\x80\x9d and some determine how much\ncare the bailee should have exercised based on the extent to which she was benefited\nfrom the transaction compared to the bailor. The bailor can be liable too for negligently\ndelivering goods likely to cause damage to the bailee. In either case reasonable\ndisclaimers of liability are allowed. If the bailed goods need repair while in the bailee\xe2\x80\x99s\npossession, the usual rule is that ordinary repairs are the bailee\xe2\x80\x99s responsibility,\nextraordinary ones the bailor\xe2\x80\x99s. Bailees are entitled to liens to enforce payment owing to\nthem. In common law, innkeepers were insurers of their guests\xe2\x80\x99 property, but hotels and\nmotels today are governed mostly by statute: they are to provide a safe for their guests\xe2\x80\x99\nvaluables and are not liable for losses from the room.\n\nE XE R C IS ES\n1. What is the \xe2\x80\x9cordinary care under the circumstances\xe2\x80\x9d test for a bailee\xe2\x80\x99s liability when\nthe bailed 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\nacceptable?\n5. Jason takes his Ford Mustang to a repair shop but fails to pay for the repairs. On\nwhat theory can the shop keep and eventually sell the car to secure payment?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n570\n\n\x0c[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\n571\n\n\x0c12.3 The Storage and Shipping of Goods\nL EA R N IN G O B JEC T IV ES\n1. Understand a warehouser\xe2\x80\x99s liability for losing goods, what types of losses a\nwarehouser is liable for, and what rights the warehouser has concerning the\ngoods.\n2. Know the duties, liabilities, and exceptions to liability a carrier of freight has,\nand what rights the carrier has.\n3. Understand the liability that is imposed on entities whose business it is to\ncarry passengers.\n\nStorage of Goods\nWarehousing has been called the \xe2\x80\x9csecond oldest profession,\xe2\x80\x9d stemming from the biblical story of Joseph,\nwho stored grain during the seven good years against the famine of the seven bad years. Whatever its\norigins, warehousing is today a big business, taking in billions of dollars to stockpile foods and other\ngoods. As noted previously, the source of law governing warehousing is Article 7 of the UCC, but noncode\nlaw also can apply. Section 7-103 of the Uniform Commercial Code (UCC) specifically provides that any\nfederal statute or treaty and any state regulation or tariff supersedes the provisions of Article 7. A federal\nexample is the United States Warehouse Act, which governs receipts for stored agricultural products.\nHere we take up, after some definitions, the warehouser\xe2\x80\x99s liabilities and rights. A warehouser is a special\ntype of bailee.\n\nDefinitions\nA warehouser is defined in UCC, Section 7-102(h), as \xe2\x80\x9ca person engaged in the business of storing goods\nfor hire,\xe2\x80\x9d and under Section 1-201(45) a warehouse receipt is any receipt issued by a warehouser. The\nwarehouse receipt is an important document because it can be used to transfer title to the goods, even\nwhile they remain in storage: it is worth money. No form is prescribed for the warehouse receipt, but\nunless it lists in its terms the following nine items, the warehouser is liable to anyone who is injured by the\nomission of any of them:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n572\n\n\x0c1.\n\nLocation of the warehouse\n\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\n5.\n\nThe rate of storage and handling charges\n\n6. Description of the goods or the packages containing them\n7.\n\nSignature of the warehouser, which his or her authorized agent may make\n\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 the\nwarehouser 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 negligence: he is\nliable for any losses or injury to the goods caused by his failure to exercise \xe2\x80\x9csuch care in regard to them as\n[1]\n\na reasonably careful man would exercise under like circumstances.\xe2\x80\x9d However, subsection 4 declares that\nthis section does not repeal or dilute any other state statute that imposes a higher responsibility on a\nwarehouser. Nor does the section invalidate contractual limitations otherwise permissible under Article 7.\nThe warehouser\xe2\x80\x99s duty of care under this section is considerably weaker than the carrier\xe2\x80\x99s duty.\nDetermining when a warehouser becomes a carrier, if the warehouser is to act as shipper, can become an\nimportant issue.\n\nLimitation of Liability\nThe warehouser may limit the amount of damages she will pay by so stating in the warehouse receipt, but\nshe must strictly observe that section\xe2\x80\x99s requirements, under which the limitation must be stated \xe2\x80\x9cper\narticle or item, or value per unit of weight.\xe2\x80\x9d\n\n[2]\n\nMoreover, the warehouser cannot force the bailor to accept\n\nthis limitation: the bailor may demand in writing increased liability, in which event the warehouser may\ncharge more for the storage. If the warehouser converts the goods to her own UCC, the limitation of\nliability does not apply.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n573\n\n\x0cSpecific 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 that were\nnot in fact delivered to the warehouse (or were misdescribed) and must pay damages to a good-faith\npurchaser of or party to a document of title. To avoid this liability, the issuer must conspicuously note on\nthe document that he does not know whether the goods were delivered or are correctly described. One\nsimple way is to mark on the receipt that \xe2\x80\x9ccontents, condition, 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 possession,\nas long as the claimant pays any outstanding liens and surrenders the document so that it can be marked\n\xe2\x80\x9ccancelled\xe2\x80\x9d (or can be partially cancelled in the case of partial delivery). The bailee can avoid liability for\nno delivery by showing that he delivered the goods to someone with a claim to possession superior to that\nof the claimant, that the goods were lost or destroyed through no fault of the bailee, or that certain other\n[3]\n\nlawful excuses apply. Suppose a thief deposits goods he has stolen with a warehouse. Discovering the\ntheft, the warehouser turns the goods over to the rightful owner. A day later the thief arrives with a receipt\nand demands delivery. Because the rightful owner had the superior claim, the warehouser is not liable in\ndamages to the thief.\n\nNow suppose you are moving and have placed your goods with a local storage company. A few weeks later,\nyou accidentally drop your wallet, which contains the receipt for the goods and all your identification. A\nthief picks up the wallet and immediately heads for the warehouse, pretending to be you. Having no\nsuspicion that anything is amiss\xe2\x80\x94it\xe2\x80\x99s a large place and no one can be expected to remember what you look\nlike\xe2\x80\x94the warehouse releases the goods to the thief. This time you are probably out of luck. Section 7-404\nsays that \xe2\x80\x9ca bailee who in good faith including observance of reasonable commercial standards has\nreceived goods and delivered\xe2\x80\xa6them according to the terms of the document of title\xe2\x80\xa6is not liable.\xe2\x80\x9d This\nrule is true even though the person to whom he made delivery had no authority to receive them, as in the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n574\n\n\x0ccase of the thief. However, if the warehouser had a suspicion and failed to take precautions, then he might\nbe 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 warehouse\nreceipt. The purpose of this rule, which may be negated by explicit language in the receipt, is to permit the\nbailor to identify and take delivery of his goods at any time.\n\nRights 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 the period\nof storage. At the termination of the period, the warehouser may notify the bailor to pay and to recover\nher goods. If no period is fixed in the receipt or other document of title, the warehouser may give notice to\npay and remove within no less than thirty days. The bailor\xe2\x80\x99s failure to pay and remove permits the\nwarehouser to sell the goods for her fee. Suppose the goods begin to deteriorate. Sections 7-207(2) and 7207(3) of the UCC permit the warehouser to sell the goods early if necessary to recover the full amount of\nher lien or if the goods present a hazard. But if the rightful owner demands delivery before such a sale, the\nwarehouser is obligated to do so.\n\nLiens\nSection 7-209(1) of the UCC provides that a warehouser has a lien on goods covered by a warehouse\nreceipt to recover the following charges and expenses: charges for storage or transportation, insurance,\nlabor, and expenses necessary to preserve the goods. The lien is not discharged if the bailor transfers his\nproperty interest in the goods by negotiating a warehouse receipt to a purchaser in good faith, although\nthe warehouser is limited then to an amount or a rate fixed in the receipt or to a reasonable amount or\nrate if none was stated. The lien attaches automatically and need not be spelled out in the warehouse\nreceipt.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n575\n\n\x0cThe warehouser may enforce the lien by selling the goods at a public or private sale, as long as she does so\nin a commercially reasonable manner, as defined in Section 7-210. All parties known to be claiming an\ninterest in the goods must be notified of the sale and told the amount due, the nature of the sale, and its\ntime and place. Any person who in good faith purchases the goods takes them free of any claim by the\nbailor, even if the warehouser failed to comply with the requirements of Section 7-210. However, her\nfailure to comply subjects her to damages, and if she has willfully violated the provisions of this section\nshe is liable to the bailor for conversion.\n\nShipment of Goods\nIntroduction and Terminology\nThe shipment of goods throughout the United States and abroad is a very big business, and many\nspecialized companies have been established to undertake it, including railways, air cargo operations,\ntrucking companies, and ocean carriers. Article 7 of the UCC applies to carriage of goods as it does to\nwarehousing, but federal law is more important. The Federal Bill of Lading Act (FBLA) covers bills of\nlading issued by common carriers for transportation of goods in interstate or foreign commerce (i.e., from\none state to another; in federal territory; or to foreign countries). The Carmack Amendment was enacted\nin 1906 as an amendment to the Interstate Commerce Act of 1887, and it is now part of the Interstate\nCommerce Commission Termination Act of 1995; it covers liability of interstate carriers for loss,\ndestruction, and damage to goods. The shipper is the entity hiring the one who transports the goods: if\nyou send your sister crystal goblets for her birthday, you are the shipper.\n\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\n\n[4]\n\nThis definition contains three elements: (1) the carrier\n\nmust hold itself out for all in common for hire\xe2\x80\x94the business is not restricted to particular customers but\nis open to all who apply for its services; (2) it must charge for his services\xe2\x80\x94it is for hire; (3) the service in\nquestion must be carriage. Included within this tripartite definition are numerous types of carriers:\nhousehold moving companies, taxicabs, towing companies, and even oil and gas pipelines. Note that to be\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n576\n\n\x0ca common carrier it is not necessary to be in the business of carrying every type of good to every possible\npoint; common carriers may limit the types of goods or the places to which they will transport them.\n\nA bill of lading is any document that evidences \xe2\x80\x9cthe receipt of goods for shipment issued by a person\nengaged in the business of transporting or forwarding goods.\xe2\x80\x9d\n\n[5]\n\nThis is a comprehensive definition and\n\nincludes documents used by contract carriers\xe2\x80\x94that is, carriers who are not common carriers. An example\nof a bill of lading is depicted in .\n\nFigure 12.2 A Bill of Lading Form\n\nDuties and Liabilities\nThe transportation of goods has been an important part of all evolved economic systems for a long time,\nand certainly it is critical to the development and operation of any capitalistic system. The law regarding it\nis well developed.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n577\n\n\x0cAbsolute Liability\nDamage, destruction, and loss are major hazards of transportation for which the carrier will be liable.\nWho will assert the claim against the carrier depends on who bears the risk of loss. The rules governing\nrisk of loss (examined in ) determine whether the buyer or seller will be the plaintiff. But whoever is the\nplaintiff, the common carrier defendant faces absolute liability. With five exceptions explored two\nparagraphs on, the common carrier is an insurer of goods, and regardless of the cause of damage or loss\xe2\x80\x94\nthat is, whether or not the carrier was negligent\xe2\x80\x94it must make the owner whole. This ancient commonlaw rule is codified in state law, in the federal Carmack Amendment, and in the UCC, Section 7-309(1), all\nof which hold the common carrier to absolute liability to the extent that the common law of the state had\npreviously done so.\n\nAbsolute liability was imposed in the early cases because the judges believed such a rule was necessary to\nprevent carriers from conspiring with thieves. Since it is difficult for the owner, who was not on the scene,\nto prove exactly what happened, the judges reasoned that putting the burden of loss on the carrier would\nprompt him to take extraordinary precautions against loss (and would certainly preclude him from\ncolluding with thieves). Note that the rules in this section govern only common carriers; contract carriers\nthat do not hold themselves out for transport 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 consignee of\nthe shipper) can make out a prima facie case by showing that it delivered the goods to the carrier in good\ncondition and that the goods either did not arrive or arrived damaged in a specified amount. Thereafter\nthe carrier has the burden of proving that it was not negligent and that the loss or damage was caused by\none of the five following recognized exceptions to the rule of absolute liability.\n\nAct of God\nNo one has ever succeeded in defining precisely what constitutes an act of God, but the courts seem\ngenerally agreed that it encompasses acts that are of sudden and extraordinary natural, as opposed to\nhuman, origin. Examples of acts of God are earthquakes, hurricanes, and fires caused by lightning against\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n578\n\n\x0cwhich the carrier could not have protected itself. Rapid River Carriers contracts to transport a refrigerated\ncargo of beef down the Mississippi River on the SS Rapid. When the ship is en route, it is hit by a tornado\nand sinks. This is an act of God. But a contributing act of negligence by a carrier overcomes the act of God\nexception. If it could be shown that the captain was negligent to set sail when the weather warned of\nimminent tornados, the 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 armed\nforces of enemies of the state to which the carrier owes allegiance. American ships at sea that are sunk\nduring wartime by enemy torpedoes would not be liable for losses to the owners of cargo. Moreover,\npublic enemies do not include lawless mobs or criminals listed on the FBI\xe2\x80\x99s Ten Most Wanted list, even if\nfederal troops are required, as in the Pullman Strike of 1894, to put down the violence. After the Pullman\nStrike, carriers were held liable for property destroyed by 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 seizes goods\nin the carrier\xe2\x80\x99s possession, the carrier is excused from liability. Imagine that federal agents board the\nSS Rapid in New Orleans and, as she is about to sail, show the captain a search warrant and seize several\nboxes of cargo marked \xe2\x80\x9cbeef\xe2\x80\x9d that turn out to hold cocaine. The owner or consignee of this illegal cargo\nwill not prevail in a suit against the carrier to recover damages. Likewise, if the rightful owner of the goods\nobtains a lawful court order permitting him to attach them, the carrier is obligated to permit the goods to\nbe taken. It is not the carrier\xe2\x80\x99s responsibility to contest a judicial writ or to face the consequences of\nresisting a court order. The courts generally agree that the carrier must notify the owner whenever goods\nare seized.\n\nAct of Shipper\nWhen goods are lost or damaged because of the shipper\xe2\x80\x99s negligence, the shipper is liable, not the carrier.\nThe usual situation under this exception arises from defective packing. The shipper who packs the goods\ndefectively is responsible for breakage unless the defect is apparent and the carrier accepts the goods\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n579\n\n\x0canyway. For example, if you ship your sister crystal goblets packed loosely in the box, they will inevitably\nbe broken when driven in trucks along the highways. The trucker who knowingly accepts boxes in this\ncondition is liable for the damage. Likewise, the carrier\xe2\x80\x99s negligence will overcome the exception and\nmake him absolutely liable. A paper supplier ships several bales of fine stationery in thin cardboard boxes\nsusceptible to moisture. Knowing their content, SS Rapid accepts the bales and exposes them to the\nelements on the upper 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 themselves. If they\nare inherently subject to deterioration or their inherent characteristics are such that they might be\ndestroyed, then the loss must lie on the owner. Common examples are chemicals that can explode\nspontaneously and perishable fruits and vegetables. Of course, the carrier is responsible for seeing that\nfoodstuffs are properly stored and cared for, but if they deteriorate naturally and not through the carrier\xe2\x80\x99s\nnegligence, 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 of one\ncarrier only. In the nineteenth century, the shipper whose goods were lost had a difficult time recovering\ntheir value. Initial carriers blamed the loss on subsequent carriers, and even if the shipper could\ndetermine which carrier actually had possession of the goods when the damage or loss occurred, diverse\nstate laws made proof burdensome. The Carmack Amendment ended the considerable confusion by\nplacing the burden on the initial carrier; connecting carriers are deemed agents of the initial carrier. So\nthe plaintiff, whether seller or buyer, need sue only the initial carrier, no matter where the loss occurred.\nLikewise, Section 7-302 of the UCC fastens liability on an initial carrier for damages or loss caused by\nconnecting carriers.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n580\n\n\x0cWhen Does Carrier Liability Begin and End?\nWhen a carrier\xe2\x80\x99s liability begins and ends is an important issue because the same company can act both to\nstore the goods and to carry them. The carrier\xe2\x80\x99s liability is more stringent than the warehouser\xe2\x80\x99s. So the\nquestion is, when does a warehouser become a carrier and vice versa?\n\nThe basic test for the beginning of carrier liability is whether the shipper must take further action or give\nfurther instructions to the carrier before its duty to transport arises. Suppose that Cotton Picking\nAssociates delivers fifty bales of cotton to Rapid River Carriers for transport on the SS Rapid. The\nSS Rapid is not due back to port for two more days, so Rapid River Carrier stores the cotton in its\nwarehouse, and on the following day the warehouse is struck by lightning and burns to the ground. Is\nRapid River Carriers liable in its capacity as a carrier or warehouse? Since nothing was left for the owner\nto do, and Rapid River was storing the cotton for its own convenience awaiting the ship\xe2\x80\x99s arrival, it was\nacting as a carrier and is liable for the loss. Now suppose that when Cotton Picking Associates delivered\nthe fifty bales it said that another fifty bales would be coming in a week and the entire lot was to be\nshipped together. Rapid River stores the first fifty bales and lightning strikes. Since more remained for\nCotton Picking to do before Rapid River was obligated to ship, the carrier was acting in its warehousing\ncapacity and is not liable.\n\nThe carrier\xe2\x80\x99s absolute liability ends when it has delivered the goods to the consignee\xe2\x80\x99s residence or place\nof business, unless the agreement states otherwise (as it often does). By custom, certain carriers\xe2\x80\x94notably\nrail carriers and carriers by water\xe2\x80\x94are not required to deliver the goods to the consignee (since rail lines\nand oceans do not take the carrier to the consignee\xe2\x80\x99s door). Instead, consignees must take delivery at the\ndock or some other place mutually agreed on or established by custom.\n\nWhen the carrier must make personal delivery to the consignee, carrier liability continues until the carrier\nhas made reasonable efforts to deliver. An express trucking company cannot call on a corporate customer\non Sunday or late at night, for instance. If reasonable efforts to deliver fail, it may store the goods in its\nown warehouse, in which case its liability reverts to that of a warehouser.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n581\n\n\x0cIf personal delivery is not required (e.g., as in shipment by rail), the states use different approaches for\ndetermining when the carrier\xe2\x80\x99s liability terminates. The most popular intrastate approach provides that\nthe carrier continues to be absolutely responsible for the goods until the consignee has been notified of\ntheir arrival and has had a reasonable opportunity to take possession of them.\n\nInterstate shipments are governed by the Carmack Amendment, which generally provides that liability\nwill be determined by language in the bill of lading. The typical bill of lading (or \xe2\x80\x9cBOL\xe2\x80\x9d and \xe2\x80\x9cB/L\xe2\x80\x9d)\nprovides that if the consignee does not take the goods within a stated period of time after receiving notice\nof 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 at least\nas to commercial transactions it may limit the damages payable under certain circumstances. Both the\nCarmack Amendment and Section 7-309 of the UCC permit the carrier to set alternate tariffs, one costing\nthe shipper more and paying full value, the other costing less and limited to a dollar per pound or some\nother rate less than full value. The shipper must have a choice; the carrier may not impose a lesser tariff\nunilaterally on the shipper, and the loss must not 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. There are\ntwo 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n582\n\n\x0cmarking 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\ncarrier 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 storage,\ntransportation, and preservation of goods. When someone has purchased a negotiable bill of lading, the\nlien is limited to charges stated in the bill, allowed under applicable tariffs, or, if none are stated, to a\nreasonable charge. A carrier who voluntarily delivers or unjustifiably refuses to deliver the goods loses its\nlien. The carrier has rights paralleling those of the warehouser to enforce the lien.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n583\n\n\x0cPassengers\nIn addition to shipping goods, common carriers also transport passengers and their baggage. The carrier\nowes passengers a high degree of care; in 1880 the Supreme Court described the standard as \xe2\x80\x9cthe utmost\n[7]\n\ncaution characteristic of very careful prudent men.\xe2\x80\x9d This duty implies liability for a host of injuries,\nincluding mental distress occasioned by insults (\xe2\x80\x9clunatic,\xe2\x80\x9d \xe2\x80\x9cwhore,\xe2\x80\x9d \xe2\x80\x9ccheap, common scalawag\xe2\x80\x9d) and by\nprofane or indecent language. In Werndli v. Greyhound,\n\n[8]\n\nMrs. Werndli deboarded the bus at her\n\ndestination at 2:30 a.m.; finding the bus station closed, she walked some distance to find a bathroom.\nWhile doing so, she became the victim of an assault. The court held Greyhound liable: it should have\nknown the station was closed at 2:30 a.m. and that it was located in a area that became dangerous after\nhours. The case illustrates the degree to which a carrier is responsible for its passengers\xe2\x80\x99 safety and\ncomfort.\nThe baggage carrier is liable as an insurer unless the baggage is not in fact delivered to the carrier. A\npassenger who retains control over his hand luggage by taking it with him to his seat has not delivered the\nbaggage to the carrier, and hence the carrier has no absolute liability for its loss or destruction. The carrier\nremains liable for negligence, however. When the passenger does deliver his luggage to the carrier, the\nquestion often arises whether the property so delivered is \xe2\x80\x9cbaggage.\xe2\x80\x9d If it is not, the carrier does not have\nan insurer\xe2\x80\x99s liability toward it. Thus a person who transports household goods in a suitcase would not\nhave given the carrier \xe2\x80\x9cbaggage,\xe2\x80\x9d as that term is usually defined (i.e., something transported for the\npassenger\xe2\x80\x99s personal use or convenience). At most, the carrier would be responsible for the goods as a\ngratuitous bailee.\n\nK E Y TA K EA WAY\nThe storage of goods is a special type of bailment. People who store goods can\nretrieve them or transfer ownership of them by transferring possession of the\nwarehouse receipt: whoever has rightful possession of the receipt can take the\ngoods, and the warehouser is liable for misdelivery or for mixing up goods. The\nwarehouser has a right to a lien to secure his fee, enforceable by selling the goods\nin a commercially reasonable way. The shipping of goods is of course an important\nbusiness. Common carriers (those firms that hire out their trucks, airplanes, ships,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n584\n\n\x0cor trains to carry cargo) are strictly liable to ensure the proper arrival of the goods\nto their destination, with five exceptions (act of God, public enemy, public\nauthority, shipper; inherent nature of the goods); the first carrier to receive them\nis liable\xe2\x80\x94others who subsequently carry are that carrier\xe2\x80\x99s agents. The carrier may\nalso store goods: if it does so for its own convenience it is liable as a carrier; if it\ndoes so for the shipper\xe2\x80\x99s convenience, it is liable as a warehouser. As with\nwarehousers, the carrier is liable for misdelivery and is entitled to a lien to enforce\npayment. Carriers also carry people, and the standard of care they owe to\npassengers is very high. Carrying passengers\xe2\x80\x99 baggage, the carrier is liable as an\ninsurer\xe2\x80\x94it is strictly liable.\n\nE XE R C IS ES\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?\n3. 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n585\n\n\x0c12.4 Negotiation and Transfer of Documents of Title\n(or Commodity Paper)\nL EA R N IN G O B JEC T IV ES\n1. Understand how commodity paper operates in the sale of goods.\n2. Recognize when the transferee of a properly negotiated document of title gets\nbetter rights than 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\ncalled commodity 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 goods it\ncovers. Examples of documents of title are warehouse receipts, bills of lading, and delivery orders. The\ndocument of title, properly negotiated (delivered), gives its holder ownership of the goods it represents. It\nis much easier to pass around a piece of paper representing the ownership interest in goods than it is to\npass around the goods themselves.\n\nIt is a basic feature of our legal system that a person cannot transfer more rights to property than he owns.\nIt would follow here that no holder of a document of title has greater rights in the goods than the holder\xe2\x80\x99s\ntransferor\xe2\x80\x94the one from whom she got the document (and thus the goods). But there are certain\nexceptions to this rule; for example, Chapter 8 "Introduction to Sales and Leases" discusses the power of a\nmerchant in certain circumstances to transfer title to goods, even though the merchant himself did not\nhave title to them. A critically important exception to the general rule arises when certain types of paper\nare sold. Chapter 14 "Negotiation of Commercial Paper"discusses this rule as it relates to commercial\npaper such as checks and notes. To conclude this chapter, we discuss the rule as it applies to documents of\ntitle, sometimes known as commodity paper.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n586\n\n\x0cThe 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 greater than\nthose of the storer or shipper. In the following discussion, we refer only to the Uniform Commercial Code\n(UCC), although federal law also distinguishes between negotiable and nonnegotiable documents of title\n(some of the technical details in the federal law may differ, but 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 becomes\nnegotiable if by its terms the goods are to be delivered \xe2\x80\x9cto bearer or to the order of\xe2\x80\x9d a named person.\n\n[1]\n\nAll\n\nother documents of title are nonnegotiable. Suppose a bill of lading says that the goods are consigned to\nTom Thumb but that they may not be delivered unless Tom signs a written order that they be delivered.\nUnder Section 7-104(2), that is not a negotiable document of title. A negotiable document of title must\nbear words such as \xe2\x80\x9cDeliver to the bearer\xe2\x80\x9d or \xe2\x80\x9cdeliver to the order of Tom Thumb.\xe2\x80\x9d These are the \xe2\x80\x9cmagic\nwords\xe2\x80\x9d that create a negotiable document.\n\nDuly Negotiated\nTo transfer title effectively through negotiation of the document of title, it must be \xe2\x80\x9cduly negotiated.\xe2\x80\x9d In\ngeneral terms, under Section 7-501 of the UCC, a negotiable document of title is duly negotiated when\nthe person named in it indorses (signs it over\xe2\x80\x94literally \xe2\x80\x9con the back of\xe2\x80\x9d) and delivers it to a holder who\npurchases it in good faith and for value, without any notice that someone else might have a claim against\nthe goods, assuming the transaction is in the regular course of business or financing. Note that last part:\nassuming the transaction is in the regular course of business. If you gave your roommate a negotiable\ndocument of title in payment for a car you bought from her, your roommate would have something of\nvalue, but it would not have been duly negotiated. Paper made out \xe2\x80\x9cto bearer\xe2\x80\x9d (bearer paper) is\nnegotiated by delivery alone; no indorsement is needed. A holder is anyone who possesses a document of\ntitle that is drawn to his order, indorsed to him, or made out \xe2\x80\x9cto bearer.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n587\n\n\x0cEffect\nAs a general rule, if these requirements are not met, the transferee acquires only those rights that the\ntransferor had and nothing more. And if a nonnegotiable document is sold, the buyer\xe2\x80\x99s rights may be\ndefeated. For example, a creditor of the transferor might be entitled to treat the sale as void.\n\nUnder Section 7-502 of the UCC, however, if the document is duly negotiated, then the holder acquires (1)\ntitle to the document, (2) title to the goods, (3) certain rights to the goods delivered to the bailee after the\ndocument itself was issued, and (4) the right to have the issuer of the document of title hold the goods or\ndeliver the goods free of any defense or claim by the issuer.\n\nTo contrast the difference between sale of goods and negotiation of the document of title, consider the\nplight of Lucy, the owner of presidential campaign pins and other political memorabilia. Lucy plans to\nhold them for ten years and then sell them for many times their present value. She does not have the room\nin her cramped apartment to keep them, so she crates them up and takes them to a friend for safekeeping.\nThe friend gives her a receipt that says simply: \xe2\x80\x9cReceived from Lucy, five cartons; to be stored for ten\nyears at $25 per year.\xe2\x80\x9d Although a document of title, the receipt is not negotiable. Two years later, a\nbrowser happens on Lucy\xe2\x80\x99s crates, discovers their contents, and offers the friend $1,000 for them.\nFiguring Lucy will forget all about them, the friend sells them. As it happens, Lucy comes by a week later\nto check on her memorabilia, discovers what her former friend has done, and sues the browser for their\nreturn. Lucy would prevail. Now suppose instead that the friend, who has authority from Lucy to store the\ngoods, takes the cartons to the Trusty Storage Company, receives a negotiable warehouse receipt (\xe2\x80\x9cdeliver\nto bearer five cartons\xe2\x80\x9d), and then negotiates the receipt. This time Lucy would be out of luck. The bona\nfide purchaser from her friend would cut off Lucy\xe2\x80\x99s right to recover the goods, even though the friend\nnever had good title to them.\n\nA major purpose of the concept is to allow banks and other creditors to loan money with the right to the\ngoods as represented on the paper as collateral. They can, in effect, accept the paper as collateral without\nfear that third parties will make some claim on the goods.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n588\n\n\x0cBut even if the requirements of negotiability are met, the document of title still will confer no rights in\ncertain cases. For example, when a thief forges the indorsement of the owner, who held negotiable\nwarehouse receipts, the bona fide purchaser from the thief does not obtain good title. Only if the receipts\nwere in bearer form would the purchaser prevail in a suit by the owner. Likewise, if the owner brought his\ngoods to a repair shop that warehoused them without any authority and then sold the negotiable receipts\nreceived for them, the owner would prevail over the subsequent purchaser.\n\nAnother instance in which an apparent negotiation of a document of title will not give the bona fide\npurchaser superior rights occurs when a term in the document is altered without authorization. But if\nblanks are filled in without authority, the rule states different consequences for bills of lading and\nwarehouse receipts. Under Section 7-306 of the UCC, any unauthorized filling in of a blank in a bill of\nlading leaves the bill enforceable only as it was originally. However, under Section 7-208, an unauthorized\nfilling in of a blank in a warehouse receipt permits the good-faith purchaser with no notice that authority\nwas lacking to treat the insertion as authorized, thus giving him good title. This section makes it\ndangerous for a warehouser to issue a receipt with blanks in it, because he will be liable for any losses to\nthe owner if a good-faith purchaser takes the goods.\n\nFinally, note that a purchaser of a document of title who is unable to get his hands on the goods\xe2\x80\x94perhaps\nthe document was forged\xe2\x80\x94might have a breach of warranty action against the seller of the document.\nUnder Section 7-507 of the UCC, a person who negotiates a document of title warrants to his immediate\npurchaser that the document is genuine, that he has no knowledge of any facts that would impair its\nvalidity, and that the negotiation is rightful and effective. Thus the purchaser of a forged warehouse\nreceipt would not be entitled to recover the goods but could sue his transferor for breach of the warranty.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n589\n\n\x0cK E Y TA K EA WAY\nIt 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,\nand the paper is transferred from one person to another by negotiation. The holder signs\non the back of the paper and indicates who its next holder should be (or foolishly leaves\nthat blank); that person then has rights to the goods and, indeed, better rights. On due\nnegotiation the transferee does not merely stand in the transferor\xe2\x80\x99s shoes: the\ntransferee takes free of defects and defenses that could have been available against the\ntransferor. For a document of title to be a negotiable one, it must indicate that the\nintention of it is that it should be passed on through commerce, with the words \xe2\x80\x9cto\nbearer\xe2\x80\x9d or \xe2\x80\x9cto the order of [somebody],\xe2\x80\x9d and it must be duly negotiated: signed off on\nby its previous holder (or without any signature needed if it was bearer paper).\n\nE XE R C IS ES\n1. \xe2\x80\x9cGeorge Baker deposited five cardboard boxes in my barn\xe2\x80\x99s loft, and he can pick\nthem up when 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\nto his order 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\nimportant?\n[1] Uniform Commercial Code, Section 7-104(1)(a).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n590\n\n\x0c12.5 Cases\nBailments and Disclaimers of Bailee\xe2\x80\x99s Liability\nCarr v. Hoosier Photo Supplies, Inc.\n\n441 N.E.2d 450 (Ind. 1982)\n\nGivan, J.\n\nLitigation in this cause began with the filing of a complaint in Marion Municipal Court by John R. Carr,\nJr. (hereinafter \xe2\x80\x9cCarr\xe2\x80\x9d), seeking damages in the amount of $10,000 from defendants Hoosier Photo\nSupplies, Inc. (hereinafter \xe2\x80\x9cHoosier\xe2\x80\x9d) and Eastman Kodak Company (hereinafter \xe2\x80\x9cKodak\xe2\x80\x9d). Carr was the\nbeneficiary of a judgment in the amount of $1,013.60. Both sides appealed. The Court of Appeals affirmed\nthe trial court in its entirety.\n\nThe facts were established by stipulation agreement between the parties and thus are not in dispute. In\nthe late spring or early summer of 1970, Carr purchased some Kodak film from a retailer not a party to\nthis action, including four rolls of Kodak Ektachrome-X 135 slide film that are the subject matter of this\ndispute. During the month of August, 1970, Carr and his family vacationed in Europe. Using his own\ncamera Carr took a great many photographs of the sites they saw, using among others the four rolls of film\nreferred to earlier. Upon their return to the United States, Carr took a total of eighteen [18] rolls of\nexposed film to Hoosier to be developed. Only fourteen [14] of the rolls were returned to Carr after\nprocessing. All efforts to find the missing rolls or the pictures developed from them were unsuccessful.\nLitigation commenced when the parties were unable to negotiate a settlement.\n\nThe film Carr purchased, manufactured by Kodak, is distributed in boxes on which there is printed the\nfollowing legend:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n591\n\n\x0cREAD THIS NOTICE\nThis film will be replaced if defective in manufacture, labeling, or packaging, or if damaged or lost by us or\nany subsidiary company even though by negligence or other fault. Except for such replacement, the sale,\nprocessing, or other handling of this film for any purpose is without other warranty of liability.\n\nIn the stipulation of facts it was agreed though Carr never read this notice on the packages of film he\nbought, he knew there was printed on such packages \xe2\x80\x9ca limitation of liability similar or identical to the\nEastman Kodak limitation of liability.\xe2\x80\x9d The source of Carr\xe2\x80\x99s knowledge was agreed to be his years of\nexperience as an attorney and as an amateur photographer.\n\nWhen Carr took all eighteen [18] rolls of exposed film to Hoosier for processing, he was given a receipt for\neach roll. Each receipt contained the following language printed on the back side:\n\nAlthough film price does not include processing by Kodak, the return of any film or print to us for\nprocessing or any other purpose, will constitute an agreement by you that if any such film or print is\ndamaged or lost by us or any subsidiary company, even though by negligence or other fault, it will be\nreplaced with an equivalent amount of Kodak film and processing and, except for such replacement, the\nhandling of such film or prints by us for any purpose is without other warranty or liability.\n\nAgain, it was agreed though Carr did not read this notice he was aware Hoosier \xe2\x80\x9c[gave] to their customers\nat the time of accepting film for processing, receipts on which there are printed limitations of liability\nsimilar or identical to the limitation of liability printed on each receipt received by Carr from Hoosier\nPhoto.\xe2\x80\x9d\n\nIt was stipulated upon receipt of the eighteen [18] rolls of exposed film only fourteen [14] were returned to\nHoosier by Kodak after processing. Finally, it was stipulated the four rolls of film were lost by either\nHoosier or Kodak.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n592\n\n\x0cThat either Kodak or Hoosier breached the bailment contract, by negligently losing the four rolls of film,\nwas established in the stipulated agreement of facts. Therefore, the next issue raised is whether either or\nboth, Hoosier or Kodak, may limit their liability as reflected on the film packages and receipts.\xe2\x80\xa6\n\n[A] prerequisite to finding a limitation of liability clause in a contract unconscionable and therefore void is\na showing of disparity in bargaining power in favor of the party whose liability is thus limited.\xe2\x80\xa6In the case\nat bar the stipulated facts foreclose a finding of disparate bargaining power between the parties or lack of\nknowledge or understanding of the liability clause by Carr. The facts show Carr is an experienced attorney\nwho practices in the field of business law. He is hardly in a position comparable to that of the plaintiff in\nWeaver, supra. Moreover, it was stipulated he was aware of the limitation of liability on both the film\npackages and the receipts. We believe these crucial facts belie a finding of disparate bargaining power\nworking to Carr\xe2\x80\x99s disadvantage.\n\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 choice but to\naccept the limitation of liability terms of the contract. As cross-appellants Hoosier and Kodak correctly\npoint out, Carr and other photographers like him do have some choice in the matter of film processing.\nThey can, for one, undertake to develop their film themselves. They can also go to independent film\nlaboratories not a part of the Kodak Company. We do not see the availability of processing as limited to\nKodak.\xe2\x80\xa6\n\nWe hold the limitation of liability clauses operating in favor of Hoosier and Kodak were assented to by\nCarr; they were not unconscionable or void. Carr is, therefore, bound by such terms and is limited in his\nremedy to recovery of the cost of four boxes of unexposed Kodak Ektachrome-X 135 slide film.\n\nThe Court of Appeals\xe2\x80\x99 opinion in this case is hereby vacated. The cause is remanded to the trial court with\ninstructions to enter a judgment in favor of appellant, John R. Carr, Jr., in the amount of $13.60, plus\ninterest. Each party is to bear its own costs.\n\nHunter and Pivarnik, JJ., concur. Prentice, J., concurs in result without opinion.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n593\n\n\x0cDeBruler, J., dissenting.\n\n\xe2\x80\xa6As a general rule the law does not permit professional bailees to escape or diminish liability for their\nown negligence by posting signs or handing out receipts. [Citations] The statements on the film box and\nclaim check used by Kodak and Hoosier Photo are in all respects like the printed forms of similar import\nwhich commonly appear on packages, signs, chits, tickets, tokens and receipts with which we are all\nbombarded daily. No one does, or can reasonably be expected, to take the time to carefully read the front,\nback, and sides of such things. We all know their gist anyway.\n\nThe distinguished trial judge below characterizes these statements before us as \xe2\x80\x9cmere notices\xe2\x80\x9d and\nconcludes that plaintiff below did not \xe2\x80\x9cassent\xe2\x80\x9d to them so as to render them a binding part of the bailment\ncontract. Implicit here is the recognition of the exception to the general rule regarding such notices,\nnamely, that they may attain the dignity of a special contract limiting liability where the bailor overtly\nassents to their terms. [Citations] To assent to provisions of this sort requires more than simply placing\nthe goods into the hands of the bailee and taking back a receipt or claim check. Such acts are as probative\nof ignorance as they are of knowledge. However, according to the agreed statement of facts, plaintiff Carr\n\xe2\x80\x9cknew\xe2\x80\x9d by past experience that the claim checks carried the limitation of liability statements, but he did\nnot read them and was unaware of the specific language in them. There is nothing in this agreed\nstatement that Carr 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 assent\nrequired by law is more than this; it is, I believe, to perform an act of understanding. There is no evidence\nof that here.\n\nThe evidence presented tending to support the award of damages included an actual uncontroverted\namount of $13.60 thereby precluding mere nominal damages. There was further evidence that 150\nexposures were lost. The actual award of $1,014.60 amounted to between $6.00 and $7.00 per picture.\nCarr provided evidence that the pictures were of exceptional value to him, having been taken in a once-ina-lifetime European trip costing $6000 [about $33,000 in 2110 dollars], including visits arranged there\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n594\n\n\x0cbefore hand with relatives. The award was fair and just compensation for the loss of value to the owner\nand does not include sentimental or fanciful value.\n\nThe trial court judgment should be affirmed.\n\nC A SE QU ES TIO NS\n1. Four out of eighteen rolls of film were not returned to the bailor, Mr. Carr.\nThe court here affirmed a judgment for about $6 per lost image. How could an\nimage taken by an amateur photographer be worth $6 a piece?\n2. The European trip cost him $6,000 in 1970; he asked for $10,000 (about\n$55,000 in 2010 dollars). Upon what basis could such damages be arrived?\nWhat did he apparently want?\n3. What argument did the plaintiff make as to why the limitation of liability\nshould not be enforced? What response did the court have to that?\n4. Would it have made a difference if the plaintiff were not himself a business\nattorney? Why or why not?\n5. Why did the dissent think the court of appeals\xe2\x80\x99 decision to award the plaintiff\n$1,000 was correct and the majority\xe2\x80\x99s opinion incorrect?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n595\n\n\x0cBailed Goods of Sentimental Value\nMieske v. Bartell Drug Co.\n\n593 P.2d 1308 (Wash. 1979)\n\nBrachtenbach, J.\n\nThis case determines the measure of damages for personal property, developed movie film, which is\ndestroyed, and which cannot be replaced or reproduced. It also decides the legal effect of a clause which\npurports to limit the responsibility of a film processor to replacement of film.\xe2\x80\xa6\n\nThe facts are that over a period of years the plaintiffs had taken movie films of their family activities. The\nfilms started with the plaintiffs\xe2\x80\x99 wedding and honeymoon and continued through vacations in Mexico,\nHawaii and other places, Christmas gatherings, birthdays, Little League participation by their son, family\npets, building of their home and irreplaceable pictures of members of their family, such as the husband\xe2\x80\x99s\nbrother, who are now deceased.\n\nPlaintiffs had 32 50-foot reels of such developed film which they wanted spliced together into four reels\nfor convenience of viewing. Plaintiff wife visited defendant Bartell\xe2\x80\x99s camera department, with which she\nhad dealt as a customer for at least 10 years. She was told that such service could be performed.\n\nThe films were put in the order which plaintiffs desired them to be spliced and so marked. They were then\nplaced in four separate paper bags which in turn were placed in one large bag and delivered to the\nmanager of Bartell. The plaintiff wife explained the desired service and the manner in which the films\nwere assembled in the various bags. The manager placed a film processing packet on the bag and gave\nplaintiff wife a receipt which contained this language: \xe2\x80\x9cWe assume no responsibility beyond retail cost of\nfilm unless otherwise agreed to in writing.\xe2\x80\x9d There was no discussion about the language on the receipt.\nRather, plaintiff wife told the manager, \xe2\x80\x9cDon\xe2\x80\x99t lose these. They are my life.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n596\n\n\x0cBartell sent the film package to defendant GAF Corporation, which intended to send them to another\nprocessing lab for splicing. Plaintiffs assumed that Bartell did this service and were unaware of the\ninvolvement of two other firms.\n\nThe bag of films arrived at the processing lab of GAF. The manager of the GAF lab described the service\nordered and the packaging as very unusual. Yet it is undisputed that the film was in the GAF lab at the end\nof one day and gone the next morning. The manager immediately searched the garbage disposal dumpster\nwhich already had been emptied. The best guess is that the plaintiffs\xe2\x80\x99 film went from GAF\xe2\x80\x99s lab to the\ngarbage dumpster to a truck to a barge to an up-Sound landfill where it may yet repose.\n\nAfter several inquiries to Bartell, plaintiff wife was advised to call GAF. Not surprisingly, after being\nadvised of the complete absence and apparent fatality of plaintiffs\xe2\x80\x99 films, this lawsuit ensued.\xe2\x80\xa6\n\nTwo main issues are raised: (1) the measure of damages and (2) the effect of the exclusionary clause\nappearing on the film receipt.\n\nOn damages, the defendants assign error to (a) the court\xe2\x80\x99s damages instruction and (b) the court\xe2\x80\x99s failure\nto give their proposed damages instruction.\n\nThe standard of recovery for destruction of personal property was summarized in [McCurdy]. We\nrecognized in McCurdy that (1) personal property which is destroyed may have a market value, in which\ncase that market value is the measure of damages; (2) if destroyed property has no market value but can\nbe replaced or reproduced, then the measure is the cost of replacement or reproduction; (3) if the\ndestroyed property has no market value and cannot be replaced or reproduced, then the value to the\nowner is to be the proper measure of damages. However, while not stated in McCurdy, we have held that\nin the third McCurdy situation, damages are not recoverable for the sentimental value which the owner\nplaces on the property. [Citations]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n597\n\n\x0cThe defendants argue that plaintiffs\xe2\x80\x99 property comes within the second rule of McCurdy, i.e., the film\ncould be replaced and that their liability is limited to the cost of replacement film. Their position is not\nwell taken. Defendants\xe2\x80\x99 proposal would award the plaintiffs the cost of acquiring film without pictures\nimposed thereon. That is not what plaintiffs lost. Plaintiffs lost not merely film able to capture images by\nexposure but rather film upon which was recorded a multitude of frames depicting many significant\nevents in their lives. Awarding plaintiffs the funds to purchase 32 rolls of blank film is hardly a\nreplacement of the 32 rolls of images which they had recorded over the years. Therefore the third rule of\nMcCurdy is the appropriate measure of damages, i.e., the property has no market value and cannot be\nreplaced or reproduced.\n\nThe law, in those circumstances, decrees that the measure of damages is to be determined by the value to\nthe owner, often referred to as the intrinsic value of the property. Restatement of Torts s. 911 (1939).\n\nNecessarily the measure of damages in these circumstances is the most imprecise of the three categories.\nYet difficulty of assessment is not cause to deny damages to a plaintiff whose property has no market\nvalue and cannot be replaced or reproduced. [Citations]\n\nThe fact that damages are difficult to ascertain and measure does not diminish the loss to the person\nwhose property has been destroyed. Indeed, the very statement of the rule suggests the opposite. If one\xe2\x80\x99s\ndestroyed property has a market value, presumably its equivalent is available on the market and the\nowner can acquire that equivalent property. However, if the owner cannot acquire the property in the\nmarket or by replacement or reproduction, then he simply cannot be made whole.\n\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 subjective\nelement, the rule has been established that compensation for sentimental or fanciful values will not be\nallowed. [Citations] That restriction was placed upon the jury in this case by the court\xe2\x80\x99s damages\ninstruction.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n598\n\n\x0cUnder these rules, the court\xe2\x80\x99s damages instruction was correct. In essence it allowed recovery for the\nactual or intrinsic value to the plaintiffs but denied recovery for any unusual sentimental value of the film\nto the plaintiffs or a fanciful price which plaintiffs, for their own special reasons, might place thereon.\xe2\x80\xa6\n\nThe next issue is to determine the legal effect of the exclusionary clause which was on the film receipt\ngiven plaintiff wife by Bartell. As noted above, it read: \xe2\x80\x9cWe assume no responsibility beyond retail cost of\nfilm unless otherwise agreed to in writing.\xe2\x80\x9d\n\nIs the exclusionary clause valid? Defendants rely upon 2-719(3), a section of the Uniform Commercial\nCode, which authorizes a limitation or exclusion of consequential damages unless the limitation is\nunconscionable.\n\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 the\nconfines of that type transaction which the Code itself defines to be a \xe2\x80\x9csale\xe2\x80\x9d; namely, the passing of title\nfrom a party called the seller to one denominated a buyer for a price. Chief opportunity for this expansion\nis found in Section 2-102, which states that the article applies to \xe2\x80\x9ctransactions in goods.\xe2\x80\x9d \xe2\x80\x9cArticle 2\nsections are finding their way into more and more decisions involving transactions which are not sales,\nbut which are used as substitutes for a sale or which to a court appear to have attributes to which sales\nprinciples or at least some of them seem appropriate for application.\xe2\x80\xa6Most important of these is the\napplication of the Article\xe2\x80\x99s warranty provisions to leases, bailments, or construction contracts. Of growing\nimportance is the tendency of courts to find the Section on unconscionability, Section 2-302, appropriate\nto nonsales deals.\xe2\x80\x9d\n\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 validates the\nexclusionary clause. Second, defendants assign error to the grounds upon which the court found the\nclause to be unconscionable and therefore invalid.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n599\n\n\x0cDefendants contend that it is the uniform trade practice of film processors to impose an exclusionary\nclause similar to that contained in Bartell\xe2\x80\x99s film receipt. However, the existence of a trade usage is to be\nestablished as a fact [Citation]. It was proved as a usage among film processors, but not as between\ncommercial film processors and their retail customers.\xe2\x80\xa6Consequently, defendants\xe2\x80\x99 reliance on trade\nusage to uphold the exclusionary clause is not well founded.\n\nAs to course of dealings, the record is clear that Mrs. Mieske and the Bartell manager never discussed the\nexclusionary clause. Mrs. Mieske had never read it, she viewed the numbered slip as merely a receipt. The\nmanager was not \xe2\x80\x9ctoo clear on what it said.\xe2\x80\x9d There was no showing what was the language on any other\nreceipt given in prior dealings between the parties. In summary, defendants\xe2\x80\x99 proof fell short of that\nrequired by the express language of 1-205(3). Defendants contend we should apply a course of dealing\nstandard as a matter of law, but cite no authority for such proposition. We decline the invitation.\n\nDefendants next assert that the trial court held the exclusionary clause to be unconscionable without\nconsidering the rules laid down inSchroeder v. Fageol Motors, Inc., 544 P.2d 20 (1975). In Schroeder, we\nrecognized that the term unconscionable is not defined in the Uniform Commercial Code. We\nacknowledge that the code mandates the court to determine unconscionability as a matter of law, 2302(1). Schroeder held that numerous factors enter into a determination of unconscionability. No one\nelement is controlling. The court must examine all the circumstances surrounding the transaction,\nincluding conspicuousness of the clause, prior course of dealings between the parties, negotiations about\nthe clause, the commercial setting and usage of the trade. Not each element will be applicable factually to\nevery transaction.\xe2\x80\xa6\n\nThe real question is whether the court considered the necessary elements of Schroeder. A review of the\nrecord convinces us that it did. The court had the facts, the Schroeder case was argued, the criteria set\nforth therein were discussed by defendants\xe2\x80\x99 counsel both on objections and on exceptions. There was no\nerror. Judgment affirmed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n600\n\n\x0cC A SE QU ES TIO NS\n1. This case presents pretty much the same fact situation as the previous one,\nbut it comes out the 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\nplaintiffs but [not for] for any unusual sentimental value of the film to the\nplaintiffs or a fanciful price which plaintiffs, for their own special reasons,\nmight place thereon.\xe2\x80\x9d What actual value does a role of film have if not\nsentimental value, and if the court were not concerned about the sentimental\nvalue, why did it mention all the irreplaceable memories recorded on the\nfilm\xe2\x80\x94what difference would it make what was on the film if it had an\nascertainable \xe2\x80\x9cactual value\xe2\x80\x9d?\n3. Determining that this bailment was governed by the UCC opened up three\nlines of argument for 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.\n\n892 F.2d 191C.A.2 (N.Y. 1989)\n\nMiner, J.\n\nDefendant-appellant Trylon Trucking Corp. (\xe2\x80\x9cTrylon\xe2\x80\x9d) appeals from a judgment\xe2\x80\xa6in favor of plaintiffappellee Calvin Klein Ltd. (\xe2\x80\x9cCalvin Klein\xe2\x80\x9d) for the full value of a lost shipment of clothing. The appeal\npresents a novel issue under New York law: whether a limitation of liability agreement between a shipper\nand a carrier is enforceable when the shipment is lost as a result of the carrier\xe2\x80\x99s gross negligence.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n601\n\n\x0cThe district court held that the parties\xe2\x80\x99 customary limitation of liability agreement did not extend to the\nshipment at issue, due to the absence of assent and consideration. The court observed that, had there\nbeen such an agreement, the liability of the carrier for its gross negligence would be limited. For the\nreasons that follow, we reverse the judgment of the district court, find that the parties agreed to the\nlimitation of liability, and determine that the agreement limits Trylon\xe2\x80\x99s liability for its gross negligence.\xe2\x80\xa6\n\nTrylon is a New Jersey trucking firm which engaged in the business of transporting goods from New York\nCity\xe2\x80\x99s airports for delivery to its customers\xe2\x80\x99 facilities. Calvin Klein, a New York clothing company, had\nused the services of Trylon for at least three years, involving hundreds of shipments, prior to the lost\nshipment at issue. In past deliveries Calvin Klein, through its customs broker, would contact Trylon to\npick up the shipment from the airport for delivery to Calvin Klein\xe2\x80\x99s facility. After completing the carriage,\nTrylon would forward to Calvin Klein an invoice, which contained a limitation of liability provision as\nfollows:\n\nIn consideration of the rate charged, the shipper agrees that the carrier shall not be liable for more than\n$50.00 on any shipment accepted for delivery to one consignee unless a greater value is declared, in\nwriting, upon receipt at time of shipment and charge for such greater value paid, or agreed to be paid, by\nthe shipper.\n\nA shipment of 2,833 blouses from Hong Kong arrived at John F. Kennedy International Airport for Calvin\nKlein on March 27, 1986. Calvin Klein arranged for Trylon to pick up the shipment and deliver it to Calvin\nKlein\xe2\x80\x99s New Jersey warehouse. On April 2, Trylon dispatched its driver, Jamahl Jefferson, to pick up this\nshipment. Jefferson signed a receipt for the shipment from Calvin Klein\xe2\x80\x99s broker. By April 2, the parties\ndiscovered that Jefferson had stolen Trylon\xe2\x80\x99s truck and its shipment. The shipment never was recovered.\nCalvin Klein sent a claim letter to Trylon for the full value of the lost blouses. In the absence of any\nresponse by Trylon, Calvin Klein filed this action\xe2\x80\xa6to recover $150,000, allegedly the value of the lost\nshipment.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n602\n\n\x0cIn their stipulation in lieu of a jury trial, the parties agreed that Trylon is liable to Calvin Klein for the loss\nof the shipment and that Trylon was grossly negligent in the hiring and supervision of Jefferson. They also\nagreed that \xe2\x80\x9c[t]he terms and conditions of [Trylon]\xe2\x80\x99s carriage [were] that liability for loss or damage to\ncargo is limited to $50 in accordance with the legend on Trylon\xe2\x80\x99s invoice forms.\xe2\x80\x9d Calvin Klein conceded\nthat it was aware of this limitation of liability, and that it did not declare a value on the blouses at the time\nof shipment.\n\nThe parties left at issue whether the limitation of liability clause was valid and enforceable. Calvin Klein\nargued in the district court, as it does here, that the limitation clause was not enforceable for two reasons:\nno agreement existed between Calvin Klein and Trylon as to the limitation of liability; and, if such an\nagreement existed, public policy would prevent its enforcement because of Trylon\xe2\x80\x99s gross negligence.\n\nThe district court applied New York law, finding that the carriage was exempt from the Interstate\nCommerce Commission\xe2\x80\x99s jurisdiction, being entirely within the New York City commercial zone.\xe2\x80\xa6\nA common carrier\xe2\x80\xa6under New York law is strictly liable for the loss of goods in its custody. \xe2\x80\x9cWhere the\nloss is not due to the excepted causes [that is, act of God or public enemy, inherent nature of goods, or\nshipper\xe2\x80\x99s fault], it is immaterial whether the carrier was negligent or not.\xe2\x80\xa6\xe2\x80\x9d [Citations] Even in the case of\nloss from theft by third parties, liability may be imposed up on a negligent common carrier. [Citation]\n\nA shipper and a common carrier may contract to limit the carrier\xe2\x80\x99s liability in cases of loss to an amount\nagreed to by the parties [Citations], so long as the language of the limitation is clear, the shipper is aware\nof the terms of the limitation, and the shipper can change the terms by indicating the true value of the\ngoods being shipped. [Citations]\xe2\x80\xa6(similar scheme under Interstate Commerce Act). Such a limitation\nagreement is generally valid and enforceable despite carrier negligence. The limitation of liability\nprovision involved here clearly provides that, at the time of delivery, the shipper may increase the\nlimitation by written notice of the value of the goods to be delivered and by payment of a commensurately\nhigher fee.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n603\n\n\x0cThe parties stipulated to the fact that the $50 limitation of liability was a term and condition of carriage\nand that Calvin Klein was aware of that limitation. This stipulated fact removes the first issue, namely\nwhether an agreement existed as to a liability limitation between the parties, from this case. Calvin Klein\xe2\x80\x99s\nargument that it never previously acknowledged this limitation by accepting only $50 in settlement of a\nlarger loss does not alter this explicit stipulation. \xe2\x80\x9c[A] stipulation of fact that is fairly entered into is\ncontrolling on the parties and the court is bound to enforce it.\xe2\x80\x9d [Citations] Neither party here has argued\nthat the stipulation was unfairly entered into.\xe2\x80\xa6\n\nThe remaining issue concerns the enforceability of the limitation clause in light of Trylon\xe2\x80\x99s conceded gross\nnegligence. The district court considered that, assuming an agreement between the parties as to Trylon\xe2\x80\x99s\nliability, Trylon\xe2\x80\x99s gross negligence would not avoid the enforcement of a limitation clause.\n\nThe district court found that New York law, as opposed to federal interstate commerce law, applies in this\ncase. The parties do not seriously contest this choice of law. With the choice thus unchallenged, we must\napply both established New York law as well as our belief of how the New York Court of Appeals would\nrule if this case were before it.\xe2\x80\xa6\n\nAlthough the New York Court of Appeals has addressed a limitation of liability provision in the context of\na contract between an airline and a passenger, [Citation] (refusing to enforce unilateral limitation\nprovision for death of passenger due to defendant\xe2\x80\x99s negligence), that court has never been called upon to\nenforce a limitation provision in the case of a grossly negligent common carrier of goods. The various\ndepartments of the Appellate Division of the New York State Supreme Court have addressed whether\ngross negligence bars enforcement of limitations of liability in the context of contracts for the installation,\nmaintenance and monitoring of burglar alarm systems and are divided on the issue. Compare [Citation]\n(enforcing limitation despite gross negligence) and [Citation] (even if gross negligence were established,\nplaintiff\xe2\x80\x99s recovery 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 complete\nexculpation and limitation \xe2\x80\x9cto a nominal sum,\xe2\x80\x9d therefore limitation is ineffective). The First Department\ndistinguished between exculpatory provisions and limitation provisions, indicating that the latter would\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n604\n\n\x0cbe effective even if the former are unenforceable due to the contracting party\xe2\x80\x99s gross negligence.\n[Citations].\xe2\x80\xa6The other departments which have considered the question applied the holding of [Citation],\nthat \xe2\x80\x9c[a]greements which purport to exempt a party from liability for willful or grossly negligent acts are\ncontrary to public policy and are void.\xe2\x80\x9d\xe2\x80\xa6\n\nAbsent a rule of decision formulated by the New York Court of Appeals, we are not bound by the opinions\nissued by the state\xe2\x80\x99s lower courts.\xe2\x80\xa6\n\nIn the absence of direct New York authority, we must make our best estimate as to how New York\xe2\x80\x99s\nhighest court would rule in this case. In making that determination, we are free to consider all the\nresources the highest court of the state could use, including decisions reached in other jurisdictions.\xe2\x80\xa6We\nbelieve that the New York Court of Appeals would not differentiate between gross negligence and ordinary\nnegligence in recognizing the validity of the limitation of liability in this case.\n\nSince carriers are strictly liable for loss of shipments in their custody and are insurers of these goods, the\ndegree of carrier negligence is immaterial. [Citation] The common carrier must exercise reasonable care\nin relation to the shipment in its custody. U.C.C. \xc2\xa7 7-309(1). Carriers can contract with their shipping\ncustomers on the amount of liability each party will bear for the loss of a shipment, regardless of the\ndegree of carrier negligence. See U.C.C. \xc2\xa7 7-309(2) (allowing limitation of liability for losses from any\ncause save carrier conversion). Unlike the parachute school student, see [Citation], or the merchant\nacquiring a burglar alarm, the shipper can calculate the specific amount of its potential damages in\nadvance, declare the value of the shipment based on that calculation, and pay a commensurately higher\nrate to carry the goods, in effect buying additional insurance from the common carrier.\n\nIn this case, Calvin Klein and Trylon were business entities with an on-going commercial relationship\ninvolving numerous carriages of Calvin Klein\xe2\x80\x99s goods by Trylon. Where such entities deal with each other\nin a commercial setting, and no special relationship exists between the parties, clear limitations between\nthem will be enforced. [Citation]. Here, each carriage was under the same terms and conditions as the\nlast, including a limitation of Trylon\xe2\x80\x99s liability. See [Citation] (court enforced limitation on shipper who\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n605\n\n\x0cpossessed over five years of the carrier\xe2\x80\x99s manifests which included the $50 limitation). This is not a case in\nwhich the shipper was dealing with the common carrier for the first time or contracting under new or\nchanged terms. Calvin Klein was aware of the terms and was free to adjust the limitation upon a written\ndeclaration of the value of a given shipment, but failed to do so with the shipment at issue here. Since\nCalvin Klein failed to adjust the limitation, the limitation applies here, and no public policy that dictates\notherwise can be identified.\n\nCalvin Klein now argues that the limitation is so low as to be void.\xe2\x80\xa6This amount is immaterial because\nCalvin Klein had the opportunity to negotiate the amount of coverage by declaring the value of the\nshipment.\xe2\x80\xa6Commercial entities can easily negotiate the degree of risk each party will bear and which\nparty will bear the cost of insurance. That this dispute actually involves who will bear the cost of insurance\nis illustrated by the fact that this case has been litigated not by the principal parties, but by their insurers.\nCalvin Klein could have increased Trylon\xe2\x80\x99s coverage by declaring the value of its shipment, but did not do\nso. Calvin Klein had the opportunity to declare a higher value and we find all of its arguments relating to\nthe unreasonableness of the limitation to be without merit.\n\nWe reverse and remand to the district court with instructions to enter judgment against defendant in the\nsum of $50.\n\nC A SE QU ES TIO NS\n1. Why is the federal court here trying to figure out what the New York high court\nwould do if it had 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\nbe valid?\n5. The common-law rule was that carriers were strictly liable. Why didn\xe2\x80\x99t the\ncourt apply that rule?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n606\n\n\x0c6. Would this case have come out differently if the shipper (a) were an\nunsophisticated in matters of relevant business or (b) if it had never done\nbusiness with Trylon before?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n607\n\n\x0c12.6 Summary and Exercises\nSummary\nOwnership and sale of goods are not the only important legal relationships involving goods. In a modern\neconomy, possession of goods is often temporarily surrendered without surrendering title. This creates a\nbailment, which is defined as the lawful possession of goods by one who is not the owner.\n\nTo create a bailment, the goods must be in the possession of the bailee. Possession requires physical\ncontrol and intent. Whether the owner or someone else must bear a loss often hinges on whether the other\nperson is or is not a bailee.\n\nThe bailee\xe2\x80\x99s liability for loss depends on the circumstances. Some courts use a straightforward standard of\nordinary care. Others use a tripartite test, depending on whether the bailment was for the benefit of the\nowner (the standard then is gross negligence), for the bailee (extraordinary care), or for both (ordinary\ncare). Bailees may disclaim liability unless they have failed to give adequate notice or unless public policy\nprohibits disclaimers. A bailee who converts the property will be held liable as an insurer.\n\nA bailor may have liability toward the bailee\xe2\x80\x94for example, for negligent failure to warn of hazards in the\nbailed property and for strict liability if the injury was caused by a dangerous object in a defective\ncondition.\n\nSpecial bailments arise in the cases of innkeepers (who have an insurer\xe2\x80\x99s liability toward their guests,\nalthough many state statutes provide exceptions to this general rule), warehouses, carriers, and leases.\n\nA warehouser is defined as a person engaged in the business of storing goods for hire. The general\nstandard of care is the same as that of ordinary negligence. Many states have statutes imposing a higher\nstandard.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n608\n\n\x0cA common carrier\xe2\x80\x94one who holds himself out to all for hire to transport goods\xe2\x80\x94has an insurer\xe2\x80\x99s liability\ntoward the goods in his possession, with five exceptions: act of God, act of public enemy, act of public\nauthority, negligence of shipper, and inherent nature of the goods. Because many carriers are involved in\nmost commercial shipments of goods, the law places liability on the initial carrier. The carrier\xe2\x80\x99s liability\nbegins once the shipper has given all instructions and taken all action required of it. The carrier\xe2\x80\x99s absolute\nliability ends when it has delivered the goods to the consignee\xe2\x80\x99s place of business or residence (unless the\nagreement states 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.\n\nCommodity paper\xe2\x80\x94any document of title\xe2\x80\x94may be negotiated; that is, through proper indorsements on\nthe paper, title may be transferred without physically touching the goods. A duly negotiated document\ngives the holder title to the document and to the goods, certain rights to the goods delivered to the bailee\nafter the document was issued, and the right to take possession free of any defense or claim by the issuer\nof the document of title. Certain rules limit the seemingly absolute right of the holder to take title better\nthan that held by the transferor.\n\nE XE R C IS ES\n1. Joe Andrews delivered his quarter horse I\xe2\x80\x99ll Call Ya (worth about $319,000 in\n2010 dollars) to Harold Stone for boarding and stabling. Later he asked Stone\nif Stone could arrange for the horse\xe2\x80\x99s transportation some distance, and Stone\nengaged the services of the Allen brothers for that purpose. Andrews did not\nknow the Allens, but Stone had previously done business with them. On the\nhighway the trailer with I\xe2\x80\x99ll Call Ya in it became disengaged from the Allens\xe2\x80\x99\ntruck and rolled over. The mare, severely injured, \xe2\x80\x9capparently lingered for\nseveral hours on the side of the road before she died without veterinary\ntreatment.\xe2\x80\x9d The evidence was that the Allens had properly secured the\nhorse\xe2\x80\x99s head at the front of the trailer and used all other equipment that a\nreasonably prudent person would use to secure and haul the horse; that the\nball was the proper size and in good condition; that the ball was used without\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n609\n\n\x0cincident to haul other trailers after the accident; that Ronny Allen was driving\nat a safe speed and in a safe manner immediately before the accident; that\nafter the accident the sleeve of the trailer hitch was still in the secured\nposition; and that they made a reasonable effort to obtain veterinary\ntreatment for the animal after the accident. The court determined this was a\nmutual-benefit bailment. Are the Allens liable? [1]\n2. Fisher Corporation, a manufacturer of electronic equipment, delivered VCRs\nto Consolidated Freightways\xe2\x80\x99 warehouse in California for shipment to World\nRadio Inc., an electronics retailer in Council Bluffs, Iowa. World Radio rejected\nthe shipments as duplicative, and they were returned to Consolidated\xe2\x80\x99s\nterminal in Sarpy County, Nebraska, pending Fisher\xe2\x80\x99s instructions. The VCRs\nwere loaded onto a trailer; the doors of the trailer were sealed but not\npadlocked, and the trailer was parked at the south end of the terminal.\nPadlocks were not used on any trailers so as not to call attention to a trailer\ncontaining expensive cargo. The doors of the trailer faced away from the\nterminal toward a cyclone fence that encircled the yard. Two weeks later, on\nSunday, 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\nhad been cut in the fence near the trailer, and half the VCRs were gone; they\nwere never recovered. Consolidated received Fisher\xe2\x80\x99s return authorization\nafter the theft occurred. If Consolidated is considered a carrier, it would be\nstrictly liable for the loss; if it is considered a bailee, it is not liable unless\nnegligent. Which is it?\n3. Plaintiff purchased a Greyhound bus ticket in St. Petersburg, Florida, for a trip\nto Fort Meyers. The bus left at 11:30 p.m. and arrived at 4:15 a.m. When\nPlaintiff got off the bus, she noticed that the station and restrooms were\ndarkened, closed, and locked. She left the terminal to cross at a lighted service\nstation to use the bathroom. As she walked away from the terminal, she was\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n610\n\n\x0cattacked by an unknown person and injured. The terminal was located in a\nhigh-crime area of Fort Meyers. Is Greyhound liable?\n4. Mrs. Carter, Plaintiff, took her fur coat to Reichlin Furriers for cleaning,\nglazing, and storage until the next winter season. She was given a printed\nreceipt form on the front of which Furrier\xe2\x80\x99s employee had written \xe2\x80\x9c$100\xe2\x80\x9d as\nthe coat\xe2\x80\x99s value, though Mrs. Carter did not discuss its value with the\nemployee, did not know that such a value had been noted, and didn\xe2\x80\x99t read the\nreceipt. A space for the customer\xe2\x80\x99s signature on the front of the receipt was\nblank; below this in prominent type was this notice: \xe2\x80\x9csee reverse side for\nterms and conditions.\xe2\x80\x9d On the back was a statement that this was a storage\ncontract and the customer would be bound by the terms unless contrary\nnotice was given within ten days. There were fifteen conditions, one of which\nwas the following: \xe2\x80\x9cStorage charges are based upon valuation herein declared\nby the depositor and amount recoverable for loss or damage shall not\nexceed\xe2\x80\xa6the depositor\xe2\x80\x99s valuation appearing in this receipt.\xe2\x80\x9d Six months later,\nwhen Mrs. Carter sought to retrieve her coat, she was informed by Furrier\nthat it was lost. Carter sued Furrier for $450 (about $2,200 in 2010 dollars);\nFurrier claimed its liability was limited to $100. Who wins and why?\n5. Michael Capezzaro (Plaintiff) reported to the police that he had been robbed\nof $30,000 (in 2010 dollars) at gunpoint by a woman. The next day police\narrested a woman with $9,800 in her possession. Plaintiff identified her as the\nwoman who had robbed him, and the money was impounded as evidence.\nTwo years later the case against her was dismissed because she was\ndetermined to have been insane when she committed the crime, and the\nmoney in the police property room was released to her. Plaintiff then sued the\npolice department, which claimed it was \xe2\x80\x9cobligated to return the money to\n[the woman] as bailor.\xe2\x80\x9d Who wins and why?\n6. Harley Hightower delivered his Cadillac to Auto Auction, where it was\ndamaged. Auto Auction defended itself against Hightower\xe2\x80\x99s claim that it was a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n611\n\n\x0cnegligent bailee by asserting (1) that he had not met the required burden of\nproof that a proximate cause of the injury was Auto Auction\xe2\x80\x99s negligence\nbecause 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\njudgment in the absence of evidence of specific acts of negligence of the\nbailee. There was evidence that a Mrs. Tune drove her automobile onto the\nlot to sell it and parked it where she was directed to; that the automobiles on\nsaid lot for sale were ordinarily lined up and numbered by Auto Auction; that\nPlaintiff\xe2\x80\x99s Cadillac was not so parked by the auction company but was parked\nso that if Mrs. Tune\xe2\x80\x99s automobile continued forward it would strike\nHightower\xe2\x80\x99s Cadillac broadside; that when Mrs. Tune stopped her Buick and\nalighted, her car rolled down the incline on the lot toward Hightower\xe2\x80\x99s car;\nthat she attempted to stop her car but it knocked her down and continued\nrolling toward appellee\xe2\x80\x99s Cadillac and, finally, struck and damaged it. Who\nwins and why?\n7. Several student radicals led by Richard Doctor, ranked number three on the\nFBI\xe2\x80\x99s Ten Most Wanted list, destroyed a shipment of military cargo en route\nfrom Colorado to a military shipping facility in Washington State. Should the\ncarrier be liable for the loss?\n8. Everlena Mitchell contracted in writing with All American Van & Storage to\ntransport and store her household goods and furnishings, and she was to pay\nall charges incurred on a monthly basis. As security she granted All American a\nwarehouser\xe2\x80\x99s lien giving it the right to sell the property if the charges\nremained unpaid for three months and if, in the opinion of the company, such\naction would be necessary to protect accrued charges. Everlena fell eight\nmonths in arrears and on October 20 she received notice that the amount\nowed was to be paid by October 31, 1975. The notice also stated that if\npayment was not made, her goods and furnishings would be sold on\nNovember 7, 1975. Everlena had a pending claim with the Social Security\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n612\n\n\x0cAdministration, and advised All American that she would be receiving a\nsubstantial sum of money soon from the Social Services Administration; this\nwas confirmed by two government agents. However, All American would not\npostpone the sale. Everlena\xe2\x80\x99s property was sold on November 7, 1975, for\n$925.50. Near the end of November 1975, Everlena received approximately\n$5,500 (about $22,000 in 2010 dollars) from the United States as a disability\npayment under the Social Security Act, and she sued All American for\nimproperly selling her goods. The trial court ruled for All American on\nsummary judgment. What result should Everlena obtain on appeal?\n9. Roland delivered a shipment of desks to Security Warehousers and received\nfrom Security a negotiable receipt. Peter broke into Roland\xe2\x80\x99s office, stole the\ndocument, and forged Roland\xe2\x80\x99s signature as an indorsement, making Peter\nhimself the holder. Peter then indorsed the document over to Billings, who\nknew nothing of the theft. Does Billings get good title to the desks?\n10. Baker\xe2\x80\x99s Transfer & Storage Company, Defendant, hauled household goods and\npersonal effects by trucks \xe2\x80\x9canywhere for hire.\xe2\x80\x9d Its trucks did not travel on\nregular routes or between established terminals; it hauled household goods\nand personal effects on private contracts with the owners as and when the\nopportunity presented itself. Baker contracted to haul the Klein family\xe2\x80\x99s\nhousehold goods from Bakersfield, California, to Hollywood. En route the\ngoods were destroyed by fire without Baker\xe2\x80\x99s negligence. Baker\xe2\x80\x99s contract\nprovided it would redeliver the property \xe2\x80\x9cdamage by the elements excepted.\xe2\x80\x9d\nIf Baker were a common carrier, its liability would be statutorily limited to less\nthan the amount ordered by the trial court; if it were a private carrier, its\nliability would be either based on ordinary negligence or as the parties\xe2\x80\x99\ncontract provided. Working with both points, what result obtains here?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n613\n\n\x0cS EL F -T E ST QU EST IO N S\n1. In a bailment, the bailee\na. must 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\na. slight\nb. extraordinary\nc. ordinary\nA disclaimer of liability by a bailee is\na. never allowed\nb. sometimes allowed\nc. always allowed\nd. unheard of in business\nA bailor may be held liable to the bailee on\na. a negligence theory\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. a common carrier\nb. a lessee\nc. a warehouser\nd. an innkeeper\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n614\n\n\x0cS EL F -T E ST A NSW E R S\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\n615\n\n\x0cChapter 13\nNature and Form of Commercial Paper\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. Why commercial paper is important in modern economic systems\n2. How the law of commercial paper has developed over the past four hundred years,\nand what role it plays in economics and finance\n3. What the types of commercial paper are, and who the parties to such paper are\n4. What is required for paper to be negotiable\n\nHere we begin our examination of commercial paper, documents representing an obligation by one party\nto pay another money. You are familiar with one kind of commercial paper: a check.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n616\n\n\x0c13.1 Introduction to Commercial Paper\nL EA R N IN G O B JEC T IV ES\n1. Understand why commercial paper is an important concept in modern finance.\n2. Be familiar with the historical development of commercial paper.\n3. Recognize how commercial paper is viewed in economics and finance.\n\nThe Importance of Commercial Paper\nBecause commercial paper is a vital invention for the working of our economic system, brief attention to\nits history and its function as a medium of exchange in economics and finance is appropriate.\n\nThe Central Role of Commercial Paper\nCommercial paper is the collective term for various financial instruments, or tools, that include checks\ndrawn on commercial banks, drafts (drawn on something other than a bank), certificates of deposit, and\nnotes evidencing a promise to pay. Like money, commercial paper is a medium of exchange, but because it\nis one step removed from money, difficulties arise that require a series of interlocking rules to protect\nboth sellers and buyers.\n\nTo understand the importance of commercial paper, consider the following example. It illustrates a\ndistinction that is critical to the discussion in our four chapters on commercial paper.\n\nLorna Love runs a tennis club. She orders a truckload of new tennis rackets from Rackets, Inc., a\nmanufacturer. The contract price of the rackets is $100,000. Rackets ships the rackets to Love. Rackets\nthen sells for $90,000 its contract rights (rights to receive the payment from Love of $100,000) to First\nBank (see Figure 13.1 "Assignment of Contract Rights"). Unfortunately, the rackets that arrive at Love\xe2\x80\x99s\nare warped and thus commercially worthless. Rackets files for bankruptcy.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n617\n\n\x0cFigure 13.1 Assignment of Contract Rights\n\nMay the bank collect from Love $100,000, the value of the contract rights it purchased? No. Under the\ncontract rule discussed in(Reference mayer_1.0-ch13 not found in Book), an assignee\xe2\x80\x94here, the bank\xe2\x80\x94\nsteps into the shoes of the assignor and takes the assigned rights subject to any defense of the obligor,\nLove. (Here, of course, Love\xe2\x80\x99s defense against paying is that the rackets are worthless.) The result would\nbe the same if Love had given Rackets a nonnegotiable note, which Rackets proceeded to sell to the bank.\n(By nonnegotiable we do not mean that the note cannot be sold but only that certain legal requirements,\ndiscussed in Section 13.3 "Requirements for Negotiability" of this chapter, have not been met.)\n\nNow let us add one fact: In addition to signing a contract, Love gives Rackets a negotiable note in\nexchange for the rackets, and Rackets sells the note to the bank. By adding that the note is negotiable, the\nresult changes significantly. Because the note is negotiable and because the bank, we assume, bought the\nnote in good faith (i.e., unaware that the rackets were warped), the bank will recover the $100,000\n(seeFigure 13.2 "Sale of Negotiable Note").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n618\n\n\x0cFigure 13.2 Sale of Negotiable Note\n\nThe key to the central role that commercial paper plays in modern finance\nis negotiability. Negotiability means that the paper is freely and unconditionally transferable from one\nperson to another by delivery or by delivery and indorsement. (\xe2\x80\x9cIndorsement,\xe2\x80\x9d not \xe2\x80\x9cendorsement,\xe2\x80\x9d is the\nspelling used in the UCC, though the latter is more common in nonlegal usage.) Without the ability to pay\nand finance through commercial paper, the business world would be paralyzed. At bottom, negotiability is\nthe means by which a person is empowered to transfer to another more than what the transferor himself\npossesses. In essence, this is the power to convey to a transferee the right in turn to convey clear title,\nwhen the original transferor does not have clear title.\n\nOverview of Chapters on Commercial Paper\nIn this chapter, we examine the history and nature of commercial paper and define the types of parties\n(persons who have an interest in the paper) and the types of instruments. We then proceed to four\nfundamental issues that must be addressed to determine whether parties such as First Bank, in the\npreceding example, can collect:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n619\n\n\x0c1.\n\nIs the paper negotiable? That is, is the paper in the proper form? We explore that issue in this\nchapter.\n\n2. Was the paper negotiated properly? See Chapter 14 "Negotiation of Commercial Paper".\n3. Is the purchaser of the paper a holder in due course? See Chapter 15 "Holder in Due Course and\nDefenses".\n4. Does the maker of the paper have available any defenses against even the holder in due course?\nSee Chapter 15 "Holder in Due Course and Defenses".\n\nIn most transactions, especially when the first three questions are answered affirmatively, the purchaser\nwill have little trouble collecting. But when the purchaser is unable to collect, questions of liability arise.\nThese questions, along with termination of liability, are discussed in Chapter 16 "Liability and Discharge".\n\nFinally, in Chapter 17 "Legal Aspects of Banking" we examine other legal aspects of banking, including\nletters of credit and electronic funds transfer.\n\nHistory of Commercial Paper\nDevelopment of the Law\nNegotiable instruments are no modern invention; we know that merchants used them as long ago as the\nage of Hammurabi, around 1700 BC. They fell into disuse after the collapse of the Roman Empire and\nthen reappeared in Italy around the fourteenth century. They became more common as long-distance\ncommerce spread. In an era before paper currency, payment in coins or bullion was awkward, especially\nfor merchants who traveled great distances across national boundaries to attend the fairs at which most\neconomic exchanges took place. Merchants and traders found it far more efficient to pay with paper.\n\nBills of exchange, today commonly known as drafts, were recognized instruments in the law merchant.\n(The \xe2\x80\x9claw merchant\xe2\x80\x9d was the system of rules and customs recognized and adopted by early-modern\ntraders and is the basis of the UCC Article 3.) A draft is an unconditional order by one person (the drawer)\ndirecting another person (drawee or payor) to pay money to a named third person or to bearer; a check is\nthe most familiar type of draft. The international merchant courts regularly enforced drafts and permitted\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n620\n\n\x0cthem to be transferred to others by indorsement (the legal spelling of endorsement). By the beginning of\nthe sixteenth century, the British common-law courts began to hear cases involving bills of exchange, but\nit took a half century before the courts became comfortable with them and accepted them as crucial to the\ngrowing economy.\n\nCourts were also hesitant until the end of the seventeenth century about sanctioning a transferor\xe2\x80\x99s\nassignment of a promissory note if it meant that the transferee would have better title than the transferor.\nOne reason for the courts\xe2\x80\x99 reluctance to sanction assignments stemmed from the law that permitted\ndebtors to be jailed, a law that was not repealed until 1870. The buyer of goods might have been willing\noriginally to give a promissory note because he knew that a particular seller would not attempt to jail him\nfor default, but who could be sure that a transferee, probably a complete stranger, would be so charitable?\n\nThe inability to negotiate promissory notes prevented a banking system from fully developing. During the\nEnglish Civil War in the seventeenth century, merchants began to deposit cash with the goldsmiths, who\nlent it out at interest and issued the depositors promissory notes, the forerunner of bank notes. But a\njudicial decision in 1703 declared that promissory notes were not negotiable, whether they were made\npayable to the order of a specific person or to the bearer. Parliament responded the following year with\nthe Promissory Notes Act, which for the first time permitted an assignee to sue the note\xe2\x80\x99s maker.\n\nThereafter the courts in both England and the United States began to shape the modern law of negotiable\ninstruments. By the late nineteenth century, Parliament had codified the law of negotiable instruments in\nEngland. Codification came later in the United States. In 1896, the National Conference of Commissioners\non Uniform State Laws proposed the Negotiable Instruments Act, which was adopted in all states by 1924.\nThat law eventually was superseded by the adoption of Articles 3 and 4 of the Uniform Commercial Code\n(UCC), which we study in these chapters.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n621\n\n\x0cIn 1990, the American Law Institute and the National Conference of Commissioners on Uniform State\nLaws approved revised Article 3, entitled \xe2\x80\x9cNegotiable Instruments,\xe2\x80\x9d and related amendments in Article 4.\nThe revisions clarified and updated the law. All states except New York and North Carolina have adopted\nArticles 3 and 4.\n\nThe Future of Commercial Paper: Federal and International Preemption\nState law governing commercial paper is vulnerable to federal preemption. This preemption could take\ntwo major forms. First, the Federal Reserve Board governs the activities of Federal Reserve Banks. As a\nresult, Federal Reserve regulations provide important guidelines for the check collection process. Second,\nArticle 3 of the UCC can be preempted by federal statutes. An important example is the Expedited Funds\nAvailability Act, which became effective in 1988 (discussed in Chapter 17 "Legal Aspects of Banking").\n\nFederal preemption may also become intertwined with international law. In 1988, the United Nations\nGeneral Assembly adopted the Convention on International Bills of Exchange and International\nPromissory Notes. Progress on the treaty emanating from the convention has been slow, however: the\nUnited States, Canada, and Russia have approved the convention (in 1989 and 1990) but have not ratified\nthe treaty; Gabon, Guinea, Honduras, Liberia, and Mexico are the only countries to have ratified it.\n\nCommercial Paper in Economics and Finance\nEconomics\nTo the economist, one type of commercial paper\xe2\x80\x94the bank check\xe2\x80\x94is the primary component of M1, the\nbasic money supply. It is easy to see why. When you deposit cash in a checking account, you may either\nwithdraw the currency\xe2\x80\x94coins and bills\xe2\x80\x94or draw on the account by writing out a check. If you write a\ncheck to \xe2\x80\x9ccash,\xe2\x80\x9d withdraw currency, and pay a creditor, there has been no change in the money supply.\nBut if you pay your creditor by check, the quantity of money has increased: the cash you deposited\nremains available, and your creditor deposits the check to his own account as though it were cash. (A\nmore broadly defined money supply, M2, includes savings deposits at commercial banks.)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n622\n\n\x0cFinance\nCommercial paper is defined more narrowly in finance than in law. To the corporate treasurer and other\nfinanciers, commercial paper ordinarily means short-term promissory notes sold by finance companies\nand large corporations for a fixed rate of interest. Maturity dates range from a low of three days to a high\nof nine months. It is an easy way for issuers to raise short-term money quickly. And although short-term\nnotes are unsecured, historically they have been almost as safe as obligations of the US government. By\ncontrast, for legal purposes, commercial paper includes long-term notes (which are often secured), drafts,\nchecks, and certificates of deposit.\n\nK E Y TA K EA WAY\nCommercial paper is a medium of exchange used like cash but safer than cash; cash is\nrarely used today except for small transactions. The key to the success of this invention\nis the concept of negotiability: through this process, a person can pass on\xe2\x80\x94in most\ncases\xe2\x80\x94better title to receive payment than he had; thus the transferee of such paper\nwill most likely get paid by the obligor and will not be subject to most defenses of any\nprior holders. The law of commercial paper has developed over the past four hundred\nyears. It is now the Uniform Commercial Code that governs most commercial paper\ntransactions in the United States, but federal or international preemption is possible in\nthe future. Commercial paper is important in both economics and finance.\n\nE XE R C IS ES\n1. If there were no such thing as commercial paper, real or virtual (electronic funds\ntransfers), how would you pay your bills? How did merchants have to pay their bills\nfour hundred years ago?\n2. What is it about negotiability that it is the key to the success of commercial paper?\n3. How could state law\xe2\x80\x94the UCC\xe2\x80\x94be preempted in regard to commercial paper?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n623\n\n\x0c13.2 Scope of Article 3 and Types of Commercial Paper\nand Parties\nL EA R N IN G O B JEC T IV ES\n1. Understand the scope of Article 3 of the Uniform Commercial Code.\n2. Recognize the types of commercial paper: drafts, checks, notes, and\ncertificates of deposit.\n3. Give the names of the various parties to commercial paper.\n\nScope of Article 3\nArticle 3 of the Uniform Commercial Code (UCC) covers commercial paper but explicitly excludes money,\ndocuments of title, and investment securities. Documents of title include bills of lading and warehouse\nreceipts and are governed by Article 7 of the UCC. Investment securities are covered by Article 8.\nInstruments that fall within the scope of Article 3 may also be subject to Article 4 (bank deposits and\ncollections), Article 8 (securities), and Article 9 (secured transactions). If so, the rules of these other\narticles supersede the provisions of Article 3 to the extent of conflict. Article 3 is a set of general provisions\non negotiability; the other articles deal more narrowly with specific transactions or instruments.\n\nTypes of Commercial Paper\nThere are four types of commercial paper: drafts, checks, notes, and certificates of deposit.\n\nDrafts\nA draft is an unconditional written order by one person (the drawer) directing another person (the\ndrawee) to pay a certain sum of money on demand or at a definite time to a named third person (the\npayee) or to bearer. The draft is one of the two basic types of commercial paper; the other is the note. As\nindicated by its definition, the draft is a three-party transaction.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n624\n\n\x0cParties to a Draft\nThe drawer is one who directs a person or an entity, usually a bank, to pay a sum of money stated in an\ninstrument\xe2\x80\x94for example, a person who makes a draft or writes a check. The drawer prepares a document\n(a form, usually)\xe2\x80\x94the draft\xe2\x80\x94ordering the drawee to remit a stated sum of money to the payee.\nThe drawee is the person or entity that a draft is directed to and that is ordered to pay the amount stated\non it. The most common drawee is a bank. The drawer, drawee, and payee need not be different people;\nthe same person may have different capacities in a single transaction. For example, a drawer (the person\nasking that payment be made) may also be the payee (the person to whom the payment is to be made). A\ndrawee who signs the draft becomes an acceptor: the drawee pledges to honor the draft as written. To\naccept, the drawee need only sign her name on the draft, usually vertically on the face, but anywhere will\ndo. Words such as \xe2\x80\x9caccepted\xe2\x80\x9d or \xe2\x80\x9cgood\xe2\x80\x9d are unnecessary. However, a drawee who indicates that she might\nrefuse to pay will not be held to have accepted. Thus in the archetypal case, the court held that a drawee\nwho signed his name and appended the words \xe2\x80\x9cKiss my foot\xe2\x80\x9d did not accept the draft.\n\n[1]\n\nThe drawer directs the funds to be drawn from\xe2\x80\x94pulled from\xe2\x80\x94the drawee, and the drawee pays the person\nentitled to payment as directed.\n\nTypes of Drafts\nDrafts can be divided into two broad subcategories: sight drafts and time drafts.\n\nA sight draft calls for payment \xe2\x80\x9con sight,\xe2\x80\x9d that is, when presented. Recall from Section 13.1\n"Introduction to Commercial Paper" that Lorna Love wished to buy tennis rackets from Rackets, Inc.\nSuppose Love had the money to pay but did not want to do so before delivery. Rackets, on the other hand,\ndid not want to ship before Love paid. The solution: a sight draft, drawn on Love, to which would be\nattached an order bill of lading that Rackets received from the trucker when it shipped the rackets. The\nsight draft and bill of lading go to a bank in Love\xe2\x80\x99s city. When the tennis rackets arrive, the carrier notifies\nthe bank, which presents the draft to Love for payment. When she has done so, the bank gives Love the\nbill of lading, entitling her to receive the shipment. The bank forwards the payment to Rackets\xe2\x80\x99 bank,\nwhich credits Rackets\xe2\x80\x99 account with the purchase amount.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n625\n\n\x0cA time draft, not surprisingly, calls for payment on a date specified in the draft. Suppose that Love will\nnot have sufficient cash to pay until she has sold the rackets but that Rackets needs to be paid\nimmediately. The solution: a common form of time draft known as a trade acceptance. Rackets, the seller,\ndraws a draft on Love, who thus becomes a drawee. The draft orders Love to pay the purchase price to the\norder of Rackets, as payee, on a fixed date. Rackets presents the draft to Love, who accepts it by signing\nher name. Rackets then can indorse the draft (by signing it) and sell it, at a discount, to its bank or some\nother financial institution. Rackets thus gets its money right away; the bank may collect from Love on the\ndate specified. See the example of a time draft in Figure 13.3 "A Time Draft".\n\nFigure 13.3 A Time Draft\n\nDrafts in International Trade\nDrafts are an international convention. In England and the British Commonwealth, drafts are called bills\nof exchange. Like a draft, a bill of exchange is a kind of check or promissory note without interest. Used\nprimarily in international trade, it is a written order by one person to pay another a specific sum on a\nspecific date sometime in the future. If the bill of exchange is drawn on a bank, it is called a bank draft. If\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n626\n\n\x0cit is drawn on another party, it is called a trade draft. Sometimes a bill of exchange will simply be called a\ndraft, but whereas a draft is always negotiable (transferable by endorsement), this is not necessarily true\nof a bill of exchange.\n\nA widely used draft in international trade is the banker\xe2\x80\x99s acceptance. It is a short-term credit\ninvestment created by a nonfinancial firm and guaranteed by a bank. This instrument is used when an\nexporter agrees to extend credit to an importer.\n\nAssume Love, the importer, is in New York; Rackets, the exporter, is in Taiwan. Rackets is willing to\npermit Love to pay ninety days after shipment. Love makes a deal with her New York bank to issue\nRackets\xe2\x80\x99 bank in Taiwan a letter of credit. This tells the seller\xe2\x80\x99s bank that the buyer\xe2\x80\x99s bank is willing to\naccept a draft drawn on the buyer in accordance with terms spelled out in the letter of credit. Love\xe2\x80\x99s bank\nmay insist on a security interest in the tennis rackets, or it may conclude that Love is creditworthy. On\nreceipt of the letter of credit, Rackets presents its bank in Taiwan with a draft drawn on Love\xe2\x80\x99s bank. That\nbank antes up the purchase amount (less its fees and interest), paying Rackets directly. It then forwards\nthe draft, bill of lading, and other papers to a correspondent bank in New York, which in turn presents it\nto Love\xe2\x80\x99s bank. If the papers are in order, Love\xe2\x80\x99s bank will \xe2\x80\x9caccept\xe2\x80\x9d the draft (sign it). The signed draft is\nthe banker\xe2\x80\x99s acceptance (see Figure 13.3 "A Time Draft"). It is returned to the bank in Taiwan, which can\nthen discount the banker\xe2\x80\x99s acceptance if it wishes payment immediately or else wait the ninety days to\npresent it to the New York bank for payment. After remitting to the Taiwanese bank, the New York bank\nthen demands payment from Love.\n\nChecks\nA second type of commercial paper is the common bank check, a special form of draft. Section 3-104(2)(b)\nof the UCC defines a check as \xe2\x80\x9ca draft drawn on a bank and payable on demand.\xe2\x80\x9d Postdating a check\n(putting in a future date) does not invalidate it or change its character as payable on demand. Postdating\nsimply changes the first time at which the payee may demand payment. Checks are, of course, usually\nwritten on paper forms, but a check can be written on anything\xe2\x80\x94a door, a shirt, a rock\xe2\x80\x94though certainly\nthe would-be holder is not obligated to accept it.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n627\n\n\x0cLike drafts, checks may be accepted by the drawee bank. Bank acceptance of a check is\ncalled certification; the check is said to be certified by stamping the word \xe2\x80\x9ccertified\xe2\x80\x9d on the face of the\ncheck. When the check is certified, the bank guarantees that it will honor the check when presented. It can\noffer this guarantee because it removes from the drawer\xe2\x80\x99s account the face amount of the check and holds\nit for payment. The payee may demand payment from the bank but not from the drawer or any prior\nindorser of the check.\n\nA certified check is distinct from a cashier\xe2\x80\x99s check. A cashier\xe2\x80\x99s check is drawn on the account of the\nbank itself and signed by an authorized bank representative in return for a cash payment to it from the\ncustomer. The bank guarantees payment of the cashier\xe2\x80\x99s check also.\n\nNotes\nA note\xe2\x80\x94often called a promissory note\xe2\x80\x94is a written promise to pay a specified sum of money on\ndemand or at a definite time. There are two parties to a note: the maker (promisor), and the payee\n(promisee). For an example of a promissory note, see Figure 13.4 "A Promissory Note". The maker might\nexecute a promissory note in return for a money loan from a bank or other financial institution or in\nreturn for the opportunity to make a purchase on credit.\n\nFigure 13.4 A Promissory Note\n\nCertificates of Deposit\nA fourth type of commercial paper is the certificate of deposit, commonly called a CD. The CD is a\nwritten acknowledgment by a bank that it has received money and agrees to repay it at a time specified in\nthe certificate. The first negotiable CD was issued in 1961 by First National City Bank of New York (now\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n628\n\n\x0cCitibank); it was designed to compete for corporate cash that companies were investing in Treasury notes\nand other funds. Because CDs are negotiable, they can be traded easily if the holder wants cash, though\ntheir price fluctuates with the market.\n\nOther Parties to Commercial Paper\nIn addition to makers, drawees, and payees, there are five other capacities in which one can deal with\ncommercial paper.\n\nIndorser and Indorsee\nThe indorser (also spelled endorser) is one who transfers ownership of a negotiable instrument by\nsigning it. A depositor indorses a check when presenting it for deposit by signing it on the back. The bank\ndeposits its own funds, in the amount of the check, to the depositor\xe2\x80\x99s account. By indorsing it, the\ndepositor transfers ownership of the check to the bank. The depositor\xe2\x80\x99s bank then can present it to the\ndrawer\xe2\x80\x99s bank for repayment from the drawer\xe2\x80\x99s funds. The indorsee is the one to whom a draft or note is\nindorsed. When a check is deposited in a bank, the bank is the indorsee.\n\nHolder\nA holder is \xe2\x80\x9ca person in possession of a negotiable that is payable either to bearer, or to an identified\nperson that is the person in possession.\xe2\x80\x9d\n\n[2]\n\nHolder is thus a generic term that embraces several of the\n\nspecific types of parties already mentioned. An indorsee and a drawee can be holders. But a holder can\nalso be someone unnamed whom the original parties did not contemplate by name\xe2\x80\x94for example, the\nholder of a bearer note.\n\nHolder in Due Course\nA holder in due course is a special type of holder who, if certain requirements are met, acquires rights\nbeyond those possessed by the transferor (we alluded to this in describing the significance of Lorna Love\xe2\x80\x99s\nmaking of a negotiable\xe2\x80\x94as opposed to a nonnegotiable\xe2\x80\x94instrument). We discuss the requirements for a\nholder in due course inChapter 15 "Holder in Due Course and Defenses".\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n629\n\n\x0cAccommodation Party\nAn accommodation party is one who signs a negotiable instrument in order to lend her name to\nanother party to the instrument. It does not matter in what capacity she signs, whether as maker or\ncomaker, drawer or codrawer, or indorser. As a signatory, an accommodation party is always a surety\n(Chapter 17 "Legal Aspects of Banking"; a surety is one who guarantees payment if the primarily obligated\nparty fails to pay). The extent of the accommodation party\xe2\x80\x99s liability to pay depends on whether she has\nadded language specifying her purposes in signing. Section 3-416 of the UCC distinguishes between a\nguaranty of payment and a guaranty of collection. An accommodation party who adds words such as\n\xe2\x80\x9cpayment guaranteed\xe2\x80\x9d subjects herself to primary liability: she is guaranteeing that she will pay if the\nprincipal signatory fails to pay when the instrument is due. But if the accommodation party signs\n\xe2\x80\x9ccollection guaranteed,\xe2\x80\x9d the holder must first sue the maker and win a court judgment. Only if the\njudgment is unsatisfied can the holder seek to collect from the accommodation party. When words of\nguaranty do not specify the type, the law presumes a payment guaranty.\n\nK E Y TA K EA WAY\nThe modern law of commercial paper is, in general, covered by UCC Article 3. The\ntwo basic types of commercial paper are drafts and notes. The note is a two-party\ninstrument whereby one person (maker) promises to pay money to a second\nperson (payee). The draft is a three-party instrument whereby one person\n(drawer) directs a second (drawee) to pay money to the third (payee). Drafts may\nbe sight drafts, payable on sight, or they may be time drafts, payable at a date\nspecified on the draft. Checks are drafts drawn on banks. Other parties include\nindorser and indorsee, holder, holder in due course, and accommodation party.\n\nE XE R C IS ES\n1. What are the two basic types of commercial paper?\n2. What are the two types of drafts?\n3. What kind of commercial paper is a check?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n630\n\n\x0c[1] Norton v. Knapp, 19 N.W. 867 (IA 1884).\n[2] Uniform Commercial Code, Section 1-201(21).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n631\n\n\x0c13.3 Requirements for Negotiability\nL EA R N IN G O B JEC T IV E\n1. Know what is required for an instrument to be negotiable.\n\nOverview\nWhether or not a paper is negotiable is the first of our four major questions, and it is one that nonlawyers\nmust confront. Auditors, retailers, and financial institutions often handle notes and checks and usually\nmust make snap judgments about negotiability. Unless the required elements of Sections 3-103 and 3-104\nof the Uniform Commercial Code (UCC) are met, the paper is not negotiable. Thus the paper meets the\nfollowing criteria:\n\n1.\n\nIt must be in writing.\n\n2. It must be signed by the maker or drawer.\n3. It must be an unconditional promise or order to pay.\n4. It must be for a fixed amount in money.\n5.\n\nIt must be payable on demand or at a definite time.\n\n6. It must be payable to order or bearer, unless it is a check.\n\nThis definition states the basic premise of a negotiable instrument: the holder must be able to ascertain all\nessential terms from the face of the instrument.\n\nAnalysis of Required Elements\nIn Writing\nUnder UCC Section 1-201, \xe2\x80\x9cwritten\xe2\x80\x9d or \xe2\x80\x9cwriting\xe2\x80\x9d includes \xe2\x80\x9cprinting, typewriting or any other intentional\nreduction to tangible form.\xe2\x80\x9d That definition is broad\xe2\x80\x94so broad, in fact, that from time to time the\nnewspapers report checks written on material ranging from a girdle (an Ohio resident wanted to make his\ntax payment stretch) to granite. Since these are tangible materials, the checks meet the writing\nrequirement. The writing can be made in any medium: ink, pencil, or even spray paint, as was the case\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n632\n\n\x0cwith the granite check. Of course, there is a danger in using pencil or an ink that can be erased, since the\ndrawer might be liable for alterations. For example, if you write out in pencil a check for $10 and someone\nerases your figures and writes in $250, you may lose your right to protest when the bank cashes it.\n\nSigned by the Maker or Drawer\nSignature is not limited to the personal handwriting of one\xe2\x80\x99s name. \xe2\x80\x9cAny symbol executed or adopted by a\nparty with present intention to authenticate a writing\xe2\x80\x9d will serve.\n\n[1]\n\nThat means that a maker or drawer\n\nmay make an impression of his signature with a rubber stamp or even an X if he intends that by so doing\nhe has signed. It can be typed or by thumbprint. In some cases, an appropriate letterhead may serve to\nmake the note or draft negotiable without any other signature. Nor does the position of the signature\nmatter. Blackstone Kent\xe2\x80\x99s handwritten note, \xe2\x80\x9cTen days from this note, I, Blackstone Kent, promise to pay\n$5,000 to the order of Webster Mews,\xe2\x80\x9d is sufficient to make the note negotiable, even though there is no\nsubsequent signature. Moreover, the signature may be in a trade name or an assumed name. (Note:\nspecial problems arise when an agent signs on behalf of a principal. We consider these problems\nin Chapter 16 "Liability and Discharge".)\n\nUnconditional Promise or Order to Pay\nSection 3-106(a) of the UCC provides that an instrument is notnegotiable if it \xe2\x80\x9cstates (i) an express\ncondition to payment, (ii) that the promise or order is subject to or governed by another writing, or (iii)\nthat rights or obligations with respect to the promise or order are stated in another writing. A reference to\nanother writing does not of itself make the promise or order conditional.\xe2\x80\x9d Under 3-106(b), a promise is\nnot made conditional by \xe2\x80\x9c(i) reference to another writing for a statement of rights with respect to\ncollateral, pre-payment, or acceleration, or (ii) because payment is limited to resort to a particular fund or\nsource.\xe2\x80\x9d As to \xe2\x80\x9creference to another writing,\xe2\x80\x9d see Holly Hill Acres, Ltd. v. Charter Bank of Gainesville,\nin Section 13.4 "Cases".\n\nThe only permissible promise or order in a negotiable instrument is to pay a sum certain in money. Any\nother promise or order negates negotiability. The reason for this rule is to prevent an instrument from\nhaving an indeterminate value. The usefulness of a negotiable instrument as a substitute for money would\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n633\n\n\x0cbe seriously eroded if the instrument\xe2\x80\x99s holder had to investigate whether a stipulation or condition had\nbeen met before the thing had any value (i.e., before the obligor\xe2\x80\x99s obligation to pay ripened).\n\nFixed Amount in Money\nThe value of the paper must be fixed (specific) so it can be ascertained, and it must be payable in money.\n\nFixed Amount\nThe instrument must recite an exact amount of money that is to be paid, although the exact amount need\nnot be expressed in a single figure. For example, the note can state that the principal is $1,000 and the\ninterest is 11.5 percent, without specifying the total amount. Or the note could state the amount in\ninstallments: twelve equal installments of $88.25. Or it could state different interest rates before and after\na certain date or depending on whether or not the maker has defaulted; it could be determinable by a\nformula or by reference to a source described in the instrument.\n\n[2]\n\nIt could permit the maker to take a\n\ndiscount if he pays before a certain date or could assess a penalty if he pays after the date. It could also\nprovide for an attorney\xe2\x80\x99s fees and the costs of collection on default. If it is clear that interest is to be\nincluded but no interest amount is set, UCC Section 3-112 provides that it is \xe2\x80\x9cpayable at the judgment rate\nin effect at the place of payment of the instrument and at the time interest first accrues.\xe2\x80\x9d The fundamental\nrule is that for any time of payment, the holder must be able to determine, after the appropriate\ncalculations, the amount then payable. See Section 13.4 "Cases", Centerre Bank of Branson v. Campbell,\nfor a case involving the \xe2\x80\x9cfixed amount\xe2\x80\x9d rule.\n\nIn Money\nSection 1-201(24) of the UCC defines money as \xe2\x80\x9ca medium of exchange authorized or adopted by a\ndomestic or foreign government as a part of its currency.\xe2\x80\x9d As long as the medium of exchange was such at\nthe time the instrument was made, it is payable in money, even if the medium of exchange has been\nabolished at the time the instrument is due. Section 3-107 provides the following as to payment in foreign\ncurrency: \xe2\x80\x9cUnless the instrument otherwise provides, an instrument that states the amount payable in\nforeign money may be paid in the foreign money or in an equivalent amount in dollars calculated by using\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n634\n\n\x0cthe current bank-offered spot rate at the place of payment for the purchase of dollars on the day on which\nthe instrument is paid.\xe2\x80\x9d\n\nPayable on Demand or at a Definite Time\nAn instrument that says it is payable on sight is payable on demand, as is one that states no time for\npayment. \xe2\x80\x9cDefinite time\xe2\x80\x9d may be stated in several ways; it is not necessary to set out a specific date. For\nexample, a note might say that it is payable on or before a stated date, at a fixed period after the date, at a\nfixed period after sight, at a definite time subject to acceleration, or at a definite time subject to extension\nat the option of the holder or automatically on or after the occurrence of a particular event. However, if\nthe only time fixed is on the occurrence of a contingent event, the time is not definite, even though the\nevent in fact has already occurred. An example of a valid acceleration clause is the following: \xe2\x80\x9cAt the\noption of the holder, this note shall become immediately due and payable in the event that the maker fails\nto comply with any of the promises contained in this note or to perform any other obligation of the maker\nto the holder.\xe2\x80\x9d\n\nIs the note \xe2\x80\x9cPayable ten days after I give birth\xe2\x80\x9d negotiable? No, because the date the baby is due is\nuncertain. Is the note \xe2\x80\x9cPayable on January 1, but if the Yankees win the World Series, payable four days\nearlier\xe2\x80\x9d negotiable? Yes: this is a valid acceleration clause attached to a definite date.\nOne practical difference between a demand instrument and a time instrument is the date on which the\nstatute of limitations begins to run. (A statute of limitations is a limit on the time a creditor has to file a\nlawsuit to collect the debt.) Section 3-118(1) of the UCC says that a lawsuit to enforce payment at a definite\ntime \xe2\x80\x9cmust be commenced within six years after the due date\xe2\x80\x9d (or the accelerated due date). For demand\npaper, an action must be brought \xe2\x80\x9cwithin six years after the demand.\xe2\x80\x9d\n\nPayable to Order or Bearer\nAn instrument payable to order is one that will be paid to a particular person or organization identifiable\nin advance. To be payable to order, the instrument must so state, as most ordinarily do, by placing the\nwords \xe2\x80\x9cpayable to order of\xe2\x80\x9d before the name of the payee. An instrument may be payable to the order of\nthe maker, drawer, drawee, or someone else. It also may be payable to the order of two or more payees\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n635\n\n\x0c(together or in the alternative), to an estate, a trust, or a fund (in which case it is payable to the\nrepresentative, to an office or officer, or to a partnership or unincorporated association). Suppose a\nprinted form says that the instrument is payable both to order and to bearer. In that event, the instrument\nis payable only to order. However, if the words \xe2\x80\x9cto bearer\xe2\x80\x9d are handwritten or typewritten, then the\ninstrument can be payable either to order or to bearer.\n\nA negotiable instrument not payable to a particular person must be payable to bearer, meaning to any\nperson who presents it. To be payable to bearer, the instrument may say \xe2\x80\x9cpayable to bearer\xe2\x80\x9d or \xe2\x80\x9cto the\norder of bearer.\xe2\x80\x9d It may also say \xe2\x80\x9cpayable to John Doe or bearer.\xe2\x80\x9d Or it may be made payable to cash or\nthe order of cash.\n\nSection 3-104(c) of the UCC excepts checks from the requirement that the instrument be \xe2\x80\x9cpayable to\nbearer or order.\xe2\x80\x9d Official Comment 2 to that section explains why checks are not required to have the\n\xe2\x80\x9cpayable\xe2\x80\x9d wording: \xe2\x80\x9cSubsection (c) is based on the belief that it is good policy to treat checks, which are\npayment instruments, as negotiable instruments whether or not they contain the words \xe2\x80\x98to the order of.\xe2\x80\x99\nThese words are almost always pre-printed on the check form.\xe2\x80\xa6Absence of the quoted words can easily be\noverlooked and should not affect the rights of holders who may pay money or give credit for a check\nwithout being aware that it is not in the conventional form.\xe2\x80\x9d\n\nAlso affecting this policy is the fact that almost all checks are now read by machines, not human beings.\nThere is no one to see that the printed form does not contain the special words, and the significance of the\nwords is recognized by very few people. In short, it doesn\xe2\x80\x99t matter for checks.\n\nMissing and Ambiguous Terms\nThe rules just stated make up the conditions for negotiability. Dealing with two additional details\xe2\x80\x94\nmissing terms or ambiguous terms\xe2\x80\x94completes the picture. Notwithstanding the presence of readily\navailable form instruments, sometimes people leave words out or draw up confusing documents.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n636\n\n\x0cIncompleteness\nAn incomplete instrument\xe2\x80\x94one that is missing an essential element, like the due date or amount\xe2\x80\x94can be\nsigned before being completed if the contents at the time of signing show that the maker or drawer\nintends it to become a negotiable instrument. Unless the date of an instrument is required to determine\nwhen it is payable, an undated instrument can still be negotiable.\n\n[3]\n\nOtherwise, to be enforceable, the\n\ninstrument must first be completed\xe2\x80\x94if not by the maker or drawer, then by the holder in accordance with\nwhatever authority he has to do so.\n\n[4]\n\nSee the case presented in Section 13.4 "Cases", Newman v.\n\nManufacturers Nat. Bank of Detroit.\n\nAmbiguity\nWhen it is unclear whether the instrument is a note or draft, the holder may treat it as either.\nHandwritten terms control typewritten and printed terms, and typewritten terms control printed terms.\nWords control figures, unless the words themselves are ambiguous, in which case the figures control. If\nthe instrument contains a \xe2\x80\x9cconspicuous statement, however expressed, to the effect that the promise or\norder is not negotiable,\xe2\x80\x9d its negotiability is destroyed, except for checks, and \xe2\x80\x9can instrument may be a\ncheck even though it is described on its face by another term, such as \xe2\x80\x98money order.\xe2\x80\x99\xe2\x80\x9d\n\n[5]\n\nK E Y TA K EA WAY\nIf an instrument is not negotiable, it generally will not be acceptable as payment in\ncommercial transactions. The UCC requires that the value of a negotiable instrument be\nascertainable on its face, without reference to other documents. Thus the negotiable\ninstrument must be in writing, signed by the maker or drawer, an unconditional promise\nor order to pay, for a fixed amount in money, payable on demand or at a definite time,\nand payable to order or bearer, unless it is a check. If the instrument is incomplete or\nambiguous, the UCC provides rules to determine what the instrument means.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n637\n\n\x0cE XE R C IS ES\n1. Why does the UCC require that the value of a negotiable instrument be\nascertainable from its face, without extrinsic reference?\n2. What are the six requirements for an instrument to meet the negotiability test?\n3. Why are the words \xe2\x80\x9cpay to order\xe2\x80\x9d or \xe2\x80\x9cpay to bearer\xe2\x80\x9d or similar words required on\nnegotiable instruments (except for checks\xe2\x80\x94and why not for checks)?\n4. If an instrument is incomplete, is it invalid?\n[1] Uniform Commercial Code, Section 1-201(39).\n[2] Uniform Commercial Code, Section 3-112(b).\n[3] Uniform Commercial Code, Section 3-113(b).\n[4] Uniform Commercial Code, Section 3-115.\n[5] Uniform Commercial Code, Section 3-104(d); Uniform Commercial Code, Section 3-104(f).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n638\n\n\x0c13.4 Cases\nNegotiability: Requires Unconditional Promise to Pay\nHolly Hill Acres, Ltd. v. Charter Bank of Gainesville\n314 So.2d 209 (Fla. App. 1975)\nScheb, J.\n\nAppellant/defendant [Holly Hill] appeals from a summary judgment in favor of appellee/plaintiff Bank in\na suit wherein the plaintiff Bank sought to foreclose a note and mortgage given by defendant.\n\nThe plaintiff Bank was the assignee from Rogers and Blythe of a promissory note and purchase money\nmortgage executed and delivered by the defendant. The note, executed April 28, 1972, contains the\nfollowing stipulation:\n\nThis note with interest is secured by a mortgage on real estate, of even date herewith, made by the maker\nhereof in favor of the said payee, and shall be construed and enforced according to the laws of the State of\nFlorida. The terms of said mortgage are by this reference made a part hereof. (emphasis\nadded)\n\nRogers and Blythe assigned the promissory note and mortgage in question to the plaintiff Bank to secure\ntheir own note. Plaintiff Bank sued defendant [Holly Hill] and joined Rogers and Blythe as defendants\nalleging a default on their note as well as a default on defendant\xe2\x80\x99s [Holly Hill\xe2\x80\x99s] note.\n\nDefendant answered incorporating an affirmative defense that fraud on the part of Rogers and Blythe\ninduced the sale which gave rise to the purchase money mortgage. Rogers and Blythe denied the fraud. In\nopposition to plaintiff Bank\xe2\x80\x99s motion for summary judgment, the defendant submitted an affidavit in\nsupport of its allegation of fraud on the part of agents of Rogers and Blythe. The trial court held the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n639\n\n\x0cplaintiff Bank was a holder in due course of the note executed by defendant and entered a summary final\njudgment against the defendant.\n\nThe note having incorporated the terms of the purchase money mortgage was not negotiable. The plaintiff\nBank was not a holder in due course, therefore, the defendant was entitled to raise against the plaintiff\nany defenses which could be raised between the appellant and Rogers and Blythe. Since defendant\nasserted an affirmative defense of fraud, it was incumbent on the plaintiff to establish the non-existence of\nany genuine issue of any material fact or the legal insufficiency of defendant\xe2\x80\x99s affirmative defense. Having\nfailed to do so, plaintiff was not entitled to a judgment as a matter of law; hence, we reverse.\n\nThe note, incorporating by reference the terms of the mortgage, did not contain the unconditional\npromise to pay required by [the UCC]. Rather, the note falls within the scope of [UCC 3-106(a)(ii)]: \xe2\x80\x9cA\npromise or order is unconditional unless it states that\xe2\x80\xa6it is subject to or governed by any other writing.\xe2\x80\x9d\n\nPlaintiff Bank relies upon Scott v. Taylor [Florida] 1912 [Citation], as authority for the proposition that its\nnote is negotiable. Scott, however, involved a note which stated: \xe2\x80\x9cthis note secured by mortgage.\xe2\x80\x9d Mere\nreference to a note being secured by mortgage is a common commercial practice and such reference in\nitself does not impede the negotiability of the note. There is, however, a significant difference in a note\nstating that it is \xe2\x80\x9csecured by a mortgage\xe2\x80\x9d from one which provides, \xe2\x80\x9cthe terms of said mortgage are by this\nreference made a part hereof.\xe2\x80\x9d In the former instance the note merely refers to a separate agreement\nwhich does not impede its negotiability, while in the latter instance the note is rendered non-negotiable.\n\nAs a general rule the assignee of a mortgage securing a non-negotiable note, even though a bona fide\npurchaser for value, takes subject to all defenses available as against the mortgagee. [Citation] Defendant\nraised the issue of fraud as between himself and other parties to the note, therefore, it was incumbent on\nthe plaintiff Bank, as movant for a summary judgment, to prove the non-existence of any genuinely triable\nissue. [Citation]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n640\n\n\x0cAccordingly, the entry of a summary final judgment is reversed and the cause remanded for further\nproceedings.\n\nC A SE QU ES TIO NS\n1. What was wrong with the promissory note that made it nonnegotiable?\n2. How did the note\xe2\x80\x99s nonnegotiability\xe2\x80\x94as determined by the court of appeals\xe2\x80\x94\nbenefit the defendant, Holly Hill?\n3. The court determined that the bank was not a holder in due course; on\nremand, what happens now?\n\nNegotiability: Requires Fixed Amount of Money\nCenterre Bank of Branson v. Campbell\n\n744 S.W.2d 490 (Mo. App. 1988)\n\nCrow, J.\n\nOn or about May 7, 1985, appellants (\xe2\x80\x9cthe Campbells\xe2\x80\x9d) signed the following document:\nFigure 13.5\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n641\n\n\x0cOn May 13, 1985, the president and secretary of Strand Investment Company (\xe2\x80\x9cStrand\xe2\x80\x9d) signed the\nfollowing provision [see Figure 22.6] on the reverse side of the above [Figure 13.5] document:\n\nFigure 13.6\n\nOn June 30, 1986, Centerre Bank of Branson (\xe2\x80\x9cCenterre\xe2\x80\x9d) sued the Campbells. Pertinent to the issues on\nthis appeal, Centerre\xe2\x80\x99s petition averred:\n\n\xe2\x80\x9c1. \xe2\x80\xa6on [May 7,] 1985, the [Campbells] made and delivered to Strand\xe2\x80\xa6their promissory note\xe2\x80\xa6and\nthereby promised to pay to Strand\xe2\x80\xa6or its order\xe2\x80\xa6($11,250.00) with interest thereon from date at the rate\nof fourteen percent (14%) per annum; that a copy of said promissory note is attached hereto\xe2\x80\xa6and\nincorporated herein by reference.\n\n2. That thereafter and before maturity, said note was assigned and delivered by Strand\xe2\x80\xa6to [Centerre] for\nvaluable consideration and [Centerre] is the owner and holder of said promissory note.\xe2\x80\x9d\n\nCenterre\xe2\x80\x99s petition went on to allege that default had been made in payment of the note and that there was\nan unpaid principal balance of $9,000, plus accrued interest, due thereon. Centerre\xe2\x80\x99s petition prayed for\njudgment against the Campbells for the unpaid principal and interest.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n642\n\n\x0c[The Campbells] aver that the note was given for the purchase of an interest in a limited partnership to be\ncreated by Strand, that no limited partnership was thereafter created by Strand, and that by reason\nthereof there was \xe2\x80\x9ca complete and total failure of consideration for the said promissory note.\xe2\x80\x9d\nConsequently, pled the answers, Centerre \xe2\x80\x9cshould be estopped from asserting a claim against [the\nCampbells] on said promissory note because of such total failure of consideration for same.\xe2\x80\x9d\n\nThe cause was tried to the court, all parties having waived trial by jury. At trial, the attorney for the\nCampbells asked Curtis D. Campbell what the consideration was for the note. Centerre\xe2\x80\x99s attorney\ninterrupted: \xe2\x80\x9cWe object to any testimony as to the consideration for the note because it\xe2\x80\x99s our position that\nis not a defense in this lawsuit since the bank is the holder in due course.\xe2\x80\x9d\xe2\x80\xa6\n\nThe trial court entered judgment in favor of Centerre and against the Campbells for $9,000, plus accrued\ninterest and costs. The trial court filed no findings of fact or conclusions of law, none having been\nrequested. The trial court did, however, include in its judgment a finding that Centerre \xe2\x80\x9cis a holder in due\ncourse of the promissory note sued upon.\xe2\x80\x9d\n\nThe Campbells appeal, briefing four points. Their first three, taken together, present a single hypothesis of\nerror consisting of these components: (a) the Campbells showed \xe2\x80\x9cby clear and convincing evidence a valid\nand meritorious defense in that there existed a total lack and failure of consideration for the promissory\nnote in question,\xe2\x80\x9d (b) Centerre acquired the note subject to such defense in that Centerre was not a holder\nin due course, as one can be a holder in due course of a note only if the note is a negotiable instrument,\nand (c) the note was not a negotiable instrument inasmuch as \xe2\x80\x9cit failed to state a sum certain due the\npayee.\xe2\x80\x9d\xe2\x80\xa6\n\nWe have already noted that if Centerre is not a holder in due course, the Campbells can assert the defense\nof failure of consideration against Centerre to the same degree they could have asserted it against Strand.\nWe have also spelled out that Centerre cannot be a holder in due course if the note is not a negotiable\ninstrument. The pivotal issue, therefore, is whether the provision that interest may vary with bank rates\ncharged to Strand prevents the note from being a negotiable instrument.\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n643\n\n\x0cNeither side has cited a Missouri case applying [UCC 3-104(a)] to a note containing a provision similar to:\n\xe2\x80\x9cInterest may vary with bank rates charged to Strand.\xe2\x80\x9d Our independent research has likewise proven\nfruitless. There are, however, instructive decisions from other jurisdictions.\n\nIn Taylor v. Roeder, [Citation, Virginia] (1987), a note provided for interest at \xe2\x80\x9c[t]hree percent (3.00%)\nover Chase Manhattan prime to be adjusted monthly.\xe2\x80\x9d A second note provided for interest at \xe2\x80\x9c3% over\nChase Manhattan prime adjusted monthly.\xe2\x80\x9d Applying sections of the Uniform Commercial Code adopted\nby Virginia identical to [the Missouri UCC], the court held the notes were not negotiable instruments in\nthat the amounts required to satisfy them could not be ascertained without reference to an extrinsic\nsource, the varying prime rate of interest charged by Chase Manhattan Bank.\n\nIn Branch Banking and Trust Co. v. Creasy, [Citation, North Carolina] (1980), a guaranty agreement\nprovided that the aggregate amount of principal of all indebtedness and liabilities at any one time for\nwhich the guarantor would be liable shall not exceed $35,000. The court, emphasizing that to be a\nnegotiable instrument a writing must contain, among other things, an unconditional promise to pay a sum\ncertain in money, held the agreement was not a negotiable instrument. The opinion recited that for the\nrequirement of a sum certain to be met, it is necessary that at the time of payment the holder be able to\ndetermine the amount which is then payable from the instrument itself, with any necessary computation,\nwithout reference to any outside source. It is essential, said the court, for a negotiable instrument \xe2\x80\x9cto bear\na definite sum so that subsequent holders may take and transfer the instrument without having to plumb\nthe intricacies of the instrument\xe2\x80\x99s background.\xe2\x80\xa6\n\nIn A. Alport & Son, Inc. v. Hotel Evans, Inc., [Citation] (1970), a note contained the notation \xe2\x80\x9cwith\ninterest at bank rates.\xe2\x80\x9d Applying a section of the Uniform Commercial Code adopted by New York\nidentical to [3-104(a)] the court held the note was not a negotiable instrument in that the amount of\ninterest had to be established by facts outside the instrument.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n644\n\n\x0cIn the instant case, the Campbells insist that it is impossible to determine from the face of the note the\namount due and payable on any payment date, as the note provides that interest may vary with bank rates\ncharged to Strand. Consequently, say the Campbells, the note is not a negotiable instrument, as it does not\ncontain a promise to pay a \xe2\x80\x9csum certain\xe2\x80\x9d [UCC 3-104(a)].\n\nCenterre responds that the provision that interest may vary with bank rates charged to Strand is not\n\xe2\x80\x9cdirectory,\xe2\x80\x9d but instead is merely \xe2\x80\x9cdiscretionary.\xe2\x80\x9d The argument begs the question. Even if one assumes\nthat Strand would elect not to vary the interest charged the Campbells if interest rates charged Strand by\nbanks changed, a holder of the note would have to investigate such facts before determining the amount\ndue on the note at any time of payment. We hold that under 3-104 and 3-106, supra, and the authorities\ndiscussed earlier, the provision that interest may vary with bank rates charged to Strand bars the note\nfrom being a negotiable instrument, thus no assignee thereof can be a holder in due course. The trial court\ntherefore erred as a matter of law in ruling that Centerre was a holder in due course.\xe2\x80\xa6\n\nAn alert reader will have noticed two other extraordinary features about the note, not mentioned in this\nopinion. First, the note provides in one place that principal and interest are to be paid in annual\ninstallments; in another place it provides that interest will be payable semiannually. Second, there is no\nacceleration clause providing that if default be made in the payment of any installment when due, then all\nremaining installments shall become due and payable immediately. It would have thus been arguable\nthat, at time of trial, only the first year\xe2\x80\x99s installment of principal and interest was due. No issue is raised,\nhowever, regarding any of these matters, and we decline to consider them sua sponte [on our own].\n\nThe judgment is reversed and the cause is remanded for a new trial.\n\nC A SE QU ES TIO NS\n\n1. What was defective about this note that made it nonnegotiable?\n2. What was the consequence to Centerre of the court\xe2\x80\x99s determination that the\nnote was nonnegotiable?\n3. What did the Campbells give the note for in the first place, and why do they\ndeny liability on it?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n645\n\n\x0cUndated or Incomplete Instruments\nNewman v. Manufacturers Nat. Bank of Detroit\n\n152 N.W.2d 564 (Mich. App. 1967)\n\nHolbrook, J.\n\nAs evidence of [a debt owed to a business associate, Belle Epstein], plaintiff [Marvin Newman in 1955]\ndrew two checks on the National Bank of Detroit, one for $1,000 [about $8,000 in 2010 dollars] and the\nother for $200 [about $1,600 in 2010 dollars]. The checks were left undated. Plaintiff testified that he\npaid all but $300 of this debt during the following next 4 years. Thereafter, Belle Epstein told plaintiff that\nshe had destroyed the two checks.\xe2\x80\xa6\n\nPlaintiff never notified defendant Bank to stop payment on the checks nor that he had issued the checks\nwithout filling in the dates. The date line of National Bank of Detroit check forms contained the first 3\nnumbers of the year but left the last numeral, month and day entries, blank, viz., \xe2\x80\x9cDetroit 1, Mich. _ _\n195_ _.\xe2\x80\x9d The checks were cashed in Phoenix, Arizona, April 17, 1964, and the date line of each check was\ncompleted\xe2\x80\xa6They were presented to and paid by Manufacturers National Bank of Detroit, April 22, 1964,\nunder the endorsement of Belle Epstein. The plaintiff protested such payment when he was informed of it\nabout a month later. Defendant Bank denied liability and plaintiff brought suit.\xe2\x80\xa6\n\nThe two checks were dated April 16, 1964. It is true that the dates were completed in pen and ink\nsubsequent to the date of issue. However, this was not known by defendant. Defendant had a right to rely\non the dates appearing on the checks as being correct. [UCC 3-113] provides in part as follows:\n\n(a) An instrument may be antedated or postdated.\n\nAlso, [UCC 3-114] provides in part as follows:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n646\n\n\x0c[T]ypewritten terms prevail over printed terms, handwritten terms prevail over both\xe2\x80\xa6\n\nWithout notice to the contrary, defendant was within its rights to assume that the dates were proper and\nfilled in by plaintiff or someone authorized by him.\xe2\x80\xa6\n\nPlaintiff admitted at trial that defendant acted in good faith in honoring the two checks of plaintiff\xe2\x80\x99s in\nquestion, and therefore defendant\xe2\x80\x99s good faith is not in issue.\n\nIn order to determine if defendant bank\xe2\x80\x99s action in honoring plaintiff\xe2\x80\x99s two checks under the facts present\nherein constituted an exercise of proper procedure, we turn to article 4 of the UCC.\xe2\x80\xa6[UCC 4-401(d)]\nprovides as follows:\n\nA bank that in good faith makes payment to a holder may charge the indicated account of its customer\naccording to:\n\n(1) the original tenor of his altered item; or\n\n(2) the tenor of his completed item, even though the bank knows the item has been completed unless the\nbank has notice that the completion was improper.\n\n\xe2\x80\xa6[W]e conclude it was shown that two checks were issued by plaintiff in 1955, filled out but for the dates\nwhich were subsequently completed by the payee or someone else to read April 16, 1964, and presented to\ndefendant bank for payment, April 22, 1964. Applying the rules set forth in the UCC as quoted herein, the\naction of the defendant bank in honoring plaintiff\xe2\x80\x99s checks was in good faith and in accord with the\nstandard of care required under the UCC.\n\nSince we have determined that there was no liability under the UCC, plaintiff cannot succeed on this\nappeal.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n647\n\n\x0cAffirmed.\n\nC A SE QU ES TIO NS\n1. Why does handwriting control over printing or typing on negotiable\ninstruments?\n2. How could the plaintiff have protected himself from liability in this case?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n648\n\n\x0c13.5 Summary and Exercises\nSummary\nCommercial paper is the collective term for a variety of instruments\xe2\x80\x94including checks, certificates of\ndeposit, and notes\xe2\x80\x94that are used to pay for goods; commercial paper is basically a contract to pay money.\nThe key to the central role of commercial paper is negotiability, the means by which a person is\nempowered to transfer to another more than what the transferor himself possesses. The law regulating\nnegotiability is Article 3 of the Universal Commercial Code.\n\nCommercial paper can be divided into two basic types: the draft and the note. A draft is a document\nprepared by a drawer ordering the drawee to remit a stated sum of money to the payee. Drafts can be\nsubdivided into two categories: sight drafts and time drafts. A note is a written promise to pay a specified\nsum of money on demand or at a definite time.\n\nA special form of draft is the common bank check, a draft drawn on a bank and payable on demand. A\nspecial form of note is the certificate of deposit, a written acknowledgment by a bank that it has received\nmoney and agrees to repay it at a time specified in the certificate.\n\nIn addition to drawers, makers, drawees, and payees, one can deal with commercial paper in five other\ncapacities: as indorsers, indorsees, holders, holders in due course, and accommodation parties.\n\nA holder of a negotiable instrument must be able to ascertain all essential terms from its face. These terms\nare that the instrument (1) be in writing, (2) be signed by the maker or drawer, (3) contain an\nunconditional promise or order to pay (4) a sum certain in money, (5) be payable on demand or at a\ndefinite time, and (6) be payable to order or to bearer. If one of these terms is missing, the document is\nnot negotiable, unless it is filled in before being negotiated according to authority given.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n649\n\n\x0cE XE R C IS ES\n1. Golf Inc. manufactures golf balls. Jack orders 1,000 balls from Golf and promises to\npay $4,000 two weeks after delivery. Golf Inc. delivers the balls and assigns its\ncontract rights to First Bank for $3,500. Golf Inc. then declares bankruptcy. May\nFirst Bank collect $3,500 from Jack? Explain.\n2. Assume in problem 1 that Jack gives Golf Inc. a nonnegotiable note for $3,500 and\nGolf sells the note to the bank shortly after delivering the balls. May the bank\ncollect the $3,500? Would the result be different if the note were negotiable?\nExplain.\n3. George decides to purchase a new stereo system on credit. He signs two\ndocuments\xe2\x80\x94a contract and a note. The note states that it is given \xe2\x80\x9cin payment for\nthe stereo\xe2\x80\x9d and \xe2\x80\x9cif stereo is not delivered by July 2, the note is cancelled.\xe2\x80\x9d Is the\nnote negotiable? Explain.\n4. Is the following instrument a note, check, or draft? Explain.\nFigure 13.7\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n650\n\n\x0c5. State whether the following provisions in an instrument otherwise in the\nproper form make the instrument nonnegotiable and explain why:\na. A note stating, \xe2\x80\x9cThis note is secured by a mortgage of the same\ndate on property located at 1436 Dayton Street, Jameson, New\nYork\xe2\x80\x9d\nb. A note for $25,000 payable in twenty installments of $1,250 each\nthat provides, \xe2\x80\x9cIn the event the maker dies all unpaid installments\nare cancelled\xe2\x80\x9d\nc. An instrument reading, \xe2\x80\x9cI.O.U., Rachel Donaldson, $3,000\xe2\x80\x9d\nd. A note for $1,500 \xe2\x80\x9cpayable to the order of Marty Dooley, six\nmonths after Nick Solster\xe2\x80\x99s death\xe2\x80\x9d\ne. A note A note reading, \xe2\x80\x9cI promise to pay Rachel Donaldson $3,000\xe2\x80\x9d\nf. A note stating, \xe2\x80\x9cIn accordance with our telephone conversation of\nJanuary 7th, I promise to pay Sally Wilkenson or order $1,500\xe2\x80\x9d\ng. An undated note for $1,500 \xe2\x80\x9cpayable one year after date\xe2\x80\x9d\nh. for $18,000 payable in regular installments also stating, \xe2\x80\x9cIn the\nevent any installment is not made as provided here, the entire\namount remaining unpaid may become due immediately\xe2\x80\x9d\nLou enters into a contract to buy Alan\xe2\x80\x99s car and gives Alan an instrument that\nstates, \xe2\x80\x9cThis acknowledges my debt to Alan in the amount of $10,000 that I owe\non my purchase of the 2008 Saturn automobile I bought from him today.\xe2\x80\x9d Alan\nassigns the note to Judy for $8,000. Alan had represented to Lou that the car had\n20,000 miles on it, but when Lou discovered the car had 120,000 miles he refused\nto make further payments on the note. Can Judy successfully collect from Lou?\nExplain.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n651\n\n\x0cThe same facts as above are true, but the instrument Lou delivered to Alan\nreads, \xe2\x80\x9cI promise to pay to Alan or order $10,000 that I owe on my purchase of the\n2008 automobile I bought from him today.\xe2\x80\x9d Can Judy successfully collect from\nLou? Explain.\nJoe Mallen, of Sequim, Washington, was angry after being cited by a US Fish\nand Wildlife Service for walking his dog without a leash in a federal bird refuge. He\nwas also aggravated with his local bank because it held an out-of-state check\nmade out to Mallen for ten days before honoring it. To vent his anger at both,\nMallen spray painted a twenty-five-pound rock from his front yard with three\ncoats of white paint, and with red paint, spelled out his account number, the\nbank\xe2\x80\x99s name, the payee, his leash law citation number, and his signature. Should\nthe US District Court in Seattle\xe2\x80\x94the payee\xe2\x80\x94attempt to cash the rock, would it be\ngood? Explain. [1]\nRaul Castana purchased a new stereo system from Eddington Electronics\nStore. He wrote a check on his account at Silver Bank in the amount of $1,200 and\ngave it to Electronics\xe2\x80\x99 clerk. David Eddington, the store owner, stamped the back\nof the check with his rubber indorsement stamp, and then wrote, \xe2\x80\x9cPay to the\norder of City Water,\xe2\x80\x9d and he mailed it to City Water to pay the utility bill.\nDesignate the parties to this instrument using the vocabulary discussed in this\nchapter.\nWould Castana\xe2\x80\x99s signed note made out to Eddington Electronics Store be\nnegotiable if it read, \xe2\x80\x9cI promise to pay Eddington\xe2\x80\x99s or order $1,200 on or before\nMay 1, 2012, but only if the stereo I bought from them works to my satisfaction\xe2\x80\x9d?\nExplain. And\xe2\x80\x94disregarding negotiability for a moment\xe2\x80\x94designate the parties to\nthis instrument using the vocabulary discussed in this chapter.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n652\n\n\x0cS EL F -T E ST QU EST IO N S\n1. A negotiable instrument must\na. be signed by the payee\nb. contain a promise to pay, which may be conditional\nc. include a sum certain\nd. be written on paper or electronically\nThe law governing negotiability is found in\na. Article 3 of the UCC\nb. Article 9 of the UCC\nc. the Uniform Negotiability Act\nd. state common law\nA sight draft\na. calls for payment on a certain date\nb. calls for payment when presented\nc. is not negotiable\nd. is the same as a certificate of deposit\nA note reads, \xe2\x80\x9cInterest hereon is 2% above the prime rate as determined\nby First National Bank in New York City.\xe2\x80\x9d Under the UCC,\na. the interest rate provision is not a \xe2\x80\x9csum certain\xe2\x80\x9d so negotiability is\ndestroyed\nb. the note is not negotiable because the holder must look to some\nextrinsic source to determine the interest rate\nc. the note isn\xe2\x80\x99t negotiable because the prime rate can vary before\nthe note comes due\nd. variable interest rates are OK\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n653\n\n\x0cA \xe2\x80\x9cmaker\xe2\x80\x9d in negotiable instrument law does what?\na. writes a check\nb. becomes obligated to pay on a draft\nc. is the primary obligor on a note\nd. buys commercial paper of dubious value for collection\n\nS EL F -T E ST A NSW E R S\n1. c\n2. a\n3. b\n4. d\n5. c\n[1] Joel Schwarz, \xe2\x80\x9cTaking Things for Granite,\xe2\x80\x9d Student Lawyer, December 1981.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n654\n\n\x0cChapter 14\nNegotiation of Commercial Paper\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. The distinction between transfer and negotiation of commercial paper\n2. The liability of a person who transfers paper\n3. The types of indorsements and their effects\n4. Special problems that arise with forged indorsements\nIn the previous chapter, we took up the requirements for paper to be negotiable. Here we take up\nnegotiation.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n655\n\n\x0c14.1 Transfer and Negotiation of Commercial Paper\nL EA R N IN G O B JEC T IV ES\n1. Understand what a transfer of commercial paper is.\n2. Recognize the rights and liabilities of transferees and the liabilities of transferors.\n3. Know how a transfer becomes a negotiation payable to order or to bearer.\n\nDefinitions, Rights, and Liabilities\nTransfer means physical delivery of any instrument\xe2\x80\x94negotiable or not\xe2\x80\x94intending to pass title. Section\n3-203(a) of the Uniform Commercial Code (UCC) provides that \xe2\x80\x9can instrument is transferred when it is\ndelivered by a person other than its issuer for the purpose of giving to the person receiving delivery the\nright to enforce the instrument.\xe2\x80\x9d\n\nNegotiation and Holder\nSection 3-201(a) of the UCC defines negotiation as \xe2\x80\x9ca transfer of possession, whether voluntary or\ninvoluntary, of an instrument to a person who thereby becomes its holder if possession is obtained from a\nperson other than the issuer of the instrument.\xe2\x80\x9d A holder is defined in Section 1-201(2) as \xe2\x80\x9ca person who\nis in possession of an instrument drawn, issued, or indorsed to him or his order or to bearer or in blank\xe2\x80\x9d\n(\xe2\x80\x9cin blank\xe2\x80\x9d means that no indorsement is required for negotiation). The original issuing or making of an\ninstrument is not negotiation, though a holder can be the beneficiary of either a transfer or a negotiation.\nThe Official Comment to 3-201(a) is helpful:\n\nA person can become holder of an instrument when the instrument is issued to that person, or the status\nof holder can arise as the result of an event that occurs after issuance. \xe2\x80\x9cNegotiation\xe2\x80\x9d is the term used in\narticle 3 to describe this post-issuance event. Normally, negotiation occurs as the result of a voluntary\ntransfer of possession of an instrument by a holder to another person who becomes the holder as a result\nof the transfer. Negotiation always requires a change in possession of the instrument because nobody can\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n656\n\n\x0cbe a holder without possessing the instrument, either directly or through an agent. But in some cases the\ntransfer of possession is involuntary and in some cases the person transferring possession is not a\nholder.\xe2\x80\xa6[S]ubsection (a) states that negotiation can occur by an involuntary transfer of possession. For\nexample, if an instrument is payable to bearer and it is stolen by Thief or is found by Finder, Thief or\nFinder becomes the holder of the instrument when possession is obtained. In this case there is an\ninvoluntary transfer of possession that results in negotiation to Thief or Finder.\n\n[1]\n\nIn other words, to qualify as a holder, a person must possess an instrument that runs to her. An\ninstrument \xe2\x80\x9cruns\xe2\x80\x9d to a person if (1) it has been issued to her or (2) it has been transferred to her by\nnegotiation (negotiation is the \xe2\x80\x9cpost-issuance event\xe2\x80\x9d cited in the comment). Commercially speaking, the\nstatus of the immediate person to whom the instrument was issued (the payee) is not very interesting; the\nthing of interest is whether the instrument is passed on by the payee after possession, through\nnegotiation. Yes, the payee of an instrument is a holder, and can be a holder in due course, but the crux of\nnegotiable instruments involves taking an instrument free of defenses that might be claimed by anybody\nagainst paying on the instrument; the payee would know of defenses, usually, so\xe2\x80\x94as the comment puts\nit\xe2\x80\x94\xe2\x80\x9cuse of the holder-in-due-course doctrine by the payee of an instrument is not the normal\nsituation.\xe2\x80\xa6[r]ather, the holder in due course is an immediate or remote transferee of the payee.\xe2\x80\x9d\n\n[2]\n\nLiability of Transferors\nWe discuss liability in Chapter 16 "Liability and Discharge". However, a brief introduction to liability will\nhelp in understanding the types of indorsements discussed in this chapter. There are two types of liability\naffecting transferors: contract liability and warranty liability.\n\nContract Liability\nPersons who sign the instrument\xe2\x80\x94that is, makers, acceptors, drawers, indorsers\xe2\x80\x94have signed a contract\nand are subject to contract liabilities. Drafts (checks) and notes are, after all, contracts. Makers and\nacceptors are primary parties and are unconditionally liable to pay the instrument. Drawers and\nindorsers are secondary parties and are conditionally liable. The conditions creating liability\xe2\x80\x94that is,\npresentment, dishonor, and notice\xe2\x80\x94are discussed in Chapter 16 "Liability and Discharge".\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n657\n\n\x0cWarranty Liability\nThe transferor\xe2\x80\x99s contract liability is limited. It applies only to those who sign and only if certain additional\nconditions are met and, as will be discussed, can even be disclaimed. Consequently, a holder who has not\nbeen paid often must resort to a suit based on one of five warranties. These warranties are implied by law;\nUCC, Section 3-416, details them:\n\n(A) A person who transfers an instrument for consideration warrants all of the following to the transferee\nand, if the transfer is by indorsement, to any subsequent transferee:\n\n(1) The warrantor is a person entitled to enforce the instrument.\n\n(2) All signatures on the instrument are authentic and authorized.\n\n(3) The instrument has not been altered.\n\n(4) The instrument is not subject to a defense or claim in recoupment of any party which can be asserted\nagainst the warrantor.\n\n(5) The warrantor has no knowledge of any insolvency proceeding commenced with respect to the maker\nor acceptor or, in the case of an unaccepted draft, the drawer.\nBreach of one of these warranties must be proven at trial if there is no general contract liability.\n\nLiability of Transferees\nThe transferee takes by assignment; as an assignee, the new owner of the instrument has only those rights\nheld by the assignor. Claims that could be asserted by third parties against the assignor can be asserted\nagainst the assignee. A negotiable instrument can be transferred in this sense without being negotiated. A\npayee, for example, might fail to meet all the requirements of negotiation; in that event, the instrument\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n658\n\n\x0cmight wind up being merely transferred (assigned). When all requirements of negotiability and\nnegotiation have been met, the buyer is a holder and may (if a holder in due course\xe2\x80\x94see Chapter 15\n"Holder in Due Course and Defenses") collect on the instrument without having to prove anything more.\nBut if the instrument was not properly negotiated, the purchaser is at most a transferee and cannot collect\nif defenses are available, even if the paper itself is negotiable.\n\nHow Negotiation Is Accomplished\nNegotiation can occur with either bearer paper or order paper.\n\nNegotiation of Instrument Payable to Bearer\nAn instrument payable to bearer\xe2\x80\x94bearer paper\xe2\x80\x94can be negotiated simply by delivering it to the\ntransferee (see Figure 14.1 "Negotiation of Bearer Paper"; recall that \xe2\x80\x9cLorna Love\xe2\x80\x9d is the proprietor of a\ntennis club introduced in Chapter 13 "Nature and Form of Commercial Paper"): bearer paper runs to\nwhoever is in possession of it, even a thief. Despite this simple rule, the purchaser of the instrument may\nrequire an indorsement on some bearer paper anyway. You may have noticed that sometimes you are\nrequested to indorse your own check when you make it out to cash. That is because the indorsement\nincreases the liability of the indorser if the holder is unable to collect.Chung v. New York Racing\nAssociation (Section 14.4 "Cases") deals with issues involving bearer paper.\n\nFigure 14.1 Negotiation of Bearer Paper\n\nNegotiation of Instrument Payable to Order\nNegotiation is usually voluntary, and the issuer usually directs payment \xe2\x80\x9cto order\xe2\x80\x9d\xe2\x80\x94that is, to someone\xe2\x80\x99s\norder, originally the payee. Order paper is this negotiable instrument that by its term is payable to a\nspecified person or his assignee. If it is to continue its course through the channels of commerce, it must\nbe indorsed\xe2\x80\x94signed, usually on the back\xe2\x80\x94by the payee and passed on to the transferee. Continuing with\nthe example used in Chapter 13 "Nature and Form of Commercial Paper", Rackets, Inc. (the payee)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n659\n\n\x0cnegotiates Lorna Love\xe2\x80\x99s check (Lorna is the issuer or drawer) drawn to the order of Rackets when an agent\nof Rackets \xe2\x80\x9csigns\xe2\x80\x9d the company\xe2\x80\x99s name on the reverse of the check and passes it to the indorsee, such as\nthe bank or someone to whom Rackets owed money. (A company\xe2\x80\x99s signature is usually a rubber stamp for\nmere deposit, but an agent can sign the company name and direct the instrument elsewhere.) The\ntransferee is a holder (see Figure 14.2 "Negotiation of Order Paper"). Had Rackets neglected to indorse\nthe check, the transferee, though in physical possession, would not be a holder. Issues regarding\nindorsement are discussed inSection 14.2 "Indorsements".\n\nFigure 14.2 Negotiation of Order Paper\n\nK E Y TA K EA WAY\nA transfer is the physical delivery of an instrument with the intention to pass title\xe2\x80\x94the\nright to enforce it. A mere transferee stands in the transferor\xe2\x80\x99s shoes and takes the\ninstrument subject to all the claims and defenses against paying it that burdened it when\nthe transferor delivered it. Negotiation is a special type of transfer\xe2\x80\x94voluntary or\ninvoluntary\xe2\x80\x94to a holder. A holder is a person who has an instrument drawn, issued, or\nindorsed to him or his order or to bearer or in blank. If the instrument is order paper,\nnegotiation is accomplished by indorsement and delivery to the next holder; if it is\nbearer paper or blank paper, delivery alone accomplishes negotiation. Transferors incur\ntwo types of liability: those who sign the instrument are contractually liable; those who\nsign or those who do not sign are liable to the transferee in warranty.\n\nE XE R C IS ES\n1. What is a transfer of commercial paper, and what rights and liabilities has the\ntransferee?\n2. What is a negotiation of commercial paper?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n660\n\n\x0c3. What is a holder?\n4. How is bearer paper negotiated?\n5. How is order paper negotiated?\n[1] Uniform Commercial Code, Section 3-201, Official Comment.\n[2] Uniform Commercial Code, Section 3-302, Comment 4.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n661\n\n\x0c14.2 Indorsements\nL EA R N IN G O B JEC T IV ES\n1. Understand the meaning of indorsement and its formal requirements.\n2. Know the effects of various types of indorsements: no indorsement, partial,\nblank, special, restrictive, conditional, qualified.\n\nDefinition and Formal Requirements of Indorsement\nDefinition\nMost commonly, paper is transferred by indorsement. The indorsement is evidence that the indorser\nintended the instrument to move along in the channels of commerce. An indorsement is defined by\nUCC Section 3-204(a) as\n\na signature, other than that of a signer as maker, drawer, or acceptor, that alone or accompanied by other\nwords is made on an instrument for the purpose of (i) negotiating the instrument, (ii) restricting payment\nof the instrument, or (iii) incurring indorser\xe2\x80\x99s liability on the instrument, but regardless of the intent of\nthe signer, a signature and its accompanying words is an indorsement unless the accompanying words,\nterms of the instrument, place of the signature, or other circumstances unambiguously indicated that the\nsignature was made for a purpose other than indorsement.\n\nPlacement of Indorsement\nIndorse (or endorse) literally means \xe2\x80\x9con the back of,\xe2\x80\x9d as fish, say, have dorsal fins\xe2\x80\x94fins on their backs.\nUsually indorsements are on the back of the instrument, but an indorsement could be on a piece of paper\naffixed to the instrument. Such an attachment is called an allonge\xe2\x80\x94it comes along with the instrument\n(UCC, Section 3-204(a)).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n662\n\n\x0cThere are rules about where indorsements are placed. The Expedited Funds Availability Act was enacted\nin 1987 by Congress to standardize holding periods on deposits made to commercial banks and to regulate\ninstitutions\xe2\x80\x99 use of deposit holds\xe2\x80\x94that is, how soon customers can access the money after they have\ndeposited a check in the bank. The Federal Reserve Board subsequently adopted \xe2\x80\x9cRegulation CC, Check\nEndorsement Standards\xe2\x80\x9d to improve funds availability and expedite the return of checks. See Figure 14.3\n"Indorsement Standard".\n\nFigure 14.3 Indorsement Standard\n\nFrom UC Irvine Administrative Policies & Procedures, Business and Financial Affairs, Financial\nServices, Sec. 704-13: Check Endorsement Procedures,\nathttp://www.policies.uci.edu/adm/procs/700/704-13.html.\n\nAs shown in Figure 14.3 "Indorsement Standard", specific implementing guidelines define criteria for the\nplacement, content, and ink color of endorsement areas on the back of checks for the depositary bank\n(bank of first deposit), subsequent indorsers (paying banks), and corporate or payee indorsers.\nIndorsements must be made within 1\xc2\xbd inches of the trailing (left) edge of the back of the check;\nremaining space is for bank indorsements. There is no penalty for violating the standard\xe2\x80\x94it is a guideline.\nThe abbreviation \xe2\x80\x9cMICR\xe2\x80\x9d stands for magnetic ink character recognition. The \xe2\x80\x9cclear band\xe2\x80\x9d is a section of\nthe back of the check that is not supposed to be intruded upon with any magnetic (machine-readable)\nprinting that would interfere with machine reading on the front side (the bank routing numbers).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n663\n\n\x0cSometimes an indorser adds words intended to strengthen the indorsement; for example, \xe2\x80\x9cI hereby assign\nall my right, title, and interest in this note to Carl Carpenter.\xe2\x80\x9d Words of assignment such as these and also\nwords of condition, waiver, guaranty, limitation, or disclaimer of liability do not negate the effect of an\nindorsement.\n\nMisspelled or Incorrect Indorsements\nWhen the instrument is made payable to a person under a misspelled name (or in a name other than his\nown), he may indorse in the wrong name or the right one or both. It is safer to sign in both names, and the\npurchaser of the instrument may demand a signature in both names (UCC, Section 3-204(d)).\n\nVarious Indorsements and Their Effects\nA holder can indorse in a variety of ways; indorsements are not identical and have different effects.\n\nNo Indorsement\nIf the instrument requires a signature, transfer without indorsement is an assignment only. Bearer paper\ndoes not require indorsement, so it can be negotiated simply by delivering it to the transferee, who\nbecomes a holder. The transferor has no contract liability on the instrument, however, because he has not\nsigned it. He does remain liable on the warranties, but only to the person who receives the paper, not to\nsubsequent transferees.\n\nBecause it is common practice for a depository bank (the bank into which a person makes a deposit) to\nreceive unindorsed checks under so-called lockbox agreements from customers who receive a high volume\nof checks, a customer who is a holder can deposit a check or other instrument for credit to his account\nwithout indorsement. Section 4-205(1) of the UCC provides that a \xe2\x80\x9cdepositary bank becomes a holder\xe2\x80\xa6at\nthe time it receives the item for collection if the customer at the time of delivery was a holder, whether or\nnot the customer indorses the item.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n664\n\n\x0cPartial Indorsement\nTo be effective as negotiation, an indorsement must convey the entire instrument. An indorsement that\npurports to convey only a portion of the sum still due amounts to a partial assignment. If Rackets\xe2\x80\x99 agent\nsigns the check \xe2\x80\x9cRackets, Inc.\xe2\x80\x9d together with the words \xe2\x80\x9cPay half to City Water, /s/ Agent\xe2\x80\x9d and delivers\nthe check to City Water, that does not operate as an indorsement, and City Water becomes an assignee,\nnot a holder.\n\nBlank Indorsement\nA blank indorsement consists of the indorser\xe2\x80\x99s signature alone (seeFigure 14.4 "Forms of\nEndorsement", left). A blank indorsement converts the instrument into paper closely akin to cash. Since\nthe indorsement does not specify to whom the instrument is to be paid, it is treated like bearer paper\xe2\x80\x94\nassuming, of course, that the first indorser is the person to whom the instrument was payable originally. A\npaper with blank indorsement may be negotiated by delivery alone, until such time as a holder converts it\ninto a special indorsement (discussed next) by writing over the signature any terms consistent with the\nindorsement. For example, a check indorsed by the payee (signed on the back) may be passed from one\nperson to another and cashed in by any of them.\n\nFigure 14.4 Forms of Endorsement\n\nA blank indorsement creates conditional contract liability in the indorser: he is liable to pay if the paper is\ndishonored. The blank indorser also has warranty liability toward subsequent holders.\n\nSpecial Indorsement\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n665\n\n\x0cA special indorsement, sometimes known as an \xe2\x80\x9cindorsement in full,\xe2\x80\x9d names the transferee-holder.\nThe payee of a check can indorse it over to a third party by writing \xe2\x80\x9cPay to the order of [name of the third\nparty]\xe2\x80\x9d and then signing his name (see Figure 14.4 "Forms of Endorsement", center). Once specially\nindorsed, the check (or other instrument) can be negotiated further only when the special indorsee adds\nhis own signature. A holder may convert a blank indorsement into a special indorsement by writing above\nthe signature of the indorser words of a contractual nature consistent with the character of the\ninstrument.\n\nSo, for example, Lorna Love\xe2\x80\x99s check to Rackets, Inc., indorsed in blank (signed by its agent or stamped\nwith Rackets\xe2\x80\x99 indorsement stamp\xe2\x80\x94its name alone) and handed to City Water, is not very safe: it is bearer\npaper. If the check fell onto the floor, anybody could be a holder and cash it. It can easily be converted into\na check with special indorsement: City Water\xe2\x80\x99s clerk need only add the words \xe2\x80\x9cPay City Water\xe2\x80\x9d above\nRackets\xe2\x80\x99 indorsement. (The magic words of negotiability\xe2\x80\x94\xe2\x80\x9cpay to order of bearer\xe2\x80\x9d\xe2\x80\x94are not required in an\nindorsement.) Before doing so, City Water could have negotiated it simply by giving it to someone (again,\na blank indorsement acts as bearer paper). After converting it to a special indorsement, City Water must\nindorse it in order to transfer it by negotiation to someone else. The liabilities of a special indorser are the\nsame as those of a blank indorser.\n\nThe dichotomy here of indorsement in blank or special indorsement is the indorser\xe2\x80\x99s way of indicating\nhow the instrument can be subsequently negotiated: with or without further indorsing.\n\nRestrictive Indorsement\nA restrictive indorsement attempts to limit payment to a particular person or otherwise prohibit\nfurther transfer or negotiation. We say \xe2\x80\x9cattempts to limit\xe2\x80\x9d because a restrictive indorsement is generally\ninvalid. Section 3-206(a) of the UCC provides that an attempt to limit payment to a particular person or\nprohibit further transfer \xe2\x80\x9cis not effective.\xe2\x80\x9d Nor is \xe2\x80\x9c[a]n indorsement stating a condition to the right of the\nindorsee to receive payment\xe2\x80\x9d; the restriction may be disregarded. However, two legitimate restrictive\nindorsements are valid: collection indorsements and trust indorsements. Wisner Elevator Company, Inc.\nv. Richland State Bank (Section 14.4 "Cases") deals with conditional and restrictive indorsements.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n666\n\n\x0cCollection Indorsement\nIt is very common for people and businesses to mail checks to their bank for deposit to their accounts.\nSometimes mail goes astray or gets stolen. Surely it must be permissible for the customer to safeguard the\ncheck by restricting its use to depositing it in her account. A collection indorsement, such as \xe2\x80\x9cFor\ndeposit\xe2\x80\x9d or \xe2\x80\x9cFor collection,\xe2\x80\x9d is effective. Section 3-206(c) of the UCC provides that anybody other than a\nbank who purchases the instrument with such an indorsement converts the instrument\xe2\x80\x94effectively steals\nit. A depositary bank that takes it must deposit it as directed, or the bank has converted it. A payor bank\nthat is also the depositary bank that takes the instrument for immediate payment over the counter\nconverts it: the check cannot be cashed; it must be deposited (see Figure 14.4 "Forms of Endorsement").\n\nTo illustrate, suppose that Kate Jones indorses her paycheck \xe2\x80\x9cFor deposit only, Kate Jones,\xe2\x80\x9d which is by\nfar the most common type of restrictive indorsement (see Figure 14.4 "Forms of Endorsement", right). A\nthief steals the check, indorses his name below the restrictive indorsement, and deposits the check in Last\nBank, where he has an account, or cashes it. The check moves through the collection process to Second\nBank and then to First Bank, which pays the check. Kate has the right to recover only from Last Bank,\nwhich did not properly honor the indorsement by depositing the payment in her account.\n\nTrust Indorsement\nA second legitimate restrictive indorsement is indorsement in trust, called\na trust indorsement (sometimes agency indorsement). Suppose Paul Payee owes Carlene Creditor a\ndebt. Payee indorses a check drawn to him by a third party, \xe2\x80\x9cPay to Tina Attorney in trust for Carlene\nCreditor.\xe2\x80\x9d Attorney indorses in blank and delivers it to (a) a holder for value, (b) a depository bank for\ncollection, or (c) a payor bank for payment. In each case, these takers can safely pay Attorney so long as\nthey have no notice under Section 3-307 of the UCC of any breach of fiduciary duty that Attorney may be\ncommitting. For example, under Section 3-307(b), these takers have notice of a breach of trust if the check\nwas taken in any transaction known by the taker to be for Attorney\xe2\x80\x99s personal benefit. Subsequent\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n667\n\n\x0ctransferees of the check from the holder or depositary bank are not affected by the restriction unless they\nhave knowledge that Attorney dealt with the check in breach of trust (adapted from UCC, Section 3-206,\nOfficial Comment 4). (Of course Attorney should not indorse in blank; she should indorse \xe2\x80\x9cTina Attorney,\nin trust for Carlene Creditor\xe2\x80\x9d and deposit the check in her trust account.)\nThe dichotomy here between restrictive and unrestrictive indorsements is the indorser\xe2\x80\x99s way of showing\nto what use the instrument may be put.\n\nConditional Indorsement\nAn indorser might want to condition the negotiation of an instrument upon some event, such as \xe2\x80\x9cPay\nCarla Green if she finishes painting my house by July 15.\xe2\x80\x9d Such a conditional indorsement is generally\nineffective: the UCC, Section 3-206(b), says a person paying for value can disregard the condition without\nliability.\n\nQualified Indorsement\nAn indorser can limit his liability by making a qualified indorsement. The usual qualified indorsement\nconsists of the words \xe2\x80\x9cwithout recourse,\xe2\x80\x9d which mean that the indorser has no contract liability to\nsubsequent holders if a maker or drawee defaults. A qualified indorsement does not impair negotiability.\nThe qualification must be in writing by signature on the instrument itself. By disclaiming contract\nliability, the qualified indorser also limits his warranty liabilities, though he does not eliminate them.\nSection 3-415(a) of the UCC narrows the indorser\xe2\x80\x99s warranty that no defense of any party is good against\nthe indorser. In its place, the qualified indorser warrants merely that he has no knowledge of any defense.\n\n\xe2\x80\x9cWithout recourse\xe2\x80\x9d indorsements can have a practical impact on the balance sheet. A company holding a\npromissory note can obtain cash by discounting it\xe2\x80\x94indorsing it over to a bank for maturity value less the\nbank\xe2\x80\x99s discount. As an indorser, however, the company remains liable to pay the amount to subsequent\nholders should the maker default at maturity. The balance sheet must reflect this possibility as a\ncontingent liability. However, if the note is indorsed without recourse, the company need not account for\nany possible default of the maker as a contingent liability.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n668\n\n\x0cThe dichotomy here between qualified and unqualified indorsements is the indorser\xe2\x80\x99s way of indicating\nwhat liability she is willing to incur to subsequent holders\n\nK E Y TA K EA WAY\n\nAn indorsement is, usually, the signature of an instrument\xe2\x80\x99s holder on the back of\nthe instrument, indicating an intention that the instrument should proceed\nthrough the channels of commerce. The Federal Reserve Board has\nrecommendations for how instruments should be indorsed to speed machine\nreading of them. Indorsements are either blank or special; they are either\nrestrictive or nonrestrictive; and they are either qualified or unqualified. These\npairings show the indorser\xe2\x80\x99s intention as to how further negotiation may be\naccomplished, to what uses the instrument may be put, and what liability the\nindorser is willing to assume.\n\nE XE R C IS ES\n1. If an instrument is not indorsed according to Federal Reserve Board standards,\nis it still valid?\n2. Suppose that Indorsee signs an instrument in blank and drops it. Suppose that\nthe instrument is found by Finder and that Finder delivers it to Third Person\nwith the intention to sell it. Is this successful negotiation?\n3. Why would a person make a restrictive indorsement? A qualified\nindorsement?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n669\n\n\x0c14.3 Problems and Issues in Negotiation\nL EA R N IN G O B JEC T IV ES\n1. Recognize under what circumstances a negotiation is subject to rescission.\n2. Know the effect of reacquisition of an instrument.\n3. Understand how instruments made payable to two or more persons are negotiated.\n4. Understand how the UCC treats forged indorsements, imposters, and other\nsignatures in the name of the payee.\n\nCommon Issues Arising in Negotiation of Commercial Paper\nA number of problems commonly arise that affect the negotiation of commercial paper. Here we take up\nthree.\n\nNegotiation Subject to Rescission\nA negotiation\xe2\x80\x94again, transfer of possession to a person who becomes a holder\xe2\x80\x94can be effective even\nwhen it is made by a person without the capacity to sign. Section 3-202(a) of the UCC declares that\nnegotiation is effective even when the indorsement is made by an infant or by a corporation exceeding its\npowers; is obtained by fraud, duress, or mistake; is part of an illegal transaction; or is made in breach of a\nduty.\n\nHowever, unless the instrument was negotiated to a holder in due course, the indorsement can be\nrescinded or subjected to another appropriate legal remedy. The Official Comment to this UCC section is\nhelpful:\n\nSubsection (a) applies even though the lack of capacity or the illegality is of a character which goes to the\nessence of the transaction and makes it entirely void. It is inherent in the character of negotiable\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n670\n\n\x0cinstruments that any person in possession of an instrument which by its terms is payable to that person or\nto bearer is a holder and may be dealt with by anyone as a holder. The principle finds its most extreme\napplication in the well-settled rule that a holder in due course may take the instrument even from a thief\nand be protected against the claim of the rightful owner. The policy of subsection (a) is that any person to\nwhom an instrument is negotiated is a holder until the instrument has been recovered from that person\xe2\x80\x99s\npossession.\n\n[1]\n\nSo suppose a mentally incapacitated person under a guardianship evades her guardian, goes to town, and\nwrites a check for a new car. Normally, contracts made by such persons are void. But the check is\nnegotiable here. If the guardian finds out about the escapade before the check leaves the dealer\xe2\x80\x99s hands,\nthe deal could be rescinded: the check could be retrieved and the car returned.\n\nEffect of Reacquisition\nA prior party who reacquires an instrument may reissue it or negotiate it further. But doing so discharges\nintervening parties as to the reacquirer and to later purchasers who are not holders in due course. Section\n3-207 of the UCC permits the reacquirer to cancel indorsements unnecessary to his title or ownership; in\nso doing, he eliminates the liability of such indorsers even as to holders in due course.\n\nInstruments Payable to Two or More Persons\nA note or draft can be payable to two or more persons. In form, the payees can be listed in the alternative\nor jointly. When a commercial paper says \xe2\x80\x9cPay to the order of Lorna Love or Rackets, Inc.,\xe2\x80\x9d it is stated in\nthe alternative. Either person may negotiate (or discharge or enforce) the paper without the consent of the\nother. On the other hand, if the paper says \xe2\x80\x9cPay to the order of Lorna Love and Rackets, Inc.\xe2\x80\x9d or does not\nclearly state that the payees are to be paid in the alternative, then the instrument is payable to both of\nthem and may be negotiated (or discharged or enforced) only by both of them acting together. The case\npresented in Section 14.4 "Cases", Wisner Elevator Company, Inc. v. Richland State Bank, deals,\nindirectly, with instruments payable to two or more persons.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n671\n\n\x0cForged Indorsements, Imposters, and Fictitious Payees\nThe General Rule on Forged Indorsements\nWhen a check already made out to a payee is stolen, an unscrupulous person may attempt to negotiate it\nby forging the payee\xe2\x80\x99s name as the indorser. Under UCC Section 1-201(43), a forgery is an \xe2\x80\x9cunauthorized\nsignature.\xe2\x80\x9d Section 3-403(a) provides that any unauthorized signature on an instrument is \xe2\x80\x9cineffective\nexcept as the signature of the unauthorized signer.\xe2\x80\x9d The consequence is that, generally, the loss falls on\nthe first party to take the instrument with a forged or unauthorized signature because that person is in the\nbest position to prevent the loss.\n\nLorna Love writes a check to Steve Supplier on her account at First State Bank, but the check goes astray\nand is found by Carl Crooks. Crooks indorses the check \xe2\x80\x9cSteve Supplier\xe2\x80\x9d and presents it for cash to a busy\nteller who fails to request identification. Two days later, Steve Supplier inquires about his check. Love\ncalls First State Bank to stop payment. Too late\xe2\x80\x94the check has been cashed. Who bears the loss\xe2\x80\x94Love,\nSupplier, or the bank? The bank does, and it must recredit Love\xe2\x80\x99s account. The forged indorsement on the\ncheck was ineffective; the bank was not a holder, and the check should not have been allowed into the\nchannels of commerce. This is why banks may retain checks for a while before allowing access to the\nmoney. It is, in part, what the Expedited Funds Availability Act (mentioned in Section 14.2\n"Indorsements", \xe2\x80\x9cIndorsements\xe2\x80\x9d) addresses\xe2\x80\x94giving banks time to assess the validity of checks.\n\nExceptions: Imposter, Fictitious Payee, and Dishonest Employee Rules\nThe loss for a forged indorsement usually falls on the first party to take the instrument with a forged\nsignature. However, there are three important exceptions to this general rule: the imposter rule, the\nfictitious payee rule, and the dishonest employee rule.\n\nThe Imposter Rule\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n672\n\n\x0cIf one person poses as the named payee or as an agent of the named payee, inducing the maker or drawer\nto issue an instrument in the name of the payee to the imposter (or his confederate), the imposter\xe2\x80\x99s\nindorsement of the payee\xe2\x80\x99s name is effective. The paper can be negotiated according to\nthe imposter rule.\nIf the named payee is a real person or firm, the negotiation of the instrument by the imposter is good and\nhas no effect on whatever obligation the drawer or maker has to the named payee. Lorna Love owes Steve\nSupplier $2,000. Knowing of the debt, Richard Wright writes to Love, pretending to be Steve Supplier,\nrequesting her to send a check to Wright\xe2\x80\x99s address in Supplier\xe2\x80\x99s name. When the check arrives, Wright\nindorses it by signing \xe2\x80\x9cPay to the order of Richard Wright, (signed) Steve Supplier,\xe2\x80\x9d and then indorses it\nin his own name and cashes it. Love remains liable to Steve Supplier for the money that she owes him, and\nLove is out the $2,000 unless she can find Wright.\n\nThe difference between this case and the one involving the forger Carl Crooks is that in the second case\nthe imposter (Wright) \xe2\x80\x9cinduced the maker or drawer [Lorna Love] to issue the instrument\xe2\x80\xa6by\nimpersonating the payee of the instrument [Steve Supplier]\xe2\x80\x9d (UCC, Section 3-404(a)), whereas in the first\ncase the thief did not induce Love to issue the check to him\xe2\x80\x94he simply found it. And the rationale for\nmaking Lorna Love bear the loss is that she failed to detect the scam: she intended the imposter, Wright,\nto receive the instrument. Section 3-404(c) provides that the indorsement of the imposter (Wright, posing\nas Steve Supplier) is effective. The same rule applies if the imposter poses as an agent: if the check is\npayable to Supplier, Inc., a company whose president is Steve Supplier, and an impostor impersonates\nSteve Supplier, the check could be negotiated if the imposter indorses it as Supplier, Inc.\xe2\x80\x99s, agent \xe2\x80\x9cSteve\nSupplier.\xe2\x80\x9d\n\n[2]\n\nSimilarly, suppose Love is approached by a young man who says to her, \xe2\x80\x9cMy company sells tennis balls,\nand we\xe2\x80\x99re offering a special deal this month: a can of three high-quality balls for $2 each. We\xe2\x80\x99ll send your\norder to you by UPS.\xe2\x80\x9d He hands her a sample ball: it is substantial, and the price is good. Love has heard\nof the company the man says he represents; she makes out a check for $100 to \xe2\x80\x9cSprocket Athletic Supply.\xe2\x80\x9d\nThe young man does not represent the company at all, but he cashes the check by forging the indorsement\nand the bank pays. Love takes the loss: surely she is more to blame than the bank.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n673\n\n\x0cThe Fictitious Payee Rule\nSuppose Lorna Love has a bookkeeper, Abby Accountant. Abby presents several checks for Love to sign,\none made out to Carlos Aquino. Perhaps there really is no such person, or perhaps he is somebody whom\nLove deals with regularly, but Accountant intends him to have no interest here. No matter: Love signs the\ncheck in the amount of $2,000. Accountant takes the check and indorses it: \xe2\x80\x9cCarlos Aquino, pay to the\norder of Abby Accountant.\xe2\x80\x9d Then she signs her name as the next indorser and cashes the check at Love\xe2\x80\x99s\nbank. The check is good, even though it was never intended by Accountant that \xe2\x80\x9cCarlos Aquino\xe2\x80\x9d\xe2\x80\x94\nthe fictitious payee\xe2\x80\x94have any interest in the instrument. The theory here is to \xe2\x80\x9cplace the loss on the\ndrawer of the check rather than on the drawee or the Depositary Bank that took the check for\ncollection.\xe2\x80\xa6The drawer is in the best position to avoid the fraud and thus should take the loss.\xe2\x80\x9d\n\n[3]\n\nThis is\n\nalso known as \xe2\x80\x9cthe padded-payroll rule.\xe2\x80\x9d\n\nIn the imposter cases, Love drew checks made out to real names but gave them to the wrong person (the\nimposter); in the fictitious payeecases she wrote checks to a nonexistent person (or a real person who was\nnot intended to have any interest at all).\n\nThe Dishonest Employee Rule\nThe UCC takes head-on the recurring problem of a dishonest employee. It says that if an employer\n\xe2\x80\x9centrust[s] an employee with responsibility with respect to the instrument and the employee or a person\nacting in concert with the employee makes a fraudulent indorsement of the instrument, the indorsement\nis effective.\xe2\x80\x9d\n\n[4]\n\nFor example (adapted from UCC 3-405, Official Comment 3; the Comment does not use\n\nthe names of these characters, of course), the duties of Abby Accountant, a bookkeeper, include posting\nthe amounts of checks payable to Lorna Love to the accounts of the drawers of the checks. Accountant\nsteals a check payable to Love, which was entrusted to Accountant, and forges Love\xe2\x80\x99s indorsement. The\ncheck is deposited by Accountant to an account in the depositary bank that Accountant opened in the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n674\n\n\x0csame name as Lorna Love, and the check is honored by the drawee bank. The indorsment is effective as\nLove\xe2\x80\x99s indorsement because Accountant\xe2\x80\x99s duties include processing checks for bookkeeping purposes.\nThus Accountant is entrusted with \xe2\x80\x9cresponsibility\xe2\x80\x9d with respect to the check. Neither the depositary bank\nnor the drawee bank is liable to Love for conversion of the check. The same result would follow if\nAccountant deposited the check in the account in the depositary bank without indorsement (UCC, Section\n4-205(a)). Under Section 4-205(c), deposit in a depositary bank in an account in a name substantially\nsimilar to that of Lorna Love is the equivalent of an indorsement in the name of Lorna Love. If, say, the\njanitor had stolen the checks, the result would be different, as the janitor is not entrusted with\nresponsibility regarding the instrument.\n\nNegligence\nNot surprisingly, though, if a person fails to exercise ordinary care and thereby substantially contributes\nto the success of a forgery, that person cannot assert \xe2\x80\x9cthe alteration or the forgery against a person that, in\ngood faith, pays the instrument or takes it for value.\xe2\x80\x9d\n\n[5]\n\nIf the issuer is also negligent, the loss is allocated\n\nbetween them based on comparative negligence theories. Perhaps the bank teller in the example about the\ntennis-ball scam should have inquired whether the young man had any authority to cash the check made\nout to Sprocket Athletic Supply. If so, the bank could be partly liable. Or suppose Lorna Love regularly\nuses a rubber signature stamp for her tennis club business but one day carelessly leaves it unprotected. As\na result, the stamp and some checks are stolen; Love bears any loss for being negligent. Similarly liable is\na person who has had previous notice that his signature has been forged and has taken no steps to prevent\nreoccurrences, as is a person who negligently mails a check to the wrong person, one who has the same\nname as the payee. The UCC provides that the negligence of two or more parties might be compared in\norder to determine whether each party bears a percentage of the loss, as illustrated in Victory Clothing\nCo., Inc. v. Wachovia Bank, N.A.(Section 14.4 "Cases").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n675\n\n\x0cK E Y TA K EA WAY\nA negotiation is effective even if the transaction involving it is void or voidable, but the\ntransferor\xe2\x80\x94liable on the instrument\xe2\x80\x94can regain its possession and rescind the deal\n(except as to holders in due course or a person paying in good faith without notice).\nInstruments may be made payable to two or more parties in the alternative or jointly\nand must be indorsed accordingly. Generally, a forged indorsement is ineffective, but\nexceptions hold for cases involving imposters, fictitious payees, and certain employee\ndishonesty. If a person\xe2\x80\x99s own negligence contributes to the forgery, that person must\nbear as much of the loss as is attributable to his or her negligence.\n\nE XE R C IS ES\n1. A makes a check out to B for $200 for property both parties know is stolen. Is the\ncheck good?\n2. What is the difference between (a) the imposter rule, (b) the fictitious payee rule,\nand (c) the dishonest employee rule?\n3. How does comparative negligence work as it relates to forged indorsements?\n[1] Uniform Commercial Code, Section 3-404, Official Comment 1.\n[2] Uniform Commercial Code, Section 3-404, Official Comment 1.\n[3] Uniform Commercial Code, Section 3-404, Comment 3.\n[4] Uniform Commercial Code, Section 3-405(B).\n[5] Uniform Commercial Code, Section 4-406(a).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n676\n\n\x0c14.4 Cases\nBearer Paper\n(Note: this is a trial court\xe2\x80\x99s opinion.)\n\nChung v. New York Racing Ass\xe2\x80\x99n\n\n714 N.Y.S.2d 429 (N.Y. Dist. Ct. 2000)\n\nGartner, J.\nA published news article recently reported that an investigation into possible money laundering being\nconducted through the racetracks operated by the defendant New York Racing Association was prompted\nby a small-time money laundering case in which a Queens bank robber used stolen money to purchase\nbetting vouchers and then exchanged the vouchers for clean cash. [Citation] The instant case does not\ninvolve any such question of wrongdoing, but does raise a novel legal issue regarding the negotiability of\nthose same vouchers when their possession is obtained by a thief or finder. The defendant concedes that\n\xe2\x80\x9cthere are no cases on point.\xe2\x80\x9d\n\nThe defendant is a private stock corporation incorporated and organized in New York as a non-profit\nracing association pursuant to [New York law]. The defendant owns and operates New York\xe2\x80\x99s largest\nthoroughbred racetracks\xe2\x80\x94Belmont Park Racetrack, Aqueduct Racetrack, and Saratoga Racetrack\xe2\x80\x94where\nit stages thoroughbred horse races and conducts pari-mutuel wagering on them pursuant to a franchise\ngranted to the defendant by the State of New York.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n677\n\n\x0cThe plaintiff was a Belmont Park Racetrack horse player. He attended the track and purchased from the\ndefendant a voucher for use in SAMS machines. As explained in [Citation]:\n\nIn addition to accepting bets placed at parimutuel facility windows staffed by facility employees, [some]\nfacilities use SAMS. SAMS are automated machines which permit a bettor to enter his bet by inserting\nmoney, vouchers or credit cards into the machine, thereby enabling him to select the number or\ncombination he wishes to purchase. A ticket is issued showing those numbers.\n\n[1]\n\nWhen a voucher is utilized for the purpose of placing a bet at a SAMS machine, the SAMS machine, after\ndeducting the amount bet by the horse player during the particular transaction, provides the horse player\nwith, in addition to his betting ticket(s), a new voucher showing the remaining balance left on the\nvoucher.\n\nIn the instant case, the unfortunate horse player departed the SAMS machine with his betting tickets,\nbut without his new voucher\xe2\x80\x94showing thousands of dollars in remaining value\xe2\x80\x94which he inadvertently\nleft sitting in the SAMS machine. Within several minutes he realized his mistake and hurried back to the\nSAMS machine, only to find the voucher gone. He immediately notified a security guard. The defendant\xe2\x80\x99s\npersonnel thereafter quickly confirmed the plaintiff as the original purchaser of the lost voucher. The\ndefendant placed a computerized \xe2\x80\x9cstop\xe2\x80\x9d on the voucher. However, whoever had happened upon the\nvoucher in the SAMS machine and taken it had acted even more quickly: the voucher had been brought to\na nearby track window and \xe2\x80\x9ccashed out\xe2\x80\x9d within a minute or so of the plaintiff having mistakenly left it in\nthe SAMS machine.\n\nThe plaintiff now sues the defendant, contending that the defendant should be liable for having failed to\n\xe2\x80\x9cprovide any minimal protection to its customers\xe2\x80\x9d in checking the identity and ownership of vouchers\nprior to permitting their \xe2\x80\x9ccash out.\xe2\x80\x9d The defendant, in response, contends that the voucher consists of\n\xe2\x80\x9cbearer paper,\xe2\x80\x9d negotiable by anyone having possession, and that it is under no obligation to purchasers\nof vouchers to provide any such identity or ownership checks.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n678\n\n\x0cAs opposed to instruments such as ordinary checks, which are typically made payable to the order of a\nspecific person and are therefore known as \xe2\x80\x9corder paper,\xe2\x80\x9d bearer paper is payable to the \xe2\x80\x9cbearer,\xe2\x80\x9d i.e.,\nwhoever walks in carrying (or \xe2\x80\x9cbearing\xe2\x80\x9d) the instrument. Pursuant to [New York\xe2\x80\x99s UCC] \xe2\x80\x9c[a]n instrument\nis payable to bearer when by its terms it is payable to\xe2\x80\xa6(c) \xe2\x80\x98cash\xe2\x80\x99 or the order of \xe2\x80\x98cash\xe2\x80\x99, or any other\nindication which does not purport to designate a specific payee.\xe2\x80\x9d\n\nEach New York Racing Association voucher is labeled \xe2\x80\x9cCash Voucher.\xe2\x80\x9d Each voucher contains the legend\n\xe2\x80\x9cBet Against the Value or Exchange for Cash.\xe2\x80\x9d Each voucher is also encoded with certain computer\nsymbols which are readable by SAMS machines. The vouchers do by their terms constitute \xe2\x80\x9cbearer paper.\xe2\x80\x9d\n\nThere is no doubt that under the [1990 Revision] Model Uniform Commercial Code the defendant would\nbe a \xe2\x80\x9cholder in due course\xe2\x80\x9d of the voucher, deemed to have taken it free from all defenses that could be\nraised by the plaintiff. As observed in 2 White & Summers, Uniform Commercial Code pp. 225\xe2\x80\x93226, 152\xe2\x80\x93\n153 (4th ed.1995):\n\nConsider theft of bearer instruments\xe2\x80\xa6[T]he thief can make his or her transferee a holder simply by\ntransfer to one who gives value in good faith. If the thief\xe2\x80\x99s transferee cashes the check and so gives value in\ngood faith and without notice of any defense, that transferee will be a holder in due course under 3-302,\nfree of all claims to the instrument on the part\xe2\x80\xa6of any person and free of all personal defenses of any\nprior party. Therefore, the holder in due course will not be liable in conversion to the true owner.\xe2\x80\xa6Of\ncourse, the owner of the check will have a good cause of action against the thief, but no other cause of\naction.\xe2\x80\xa6\n\nIf an instrument is payable to bearer\xe2\x80\xa6the possessor of the instrument will be a holder and, if he meets the\nother tests, a holder in due course. This is so even though the instrument may have passed through the\nhands of a thief; the holder in due course is one of the few purchasers in Anglo-Saxon jurisprudence who\nmay derive a good title from a chain of title that includes a thief in its links.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n679\n\n\x0cHowever, the Model Uniform Commercial Code in its present form is not in effect in New York.\n\n[2]\n\nIn 1990,\n\nthe National Conference of Commissioners on Uniform State Laws and the American Law Institute\napproved a revised Article 3. This revised Article 3 has never been enacted in New York. Comment 1 to \xc2\xa7\n3-201 of the [1990] Uniform Commercial Code, commenting on the difference between it and its\npredecessor (which is still in effect in New York), states:\n\nA person can become holder of an instrument\xe2\x80\xa6as the result of an event that occurs after issuance.\n\xe2\x80\x9cNegotiation\xe2\x80\x9d is the term used in Article 3 to describe this post-issuance event.\xe2\x80\xa6In defining \xe2\x80\x9cnegotiation\xe2\x80\x9d\nformer Section 3-202(1) used the word \xe2\x80\x9ctransfer,\xe2\x80\x9d an undefined term, and \xe2\x80\x9cdelivery,\xe2\x80\x9d defined in Section 1201(14) to mean voluntary change of possession. Instead, subsections (a) and (b) [now] use the term\n\xe2\x80\x9ctransfer of possession,\xe2\x80\x9d and subsection (a) states that negotiation can occur by an involuntary transfer of\npossession. For example, if an instrument is payable to bearer and it is stolen by Thief or is found by\nFinder, Thief or Finder becomes the holder of the instrument when possession is obtained. In this case\nthere is an involuntary transfer of possession that results in negotiation to Thief or Finder.\n\nThus, it would initially appear that under the prior Model Uniform Commercial Code, still in effect in New\nYork, a thief or finder of bearer paper, as the recipient of an involuntary transfer, could not become a\n\xe2\x80\x9cholder,\xe2\x80\x9d and thus could not pass holder-in-due-course status, or good title, to someone in the position of\nthe defendant.\n\nThis conclusion, however, is not without doubt. For instance, in 2 Anderson, Uniform Commercial Code \xc2\xa7\n3-202:35 (2nd ed.1971), it was observed that:\n\nThe Code states that bearer paper is negotiated by \xe2\x80\x9cdelivery.\xe2\x80\x9d This is likely to mislead for one is not\ninclined to think of the acquisition of paper by a finder or a thief as a \xe2\x80\x9cvoluntary transfer of possession.\xe2\x80\x9d\n\nBy stating that the Code\xe2\x80\x99s terminology was \xe2\x80\x9cmisleading,\xe2\x80\x9d the treatise appears to imply that despite the\nliteral import of the words, the contrary was true\xe2\x80\x94negotiation could be accomplished by involuntary\ntransfer, i.e., loss or theft.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n680\n\n\x0cIn [Citation], the Appellate Division determined that the Tropicana Casino in New Jersey became a holder\nin due course of signed cashier\xe2\x80\x99s checks with blank payee designations which a thief had stolen from the\ndefendant and negotiated to the casino for value after filling in the payee designation with his brother-inlaw\xe2\x80\x99s name. The Appellate Division, assuming without discussion that the thief was a \xe2\x80\x9cholder\xe2\x80\x9d of the\nstolen instruments and therefore able to transfer good title, held the defendant obligated to make\npayment on the stolen checks. Accord[Citation] (check cashing service which unknowingly took for value\nfrom an intervening thief the plaintiff\xe2\x80\x99s check, which the plaintiff had endorsed in blank and thus\nconverted to a bearer instrument, was a holder in due course of the check, having received good title from\nthe thief).\n\nPresumably, these results have occurred because the courts in New York have implicitly interpreted the\nundefined term \xe2\x80\x9ctransfer\xe2\x80\x9d as utilized in [the pre-1990] U.C.C. \xc2\xa7 3-202(1) as including the involuntary\ntransfer of possession, so that as a practical matter the old Code (as still in effect in New York) has the\nsame meaning as the new Model Uniform Commercial Code, which represents a clarification rather than a\nchange in the law.\n\nThis result makes sense. A contrary result would require extensive verification procedures to be\nundertaken by all transferees of bearer paper. The problem with imposing an identity or ownership check\nrequirement on the negotiation of bearer paper is that such a requirement would impede the free\nnegotiability which is the essence of bearer paper. As held in [Citation (1970)],\n\n[Where] the instrument entrusted to a dishonest messenger or agent was freely negotiable bearer\npaper\xe2\x80\xa6the drawee bank [cannot] be held liable for making payment to one presenting a negotiable\ninstrument in bearer form who may properly be presumed to be a holder [citations omitted].\n\n\xe2\x80\xa6Moreover, the plaintiff in the instant case knew that the voucher could be \xe2\x80\x9cExchange[d] for cash.\xe2\x80\x9d The\nplaintiff conceded at trial that (1) when he himself utilized the voucher prior to its loss, no identity or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n681\n\n\x0cownership check was ever made; and (2) he nevertheless continued to use it. The plaintiff could therefore\nnot contend that he had any expectation that the defendant had in place any safeguards against the\nvoucher\xe2\x80\x99s unencumbered use, or that he had taken any actions in reliance on the same.\n\nThis Court is compelled to render judgment denying the plaintiff\xe2\x80\x99s claim, and in favor of the defendant.\n\nC A SE QU ES TIO NS\n1. Was the instrument in question a note or a draft?\n2. How did the court determine it was bearer paper?\n3. What would the racetrack have to have done if it wanted the machine to dispense\norder paper?\n4. What confusion arose from the UCC\xe2\x80\x99s pre-1990 use of the words \xe2\x80\x9ctransfer\xe2\x80\x9d and\n\xe2\x80\x9cdelivery,\xe2\x80\x9d which was clarified by the revised Article 3\xe2\x80\x99s use of the phrase \xe2\x80\x9ctransfer\nof possession\xe2\x80\x9d? Does this offer any insight into why the change was made?\n5. How had\xe2\x80\x94have\xe2\x80\x94the New York courts decided the question as to whether a thief\ncould be a holder when the instrument was acquired from its previous owner\ninvoluntarily?\n\nForged Drawer\xe2\x80\x99s Signature, Forged Indorsements, Fictitious Payee,\nand Comparative Negligence\nVictory Clothing Co., Inc. v. Wachovia Bank, N.A.\n\n2006 WL 773020 (Penn. [Trial Court] 2006)\n\nAbramson, J.\n\nBackground\nThis is a subrogation action brought by the insurance carrier for plaintiff Victory Clothing, Inc.\n(\xe2\x80\x9cVictory\xe2\x80\x9d), to recover funds paid to Victory under an insurance policy. This matter arises out of thefts\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n682\n\n\x0cfrom Victory\xe2\x80\x99s commercial checking account by its office manager and bookkeeper, Jeanette Lunny\n(\xe2\x80\x9cLunny\xe2\x80\x9d). Lunny was employed by Victory for approximately twenty-four (24) years until she resigned in\nMay 2003. From August 2001 through May 2003, Lunny deposited approximately two hundred (200)\nchecks drawn on Victory\xe2\x80\x99s corporate account totaling $188,273.00 into her personal checking account at\ndefendant Wachovia Bank (\xe2\x80\x9cWachovia\xe2\x80\x9d). Lunny\xe2\x80\x99s scheme called for engaging in \xe2\x80\x9cdouble forgeries\xe2\x80\x9d\n(discussed infra). Lunny would prepare the checks in the company\xe2\x80\x99s computer system, and make the\nchecks payable to known vendors of Victory (e.g., Adidas, Sean John), to whom no money was actually\nowed. The checks were for dollar amounts that were consistent with the legitimate checks to those\nvendors. She would then forge the signature of Victory\xe2\x80\x99s owner, Mark Rosenfeld (\xe2\x80\x9cRosenfeld\xe2\x80\x9d), on the\nfront of the check, and then forge the indorsement of the unintended payee (Victory\xe2\x80\x99s various vendors) on\nthe reverse side of the check. The unauthorized checks were drawn on Victory\xe2\x80\x99s bank account at Hudson\nBank (the \xe2\x80\x9cdrawee bank\xe2\x80\x9d or \xe2\x80\x9cpayor bank\xe2\x80\x9d). After forging the indorsement of the payee, Lunny either\nindorsed the check with her name followed by her account number, or referenced her account number\nfollowing the forged indorsement. She then deposited the funds into her personal bank account at\nWachovia (the \xe2\x80\x9cdepositary bank\xe2\x80\x9d or \xe2\x80\x9ccollecting bank\xe2\x80\x9d).\n\nAt the time of the fraud by Lunny, Wachovia\xe2\x80\x99s policies and regulations regarding the acceptance of checks\nfor deposit provided that \xe2\x80\x9cchecks payable to a non-personal payee can be deposited ONLY into a nonpersonal account with the same name.\xe2\x80\x9d [Emphasis in original]\n\nRosenfeld reviewed the bank statements from Hudson Bank on a monthly basis. However, among other\nobservable irregularities, he failed to detect that Lunny had forged his signature on approximately two\nhundred (200) checks. Nor did he have a procedure to match checks to invoices.\n\nIn its Complaint, Victory asserted a claim against Wachovia pursuant to the Pennsylvania Commercial\nCode, [3-405]\xe2\x80\xa6[it] states, in relevant part:\n\nEmployer\xe2\x80\x99s responsibility for fraudulent indorsement by employee\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n683\n\n\x0c(b) RIGHTS AND LIABILITIES.-For the purpose of determining the rights and liabilities of a person who,\nin good faith, pays an instrument or takes it for value or for collection, if an employer entrusted an\nemployee with responsibility with respect to the instrument and the employee or a person acting in\nconcert with the employee makes a fraudulent indorsement of the instrument, the indorsement is\neffective as the indorsement of the person to whom the instrument is payable if it is made in the name of\nthat person. If the person paying the instrument or taking it for value or for collection fails to exercise\nordinary care in paying or taking the instrument and that failure substantially contributes to loss resulting\nfrom the fraud, the person bearing the loss may recover from the person failing to exercise ordinary care\nto the extent the failure to exercise ordinary care contributed to the loss.\n\nIn essence, Victory contends that Wachovia\xe2\x80\x99s actions in accepting the checks payable to various\nbusinesses for deposit into Lunny\xe2\x80\x99s personal account were commercially unreasonable, contrary to\nWachovia\xe2\x80\x99s own internal rules and regulations, and exhibited a want of ordinary care.\n\nDiscussion\nI. Double Forgeries\nAs stated supra, this case involves a double forgery situation. This matter presents a question of first\nimpression in the Pennsylvania state courts, namely how should the loss be allocated in double forgery\nsituations. A double forgery occurs when the negotiable instrument contains both a forged maker\xe2\x80\x99s [bank\ncustomer\xe2\x80\x99s] signature and a forged indorsement. The Uniform Commercial Code (\xe2\x80\x9cUCC\xe2\x80\x9d or \xe2\x80\x9cCode\xe2\x80\x9d)\naddresses the allocation of liability in cases where either the maker\xe2\x80\x99s signature is forged or where the\nindorsement of the payee or holder is forged. [Citation] (\xe2\x80\x9cthe Code accords separate treatment to forged\ndrawer signatures\xe2\x80\xa6and forged indorsements\xe2\x80\x9d). However, the drafters of the UCC failed to specifically\naddress the allocation of liability in double forgery situations.\xe2\x80\xa6Consequently, the courts have been left to\ndetermine how liability should be allocated in a double forgery case.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n684\n\n\x0cII. The Effect of the UCC Revisions\nIn 1990, new revisions to Articles 3 and 4 of the UCC were implemented (the \xe2\x80\x9crevisions\xe2\x80\x9d).\xe2\x80\xa6The new\nrevisions made a major change in the area of double forgeries. Before the revisions, the case law was\nuniform in treating a double forgery case as a forged drawer\xe2\x80\x99s signature case [only], with the loss falling\n[only] on the drawee bank. The revisions, however, changed this rule by shifting to a comparative fault\napproach. Under the revised version of the UCC, the loss in double forgery cases is allocated between the\ndepositary and drawee banks based on the extent that each contributed to the loss.\xe2\x80\xa6\n\nSpecifically, revised \xc2\xa7 3-405 of the UCC, entitled \xe2\x80\x9cEmployer\xe2\x80\x99s Responsibility for Fraudulent Indorsement\nby Employee,\xe2\x80\x9d introduced the concept of comparative fault as between the employer of the dishonest\nemployee/embezzler and the bank(s). This is the section under which Victory sued Wachovia. Section 3405(b) states, in relevant part:\n\nIf the person paying the instrument or taking it for value or for collection fails to exercise ordinary care in\npaying or taking the instrument and that failure substantially contributes to loss resulting from the fraud,\nthe person bearing the loss may recover from the person failing to exercise ordinary care to the extent the\nfailure to exercise ordinary care contributed to the loss.\n\nWachovia argues that this section is applicable only in cases of forged indorsements, and not in double\nforgery situations. However, at least one court has found that the new revisions have made section 3-405\napply to double forgery situations. \xe2\x80\x9cNothing in the [Revised UCC] statutory language indicates that, where\nthe signature of the drawer is forged\xe2\x80\xa6the drawer is otherwise precluded from seeking recovery from a\ndepositary bank under these sections\xe2\x80\x9d [Citation]\xe2\x80\xa6The Court finds the reasoning persuasive and holds\nthat\xe2\x80\xa6Victory can maintain its cause of action against Wachovia.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n685\n\n\x0cIII. The Fictitious Payee Rule\nLunny made the fraudulent checks payable to actual vendors of Victory with the intention that the\nvendors not get paid. Wachovia therefore argues that Victory\xe2\x80\x99s action against it should be barred by the\nfictitious payee rule under UCC 3-404 [which] states, in relevant part:\n\n(b) Fictitious Payee. If a person\xe2\x80\xa6does not intend the person identified as payee to have any interest in the\ninstrument or the person identified as payee of an instrument is a fictitious person, the following rules\napply until the instrument is negotiated by special indorsement:\n\n(1) Any person in possession of the instrument is its holder.\n\n2) An indorsement by any person in the name of the payee stated in the instrument is effective as the\nindorsement of the payee in favor of a person who, in good faith, pays the instrument or takes it for value\nor for collection.\xe2\x80\xa6\n\nThe theory under the rule is that since the indorsement is \xe2\x80\x9ceffective,\xe2\x80\x9d the drawee bank was justified in\ndebiting the company\xe2\x80\x99s account. Therefore, [Wachovia argues] the loss should fall on the company whose\nemployee committed the fraud.\n\n\xe2\x80\xa6[However] under revised UCC \xc2\xa7\xc2\xa7 3-404 and 3-405, the fictitious payee defense triggers principles of\ncomparative fault, so a depositary bank\xe2\x80\x99s own negligence may be considered by the trier of\nfact.\xe2\x80\xa6Therefore, based on the foregoing reasons, the fictitious payee defense does not help Wachovia in\nthis case.\n\nIV. Allocation of Liability\nAs stated supra, comparative negligence applies in this case because of the revisions in the Code. In\ndetermining the liability of the parties, the Court has considered, inter alia [among other things], the\nfollowing factors:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n686\n\n\x0c\xe2\x80\xa2\n\nAt the time of the fraud by Lunny, Wachovia\xe2\x80\x99s policies and regulations regarding the acceptance\nof checks for deposit provided that \xe2\x80\x9cchecks payable to a non-personal payee can be deposited\nONLY into a non-personal account with the same name.\xe2\x80\x9d [Emphasis in original]\n\n\xe2\x80\xa2\n\nApproximately two hundred (200) checks drawn on Victory\xe2\x80\x99s corporate account were deposited\ninto Lunny\xe2\x80\x99s personal account at Wachovia.\n\n\xe2\x80\xa2\n\nThe first twenty-three (23) fraudulent checks were made payable to entities that were not readily\ndistinguishable as businesses, such as \xe2\x80\x9cSean John.\xe2\x80\x9d The check dated December 17, 2001 was the\nfirst fraudulent check made payable to a payee that was clearly a business, specifically \xe2\x80\x9cBeverly\nHills Shoes, Inc.\xe2\x80\x9d\n\n\xe2\x80\xa2\n\nIn 2001, Victory had approximately seventeen (17) employees, including Lunny.\n\n\xe2\x80\xa2\n\nLunny had been a bookkeeper for Victory from approximately 1982 until she resigned in May\n2003. Rosenfeld never had any problems with Lunny\xe2\x80\x99s bookkeeping before she resigned.\n\n\xe2\x80\xa2\n\nLunny exercised primary control over Victory\xe2\x80\x99s bank accounts.\n\n\xe2\x80\xa2\n\nBetween 2001 and 2003, the checks that were generated to make payments to Victory\xe2\x80\x99s vendors\nwere all computerized checks generated by Lunny. No other Victory employee, other than Lunny,\nknew how to generate the computerized checks, including Rosenfeld.\n\n\xe2\x80\xa2\n\nThe fraudulent checks were made payable to known vendors of Victory in amounts that were\nconsistent with previous legitimate checks to those vendors.\n\n\xe2\x80\xa2\n\nAfter forging the indorsement of the payee, Lunny either indorsed the check with her name\nfollowed by her account number, or referenced her account number following the forged\nindorsement.\n\n\xe2\x80\xa2\n\nAbout ten (10) out of approximately three hundred (300) checks each month were forged by\nLunny and deposited into her personal account.\n\n\xe2\x80\xa2\n\nRosenfeld reviewed his bank statements from Hudson Bank on a monthly basis.\n\n\xe2\x80\xa2\n\nRosenfeld received copies of Victory\xe2\x80\x99s cancelled checks from Hudson Bank on a monthly basis.\nHowever, the copies of the cancelled checks were not in their normal size; instead, they were\nsmaller, with six checks (front and back side) on each page.\n\n\xe2\x80\xa2\n\nThe forged indorsements were written out in longhand, i.e., Lunny\xe2\x80\x99s own handwriting, rather\nthan a corporate stamped signature.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n687\n\n\x0c\xe2\x80\xa2\n\nVictory did not match its invoices for each check at the end of each month.\n\n\xe2\x80\xa2\n\nAn outside accounting firm performed quarterly reviews of Victory\xe2\x80\x99s bookkeeping records, and\nthen met with Rosenfeld. This review was not designed to pick up fraud or misappropriation.\n\nBased on the foregoing, the Court finds that Victory and Wachovia are comparatively negligent.\n\nWith regard to Wachovia\xe2\x80\x99s negligence, it is clear that Wachovia was negligent in violating its own rules in\nrepeatedly depositing corporate checks into Lunny\xe2\x80\x99s personal account at Wachovia. Standard commercial\nbank procedures dictate that a check made payable to a business be accepted only into a business\nchecking account with the same title as the business. Had a single teller at Wachovia followed Wachovia\xe2\x80\x99s\nrules, the fraud would have been detected as early as December 17, 2001, when the first fraudulently\ncreated non-personal payee check was presented for deposit into Lunny\xe2\x80\x99s personal checking account.\nInstead, Wachovia permitted another one hundred and seventy-six (176) checks to be deposited into\nLunny\xe2\x80\x99s account after December 17, 2001. The Court finds that Wachovia failed to exercise ordinary care,\nand that failure substantially contributed to Victory\xe2\x80\x99s loss resulting from the fraud. Therefore, the Court\nconcludes that Wachovia is seventy (70) percent liable for Victory\xe2\x80\x99s loss.\n\nVictory, on the other hand, was also negligent in its supervision of Lunny, and for not discovering the\nfraud for almost a two-year period. Rosenfeld received copies of the cancelled checks, albeit smaller in\nsize, on a monthly basis from Hudson Bank. The copies of the checks displayed both the front and back of\nthe checks. Rosenfeld was negligent in not recognizing his own forged signature on the front of the checks,\nas well as not spotting his own bookkeeper\xe2\x80\x99s name and/or account number on the back of the checks\n(which appeared far too many times and on various \xe2\x80\x9cpayees\xe2\x80\x9d checks to be seen as regular by a nonnegligent business owner).\n\nFurther, there were inadequate checks and balances in Victory\xe2\x80\x99s record keeping process. For example,\nVictory could have ensured that it had an adequate segregation of duties, meaning that more than one\nperson would be involved in any control activity. Here, Lunny exercised primary control over Victory\xe2\x80\x99s\nbank accounts. Another Victory employee, or Rosenfeld himself, could have reviewed Lunny\xe2\x80\x99s work. In\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n688\n\n\x0caddition, Victory could have increased the amount of authorization that was needed to perform certain\ntransactions. For example, any check that was over a threshold monetary amount would have to be\nauthorized by more than one individual. This would ensure an additional control on checks that were\nlarger in amounts. Furthermore, Victory did not match its invoices for each check at the end of each\nmonth. When any check was created by Victory\xe2\x80\x99s computer system, the value of the check was\nautomatically assigned to a general ledger account before the check could be printed. The values in the\ngeneral ledger account could have been reconciled at the end of each month with the actual checks and\ninvoices. This would not have been overly burdensome or costly because Victory already had the computer\nsystem that could do this in place. Based on the foregoing, the Court concludes that Victory is also thirty\n(30) percent liable for the loss.\n\nConclusion\nFor all the foregoing reasons, the Court finds that Wachovia is 70% liable and Victory is 30% liable for the\n$188,273.00 loss. Therefore, Victory Clothing Company, Inc. is awarded $131,791.10.\n\nC A SE QU ES TIO NS\n1. How does the double-forgery scam work?\n2. What argument did Wachovia make as to why it should not be liable for the double\nforgeries?\n3. What argument did Wachovia make as to why it should not be liable under the\nfictitious payee rule?\n4. What change in the revised UCC (from the pre-1990 version) made Wachovia\xe2\x80\x99s\narguments invalid, in the court\xe2\x80\x99s opinion?\n5. What factors appear to have caused the court to decide that Wachovia was more\nthan twice as responsible for the embezzlement as Victory was?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n689\n\n\x0cJoint Payees and Conditional and Restrictive Indorsements\nWisner Elevator Company, Inc. v. Richland State Bank\n\n862 So.. 2003) 2d 1112 (La. App\n\nGaskins, J.\n\nWisner Elevator Company, Inc. [plaintiff] (\xe2\x80\x9cWisner\xe2\x80\x9d), appeals from a summary judgment in favor of the\ndefendant, Richland State Bank. At issue is the deposit of a check with a typed statement on the back\ndirecting that a portion of the funds be paid to a third party. We affirm the trial court judgment.\n\nFacts\nOn July 13, 2001, the United States Treasury, through the Farm Service Agency, issued a check in the\namount of $17,420.00, made payable to Chad E. Gill. On the back of the check the following was typed:\n\nPAY TO THE ORDER OF RICHLAND STATE BANK FOR ISSUANCE OF A CASHIER\xe2\x80\x99S CHECK\nPAYABLE TO WISNER ELEVATOR IN THE AMOUNT OF $13,200.50 AND PAY THE BALANCE TO\nCHAD GILL IN THE AMOUNT OF $4,219.50.\n\nOn July 23, 2001, the check was deposited into Gill\xe2\x80\x99s checking account at Richland State Bank. Gill\xe2\x80\x99s\nsignature is found on the back of the check below the typed paragraph. No cashier check to Wisner\nElevator was issued; instead the entire amount was deposited into Gill\xe2\x80\x99s checking account as per Gill\xe2\x80\x99s\ndeposit ticket.\n\n\xe2\x80\xa6On May 28, 2002, Wisner filed suit against the bank, claiming that its failure to apply the funds as per\nthe restrictive indorsement constituted a conversion of the portion of the check due to Wisner under UCC\n3-206(c)(2) [that a depositary bank converts an instrument if it pays out on an indorsement \xe2\x80\x9cindicating a\npurpose of having the instrument collected for the indorser or for a particular account\xe2\x80\x9d].\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n690\n\n\x0c[The bank] asserted that the indorsement on the back of the check was a conditional indorsement and\nineffective under 3-206(b), [which states:]\n\nAn indorsement stating a condition to the right of the indorsee to receive payment does not affect the\nright of the indorsee to enforce the instrument. A person paying the instrument or taking it for value or\ncollection may disregard the condition, and the rights and liabilities of that person are not affected by\nwhether the condition has been fulfilled.\n\n\xe2\x80\xa6[T]he bank asserts the fault of the United States Treasury\xe2\x80\xa6, in failing to make the check payable to both\nGill and Wisner. To the extent that the indorsement was conditional, the bank contends that it was\nunenforceable; to the extent that it was restrictive, it maintains that the restrictions were waived by the\nindorser when he deposited the full amount of the check into his own checking account.\n\nWisner\xe2\x80\xa6[stated that it] was owed $13,200.50 by Gill for seeds, chemicals, crop supplies and agricultural\nseed technology fees. [It] further stated that Gill never paid the $13,200.50 he owed and that Wisner did\nnot receive a cashier\xe2\x80\x99s check issued in that amount by Richland State Bank.\xe2\x80\xa6According to [the bank\nteller], Gill asked to deposit the entire amount in his account. She further stated that the bank was\nunaware that the indorsement was written by someone other than Gill.\n\n\xe2\x80\xa6The court found that the typed indorsement placed on the check was the indorsement of the maker, not\nGill. However, when Gill signed below the indorsement, he made it his own indorsement. The court\nconcluded that Gill had the legal power and authority to verbally instruct that the entire proceeds be\ndeposited into his account. The court stated that as long as the indorsement was his own, whether it was\nrestrictive or conditional, Gill had the power to ignore it, strike it out or give contrary instructions. The\ncourt further concluded that the bank acted properly when it followed the verbal instructions given by Gill\nto the teller and the written instructions on his deposit slip to deposit the entire proceeds into Gill\xe2\x80\x99s\naccount. Consequently, the court gave summary judgment in favor of the bank. Wisner appeals.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n691\n\n\x0cDiscussion\nWisner contends that the trial court erred in holding that the bank could disregard what Wisner\ncharacterizes as a special and restrictive indorsement on the back of the check. It claims that under UCC\n3-206, the amount paid by the bank had to be \xe2\x80\x9capplied consistently with\xe2\x80\x9d the indorsement and that the\nbank\xe2\x80\x99s failure to comply with the indorsement made it liable to Wisner. According to Wisner, Gill was not\nentitled to deposit the amount due to Wisner by virtue of his own special indorsement and the bank\nconverted the check under 3-420 by crediting the full amount to Gill\xe2\x80\x99s account.\n\nThe bank argues that the indorsement was conditional and thus could be ignored pursuant to 3-206(b). It\nalso asserts that nothing on the check indicated that the indorsement was written by someone other than\nGill. Since the check was made payable to Gill, the indorsement was not necessary to his title and could be\nignored, struck out or simply waived. The bank also claims that Wisner had no ownership interest in the\ncheck, did not receive delivery of the check, and had no claim for conversion under 3-420.\n\nWe agree with the bank that the true problem in this case is the failure of the government to issue the\ncheck jointly to Gill and Wisner as co-payees. Had the government done so, there would be no question as\nto Wisner\xe2\x80\x99s entitlement to a portion of the proceeds from the check.\n\nAlthough the writing on the back of the check is referred to as an indorsement, we note that, standing\nalone, it does not truly conform to the definition found in 3-204(a) [which states]:\n\n\xe2\x80\x9cIndorsement\xe2\x80\x9d means a signature, other than that of a signer as maker, drawer, or acceptor, that alone or\naccompanied by other words is made on an instrument for the purpose of (i) negotiating the instrument,\n(ii) restricting payment of the instrument, or (iii) incurring indorser\xe2\x80\x99s liability on the instrument, but\nregardless of the intent of the signer, a signature and its accompanying words is an indorsement unless\nthe accompanying words, terms of the instrument, place of the signature, or other circumstances\nunambiguously indicate that the signature was made for a purpose other than indorsement.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n692\n\n\x0cThis paragraph was placed on the back of the check by the government as the maker or drawer of the\ncheck. Consequently, the bank argues that Gill as sole payee could waive, ignore or strike out the\nlanguage.\n\nAlthough the Louisiana jurisprudence contains no similar case dealing with the Uniform Commercial\nCode, we may look to other jurisdictions for guidance\xe2\x80\xa6In [Citation, a New Jersey case] (1975), the drawer\nof a check placed instructions on the backs of several checks\xe2\x80\xa6that the instruments not be deposited until\na specific future date. However, the payee presented some of the checks prior to the date specified on the\nback. The court found that the drawer did not have the capacity to indorse the instruments; as a result the\ntyped instructions on the backs of the checks could not be indorsements. Instead, they were \xe2\x80\x9cmerely\nrequests to plaintiff who may or may not comply at its own pleasure. The instructions are neither binding\non plaintiff nor the subsequent holders.\xe2\x80\x9d In other words, the payee could ignore the instructions.\n\nIn the instant case, the payee did precisely that. Gill ignored the writing on the back of the check and\ninstructed the teller at the defendant bank to do the same through verbal and written instructions.\n\nWisner argues that by affixing his signature under the writing on the back of the check, Gill made it his\nown indorsement. Furthermore, it asserts that it was a restrictive indorsement, not a conditional one\nwhich could be disregarded pursuant to 3-206. Wisner relies upon the provisions of 3-206 for the\nproposition that the check had a restrictive indorsement and that the bank converted the check because it\nfailed to apply the amount it paid consistently with the indorsement. However, Comment 3 to 3-206\nstates, in pertinent part:\n\nThis Article does not displace the law of waiver as it may apply to restrictive indorsements. The\ncircumstances under which a restrictive indorsement may be waived by the person who made it is not\ndetermined by this Article.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n693\n\n\x0cNot all jurisdictions recognize a doctrine of waiver of restrictive indorsements. [Citing cases from various\njurisdictions in which a bank customer effectively requested the bank to disregard a restrictive\nindorsement; some cases affirmed the concept that the restriction could be waived (disregarded), others\ndid not.]\xe2\x80\xa6\n\nIn two cases arising under pre-UCC law, Louisiana recognized that indorsements could be ignored or\nstruck out. In [Citation] (1925), the Louisiana Supreme Court held that the holder of a check could erase\nor strike out a restrictive indorsement on a check that was not necessary to the holder\xe2\x80\x99s title. In [Citation]\n(1967), the court stated that an erroneous indorsement could be ignored and even struck out as\nunnecessary to the plaintiff\xe2\x80\x99s title.\n\nLike the trial court, we find that when Gill affixed his signature under the writing on the back of the check,\nhe made it his own indorsement. We further find that the indorsement was restrictive, not conditional. As\nGill\xe2\x80\x99s own restrictive indorsement, he could waive it and direct that the check, upon which he was\ndesignated as the sole payee, be deposited in his account in its entirety.\n\nAffirmed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n694\n\n\x0cC A SE QU ES TIO NS\n1. Notice that the check was made payable to Chad Gill\xe2\x80\x94he was the named payee on\nthe front side of the check. To avoid the problems here, if the drawer (the US\ngovernment) wanted to control the uses to which the check could be put, how\nshould it have named the payee?\n2. The court held that when Gill \xe2\x80\x9caffixed his signature under the writing on the back of\nthe check, he made it his own indorsement.\xe2\x80\x9d But why wasn\xe2\x80\x99t it the indorsement of\nthe drawer\xe2\x80\x94the US government?\n3. If the language on the back was considered his own conditional indorsement (the\ninstrument was not valid unless the stated conditions were met), how could the\ncondition be disregarded by the bank?\n4. If it was his own restrictive indorsement, how could it be disregarded by the bank?\n5. What recourse does Wisner have now?\n[1] Authors\xe2\x80\x99 note: Pari-mutuel betting (from the French pari mutuel, meaning mutual stake) is a\nbetting system in which all bets of a particular type are placed together in a pool; taxes and a\nhouse take are removed, and payoff odds are calculated by sharing the pool among all winning\nbets.\n[2] Authors\xe2\x80\x99 note: As of 2010, New York is the sole remaining state yet to adopt the 1990\nrevisions to Articles 3 and 4; it entertained a bill in 2007 and 2008 that would have enacted the\n1990 revisions as amended by the 2002 amendments. However, that bill floundered. Keith A.\nRowley, UCC Update[American Bar Association, Business Law Committee], available\nathttp://www.abanet.org/buslaw/committees/CL190000pub/newsletter/200901/subcommitte\nes/developments.pdf.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n695\n\n\x0c14.5 Summary and Exercises\nSummary\nNegotiation is the transfer of an instrument in such a form that the transferee becomes a holder. There are\nvarious methods for doing so; if the procedures are not properly adhered to, the transfer is only an\nassignment.\n\nAn instrument payable to the order of someone must be negotiated by indorsement and delivery to the\ntransferee. The indorsement must convey the entire instrument. An instrument payable to bearer may be\nnegotiated simply by delivery to the transferee.\n\nThose who sign the instrument have made a contract and are liable for its breach. Makers and acceptors\nare primary parties and are liable to pay the instrument. Drawers and indorsers are secondary parties and\nare conditionally liable. Signatories are liable under a warranty theory.\n\nVarious forms of indorsement are possible: blank or special, restrictive or unrestrictive, qualified or\nunqualified.\n\nBetween drawer and drawee, liability for a forged instrument\xe2\x80\x94one signed without authority\xe2\x80\x94usually falls\non the drawee who paid it. There are, however, several exceptions to this rule: where an imposter induces\nthe maker or drawer to issue an instrument in the name of the payee, where the instrument is made to a\nfictitious payee (or to a real person who is intended to have no interest in it), and where the instrument is\nmade by an employee authorized generally to deal in such paper\n\n]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n696\n\n\x0cE XE R C IS ES\n1. Mal, a minor, purchased a stereo from Howard for $425 and gave Howard a\nnegotiable note in that amount. Tanker, a thief, stole the note from Howard,\nindorsed Howard\xe2\x80\x99s signature and sold the note to Betty. Betty then sold the\nnote to Carl; she did not indorse it. Carl was unable to collect on the note\nbecause Mal disaffirmed the contract. Is Betty liable to Carl on a contract or\nwarranty theory? Why?\n2. Would the result in Exercise 1 be different if Betty had given a qualified\nindorsement? Explain.\n3. Alphonse received a check one Friday from his employer and cashed the check\nat his favorite tavern, using a blank indorsement. After the tavern closed that\nevening, the owner, in reviewing the receipts for the evening, became\nconcerned that if the check was stolen and cashed by a thief, the loss would\nfall on the tavern. Is this concern justified? What can the owner of the tavern\ndo for protection?\n4. Martha owns a sporting goods store. She employs a bookkeeper, Bob, who is\nauthorized to indorse checks received by the store and to deposit them in the\nstore\xe2\x80\x99s bank account at Second Bank. Instead of depositing all the checks, Bob\ncashes some of them and uses the proceeds for personal purposes. Martha\nsues the bank for her loss, claiming that the bank should have deposited the\nmoney in the store\xe2\x80\x99s account rather than paying Bob. Is the bank liable?\nExplain.\n5. Daniel worked as a writer in order to support himself and his wife while she\nearned her MBA degree. Daniel\xe2\x80\x99s paychecks were important, as the couple\nhad no other source of income. One day, Daniel drove to Old Faithful State\nBank to deposit his paycheck. Standing at a counter, he indorsed the check\nwith a blank indorsement and then proceeded to fill out a deposit slip. While\nhe was completing the slip, a thief stole the check and cashed it. Whose loss?\nHow could the loss be avoided?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n697\n\n\x0c6. You are the branch manager of a bank. A well-respected local attorney walks\ninto the bank with a check for $100,000 that he wants to deposit in the\ngeneral account his firm has at your bank. The payee on the check is an elderly\nwidow, Hilda Jones, who received the check from the profit-sharing plan of\nher deceased husband, Horatio Jones. The widow indorsed the check \xe2\x80\x9cPay to\nthe order of the estate of Horatio Jones. Hilda Jones.\xe2\x80\x9d The attorney produces\ncourt documents showing that he is the executor of the estate. After the\nattorney indorses the check, you deposit the check in the attorney\xe2\x80\x99s account.\nThe attorney later withdraws the $100,000 and spends it on a pleasure trip, in\nviolation of his duties as executor. Discuss the bank\xe2\x80\x99s liability.\n7. Stephanie borrows $50,000 from Ginny and gives Ginny a negotiable note in\nthat amount. Ginny sells the note to Roe for $45,000. Ginny\xe2\x80\x99s indorsement\nreads, \xe2\x80\x9cFor valuable consideration, I assign all of my rights in this note to Roe.\nGinny.\xe2\x80\x9d When Stephanie refuses to pay the note and skips town, Roe\ndemands payment from Ginny, claiming contract liability on the basis of her\nsignature. Ginny argues that she is not liable because the indorsement is\nqualified by the language she used on the note. Who is correct? Explain.\n8. The state of California issued a check that read, \xe2\x80\x9cTo Alberto Cruz and Roberta\nGonzales.\xe2\x80\x9d Alberto endorsed it \xe2\x80\x9cPay to the order of Olivia Cruz.\xe2\x80\x9d What rights\ndoes Olivia get in the instrument?\n9.\na. Bill\xe2\x80\x99s weekly paycheck was stolen by a thief. The thief indorsed\nBill\xe2\x80\x99s name and cashed the check at the drawee bank before Bill\xe2\x80\x99s\nemployer had time to stop payment. May the drawee bank charge\nthis payment against the drawer\xe2\x80\x99s account? Explain.\nb. Would the result change in (a) if Bill had carelessly left his check\nwhere it could easily be picked up by the thief? Explain.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n698\n\n\x0cc. Would the result change in (a) if the bank had specific regulations\nthat tellers were not to cash any check without examining the\nidentification of the person asking for cash?\nd. Would the result change if Bill\xe2\x80\x99s employer had carelessly left the\ncheck where it could be found by the thief?\n\nS EL F -T E ST QU EST IO N S\n1. A person who signs a negotiable instrument with a blank endorsement has\na. warranty liability\nb. contract liability\nc. both of the above\nd. neither of the above\n\xe2\x80\x9cFor deposit\xe2\x80\x9d is an example of\na. a special indorsement\nb. a restrictive indorsement\nc. a qualified indorsement\nd. a blank indorsement\n\xe2\x80\x9cPay to the order of XYZ Company\xe2\x80\x9d is an example of\na. a special indorsement\nb. a restrictive indorsement\nc. a qualified indorsement\nd. a blank indorsement\nThe indorser\xe2\x80\x99s signature alone is\na. a special indorsement\nb. a restrictive indorsement\nc. a qualified indorsement\nd. a blank indorsement\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n699\n\n\x0cGenerally, liability for a forged instrument falls on\na. the drawer\nb. the drawee\nc. both of the above\nd. neither of the above\nState whether each of the following is (1) blank or special, (2) restrictive or\nnonrestrictive, or (3) qualified or unqualified:\na. \xe2\x80\x9cPay to David Murphy without recourse.\xe2\x80\x9d\nb. \xe2\x80\x9cRonald Jackson\xe2\x80\x9d\nc. \xe2\x80\x9cFor deposit only in my account at Industrial Credit Union.\xe2\x80\x9d\nd. \xe2\x80\x9cPay to ABC Co.\xe2\x80\x9d\ne. \xe2\x80\x9cI assign to Ken Watson all my rights in this note.\xe2\x80\x9d\n\nS EL F -T E ST A NSW E R S\n1. c\n2. b\n3. a\n4. d\n5. b\n6.\na. special, nonrestrictive, qualified\nb. blank, nonrestrictive, unqualified\nc. special, nonrestrictive, unqualified\nd. special, restrictive, unqualified\ne. special, restrictive, unqualified\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n700\n\n\x0cChapter 15\nHolder in Due Course and Defenses\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. What a holder in due course is, and why that status is critical to commercial paper\n2. What defenses are good against a holder in due course\n3. How the holder-in-due-course doctrine is modified in consumer transactions\nIn this chapter, we consider the final two questions that are raised in determining whether a holder can\ncollect:\n1.\n\nIs the holder a holder in due course?\n\n2. What defenses, if any, can be asserted against the holder in due course to prevent collection on\nthe instrument?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n701\n\n\x0c15.1 Holder in Due Course\nL EA R N IN G O B JEC T IV ES\n1. Understand why the concept of holder in due course is important in commercial\ntransactions.\n2. Know what the requirements are for being a holder in due course.\n3. Determine whether a payee may be a holder in due course.\n4. Know what the shelter rule is and why the rule exists.\n\nOverview of the Holder-in-Due-Course Concept\nImportance of the Holder-in-Due-Course Concept\nA holder is a person in possession of an instrument payable to bearer or to the identified person\npossessing it. But a holder\xe2\x80\x99s rights are ordinary, as we noted briefly in Chapter 13 "Nature and Form of\nCommercial Paper". If a person to whom an instrument is negotiated becomes nothing more than a\nholder, the law of commercial paper would not be very significant, nor would a negotiable instrument be a\nparticularly useful commercial device. A mere holder is simply an assignee, who acquires the assignor\xe2\x80\x99s\nrights but also his liabilities; an ordinary holder must defend against claims and overcome defenses just as\nhis assignor would. The holder in due course is really the crux of the concept of commercial paper and the\nkey to its success and importance. What the holder in due course gets is an instrument free of claims or\ndefenses by previous possessors. A holder with such a preferred position can then treat the instrument\nalmost as money, free from the worry that someone might show up and prove it defective.\n\nRequirements for Being a Holder in Due Course\nUnder Section 3-302 of the Uniform Commercial Code (UCC), to be a holder in due course (HDC), a\ntransferee must fulfill the following:\n\n1. Be a holder of a negotiable instrument;\n2. Have taken it:\na) for value,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n702\n\n\x0cb) in good faith,\n\nc) without notice\n\n(1) that it is overdue or\n\n(2) has been dishonored (not paid), or\n\n(3) is subject to a valid claim or defense by any party, or\n\n(4) that there is an uncured default with respect to payment of another instrument issued as part of the\nsame series, or\n\n(5) that it contains an unauthorized signature or has been altered, and\n\n3. Have no reason to question its authenticity on account of apparent evidence of forgery, alteration,\nirregularity or incompleteness.\n\nThe point is that the HDC should honestly pay for the instrument and not know of anything wrong with it.\nIf that\xe2\x80\x99s her status, she gets paid on it, almost no matter what.\n\nSpecific Analysis of Holder-in-Due-Course Requirements\nHolder\nAgain, a holder is a person who possesses a negotiable instrument \xe2\x80\x9cpayable to bearer or, the case of an\ninstrument payable to an identified person, if the identified person is in possession.\xe2\x80\x9d\n\n[1]\n\nAn instrument is\n\npayable to an identified person if she is the named payee, or if it is indorsed to her. So a holder is one who\npossesses an instrument and who has all the necessary indorsements.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n703\n\n\x0cTaken for Value\nSection 3-303 of the UCC describes what is meant by transferring an instrument \xe2\x80\x9cfor value.\xe2\x80\x9d In a broad\nsense, it means the holder has given something for it, which sounds like consideration. But \xe2\x80\x9cvalue\xe2\x80\x9d here is\nnot the same as consideration under contract law. Here is the UCC language:\n\nAn instrument is issued or transferred for value if any of the following apply:\n\n(1) The instrument is issued or transferred for a promise of performance, to the extent the promise has\nbeen performed.\n\n(2) The transferee acquires a security interest or other lien in the instrument other than a lien obtained by\njudicial proceeding.\n\n(3) The instrument is issued or transferred as payment of, or as security for, an antecedent claim against\nany person, whether or not the claim is due.\n\n(4) The instrument is issued or transferred in exchange for a negotiable instrument.\n\n(5) The instrument is issued or transferred in exchange for the incurring of an irrevocable obligation to a\nthird party by the person taking the instrument.\n\n1. For a promise, to the extent performed. Suppose A contracts with B: \xe2\x80\x9cI\xe2\x80\x99ll buy your car for $5,000.\xe2\x80\x9d\nUnder contract law, A has given consideration: the promise is enough. But this executory (not yet\nperformed) promise given by A is not giving \xe2\x80\x9cvalue\xe2\x80\x9d to support the HDC status because the promise has\nnot been performed.\n\nLorna Love sells her car to Paul Purchaser for $5,000, and Purchaser gives her a note in that amount.\nLove negotiates the note to Rackets, Inc., for a new shipment of tennis rackets to be delivered in thirty\ndays. Rackets never delivers the tennis rackets. Love has a claim for $5,000 against Rackets, which is not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n704\n\n\x0can HDC because its promise to deliver is still executory. Assume Paul Purchaser has a defense against\nLove (a reason why he doesn\xe2\x80\x99t want to pay on the note), perhaps because the car was defective. When\nRackets presents the note to Purchaser for payment, he refuses to pay, raising his defense against Love. If\nRackets had been an HDC, Purchaser would be obligated to pay on the note regardless of the defense he\nmight have had against Love, the payee. See Carter & Grimsley v. Omni Trading, Inc., Section 15.3\n"Cases", regarding value as related to executory contracts.\n\nA taker for value can be a partial HDC if the consideration was only partly performed. Suppose the tennis\nrackets were to come in two lots, each worth $2,500, and Rackets only delivered one lot. Rackets would be\nan HDC only to the extent of $2,500, and the debtor\xe2\x80\x94Paul Purchaser\xe2\x80\x94could refuse to pay $2,500 of the\npromised sum.\n\nThe UCC presents two exceptions to the rule that an executory promise is not value. Section 3-303(a)(4)\nprovides that an instrument is issued or transferred for value if the issuer or transferor gives it in\nexchange for a negotiable instrument, and Section 3-303(5) says an instrument is transferred for value if\nthe issuer gives it in exchange for an irrevocable obligation to a third party.\n\n2. Security interest. Value is not limited to cash or the fulfillment of a contractual obligation. A holder\nwho acquires a lien on, or a security interest in, an instrument other than by legal process has taken for\nvalue.\n\n3. Antecedent debt. Likewise, taking an instrument in payment of, or as security for, a prior claim,\nwhether or not the claim is due, is a taking for value. Blackstone owes Webster $1,000, due in thirty days.\nBlackstone unexpectedly receives a refund check for $1,000 from the Internal Revenue Service and\nindorses it to Webster. Webster is an HDC though he gave value in the past.\n\nThe rationale for the rule of value is that if the holder has not yet given anything of value in exchange for\nthe instrument, he still has an effective remedy should the instrument prove defective: he can rescind the\ntransaction, given the transferor\xe2\x80\x99s breach of warranty.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n705\n\n\x0cIn Good Faith\nSection 3-103(4) of the UCC defines good faith as \xe2\x80\x9chonesty in fact and the observance of reasonable\ncommercial standards of fair dealing.\xe2\x80\x9d\n\nHonesty in Fact\n\xe2\x80\x9cHonesty in fact\xe2\x80\x9d is subjectively tested. Suppose Lorna Love had given Rackets, Inc., a promissory note for\nthe tennis rackets. Knowing that it intended to deliver defective tennis rackets and that Love is likely to\nprotest as soon as the shipment arrives, Rackets offers a deep discount on the note to its fleet mechanic:\ninstead of the $1,000 face value of the note, Rackets will give it to him in payment of an outstanding bill of\n$400. The mechanic, being naive in commercial dealings, has no suspicion from the large discount that\nRackets might be committing fraud. He has acted in good faith under the UCC test. That is not to say that\nno set of circumstances will ever exist to warrant a finding that there was a lack of good faith.\n\nObservance of Reasonable Commercial Standards of Fair Dealing\nWhether reasonable commercial standards were observed in the dealings is objectively tested, but buying\nan instrument at a discount\xe2\x80\x94as was done in the tennis rackets example\xe2\x80\x94is not commercially\nunreasonable, necessarily.\n\nWithout Notice\nIt obviously would be unjust to permit a holder to enforce an instrument that he knew\xe2\x80\x94when he acquired\nit\xe2\x80\x94was defective, was subject to claims or defenses, or had been dishonored. A purchaser with knowledge\ncannot become an HDC. But proving knowledge is difficult, so the UCC at Section 3-302(2) lists several\ntypes of notice that presumptively defeat any entitlement to status as HDC. Notice is not limited to receipt\nof an explicit statement; it includes an inference that a person should have made from the circumstances.\nThe explicit things that give a person notice include those that follow.\n\nWithout Notice That an Instrument Is Overdue\nThe UCC provides generally that a person who has notice that an instrument is overdue cannot be an\nHDC. What constitutes notice? When an inspection of the instrument itself would show that it was due\nbefore the purchaser acquired it, notice is presumed. A transferee to whom a promissory note due April\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n706\n\n\x0c23 is negotiated on April 24 has notice that it was overdue and consequently is not an HDC. Not all paper\ncontains a due date for the entire amount, and demand paper has no due date at all. In Sections 3302(a)(2) and 3-304, the UCC sets out specific rules dictating what is overdue paper.\n\nWithout Notice That an Instrument Has Been Dishonored\nDishonor means that instrument is not paid when it is presented to the party who should pay it.\n\nWithout Notice of a Defense or Claim\nA purchaser of an instrument cannot be an HDC if he has notice that there are any defenses or claims\nagainst it. A defense is a reason why the would-be obligor will not pay; a claim is an assertion of\nownership in the instrument. If a person is fraudulently induced to issue or make an instrument, he has a\nclaim to its ownership and a defense against paying.\n\nWithout Notice of Unauthorized Signature or Alteration\nThis is pretty clear: a person will fail to achieve the HDC status if he has notice of\nalteration or an unauthorized signature.\n\nWithout Reason to Question the Instrument\xe2\x80\x99s Authenticity Because of Apparent\nForgery, Alteration, or Other Irregularity or Incompleteness as to Call into\nQuestion Its Authenticity\nThis also is pretty straightforward, though it is worth observing that a holder will flunk the HDC test if she\nhas notice of unauthorized signature or alteration, or if she should have notice on account of apparent\nirregularity. So a clever forgery would not by itself defeat the HDC status, unless the holder had notice of\nit.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n707\n\n\x0cPayee as Holder in Due Course\nThe payee can be an HDC, but in the usual circumstances, a payee would have knowledge of claims or\ndefenses because the payee would be one of the original parties to the instrument. Nevertheless, a payee\nmay be an HDC if all the prerequisites are met. For instance, Blackstone fraudulently convinces\nWhitestone into signing a note as a comaker, with Greenstone as the payee. Without authority, Blackstone\nthen delivers the note for value to Greenstone. Having taken the note in good faith, for value, without\nnotice of any problems, and without cause to question its validity because of apparent irregularities,\nGreenstone is an HDC. In any event, typically the HDC is not the payee of the instrument, but rather, is an\nimmediate or remote transferee of the payee.\n\nThe Shelter Rule\nThere is one last point to mention before we get to the real nub of the holder-in-due-course concept (that\nthe sins of her predecessors are washed away for an HDC). The shelter rule provides that the transferee\nof an instrument acquires the same rights that the transferor had. Thus a person who does not himself\nqualify as an HDC can still acquire that status if some previous holder (someone \xe2\x80\x9cupstream\xe2\x80\x9d) was an\nHDC.\nOn June 1, Clifford sells Harold the original manuscript of Benjamin Franklin\xe2\x80\x99s autobiography. Unknown\nto Harold, however, the manuscript is a forgery. Harold signs a promissory note payable to Clifford for\n$250,000 on August 1. Clifford negotiates the note to Betsy on July 1 for $200,000; she is unaware of the\nfraud. On August 2, Betsy gives the note to Al as a token of her affection. Al is Clifford\xe2\x80\x99s friend and knows\nabout the scam (see Figure 15.1 "The Shelter Rule"). May Al collect?\n\nFigure 15.1 The Shelter Rule\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n708\n\n\x0cBegin the analysis by noting that Al is not an HDC. Why? For three reasons: he did not take the\ninstrument for value (it was a gift), he did not take in good faith (he knew of the fraud), and he had notice\n(he acquired it after the due date). Nevertheless, Al is entitled to collect from Harold the full $250,000.\nHis right to do so flows from UCC, Section 3-203(b): \xe2\x80\x9cTransfer of an instrument, whether or not the\ntransfer is a negotiation, vests in the transferee any right of the transferor to enforce the instrument,\nincluding any right as a holder in due course, but the transferee cannot acquire rights of a holder in due\ncourse by a direct or indirect transfer from a holder in due course if the transferee engaged in fraud or\nillegality affecting the instrument.\xe2\x80\x9d\n\nBy virtue of the shelter rule, Al as transferee from Betsy acquires all rights that she had as transferor.\nClearly Betsy is an HDC: she paid for the instrument, she took it in good faith, had no notice of any claim\nor defense against the instrument, and there were no apparent irregularities. Since Betsy is an HDC, so is\nAl. His knowledge of the fraud does not undercut his rights as HDC because he was not a party to it and\nwas not a prior holder. Now suppose that after negotiating the instrument to Betsy, Clifford repurchased\nit from her. He would not be an HDC\xe2\x80\x94and would not acquire all Betsy\xe2\x80\x99s rights\xe2\x80\x94because he had been a\nparty to fraud and as a prior holder had notice of a defense. The purpose of the shelter rule is \xe2\x80\x9cto assure\nthe holder in due course a free market for the paper.\xe2\x80\x9d\n\n[2]\n\nK E Y TA K EA WAY\nThe holder-in-due-course doctrine is important because it allows the holder of a\nnegotiable instrument to take the paper free from most claims and defenses against it.\nWithout the doctrine, such a holder would be a mere transferee. The UCC provides that\nto be an HDC, a person must be a holder of paper that is not suspiciously irregular, and\nshe must take it in good faith, for value, and without notice of anything that a\nreasonable person would recognize as tainting the instrument. A payee may be an HDC\nbut usually would not be (because he would know of problems with it). The shelter rule\nsays that a transferee of an instrument acquires the same rights her transferor had, so a\nperson can have the rights of an HDC without satisfying the requirements of an HDC\n(provided she does not engage in any fraud or illegality related to the transaction).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n709\n\n\x0cE XE R C IS ES\n1. Summarize the requirements to be a holder in due course.\n2. Why is the status of holder in due course important in commercial transactions?\n3. Why is it unlikely that a payee would be a holder in due course?\n4. What is the shelter rule, and why does it exist?\n[1] Uniform Commercial Code, Section 1-201(20).\n[2] Uniform Commercial Code, Section 3-203, Comment 2.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n710\n\n\x0c15.2 Defenses and Role in Consumer Transactions\nL EA R N IN G O B JEC T IV E\n1. Know to what defenses the holder in due course is not subject.\n2. Know to what defenses the holder in due course is subject.\n3. Understand how the holder-in-due-course doctrine has been modified for consumer\ntransactions and why.\n\nDefenses\nWe mentioned in Section 15.1 "Holder in Due Course" that the importance of the holder-in-due-course\nstatus is that it promotes ready transferability of commercial paper by giving transferees confidence that\nthey can buy and in turn sell negotiable instruments without concern that somebody upstream\xe2\x80\x94previous\nholders in the chain of distribution\xe2\x80\x94will have some reason not to pay. The holder-in-due-course doctrine\nmakes the paper almost as readily transferable as cash. Almost, but not quite. We examine first the\ndefenses to which the holder in due course (HDC) is not subject and then\xe2\x80\x94the \xe2\x80\x9calmost\xe2\x80\x9d part\xe2\x80\x94the\ndefenses to which even HDCs are subject.\n\nHolder in Due Course Is Not Subject to Personal Defenses\nAn HDC is not subject to the obligor\xe2\x80\x99s personal defenses. But a holder who is not an HDC is subject to\nthem: he takes a negotiable instrument subject to the possible personal claims and defenses of numerous\npeople.\n\nIn general, the personal defenses\xe2\x80\x94to which the HDC is not subject\xe2\x80\x94are similar to the whole range of\ndefenses for breach of simple contract: lack of consideration; failure of consideration; duress, undue\ninfluence, and misrepresentation that does not render the transaction void; breach of warranty;\nunauthorized completion of an incomplete instrument; prior payment. Incapacity that does not render the\ntransaction void (except infancy) is also a personal defense. As the Uniform Commercial Code (UCC) puts\nit, this includes \xe2\x80\x9cmental incompetence, guardianship, ultra vires acts or lack of corporate capacity to do\nbusiness, or any other incapacity apart from infancy. If under the state law the effect is to render the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n711\n\n\x0cobligation of the instrument entirely null and void, the defense may be asserted against a holder in due\ncourse. If the effect is merely to render the obligation voidable at the election of the obligor, the defense is\ncut off.\xe2\x80\x9d\n\n[1]\n\nJames White and Robert Summers, in their hornbook on the UCC, opine that unconscionability\n\nis almost always a personal defense, not assertable against an HDC.\n\n[2]\n\nBut again, the HDC takes free only\n\nfrom personal defenses of parties with whom she has not dealt. So while the payee of a note can be an\nHDC, if he dealt with the maker, he is subject to the maker\xe2\x80\x99s defenses.\n\nHolder in Due Course Is Subject to Real Defenses\nAn HDC in a nonconsumer transaction is not subject to personal defenses, but he is subject to the socalled real defenses (or \xe2\x80\x9cuniversal defenses\xe2\x80\x9d)\xe2\x80\x94they are good against an HDC.\nThe real defenses good against any holder, including HDCs, are as follows (see Figure 15.2 "Real\nDefenses"):\n1.\n\nUnauthorized signature (forgery) (UCC, Section 3-401(a))\n\n2. Bankruptcy (UCC, Section 3-305(a))\n3. Infancy (UCC, Section 3-305(a))\n4. Fraudulent alteration (UCC, Section 3-407(b) and (c))\n5.\n\nDuress, mental incapacity, or illegality that renders the obligation void (UCC, Section 3-305(a))\n\n6. Fraud in the execution (UCC, Section 3-305(a))\n7.\n\nDischarge of which the holder has notice when he takes the instrument (UCC, Section 3-601)\n\nFigure 15.2 Real Defenses\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n712\n\n\x0cAnalysis of the Real Defenses\nThough most of these concepts are pretty clear, a few comments by way of analysis are appropriate.\n\nForgery\nForgery is a real defense to an action by an HDC. As we have noted, though, negligence in the making or\nhandling of a negotiable instrument may cut off this defense against an HDC\xe2\x80\x94as, for example, when a\ndrawer who uses a rubber signature stamp carelessly leaves it unattended. And notice, too, that Section 3308 of the UCC provides that signatures are presumed valid unless their validity is specifically denied, at\nwhich time the burden shifts to the person claiming validity. These issues are discussed in Triffin v.\nSomerset Valley Bank, inSection 15.3 "Cases" of this chapter.\n\nBankruptcy\nDrawers, makers, and subsequent indorsers are not liable to an HDC if they have been discharged in\nbankruptcy. If they were, bankruptcy would not serve much purpose.\n\nInfancy\nWhether an infant\xe2\x80\x99s signature on a negotiable instrument is a valid defense depends on the law of the\nstate. In some states, for instance, an infant who misrepresents his age is estopped from asserting infancy\nas a defense to a breach of contract. In those states, infancy would not be available as a defense against the\neffort of an HDC to collect.\n\nFraudulent Alteration\nUnder Section 3-407 of the UCC, \xe2\x80\x9cfraudulent alteration\xe2\x80\x9d means either (1) an unauthorized change in an\ninstrument that purports to modify in any respect the obligation of a party or (2) an unauthorized\naddition of words or numbers or other change to an incomplete instrument relating to the obligation of a\nparty. An alteration fraudulently made discharges a party whose obligation is affected by the alteration\nunless that party assents or is precluded from asserting the alteration. But a nonfraudulent alteration\xe2\x80\x94for\nexample, filling in an omitted date or giving the obligor the benefit of a lower interest rate\xe2\x80\x94does not\ndischarge the obligor. In any case, the person paying or taking the instrument may pay or collect\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n713\n\n\x0c\xe2\x80\x9caccording to its original terms, or in the case of an incomplete instrument that is altered by unauthorized\ncompletion, according to its terms as completed. If blanks are filled or an incomplete instrument is\notherwise completed, subsection (c) places the loss upon the party who left the instrument incomplete by\npermitting enforcement in its completed form. This result is intended even though the instrument was\nstolen from the issuer and completed after the theft.\xe2\x80\x9d A moral here: don\xe2\x80\x99t leave instruments lying around\nwith blanks that could be filled in.\n\nVoid Contract\nA void contract is distinguished from a voidable contract; only the former is a real defense.\n\nFraud in the Execution\nYou may recall that this is the rather unusual situation in which a person is tricked into signing a\ndocument. Able holds out a piece of paper for her boss and points to the signature line, saying, \xe2\x80\x9cThis is a\nreceipt for goods we received a little while ago.\xe2\x80\x9d Baker signs it. It is not a receipt; it\xe2\x80\x99s the signature line on\na promissory note. Able has committed fraud in the execution, and the note is void.\n\nDischarge of Which the Holder Has Notice\nIf the holder knows that the paper\xe2\x80\x94a note, say\xe2\x80\x94has already been paid, she cannot enforce it. That\xe2\x80\x99s a\ngood reason to take back any note you have made from the person who presents it to you for payment.\n\nConsumer Transactions and Holders in Due Course\nThe holder-in-due-course doctrine often worked considerable hardship on the consumer, usually as the\nmaker of an installment note.\n\nFor example, a number of students are approached by a gym owner who induces them to sign one-year\npromissory notes for $150 for a one-year gym membership. The owner says, \xe2\x80\x9cI know that right now the\nequipment in the gym is pretty rudimentary, but then, too, $150 is about half what you\xe2\x80\x99d pay at the YMCA\nor Gold\xe2\x80\x99s Gym. And the thing is, as we get more customers signing up, we\xe2\x80\x99re going to use the money to\ninvest in new equipment. So within several months we\xe2\x80\x99ll have a fully equipped facility for your use.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n714\n\n\x0cSeveral students sign the notes, which the owner sells to a factor (one that lends money to another,\ntaking back a negotiable instrument as security, usually at about a 20 percent discount). The factor takes\nas an apparent HDC, but the gym idea doesn\xe2\x80\x99t work and the owner declares bankruptcy. If this were a\ncommercial transaction, the makers (the students) would still owe on the notes even if there was, as here,\na complete failure of consideration (called \xe2\x80\x9cpaying on a dead horse\xe2\x80\x9d). But the students don\xe2\x80\x99t have to pay.\n\nWhether the gym owner here committed fraud is uncertain, but the holder-in-due-course doctrine did\noften work to promote fraud. Courts frequently saw cases brought by credit companies (factors) against\nconsumers who bought machines that did not work and services that did not live up to their promises. The\nancient concept of an HDC did not square with the realities of modern commerce, in which instruments\nby the millions are negotiated for uncompleted transactions. The finance company that bought such\ncommercial paper could never have honestly claimed (in the sociological sense) to be wholly ignorant that\nmany makers will have claims against their payees (though they could and did make the claim in the legal\nsense).\n\nActing to curb abuses, the Federal Trade Commission (FTC) in 1976 promulgated a trade regulation rule\nthat in effect abolished the holder-in-due-course rule for consumer credit transactions. Under the FTC\nrule titled \xe2\x80\x9cPreservation of Consumers\xe2\x80\x99 Claims and Defenses,\xe2\x80\x9d\n\n[3]\n\nthe creditor becomes a mere holder and\n\nstands in the shoes of the seller, subject to all claims and defenses that the debtor could assert against the\nseller. Specifically, the rule requires the seller to provide notice in any consumer credit contract that the\ndebtor is entitled to raise defenses against any subsequent purchaser of the paper. It also bars the seller\nfrom accepting any outside financing unless the loan contract between the consumer and the outside\nfinance company contains a similar notice. (The required notice, to be printed in no less than ten-point,\nboldface type, is set out in Figure 15.3 "Notice of Defense".) The effect of the rule is to ensure that a\nconsumer\xe2\x80\x99s claim against the seller will not be defeated by a transfer of the paper. The FTC rule has this\neffect because the paragraph to be inserted in the consumer credit contract gives the holder notice\nsufficient to prevent him from becoming an HDC.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n715\n\n\x0cThe rule applies only to consumer credit transactions. A consumer transaction is defined as a\npurchase of goods or services by a natural person, not a corporation or partnership, for personal, family,\nor household use from a seller in the ordinary course of business.\n\n[4]\n\nPurchases of goods or services for\n\ncommercial purposes and purchases of interests in real property, commodities, or securities are not\naffected. The rule applies to any credit extended by the seller himself (except for credit card transactions)\nor to any \xe2\x80\x9cpurchase money loan.\xe2\x80\x9d This type of loan is defined as a cash advance to the consumer applied in\nwhole or substantial part to a purchase of goods or services from a seller who either (a) refers consumers\nto the creditor or (b) is affiliated with the creditor. The purpose of this definition is to prevent the seller\nfrom making an end run around the rule by arranging a loan for the consumer through an outside finance\ncompany. The rule does not apply to a loan that the consumer arranges with an independent finance\ncompany entirely on his own.\n\nThe net effect of the FTC rule is this: the holder-in-due-course doctrine is virtually dead in consumer\ncredit contracts. It remains alive and flourishing as a legal doctrine in all other business transactions.\n\nFigure 15.3 Notice of Defense\n\nK E Y TA K EA WAY\nThe privileged position of the HDC stands up against the so-called personal defenses,\nwhich are\xe2\x80\x94more or less\xe2\x80\x94the same as typical defenses to obligation on any\ncontract, not including, however, the real defenses. Real defenses are good against any\nholder, including an HDC. These are infancy, void obligations, fraud in the execution,\nbankruptcy, discharge of which holder has notice, unauthorized signatures, and\nfraudulent alterations. While a payee may be an HDC, his or her rights as such are\nlimited to avoiding defenses of persons the payee did not deal with. The shelter rule says\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n716\n\n\x0cthat the transferee of an instrument takes the same rights that the transferor had. The\nFederal Trade Commission has abrogated the holder-in-due-course doctrine for\nconsumer transactions.\n\nE XE R C IS ES\n1. What purpose does the holder-in-due-course doctrine serve?\n2. What defenses is an HDC not subject to? What defenses is an HDC subject to?\n3. What is the Shelter Rule, and what purpose does it serve?\n4. For what transactions has the FTC abolished the holder-in-due-course doctrine and\nwhy?\n5. Under what circumstances is a forged signature valid?\n[1] Uniform Commercial Code, Section 3-305, Comment 1.\n[2] James White and Robert Summers, Uniform Commercial Code, 2/e, 575 (1980).\n[3] 16 Code of Federal Regulations, Section 433.\n[4] Uniform Commercial Code, Section 2-201(11).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n717\n\n\x0c15.3 Cases\nExecutory Promise as Satisfying \xe2\x80\x9cValue\xe2\x80\x9d\nCarter & Grimsley v. Omni Trading, Inc.\n\n716 N.E.2d 320 (Ill. App. 1999)\n\nLytton, J.\n\nFacts\nOmni purchased some grain from Country Grain, and on February 2, 1996, it issued two checks, totaling\n$75,000, to Country Grain. Country Grain, in turn, endorsed the checks over to Carter as a retainer for\nfuture legal services. Carter deposited the checks on February 5; Country Grain failed the next day. On\nFebruary 8, Carter was notified that Omni had stopped payment on the checks. Carter subsequently filed\na complaint against Omni\xe2\x80\xa6alleging that it was entitled to the proceeds of the checks, plus pre-judgment\ninterest, as a holder in due course.\xe2\x80\xa6[Carter moved for summary judgment; the motion was denied.]\n\nDiscussion\nCarter argues that its motion for summary judgment should have been granted because, as a holder in due\ncourse, it has the right to recover on the checks from the drawer, Omni.\n\nThe Illinois Uniform Commercial Code (UCC) defines a holder in due course as:\n\n\xe2\x80\x9cthe holder of an instrument if:\n\n(1) the instrument when issued does not bear such apparent evidence of forgery or alteration or is not\notherwise so irregular or incomplete as to call into question its authenticity, and (2) the holder took the\ninstrument (i) for value,\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n718\n\n\x0cSection 3-303(a) of the UCC also states that:\n\n(a) \xe2\x80\x9cAn instrument is issued or transferred for value if: (1) the instrument is issued or transferred for a\npromise of performance, to the extent that the promise has been performed * * *.\xe2\x80\x9d (emphasis\nadded)\n\nCarter contends that in Illinois a contract for future legal services should be treated differently than other\nexecutory contracts. It contends that when the attorney-client relationship is created by payment of a fee\nor retainer, the contract is no longer executory. Thus, Carter would achieve holder in due course status.\nWe are not persuaded.\n\nA retainer is the act of a client employing an attorney; it also denotes the fee paid by the client when he\nretains the attorney to act for him. [Citation] We have found no Illinois cases construing section 3-303(a)\nas it relates to a promise to perform future legal services under a retainer. The general rule, however, is\nthat \xe2\x80\x9can executory promise is not value.\xe2\x80\x9d [Citation] \xe2\x80\x9c[T]he promise does not rise to the level of \xe2\x80\x98value\xe2\x80\x99 in\nthe commercial paper market until it is actually performed.\xe2\x80\x9d [Citation]\n\nThe UCC comment to section 303 gives the following example:\n\n\xe2\x80\x9cCase # 2. X issues a check to Y in consideration of Y\xe2\x80\x99s promise to perform services in the future. Although\nthe executory promise is consideration for issuance of the check it is value only to the extent the promise\nis performed.\n\nWe have found no exceptions to these principles for retainers. Indeed, courts in other jurisdictions\ninterpreting similar language under section 3-303 have held that attorneys may be holders in due course\nonly to the extent that they have actually performed legal services prior to acquiring a negotiable\ninstrument. See [Citations: Pennsylvania, Florida, Massachusetts]. We agree.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n719\n\n\x0cThis retainer was a contract for future legal services. Under section 3-303(a)(1), it was a \xe2\x80\x9cpromise of\nperformance,\xe2\x80\x9d not yet performed. Thus, no value was received, and Carter is not a holder in due course.\n\nFurthermore, in this case, no evidence was presented in the trial court that Carter performed any legal\nservices for Country Grain prior to receiving the checks. Without an evidentiary basis for finding that\nCarter received the checks for services performed, the trial court correctly found that Carter failed to\nprove that it was a holder in due course. [Citations]\n\nConclusion\nBecause we have decided that Carter did not take the checks for value under section 3-303(a) of the UCC,\nwe need not address its other arguments.\nThe judgment of the circuit court of Peoria County is affirmed.\nHoldridge, J., dissenting.\nI respectfully dissent. In a contractual relationship between attorney and client, the payment of a fee or\nretainer creates the relationship, and once that relationship is created the contract is no longer executory.\n[Citation] Carter\xe2\x80\x99s agreement to enter into an attorney-client relationship with Country Grain was the\nvalue exchanged for the checks endorsed over to the firm. Thus, the general rule cited by the majority that\n\xe2\x80\x9can executory promise is not value\xe2\x80\x9d does not apply to the case at bar. On that basis I would hold that the\ntrial court erred in determining that Carter was not entitled to the check proceeds and I therefore dissent.\n\nC A SE QU ES TIO NS\n1. How did Carter & Grimsley obtain the two checks drawn by Omni?\n2. Why\xe2\x80\x94apparently\xe2\x80\x94did Omni stop payments on the checks?\n3. Why did the court determine that Carter was not an HDC?\n4. Who is it that must have performed here in order for Carter to have been an HDC,\nCountry Grain or Carter?\n5. How could making a retainer payment to an attorney be considered anything other\nthan payment on an executory contract, as the dissent argues?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n720\n\n\x0cThe \xe2\x80\x9cGood Faith and Reasonable Commercial Standards\xe2\x80\x9d\nRequirement\nBuckeye Check Cashing, Inc. v. Camp\n\n825 N.E.2d 644 (Ohio App. 2005)\n\nDonovan, J.\n\nDefendant-appellant Shawn Sheth appeals from a judgment of the Xenia Municipal Court in favor of\nplaintiff-appellee Buckeye Check Cashing, Inc. (\xe2\x80\x9cBuckeye\xe2\x80\x9d). Sheth contends that the trial court erred in\nfinding that Buckeye was a holder in due course of a postdated check drawn by Sheth and therefore was\nentitled to payment on the instrument despite the fact that Sheth had issued a stop-payment order to his\nbank.\n\nIn support of this assertion, Sheth argues that the trial court did not use the correct legal standard in\ngranting holder-in-due-course status to Buckeye. In particular, Sheth asserts that the trial court used the\npre-1990 Uniform Commercial Code (\xe2\x80\x9cUCC\xe2\x80\x9d) definition of \xe2\x80\x9cgood faith\xe2\x80\x9d as it pertains to holder-in-duecourse status, which defined it as \xe2\x80\x9chonesty in fact.\xe2\x80\x9d The definition of \xe2\x80\x9cgood faith\xe2\x80\x9d was extended by the\nauthors of the UCC in 1990 to also mean \xe2\x80\x9cthe observance of reasonable commercial standards of fair\ndealing.\xe2\x80\x9d The post-1990 definition was adopted by the Ohio legislature in 1994.\n\nSheth argues that while Buckeye would prevail under the pre-1990, \xe2\x80\x9chonesty in fact\xe2\x80\x9d definition of \xe2\x80\x9cgood\nfaith,\xe2\x80\x9d it failed to act in a commercially reasonable manner when it chose to cash the postdated check\ndrawn by Sheth. The lower court\xe2\x80\xa6adjudged Buckeye to be a holder in due course and, therefore, entitled\nto payment. We conclude that the trial court used the incorrect \xe2\x80\x9cgood faith\xe2\x80\x9d standard when it granted\nholder-in-due-course status to Buckeye because Buckeye did not act in a commercially reasonable manner\nwhen it cashed the postdated check drawn by Sheth. Because we accept Sheth\xe2\x80\x99s sole assignment of error,\nthe judgment of the trial court is reversed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n721\n\n\x0cOn or about October 12, 2003, Sheth entered into negotiations with James A. Camp for Camp to provide\ncertain services to Sheth by October 15, 2003. To that end, Sheth issued Camp a check for $1,300. The\ncheck was postdated to October 15, 2003.\n\nOn October 13, 2003, Camp negotiated the check to Buckeye and received a payment of $1,261.31.\nApparently fearing that Camp did not intend to fulfill his end of the contract, Sheth contacted his bank on\nOctober 14, 2003, and issued a stop-payment order on the check. Unaware of the stop-payment order,\nBuckeye deposited the check with its own bank on October 14, 2003, believing that the check would reach\nSheth\xe2\x80\x99s bank by October 15, 2003. Because the stop-payment order was in effect, the check was ultimately\ndishonored by Sheth\xe2\x80\x99s bank. After an unsuccessful attempt to obtain payment directly from Sheth,\nBuckeye brought suit.\n\nSheth\xe2\x80\x99s sole assignment of error is as follows:\n\n\xe2\x80\x9cThe trial court erred by applying the incorrect legal standard in granting holder in due course status to\nthe plaintiff-appellee because the plaintiff-appellee failed to follow commercially reasonable standards in\nelecting to cash the check that gives rise to this dispute.\xe2\x80\x9d\n\n[UCC 3-302] outlines the elements required to receive holder-in-due-course status. The statute states:\n\xe2\x80\xa6\xe2\x80\x98holder in due course\xe2\x80\x99 means the holder of an instrument if both of the following apply:\n\n\xe2\x80\x9c(1) The instrument when issued or negotiated to the holder does not bear evidence of forgery or\nalteration that is so apparent, or is otherwise so irregular or incomplete as to call into question its\nauthenticity;\n\n\xe2\x80\x9c(2) The holder took the instrument under all of the following circumstances:\n\n(a) For value;\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n722\n\n\x0c(b) In good faith;\n\n(c) Without notice that the instrument is overdue or has been dishonored or that there is an uncured\ndefault with respect to payment of another instrument issued as part of the same series;\n\n(d) Without notice that the instrument contains an unauthorized signature or has been altered;\n\n(e) Without notice of any claim to the instrument as described in [3-306];\n\n(f) Without notice that any party has a defense or claim in recoupment described in [UCC 3-305(a);\nemphasis added].\n\nAt issue in the instant appeal is whether Buckeye acted in \xe2\x80\x9cgood faith\xe2\x80\x9d when it chose to honor the\npostdated check originally drawn by Sheth.\xe2\x80\xa6UCC 1-201, defines \xe2\x80\x9cgood faith\xe2\x80\x9d as \xe2\x80\x9chonesty in fact and the\nobservance of reasonable commercial standards of fair dealing.\xe2\x80\x9d Before the Ohio legislature amended\nUCC 1-201 in 1994, that section did not define \xe2\x80\x9cgood faith\xe2\x80\x9d; the definition of \xe2\x80\x9cgood faith\xe2\x80\x9d as \xe2\x80\x9chonesty in\nfact\xe2\x80\x9d in UCC 1-201 was the definition that applied[.]\xe2\x80\xa6\n\n\xe2\x80\x9cHonesty in fact\xe2\x80\x9d is defined as the absence of bad faith or dishonesty with respect to a party\xe2\x80\x99s conduct\nwithin a commercial transaction. [Citation] Under that standard, absent fraudulent behavior, an\notherwise innocent party was assumed to have acted in good faith. The \xe2\x80\x9chonesty in fact\xe2\x80\x9d requirement, also\nknown as the \xe2\x80\x9cpure heart and empty head\xe2\x80\x9d doctrine, is a subjective test under which a holder had to\nsubjectively believe he was negotiating an instrument in good faith for him to become a holder in due\ncourse. Maine [Citation, 1999].\n\nIn 1994, however, the Ohio legislature amended the definition of \xe2\x80\x9cgood faith\xe2\x80\x9d to include not only the\nsubjective \xe2\x80\x9chonesty in fact\xe2\x80\x9d test, but also an objective test: \xe2\x80\x9cthe observance of reasonable commercial\nstandards of fair dealing.\xe2\x80\x9d Ohio UCC 1-201(20). A holder in due course must now satisfy both a subjective\nand an objective test of good faith. What constitutes \xe2\x80\x9creasonable commercial standards of fair dealing\xe2\x80\x9d for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n723\n\n\x0cparties claiming holder-in-due-course status, however, has not heretofore been defined in the state of\nOhio.\n\nIn support of his contention that Buckeye is not a holder in due course, Sheth cites a decision from the\nSupreme Court of Maine, [referred to above] in which the court provided clarification with respect to the\nobjective prong of the \xe2\x80\x9cgood faith\xe2\x80\x9d analysis:\n\n\xe2\x80\x9cThe fact finder must therefore determine, first, whether the conduct of the holder comported with\nindustry or \xe2\x80\x98commercial\xe2\x80\x99 standards applicable to the transaction and second, whether those standards\nwere reasonable standards intended to result in fair dealing. Each of those determinations must be made\nin the context of the specific transaction at hand. If the fact finder\xe2\x80\x99s conclusion on each point is \xe2\x80\x98yes,\xe2\x80\x99 the\nholder will be determined to have acted in good faith even if, in the individual transaction at issue, the\nresult appears unreasonable. Thus, a holder may be accorded holder in due course where it acts pursuant\nto those reasonable commercial standards of fair dealing\xe2\x80\x94even if it is negligent\xe2\x80\x94but may lose that status,\neven where it complies with commercial standards, if those standards are not reasonably related to\nachieving fair dealing.\xe2\x80\x9d [Citation]\n\nCheck cashing is an unlicensed and unregulated business in Ohio. [Citation] Thus, there are no concrete\ncommercial standards by which check-cashing businesses must operate. Moreover, Buckeye argues that\nits own internal operating policies do not require that it verify the availability of funds, nor does Buckeye\napparently have any guidelines with respect to the acceptance of postdated checks. Buckeye asserts that\ncashing a postdated check does not prevent a holder from obtaining holder-in-due-course status and cites\nseveral cases in support of this contention. All of the cases cited by Buckeye, however, were decided prior\nto the UCC\xe2\x80\x99s addition of the objective prong to the definition of \xe2\x80\x9cgood faith.\xe2\x80\x9d\n\nUnder a purely subjective \xe2\x80\x9chonesty in fact\xe2\x80\x9d analysis, it is clear that Buckeye accepted the check from Camp\nin good faith and would therefore achieve holder-in-due-course status. When the objective prong of the\ngood faith test is applied, however, we find that Buckeye did not conduct itself in a commercially\nreasonable manner. While not going so far as to say that cashing a postdated check prevents a holder from\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n724\n\n\x0cobtaining holder-in-due-course status in every instance, the presentation of a postdated check should put\nthe check cashing entity on notice that the check might not be good. Buckeye accepted the postdated\ncheck at its own peril. Some attempt at verification should be made before a check-cashing business\ncashes a postdated check. Such a failure to act does not constitute taking an instrument in good faith\nunder the current objective test of \xe2\x80\x9creasonable commercial standards\xe2\x80\x9d enunciated in [the UCC].\n\nWe conclude that in deciding to amend the good faith requirement to include an objective component of\n\xe2\x80\x9creasonable commercial standards,\xe2\x80\x9d the Ohio legislature intended to place a duty on the holders of certain\ninstruments to act in a responsible manner in order to obtain holder-in-due-course status. When Buckeye\ndecided to cash the postdated check presented by Camp, it did so without making any attempt to verify its\nvalidity. This court in no way seeks to curtail the free negotiability of commercial instruments. However,\nthe nature of certain instruments, such as the postdated check in this case, renders it necessary for\nappellee Buckeye to take minimal steps to protect its interests. That was not done. Buckeye was put on\nnotice that the check was not good until October 15, 2003. \xe2\x80\x9cGood faith,\xe2\x80\x9d as it is defined in the UCC and the\nOhio Revised Code, requires that a holder demonstrate not only honesty in fact but also that the holder\nact in a commercially reasonable manner. Without taking any steps to discover whether the postdated\ncheck issued by Sheth was valid, Buckeye failed to act in a commercially reasonable manner and therefore\nwas not a holder in due course.\n\nBased upon the foregoing, Sheth\xe2\x80\x99s single assignment of error is sustained, the judgment of the Xenia\nMunicipal Court is reversed, and this matter is remanded to that court for further proceedings in\naccordance with law and consistent with this opinion.\n\nJudgment reversed, and cause remanded.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n725\n\n\x0cC A SE QU ES TIO NS\n1. Who was Camp? Why did Sheth give him a check? Why is the case titled Buckeye v.\nCamp?\n2. How does giving someone a postdated check offer the drawer any protection? How\ndoes it give rise to any \xe2\x80\x9cnotice that the check might not be good\xe2\x80\x9d?\n3. If Camp had taken the check to Sheth\xe2\x80\x99s bank to cash it, what would have happened?\n4. What difference did the court discern between the pre-1990 UCC Article 3 and the\npost-1990 Article 3 (that Ohio adopted in 1994)?\n\nThe Shelter Rule\nTriffin v. Somerset Valley Bank\n\n777 A.2d 993 (N.J. Ct. App. 2001)\n\nCuff, J.\n\nThis case concerns the enforceability of dishonored checks against the issuer of the checks under Article 3\nof the Uniform Commercial Code (UCC), as implemented in New Jersey[.]\n\nPlaintiff [Robert J. Triffin] purchased, through assignment agreements with check cashing companies,\neighteen dishonored checks, issued by defendant Hauser Contracting Company (Hauser Co.). Plaintiff\nthen filed suit\xe2\x80\xa6to enforce Hauser Co.\xe2\x80\x99s liability on the checks. The trial court granted plaintiff\xe2\x80\x99s motion for\nsummary judgment. Hauser Co. appeals the grant of summary judgment.\xe2\x80\xa6We affirm.\n\nIn October 1998, Alfred M. Hauser, president of Hauser Co., was notified by Edwards Food Store in\nRaritan and the Somerset Valley Bank (the Bank), that several individuals were cashing what appeared to\nbe Hauser Co. payroll checks. Mr. Hauser reviewed the checks, ascertained that the checks were\ncounterfeits and contacted the Raritan Borough and Hillsborough Police Departments. Mr. Hauser\nconcluded that the checks were counterfeits because none of the payees were employees of Hauser Co.,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n726\n\n\x0cand because he did not write the checks or authorize anyone to sign those checks on his behalf. At that\ntime, Hauser Co. employed Automatic Data Processing, Inc. (ADP) to provide payroll services and a\nfacsimile signature was utilized on all Hauser Co. payroll checks.\n\nMr. Hauser executed affidavits of stolen and forged checks at the Bank, stopping payment on the checks at\nissue. Subsequently, the Bank received more than eighty similar checks valued at $25,000 all drawn on\nHauser Co.\xe2\x80\x99s account.\n\nPlaintiff is in the business of purchasing dishonored negotiable instruments. In February and March 1999,\nplaintiff purchased eighteen dishonored checks from four different check cashing agencies, specifying\nHauser Co. as the drawer. The checks totaled $8,826.42. Pursuant to assignment agreements executed by\nplaintiff, each agency stated that it cashed the checks for value, in good faith, without notice of any claims\nor defenses to the checks, without knowledge that any of the signatures were unauthorized or forged, and\nwith the expectation that the checks would be paid upon presentment to the bank upon which the checks\nwere drawn. All eighteen checks bore a red and green facsimile drawer\xe2\x80\x99s signature stamp in the name of\nAlfred M. Hauser. All eighteen checks were marked by the Bank as \xe2\x80\x9cstolen check\xe2\x80\x9d and stamped with the\nwarning, \xe2\x80\x9cdo not present again.\xe2\x80\x9d\xe2\x80\xa6\n\nPlaintiff then filed this action against the Bank, Hauser Co.,\xe2\x80\xa6Plaintiff contended that Hauser Co. was\nnegligent in failing to safeguard both its payroll checks and its authorized drawer\xe2\x80\x99s facsimile stamp, and\nwas liable for payment of the checks.\n\nThe trial court granted plaintiff\xe2\x80\x99s summary judgment motion, concluding that no genuine issue of fact\nexisted as to the authenticity of the eighteen checks at issue. Judge Hoens concluded that because the\ncheck cashing companies took the checks in good faith, plaintiff was a holder in due course as assignee.\nJudge Hoens also found that because the checks appeared to be genuine, Hauser Co. was required, but\nhad failed, to show that plaintiff\xe2\x80\x99s assignor had any notice that the checks were not validly drawn.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n727\n\n\x0cHauser Co. argues that summary judgment was improperly granted because the court failed to properly\naddress Hauser Co.\xe2\x80\x99s defense that the checks at issue were invalid negotiable instruments and therefore\nerred in finding plaintiff was a holder in due course.\n\nAs a threshold matter, it is evident that the eighteen checks meet the definition of a negotiable instrument\n[UCC 3-104]. Each check is payable to a bearer for a fixed amount, on demand, and does not state any\nother undertaking by the person promising payment, aside from the payment of money. In addition, each\ncheck appears to have been signed by Mr. Hauser, through the use of a facsimile stamp, permitted by the\nUCC to take the place of a manual signature. [Section 3-401(b) of the UCC] provides that a \xe2\x80\x9csignature may\nbe made manually or by means of a device or machine\xe2\x80\xa6with present intention to authenticate a writing.\xe2\x80\x9d\nIt is uncontroverted by Hauser Co. that the facsimile signature stamp on the checks is identical to Hauser\nCo.\xe2\x80\x99s authorized stamp.\n\nHauser Co., however, contends that the checks are not negotiable instruments because Mr. Hauser did not\nsign the checks, did not authorize their signing, and its payroll service, ADP, did not produce the checks.\nLack of authorization, however, is a separate issue from whether the checks are negotiable instruments.\nConsequently, given that the checks are negotiable instruments, the next issue is whether the checks are\nunenforceable by a holder in due course, because the signature on the checks was forged or unauthorized.\n\n[Sections 3-203 and 3-302 of the UCC] discuss the rights of a holder in due course and the rights of a\ntransferee of a holder in due course. Section 3-302 establishes that a person is a holder in due course if:\n\n(1) the instrument when issued or negotiated to the holder does not bear such apparent evidence of\nforgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity;\nand\n\n(2) the holder took the instrument for value, in good faith, without notice that the instrument is overdue\nor has been dishonored or that there is an uncured default with respect to payment of another instrument\nissued as part of the same series, without notice that the instrument contains an unauthorized signature\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n728\n\n\x0cor has been altered, without notice of any claim to the instrument described in 3-306, and without notice\nthat any party has a defense or claim in recoupment described in subsection a. of 3-305.\n\nSection 3-203 deals with transfer of instruments and provides:\n\na. An instrument is transferred when it is delivered by a person other than its issuer for the purpose of\ngiving to the person receiving delivery the right to enforce the instrument.\n\nb. Transfer of an instrument, whether or not the transfer is a negotiation, vests in the transferee any right\nof the transferor to enforce the instrument, including any right as a holder in due course, but the\ntransferee cannot acquire rights of a holder in due course by a transfer, directly or indirectly, from a\nholder in due course if the transferee engaged in fraud or illegality affecting the instrument.\xe2\x80\xa6\n\nUnder subsection (b) a holder in due course that transfers an instrument transfers those rights as a holder\nin due course to the purchaser. The policy is to assure the holder in due course a free market for the\ninstrument.\n\nThe record indicates that plaintiff has complied with the requirements of both sections 3-302 and 3-203.\nEach of the check cashing companies from whom plaintiff purchased the dishonored checks were holders\nin due course. In support of his summary judgment motion, plaintiff submitted an affidavit from each\ncompany; each company swore that it cashed the checks for value, in good faith, without notice of any\nclaims or defenses by any party, without knowledge that any of the signatures on the checks were\nunauthorized or fraudulent, and with the expectation that the checks would be paid upon their\npresentment to the bank upon which the checks were drawn. Hauser Co. does not dispute any of the facts\nsworn to by the check cashing companies.\n\nThe checks were then transferred to plaintiff in accordance with section 3-303, vesting plaintiff with\nholder in due course status. Each company swore that it assigned the checks to plaintiff in exchange for\nconsideration received from plaintiff. Plaintiff thus acquired the check cashing companies\xe2\x80\x99 holder in due\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n729\n\n\x0ccourse status when the checks were assigned to plaintiff. Moreover, pursuant to section 3-403(a)\xe2\x80\x99s\nrequirement that the transfer must have been made for the purpose of giving the transferee the right to\nenforce the instrument, the assignment agreements expressly provided plaintiff with that right, stating\nthat \xe2\x80\x9call payments [assignor] may receive from any of the referenced Debtors\xe2\x80\xa6shall be the exclusive\nproperty of [assignee].\xe2\x80\x9d Again, Hauser Co. does not dispute any facts relating to the assignment of the\nchecks to plaintiff.\n\nHauser Co. contends, instead, that the checks are per se invalid because they were fraudulent and\nunauthorized. Presumably, this argument is predicated on section 3-302. This section states a person is\nnot a holder in due course if the instrument bears \xe2\x80\x9capparent evidence of forgery or alteration\xe2\x80\x9d or is\notherwise \xe2\x80\x9cso irregular or incomplete as to call into question its authenticity.\xe2\x80\x9d\n\nIn order to preclude liability from a holder in due course under section 3-302, it must be apparent on the\nface of the instrument that it is fraudulent. The trial court specifically found that Hauser Co. had provided\nno such evidence, stating that Hauser Co. had failed to show that there was anything about the\nappearance of the checks to place the check cashing company on notice that any check was not valid.\nSpecifically, with respect to Hauser Co.\xe2\x80\x99s facsimile signature on the checks, the court stated that the\nsignature was identical to Hauser Co.\xe2\x80\x99s authorized facsimile signature. Moreover, each of the check\ncashing companies certified that they had no knowledge that the signatures on the checks were fraudulent\nor that there were any claims or defenses to enforcement of the checks. Hence, the trial court\xe2\x80\x99s conclusion\nthat there was no apparent evidence of invalidity was not an abuse of discretion and was based on a\nreasonable reading of the record.\n\nTo be sure, section 3-308(a) does shift the burden of establishing the validity of the signature to the\nplaintiff, but only if the defendant specifically denies the signature\xe2\x80\x99s validity in the pleadings. The section\nstates:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n730\n\n\x0cIn an action with respect to an instrument, the authenticity of, and authority to make, each signature on\nthe instrument is admitted unless specifically denied in the pleadings. If the validity of a signature is\ndenied in the pleadings, the burden of establishing validity is on the person claiming validity, but the\nsignature is presumed to be authentic and authorized unless the action is to enforce the liability of the\npurported signer and the signer is dead or incompetent at the time of trial of the issue of validity of the\nsignature.\n\nExamination of the pleadings reveals that Hauser Co. did not specifically deny the factual assertions in\nplaintiff\xe2\x80\x99s complaint.\n\nHence, the trial court\xe2\x80\x99s conclusion that there was no apparent evidence of invalidity was not an abuse of\ndiscretion and was based on a reasonable reading of the record.\n\nIn conclusion, we hold that Judge Hoens properly granted summary judgment. There was no issue of\nmaterial fact as to: (1) the status of the checks as negotiable instruments; (2) the status of the check\ncashing companies as holders in due course; (3) the status of plaintiff as a holder in due course; and (4)\nthe lack of apparent evidence on the face of the checks that they were forged, altered or otherwise\nirregular. Moreover, Hauser Co.\xe2\x80\x99s failure to submit some factual evidence indicating that the facsimile\nsignature was forged or otherwise unauthorized left unchallenged the UCC\xe2\x80\x99s rebuttable presumption that\na signature on an instrument is valid. Consequently, the trial court properly held, as a matter of law, that\nplaintiff was a holder in due course and entitled to enforce the checks. Affirmed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n731\n\n\x0cC A SE QU ES TIO NS\n1. Why did the plaintiff, Mr. Triffin, obtain possession of the dishonored checks?\nRegarding the plaintiff, consider this:http://caselaw.findlaw.com/nj-supremecourt/1332248.html.\n2. Section 4-401 of the UCC says nobody is liable on an instrument unless the person\nsigned it, and Section 4-403(a) provides that \xe2\x80\x9can unauthorized signature is\nineffective\xe2\x80\x9d (except as the signature of the unauthorized person), so how could\nHauser Co. be liable at all? And why did the court never discuss plaintiff\xe2\x80\x99s contention\nthat the defendant \xe2\x80\x9cwas negligent in failing to safeguard both its payroll checks and\nits authorized drawer\xe2\x80\x99s facsimile stamp\xe2\x80\x9d?\n3. Why didn\xe2\x80\x99t the Hauser Co. specifically deny the authenticity of the signatures?\n4. Obviously, the plaintiff must have known that there was something wrong with the\nchecks when he bought them from the check-cashing companies: they had been\ndishonored and were marked \xe2\x80\x9cStolen, do not present again.\xe2\x80\x9d Did he present them\nagain?\n5. While the UCC does not require that the transferee of an instrument acted in good\nfaith in order to collect on the instrument as an HDC (though he can\xe2\x80\x99t have\nparticipated in any scam), it disallows a person from being an HDC if he takes an\ninstrument with notice of dishonor. Surely the plaintiff had notice of that. What\ndoes the UCC require that transformed Mr. Triffin\xe2\x80\x94via the shelter rule\xe2\x80\x94into a\nperson with the rights of an HDC?\n6. If the plaintiff had not purchased the checks from the check-cashing companies,\nwho would have taken the loss here?\n7. What recourse does the defendant, Hauser Co., have now?\n8. Authors\xe2\x80\x99 comment: How this scam unfolded is suggested in the following\nsegment of an online guide to reducing financial transaction fraud.\nRecommendations: It is clear from this case that if a thief can get check stock\nthat looks genuine, your company can be held liable for losses that may occur\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n732\n\n\x0cfrom those counterfeit checks. Most companies buy check stock from vendors\nthat sell the identical check stock entirely blank to other companies, totally\nuncontrolled, thus aiding the forgers. Many companies opt for these checks\nbecause they are less expensive than controlled, high security checks (excluding\nlegal fees and holder in due course judgments). Forgers buy the check stock, and\nusing a $99 scanner and Adobe Illustrator, create counterfeit checks that cannot\nbe distinguished from the account holder\xe2\x80\x99s original checks. This is how legal\nexposure to a holder in due course claim can be and is created. Companies\nshould use checks uniquely designed and manufactured for them, or buy from\nvendors such as SAFEChecks (http://www.safechecks.com) that customize every\ncompany\xe2\x80\x99s check and never sells check stock entirely blank without it first being\ncustomized for the end user. [1]\n[1] Frank Abagnale and Greg Litster, Holder in Due Course and Check Fraud,\nTransactionDirectory.com,http://www.parascript.com/objects/0707TransactionDirectory.pdf.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n733\n\n\x0c15.4 Summary and Exercises\nSummary\nA holder is a holder in due course (HDC) if he takes the instrument without reason to question its\nauthenticity on account of obvious facial irregularities, for value, in good faith, and without notice that it\nis overdue or has been dishonored, or that it contains a forgery or alteration, or that that any person has\nany defense against it or claim to it. The HDC takes the paper free of most defenses; an ordinary holder\ntakes the paper as an assignee, acquiring only the rights of the assignor.\n\nValue is not the same as consideration; hence, a promise will not satisfy this criterion until it has been\nperformed. The HDC must have given something of value other than a promise to give.\n\nGood faith means (1) honesty in fact in the conduct or transaction concerned and (2) the observance of\nreasonable commercial standards of fair dealing. Honesty in fact is a subjective test, but the observance of\nreasonable commercial standards is objective.\n\nNotice is not limited to receipt of an explicit statement of defenses; a holder may be given notice through\ninferences that should be drawn from the character of the instrument. Thus an incomplete instrument,\none that bears marks of forgery, or one that indicates it is overdue may give notice on its face. Certain\nfacts do not necessarily give notice of defense or claim: that the instrument is antedated or postdated, that\nthe instrument was negotiated in return for an executory promise, that any party has signed for\naccommodation, that an incomplete instrument has been completed, that any person negotiating the\ninstrument is or was a fiduciary, or that there has been default in payment of interest or principal.\n\nA person who could not have become an HDC directly (e.g., because he had notice of a defense or claim)\nmay become so if he takes as transferee from an HDC as long as he was not a party to any fraud or\nillegality affecting the instrument or had not previously been a holder with notice of a defense or claim.\nThis is the shelter rule.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n734\n\n\x0cHolders in due course are not immune from all defenses. A real, as opposed to a personal, defense may be\nasserted against the HDC. Personal defenses include fraud in the inducement, failure of consideration,\nnonperformance of a condition precedent, and the like. Real defenses consist of infancy, acts that would\nmake a contract void (such as duress), fraud in the execution, forgery, and discharge in bankruptcy. A\n1976 trade regulation rule of the Federal Trade Commission abolishes the holder-in-due-course rule for\nconsumer transactions.\n\nE XE R C IS ES\n1. Mike signed and delivered a note for $9,000 to Paul Payee in exchange for\nPaul\xe2\x80\x99s tractor. Paul transferred the note to Hilda, who promised to pay $7,500\nfor it. After Hilda had paid Paul $5,000 of the promised $7,500, Hilda learned\nthat Mike had a defense: the tractor was defective. How much, if anything,\ncan Hilda collect from Mike on the note, and why?\n2. In Exercise 1, if Hilda had paid Paul $7,500 and then learned of Mike\xe2\x80\x99s\ndefense, how much\xe2\x80\x94if any of the amount\xe2\x80\x94could she collect from Mike?\n3. Tex fraudulently sold a boat, to which he did not have title, to Sheryl for\n$30,000 and received, as a deposit from her, a check in the amount of $5,000.\nHe deposited the check in his account at First Bank and immediately withdrew\n$3,000 of the proceeds. When Sheryl discovered that Tex had no title, she\ncalled her bank (the drawee) and stopped payment on the check. Tex, in the\nmeantime, disappeared. First Bank now wishes to collect the $3,000 from\nSheryl, but she claims it is not an HDC because it did not give value for the\ncheck in that the payment to Tex was conditional: the bank retained the right\nto collect from Tex if it could not collect on the check. Is Sheryl correct?\nExplain.\n4. Corporation draws a check payable to First Bank. The check is given to an\nofficer of Corporation (known to Bank), who is instructed to deliver it to Bank\nin payment of a debt owed by Corporation to Bank. Instead, the officer,\nintending to defraud Corporation, delivers the check to Bank in payment of his\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n735\n\n\x0cpersonal debt. Bank has received funds of Corporation that have been used\nfor the personal benefit of the officer. Corporation asserts a claim to the\nproceeds of the check against Bank. Is Bank an HDC of the check?\n5. Contractor contracted with Betty Baker to install a new furnace in Baker\xe2\x80\x99s\nbusiness. Baker wrote a check for $8,000 (the price quoted by Contractor)\npayable to Furnace Co., which Contractor delivered to Furnace Co. in payment\nof his own debt to it. Furnace Co. knew nothing of what went on between\nContractor and Baker. When Contractor did not complete the job, Baker\nstopped payment on the check. Furnace Co. sued Baker, who defended by\nclaiming failure of consideration. Is this a good defense against Furnace Co.?\n6. Benson purchased a double-paned, gas-filled picture window for his house\nfrom Wonder Window, making a $200 deposit and signing an installment\ncontract, which is here set out in its entirety:\nOctober 3, 2012\nI promise to pay to Wonder Window or order the sum of $1,000 in five\nequal installments of $200.\n[Signed] Benson\nWonder Window negotiated the installment contract to Devon, who took\nthe instrument for value, in good faith, without notice of any claim or\ndefense of any party, and without question of the instrument\xe2\x80\x99s\nauthenticity. After Benson made three payments, the window fogged up\ninside and was unacceptable. Benson wants his money back from Wonder\nWindow, and he wants to discontinue further payments. Can he do that?\nExplain.\n7. The Turmans executed a deed of trust note (a note and mortgage) dated\nNovember 12, 2012, for $100,000 payable to Ward\xe2\x80\x99s Home Improvement, Inc.\nThe note was consideration for a contract: Ward was to construct a home on the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n736\n\n\x0cTurmans\xe2\x80\x99 property. The same day, Ward executed a separate written assignment\nof the note to Robert L. Pomerantz, which specifically used the word \xe2\x80\x9cassigns.\xe2\x80\x9d\nWard did not endorse the note to Pomerantz or otherwise write on it. Ward did\nnot complete the house; to do so would require the expenditure of an additional\n$42,000. Pomerantz maintained he is a holder in due course of the $100,000 note\nand demanded payment from the Turmans. Does he get paid? Explain. [1]\n\nS EL F -T E ST QU EST IO N S\n1. Which defeats a person from being an HDC?\na. She takes the paper in return for a promise by the maker or drawer\nto perform a service in the future.\nb. She subjectively takes it in good faith, but most people would\nrecognize the deal as suspect.\nc. The instrument contains a very clever, almost undetectable forged\nsignature.\nd. The instrument was postdated.\ne. All these are grounds to defeat the HDC status.\nPersonal defenses are\na. good against all holders\nb. good against holders but not HDCs\nc. good against HDCs but not holders\nd. not good against any holder, HDC or otherwise\ne. sometimes good against HDCs, depending on the facts\nFraud in the inducement is a ________________ defense.\na. real\nb. personal\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n737\n\n\x0cA person would not be an HDC if she\na. was notified that payment on the instrument had been refused\nb. knew that one of the prior indorsers had been discharged\nc. understood that the note was collateral for a loan\nd. purchased the note at a discount\nRock Industries agreed to sell Contractor gravel to repair an airport drain\nfield. Contractor was uncertain how many loads of gravel would be needed,\nso he drew a check made out to \xe2\x80\x9cRock Industries\xe2\x80\x9d as the payee but left the\namount blank, to be filled in on the job site when the last load of gravel was\ndelivered. Five truckloads, each carrying ten tons of gravel, were required,\nwith gravel priced at $20 per ton. Thus Contractor figured he\xe2\x80\x99d pay for fifty\ntons, or $1,000, but Rock Industries had apparently filled in the amount as\n$1,400 and negotiated it to Fairchild Truck Repair. Fairchild took it in good\nfaith for an antecedent debt. Contractor will\na. be liable to Fairchild, but only for $1,000\nb. be liable to Fairchild for $1,400\nc. not be liable to Fairchild because the check was materially altered\nd. not be liable to Fairchild because it did not give \xe2\x80\x9cvalue\xe2\x80\x9d for it to\nRock Industries\n\nS EL F -T E ST A NSW E R S\n1. a\n2. b\n3. b\n4. a\n5. b\n[1] Turman v. Ward\xe2\x80\x99s Home Imp., Inc., 1995 WL 1055769, Va. Cir. Ct. (1995).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n738\n\n\x0cChapter 16\nLiability and Discharge\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. The liability of an agent who signs commercial paper\n2. What contract liability is imposed when a person signs commercial paper\n3. What warranty liability is imposed upon a transferor\n4. What happens if there is payment or acceptance by mistake\n5. How parties are discharged from liability on commercial paper\n\nIn Chapter 13 "Nature and Form of Commercial Paper", Chapter 14 "Negotiation of Commercial Paper",\nand Chapter 15 "Holder in Due Course and Defenses", we focused on the methods and consequences of\nnegotiating commercial paper when all the proper steps are followed. For example, a maker gives a\nnegotiable note to a payee, who properly negotiates the paper to a third-party holder in due course. As a\nresult, this third party is entitled to collect from the maker, unless the latter has a real defense.\nIn this chapter, we begin by examining a question especially important to management: personal liability\nfor signing company notes and checks. Then we look at the two general types of liability\xe2\x80\x94contract and\nwarranty\xe2\x80\x94introduced in Chapter 14 "Negotiation of Commercial Paper". We conclude the chapter by\nreviewing the ways in which parties are discharged from liability.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n739\n\n\x0c16.1 Liability Imposed by Signature: Agents,\nAuthorized and Unauthorized\nL EA R N IN G O B JEC T IV ES\n1. Recognize what a signature is under Article 3 of the Uniform Commercial\nCode.\n2. Understand how a person\xe2\x80\x99s signature on an instrument affects liability if the\nperson is an agent, or a purported agent, for another.\n\nThe liability of an agent who signs commercial paper is one of the most frequently litigated issues in this\narea of law. For example, Igor is an agent (treasurer) of Frank N. Stein, Inc. Igor signs a note showing that\nthe corporation has borrowed $50,000 from First Bank. The company later becomes bankrupt. The\nquestion: Is Igor personally liable on the note? The unhappy treasurer might be sued by the bank\xe2\x80\x94the\nimmediate party with whom he dealt\xe2\x80\x94or by a third party to whom the note was transferred (see Figure\n16.1 "Signature by Representative").\n\nFigure 16.1 Signature by Representative\n\nThere are two possibilities regarding an agent who signs commercial paper: the agent was authorized to\ndo so, or the agent was not authorized to do so. First, though, what is a signature?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n740\n\n\x0cA \xe2\x80\x9cSignature\xe2\x80\x9d under the Uniform Commercial Code\nSection 3-401 of the Uniform Commercial Code (UCC) provides fairly straightforwardly that \xe2\x80\x9ca signature\ncan be made (i) manually or by means of a device or machine, and (ii) by the use of any name, including\nany trade or assumed name, or by any word, mark, or symbol executed or adopted by a person with the\npresent intention to authenticate a writing.\xe2\x80\x9d\n\nLiability of an Agent Who Has Authority to Sign\nAgents often sign instruments on behalf of their principals, and\xe2\x80\x94of course\xe2\x80\x94because a corporation\xe2\x80\x99s\nexistence is a legal fiction (you can\xe2\x80\x99t go up and shake hands with General Motors), corporations can only\nact through their agents.\n\nThe General Rule\nSection 3-402(a) of the UCC provides that a person acting (or purporting to act) as an agent who signs an\ninstrument binds the principal to the same extent that the principal would be bound if the signature were\non a simple contract. The drafters of the UCC here punt to the common law of agency: if, under agency\nlaw, the principal would be bound by the act of the agent, the signature is the authorized signature of the\nprincipal. And the general rule in agency law is that the agent is not liable if he signs his own name and\nmakes clear he is doing so as an agent. In our example, Igor should sign as follows: \xe2\x80\x9cFrank N. Stein, Inc.,\nby Igor, Agent.\xe2\x80\x9d Now it is clear under agency law that the corporation is liable and Igor is not.\n\n[1]\n\nGood job,\n\nIgor.\n\nIncorrect Signatures\nThe problems arise where the agent, although authorized, signs in an incorrect way. There are three\npossibilities: (1) the agent signs only his own name\xe2\x80\x94\xe2\x80\x9cIgor\xe2\x80\x9d; (2) the agent signs both names but without\nindication of any agency\xe2\x80\x94\xe2\x80\x9cFrank N. Stein, Inc., / Igor\xe2\x80\x9d (the signature is ambiguous\xe2\x80\x94are both parties to be\nliable, or is Igor merely an agent?); (3) the agent signs as agent but doesn\xe2\x80\x99t identify the principal\xe2\x80\x94\xe2\x80\x9cIgor,\nAgent.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n741\n\n\x0cThe UCC provides that in each case, the agent is liable to a holder in due course (HDC) who took the\ninstrument without notice that the agent wasn\xe2\x80\x99t intended to be liable on the instrument. As to any other\nperson (holder or transferee), the agent is liable unless she proves that the original parties to the\ninstrument did not intend her to be liable on it. Section 3-402(c) says that, as to a check, if an agent signs\nhis name without indicating agency status but the check has the principal\xe2\x80\x99s identification on it (that would\nbe in the upper left corner), the authorized agent is not liable.\n\nLiability of an \xe2\x80\x9cAgent\xe2\x80\x9d Who Has No Authority to Sign\nA person who has no authority to sign an instrument cannot really be an \xe2\x80\x9cagent\xe2\x80\x9d because by definition an\nagent is a person or entity authorized to act on behalf of and under the control of another in dealing with\nthird parties. Nevertheless, unauthorized persons not infrequently purport to act as agents: either they are\nmistaken or they are crooks. Are their signatures binding on the \xe2\x80\x9cprincipal\xe2\x80\x9d?\n\nThe General Rule\nAn unauthorized signature is not binding; it is\xe2\x80\x94as the UCC puts it\xe2\x80\x94\xe2\x80\x9cineffective except as the signature of\n[2]\n\nthe unauthorized signer.\xe2\x80\x9d So if Crook signs a Frank N. Stein, Inc., check with the name \xe2\x80\x9cIgor,\xe2\x80\x9d the only\nperson liable on the check is Crook.\n\nThe Exceptions\nThere are two exceptions. Section 4-403(a) of the UCC provides that an unauthorized signature may be\nratified by the principal, and Section 3-406 says that if negligence contributed to an instrument\xe2\x80\x99s\nalteration or forgery, the negligent person cannot assert lack of authority against an HDC or a person who\nin good faith pays or takes the instrument for value or for collection. This is the situation where Principal\nleaves the rubber signature stamp lying about and Crook makes mischief with it, making out a check to\nPayee using the stamp. But if Payee herself failed to exercise reasonable care in taking a suspicious\ninstrument, both Principal and Payee could be liable, based on comparative negligence principles.\n\nSaylor URL: http://www.saylor.org/books\n\n[3]\n\nSaylor.org\n742\n\n\x0cK E Y TA K EA WAY\nUnder the UCC, a \xe2\x80\x9csignature\xe2\x80\x9d is any writing or mark used by a person to indicate\nthat a writing is authentic. Agents often sign on behalf of principals, and when the\nauthorized agent makes clear that she is so signing\xe2\x80\x94by naming the principal and\nsigning her name as \xe2\x80\x9cagent\xe2\x80\x9d\xe2\x80\x94the principal is liable, not the agent. But when the\nagent signs incorrectly, the UCC says, in general, that the agent is personally liable\nto an HDC who takes the paper without notice that the agent is not intended to be\nliable. Unauthorized signatures (forgeries) are ineffective as to the principal: they\nare effective as the forger\xe2\x80\x99s signature, unless the principal or the person paying on\nthe instrument has been negligent in contributing to, or in failing to notice, the\nforgery, in which case comparative negligence principles are applied.\n\nE XE R C IS ES\n1. Able signs his name on a note with an entirely illegible squiggle. Is that a valid\nsignature?\n2. Under what circumstances is an agent clearly not personally liable on an\ninstrument?\n3. Under what circumstances is a forgery effective as to the person whose name\nis forged?\n[1] Uniform Commercial Code, Section 4-402(b)(1).\n[2] Uniform Commercial Code, Section 3-403.\n[3] Uniform Commercial Code, Section 3-406(b).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n743\n\n\x0c16.2 Contract Liability of Parties\nL EA R N IN G O B JEC T IV E\n1. Understand that a person who signs commercial paper incurs contract\nliability.\n2. Recognize the two types of such liability: primary and secondary.\n3. Know the conditions that must be met before secondary liability attaches.\n\nTwo types of liability can attach to those who deal in commercial paper: contract liability and warranty\nliability. Contract liability is based on a party\xe2\x80\x99s signature on the paper. For contract liability purposes,\nsigning parties are divided into two categories: primary parties and secondary parties.\n\nWe discuss here the liability of various parties. You may recall the discussion in Chapter 13 "Nature and\nForm of Commercial Paper"about accommodation parties. An accommodation party signs a negotiable\ninstrument in order to lend his name to another party to the instrument. The Uniform Commercial Code\n(UCC) provides that such a person \xe2\x80\x9cmay sign the instrument as maker, drawer, acceptor, or indorser\xe2\x80\x9d and\nthat in whatever capacity the person signs, he will be liable in that capacity.\n\n[1]\n\nLiability of Primary Parties\nTwo parties are primarily liable: the maker of a note and the acceptor of a draft. They are required to pay\nby the terms of the instrument itself, and their liability is unconditional.\n\nMaker\nBy signing a promissory note, the maker promises to pay the instrument\xe2\x80\x94that\xe2\x80\x99s the maker\xe2\x80\x99s contract and,\nof course, the whole point to a note. The obligation is owed to a person entitled to enforce the note or to\nan indorser that paid the note.\n\n[2]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n744\n\n\x0cAcceptor\nRecall that acceptance is the drawee\xe2\x80\x99s signed engagement to honor a draft as presented. The drawee\xe2\x80\x99s\nsignature on the draft is necessary and sufficient to accept, and if that happens, the drawee as acceptor is\nprimarily liable. The acceptance must be written on the draft by some means\xe2\x80\x94any means is good. The\nsignature is usually accompanied by some wording, such as \xe2\x80\x9caccepted,\xe2\x80\x9d \xe2\x80\x9cgood,\xe2\x80\x9d \xe2\x80\x9cI accept.\xe2\x80\x9d When a\nbankcertifies a check, that is the drawee bank\xe2\x80\x99s acceptance, and the bank as acceptor becomes liable to the\nholder; the drawer and all indorsers prior to the bank\xe2\x80\x99s acceptance are discharged. So the holder\xe2\x80\x94\nwhether a payee or an indorsee\xe2\x80\x94can look only to the bank, not to the drawer, for payment.\n\n[3]\n\ndrawee varies the terms when accepting the draft, it is liable according to the terms as varied.\n\nIf the\n[4]\n\nLiability of Secondary Parties\nUnlike primary liability, secondary liability is conditional, arising only if the primarily liable party fails to\npay. The parties for whom these conditions are significant are the drawers and the indorsers. By virtue of\nUCC Sections 3-414 and 3-415, drawers and indorsers engage to pay the amount of an unaccepted draft to\nany subsequent holder or indorser who takes it up, again, if (this is the conditional part) the (1) the\ninstrument is dishonored and, in some cases, (2) notice of dishonor is given to the drawer or indorser.\n\nDrawer\xe2\x80\x99s Liability\nIf Carlos writes (more properly \xe2\x80\x9cdraws\xe2\x80\x9d) a check to his landlord for $700, Carlos does not expect the\nlandlord to turn around and approach him for the money: Carlos\xe2\x80\x99s bank\xe2\x80\x94the drawee\xe2\x80\x94is supposed to pay\nfrom Carlos\xe2\x80\x99s account. But if the bank dishonors the check\xe2\x80\x94most commonly because of insufficient funds\nto pay it\xe2\x80\x94then Carlos is liable to pay according to the instrument\xe2\x80\x99s terms when he wrote the check or, if it\nwas incomplete when he wrote it, according to its terms when completed (subject to some\nlimitations).\n\n[5]\n\nUnder the pre-1997 UCC, Carlos\xe2\x80\x99s liability was conditioned not only upon dishonor but\n\nalso upon notice of dishonor; however, under the revised UCC, notice is not required for the drawer to be\nliable unless the draft has been accepted and the acceptor is not a bank. Most commonly, if a check\nbounces, the person who wrote it is liable to make it good.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n745\n\n\x0cThe drawer of a noncheck draft may disclaim her contractual liability on the instrument by drawing\n\xe2\x80\x9cwithout recourse.\xe2\x80\x9d\n\n[6]\n\nIndorser\xe2\x80\x99s Liability\nUnder UCC Section 3-415, an indorser promises to pay on the instrument according to its terms if it is\ndishonored or, if it was incomplete when indorsed, according to its terms when completed. The liability\nhere is conditioned upon the indorser\xe2\x80\x99s receipt of notice of dishonor (with some exceptions, noted\nin Section 16.2 "Contract Liability of Parties" on contract liability of parties. Indorsers may disclaim\ncontractual liability by indorsing \xe2\x80\x9cwithout recourse.\xe2\x80\x9d\n\n[7]\n\nConditions Required for Liability\nWe have alluded to the point that secondary parties do not become liable unless the proper conditions are\nmet\xe2\x80\x94there are conditions precedent to liability (i.e., things have to happen before liability \xe2\x80\x9cripens\xe2\x80\x9d).\n\nConditions for Liability in General\nThe conditions are slightly different for two classes of instruments. For an unaccepted draft, the drawer\xe2\x80\x99s\nliability is conditioned on (1) presentment and (2) dishonor. For an accepted draft on a nonbank, or for an\nindorser, the conditions are (1) presentment, (2) dishonor, and (3) notice of dishonor.\n\nPresentment\nPresentment occurs when a person entitled to enforce the instrument (creditor)\ndemands payment from the maker, drawee, or acceptor, or when a person entitled to enforce the\ninstrument (again, the creditor) demands acceptance of a draft from the drawee.\n\n[8]\n\nThe common-law tort that makes a person who wrongfully takes another\xe2\x80\x99s property liable for that taking\nis conversion\xe2\x80\x94it\xe2\x80\x99s the civil equivalent of theft. The UCC provides that \xe2\x80\x9cthe law applicable to conversion\nof personal property applies to instruments.\xe2\x80\x9d\n\n[9]\n\nConversion is relevant here because if an instrument is\n\npresented for payment or acceptance and the person to whom it is presented refuses to pay, accept, or\nreturn it, the instrument is converted. An instrument is also converted if a person pays an instrument on a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n746\n\n\x0cforged indorsement: a bank that pays a check on a forged indorsement has converted the instrument and\nis liable to the person whose indorsement was forged. There are various permutations on the theme of\nconversion; here is one example from the Official Comment:\n\nA check is payable to the order of A. A indorses it to B and puts it into an envelope addressed to B. The\nenvelope is never delivered to B. Rather, Thief steals the envelope, forges B\xe2\x80\x99s indorsement to the check\nand obtains payment. Because the check was never delivered to B, the indorsee, B has no cause of action\nfor conversion, but A does have such an action. A is the owner of the check. B never obtained rights in the\ncheck. If A intended to negotiate the check to B in payment of an obligation, that obligation was not\naffected by the conduct of Thief. B can enforce that obligation. Thief stole A\xe2\x80\x99s property not B\xe2\x80\x99s.\n\n[10]\n\nDishonor\nDishonor generally means failure by the obligor to pay on the instrument when presentment for\npayment is made (but return of an instrument because it has not been properly indorsed does not\nconstitute dishonor). The UCC at Section 3-502 has (laborious) rules governing what constitutes dishonor\nand when dishonor occurs for a note, an unaccepted draft, and an unaccepted documentary draft. (A\ndocumentary draft is a draft to be presented for acceptance or payment if specified documents,\ncertificates, statements, or the like are to be received by the drawee or other payor before acceptance or\npayment of the draft.)\n\nNotice of Dishonor\nAgain, when acceptance or payment is refused after presentment, the instrument is said to be dishonored.\nThe holder has a right of recourse against the drawers and indorsers, but he is usually supposed to give\nnotice of the dishonor. Section 3-503(a) of the UCC requires the holder to give notice to a party before the\nparty can be charged with liability, unless such notice is excused, but the UCC exempts notice in a number\nof circumstances (Section 3-504, discussed in Section 16.2 "Contract Liability of Parties" on contract\nliability). The UCC makes giving notice pretty easy: it permits any party who may be compelled to pay the\ninstrument to notify any party who may be liable on it (but each person who is to be charged with liability\nmust actually be notified); notice of dishonor may \xe2\x80\x9cbe given by any commercially reasonable means\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n747\n\n\x0cincluding an oral, written, or electronic communication\xe2\x80\x9d; and no specific form of notice is required\xe2\x80\x94it is\n\xe2\x80\x9csufficient if it reasonably identifies the instrument and indicates that the instrument has been\ndishonored or has not been paid or accepted.\xe2\x80\x9d\n\n[11]\n\nSection 3-503(c) sets out time limits when notice of\n\ndishonor must be given for collecting banks and for other persons. An oral notice is unwise because it\nmight be difficult to prove. Usually, notice of dishonor is given when the instrument is returned with a\nstamp (\xe2\x80\x9cNSF\xe2\x80\x9d\xe2\x80\x94the dreaded \xe2\x80\x9cnonsufficient funds\xe2\x80\x9d), a ticket, or a memo.\n\nSuppose\xe2\x80\x94you\xe2\x80\x99ll want to graph this out\xe2\x80\x94Ann signs a note payable to Betty, who indorses it to Carl, who in\nturn indorses it to Darlene. Darlene indorses it to Earl, who presents it to Ann for payment. Ann refuses.\nAnn is the only primary party, so if Earl is to be paid he must give notice of dishonor to one or more of the\nsecondary parties, in this case, the indorsers. He knows that Darlene is rich, so he notifies only Darlene.\nHe may collect from Darlene but not from the others. If Darlene wishes to be reimbursed, she may notify\nBetty (the payee) and Carl (a prior indorser). If she fails to notify either of them, she will have no recourse.\nIf she notifies both, she may recover from either. Carl in turn may collect from Betty, because Betty\nalready will have been notified. If Darlene notifies only Carl, then she may collect only from him, but he\nmust notify Betty or he cannot be reimbursed. Suppose Earl notified only Betty. Then Carl and Darlene\nare discharged. Why? Earl cannot proceed against them because he did not notify them. Betty cannot\nproceed against them because they indorsed subsequent to her and therefore were not contractually\nobligated to her. However, if, mistakenly believing that she could collect from either Carl or Darlene, Betty\ngave each notice within the time allowed to Earl, then he would be entitled to collect from one of them if\nBetty failed to pay, because they would have received notice. It is not necessary to receive notice from one\nto whom you are liable; Section 3-503(b) says that notice may be given by any person, so that notice\noperates for the benefit of all others who have rights against the obligor.\n\nThere are some deadlines for giving notice: on an instrument taken for collection, a bank must give notice\nbefore midnight on the next banking day following the day on which it receives notice of dishonor; a\nnonbank must give notice within thirty days after the day it received notice; and in all other situations, the\ndeadline is thirty days after the day dishonor occurred.\n\nSaylor URL: http://www.saylor.org/books\n\n[12]\n\nSaylor.org\n748\n\n\x0cWaived or Excused Conditions\nPresentment and notice of dishonor have been discussed as conditions precedent for imposing liability\nupon secondarily liable parties (again, drawers and indorsers). But the UCC provides circumstances in\nwhich such conditions may be waived or excused.\n\nPresentment Waived or Excused\nUnder UCC Section 3-504(a), presentment is excused if (1) the creditor cannot with reasonable diligence\npresent the instrument; (2) the maker or acceptor has repudiated the obligation to pay, is dead, or is in\ninsolvency proceedings; (3) no presentment is necessary by the instrument\xe2\x80\x99s terms; (4) the drawer or\nindorsers waived presentment; (5) the drawer instructed the drawee not to pay or accept; or (6) the\ndrawee was not obligated to the drawer to pay the draft.\n\nNotice of Dishonor Excused\nNotice of dishonor is not required if (1) the instrument\xe2\x80\x99s terms do not require it or (2) the debtor waived\nthe notice of dishonor. Moreover, a waiver of presentment is also a waiver of notice of dishonor. Delay in\ngiving the notice is excused, too, if it is caused by circumstances beyond the control of the person giving\nnotice and she exercised reasonable diligence when the cause of delay stopped.\n\n[13]\n\nIn fact, in real life, presentment and notice of dishonor don\xe2\x80\x99t happen very often, at least as to notes. Going\nback to presentment for a minute: the UCC provides that the \xe2\x80\x9cparty to whom presentment is made [the\ndebtor] may require exhibition of the instrument,\xe2\x80\xa6reasonable identification of the person demanding\npayment,\xe2\x80\xa6[and] a signed receipt [from the creditor (among other things)]\xe2\x80\x9d (Section 3-501). This all\nmakes sense: for example, certainly the prudent contractor paying on a note for his bulldozer wants to\nmake sure the creditor actually still has the note (hasn\xe2\x80\x99t negotiated it to a third party) and is the correct\nperson to pay, and getting a signed receipt when you pay for something is always a good idea.\n\xe2\x80\x9cPresentment\xe2\x80\x9d here is listed as a condition of liability, but in fact, most of the time there is no\npresentment at all:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n749\n\n\x0c[I]t\xe2\x80\x99s a fantasy. Every month millions of homeowners make payments on the notes that they signed when\nthey borrowed money to buy their houses. Millions of college graduates similarly make payments on their\nstudent loan notes. And millions of drivers and boaters pay down the notes that they signed when they\nborrowed money to purchase automobiles or vessels. [Probably] none of these borrowers sees the notes\nthat they are paying. There is no \xe2\x80\x9cexhibition\xe2\x80\x9d of the instruments as section 3-501 [puts it]. There is no\nshowing of identification. In some cases\xe2\x80\xa6there is no signing of a receipt for payment. Instead, each\nmonth, the borrowers simply mail a check to an address that they have been given.\n\n[14]\n\nThe Official Comment to UCC Section 5-502 says about the same thing:\n\nIn the great majority of cases presentment and notice of dishonor are waived with respect to notes. In\nmost cases a formal demand for payment to the maker of the note is not contemplated. Rather, the maker\nis expected to send payment to the holder of the note on the date or dates on which payment is due. If\npayment is not made when due, the holder usually makes a demand for payment, but in the normal case\nin which presentment is waived, demand is irrelevant and the holder can proceed against indorsers when\npayment is not received.\n\nK E Y TA K EA WAY\nPeople who sign commercial paper become liable on the instrument by contract:\nthey contract to honor the instrument. There are two types of liability: primary\nand secondary. The primarily liable parties are makers of notes and drawees of\ndrafts (your bank is the drawee for your check), and their liability is unconditional.\nThe secondary parties are drawers and indorsers. Their liability is conditional: it\narises if the instrument has been presented for payment or collection by the\nprimarily liable party, the instrument has been dishonored, and notice of dishonor\nis provided to the secondarily liable parties. The presentment and notice of\ndishonor are often unnecessary to enforce contractual liability.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n750\n\n\x0cE XE R C IS ES\n1. What parties have primary liability on a negotiable instrument?\n2. What parties have secondary liability on a negotiable instrument?\n3. Secondary liability is conditional. What are the conditions precedent to\nliability?\n4. What conditions may be waived or excused, and how?\n[1] Uniform Commercial Code, Section 3-419.\n[2] Uniform Commercial Code, Section 3-412.\n[3] Uniform Commercial Code, Section 3-414(b).\n[4] Uniform Commercial Code, Section 3-413(a)(iii).\n[5] Uniform Commercial Code, Section 3-414.\n[6] Uniform Commercial Code, Section 3-414(d).\n[7] Uniform Commercial Code, Section 3-415(b).\n[8] Uniform Commercial Code, Section 3-501.\n[9] Uniform Commercial Code, Section 3-420.\n[10] Uniform Commercial Code, Section 3-420, Official Comment 1.\n[11] Uniform Commercial Code, Section 3-503(b).\n[12] Uniform Commercial Code, Section 3-503(c).\n[13] Uniform Commercial Code, Section 3-504.\n[14] Gregory E. Maggs, \xe2\x80\x9cA Complaint about Payment Law Under the U.C.C.: What You See Is\nOften Not What You Get,\xe2\x80\x9d Ohio State Law Journal 68, no. 201, no. 207\n(2007), http://ssrn.com/abstract=1029647.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n751\n\n\x0c16.3 Warranty Liability of Parties\n\nL EA R N IN G O B JEC T IV ES\n\n1. Understand that independent of contract liability, parties to negotiable\ninstruments incur warranty liability.\n2. Know what warranties a person makes when she transfers an instrument.\n3. Know what warranties a person makes when he presents an instrument for\npayment or acceptance.\n4. Understand what happens if a bank pays or accepts a check by mistake.\n\nOverview of Warranty Liability\nWe discussed the contract liability of primary and secondary parties, which applies to those who sign the\ninstrument. Liability arises a second way, too\xe2\x80\x94by warranty. A negotiable instrument is a type of property\nthat is sold and bought, just the way an automobile is, or a toaster. If you buy a car, you generally expect\nthat it will, more or less, work the way cars are supposed to work\xe2\x80\x94that\xe2\x80\x99s the implied warranty of\nmerchantability. Similarly, when an instrument is transferred from A to B for consideration, the\ntransferee (B) expects that the instrument will work the way such instruments are supposed to work. If A\ntransfers to B a promissory note made by Maker, B figures that when the time is right, she can go to\nMaker and get paid on the note. So A makes some implied warranties to B\xe2\x80\x94transfer warranties. And\nwhen B presents the instrument to Maker for payment, Maker assumes that B as the indorsee from A is\nentitled to payment, that the signatures are genuine, and the like. So B makes some implied warranties to\nMaker\xe2\x80\x94presentment warranties. Usually, claims of breach of warranty arise in cases involving forged,\naltered, or stolen instruments, and they serve to allocate the loss to the person in the best position to have\navoided the loss, putting it on the person (or bank) who dealt with the wrongdoer. We take up both\ntransfer and presentment warranties.\n\nTransfer Warranties\nTransfer warranties are important because\xe2\x80\x94as we\xe2\x80\x99ve seen\xe2\x80\x94contract liability is limited to those who have\nactually signed the instrument. Of course, secondary liability will provide a holder with sufficient grounds\nfor recovery against a previous indorser who did not qualify his indorsement. But sometimes there is no\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n752\n\n\x0cindorsement, and sometimes the indorsement is qualified. Sometimes, also, the holder fails to make\ntimely presentment or notice of dishonor, thereby discharging a previous indorsee. In such cases, the\ntransferee-holder can still sue a prior party on one or more of the five implied warranties.\n\nA person who receives consideration for transferring an instrument makes the five warranties listed in\nUCC Section 3-416. The warranty may be sued on by the immediate transferee or, if the transfer was by\nindorsement, by any subsequent holder who takes the instrument in good faith. The warranties thus run\nwith the instrument. They are as follows:\n\n1.\n\nThe transferor is entitled to enforce the instrument. The transferor warrants that he is\xe2\x80\x94or would\nhave been if he weren\xe2\x80\x99t transferring it\xe2\x80\x94entitled to enforce the instrument. As UCC Section 3-416,\nComment 2, puts it, this \xe2\x80\x9cis in effect a warranty that there are no unauthorized or missing\nindorsements that prevent the transferor from making the transferee a person entitled to enforce\nthe instrument.\xe2\x80\x9d Suppose Maker makes a note payable to Payee; Thief steals the note, forges\nPayee\xe2\x80\x99s indorsement, and sells the note. Buyer is not a holder because he is not \xe2\x80\x9ca person in\npossession of an instrument drawn, issued, or indorsed to him, or to his order, or to bearer, or in\nblank,\xe2\x80\x9d so he is not entitled to enforce it. \xe2\x80\x9c\xe2\x80\x98Person entitled to enforce\xe2\x80\x99 means (i) the holder, (ii) a\nnon-holder in possession of the instrument who has the rights of a holder [because of the shelter\nrule]\xe2\x80\x9d (UCC, Section 3-301). Buyer sells the note to Another Party, who can hold Buyer liable for\nbreach of the warranty: he was not entitled to enforce it.\n\n2. All signatures on the instrument are authentic and authorized. This warranty would be breached,\ntoo, in the example just presented.\n3. The instrument has not been altered.\n4. The instrument is not subject to a defense or claim in recoupment of any party that can be\nasserted against the warrantor. \xe2\x80\x9cRecoupment\xe2\x80\x9d means to hold back or deduct part of what is due\nto another. The Official Comment to UCC Section 3-416 observes, \xe2\x80\x9c[T]he transferee does not\nundertake to buy an instrument that is not enforceable in whole or in part, unless there is a\ncontrary agreement. Even if the transferee takes as a holder in due course who takes free of the\ndefense or claim in recoupment, the warranty gives the transferee the option of proceeding\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n753\n\n\x0cagainst the transferor rather than litigating with the obligor on the instrument the issue of the\nholder-in-due-course status of the transferee.\xe2\x80\x9d\n5.\n\nThe warrantor has no knowledge of any insolvency proceeding commenced with respect to the\nmaker or acceptor or, in the case of an unaccepted draft, the drawer. The UCC Official Comment\nhere provides the following: \xe2\x80\x9cThe transferor does not warrant against difficulties of collection,\nimpairment of the credit of the obligor or even insolvency [only knowledge of insolvency]. The\ntransferee is expected to determine such questions before taking the obligation. If insolvency\nproceedings\xe2\x80\xa6have been instituted against the party who is expected to pay and the transferor\nknows it, the concealment of that fact amounts to a fraud upon the transferee, and the warranty\nagainst knowledge of such proceedings is provided accordingly.\xe2\x80\x9d\n\n[1]\n\nPresentment Warranties\nA payor paying or accepting an instrument in effect takes the paper from the party who presents it to the\npayor, and that party has his hand out. In doing so, the presenter makes certain implied promises to the\npayor, who is about to fork over cash (or an acceptance). The UCC distinguishes between warranties made\nby one who presents an unaccepted draft for payment and warranties made by one who presents other\ninstruments for payment. The warranties made by the presenter are as follows.\n\n[2]\n\nWarranties Made by One Who Presents an Unaccepted Draft\n1.\n\nThe presenter is entitled to enforce the draft or to obtain payment or acceptance. This is \xe2\x80\x9cin\neffect a warranty that there are no unauthorized or missing indorsements.\xe2\x80\x9d\n\n[3]\n\nSuppose Thief steals\n\na check drawn by Drawer to Payee and forges Payee\xe2\x80\x99s signature, then presents it to the bank. If\nthe bank pays it, the bank cannot charge Drawer\xe2\x80\x99s account because it has not followed Drawer\xe2\x80\x99s\norder in paying to the wrong person (except in the case of an imposter or fictitious payee). It can,\nthough, go back to Thief (fat chance it can find her) on the claim that she breached the warranty\nof no unauthorized indorsement.\n2. There has been no alteration of the instrument. If Thief takes a check and changes the amount\nfrom $100 to $1,000 and the bank pays it, the bank can recover from Thief $900, the difference\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n754\n\n\x0cbetween the amount paid by the bank and the amount Drawer (customer) authorized the bank to\npay.\n\n[4]\n\nIf the drawee accepts the draft, the same rules apply.\n\n3. The presenter has no knowledge that the signature of the drawer is unauthorized. If the\npresenter doesn\xe2\x80\x99t know Drawer\xe2\x80\x99s signature is forged and the drawee pays out on a forged\nsignature, the drawee bears the loss. (The bank would be liable for paying out over the forged\ndrawer\xe2\x80\x99s signature: that\xe2\x80\x99s why it has the customer\xe2\x80\x99s signature on file.)\n\nThese rules apply\xe2\x80\x94again\xe2\x80\x94to warranties made by the presenter to a drawee paying out on an unaccepted\ndraft. The most common situation would be where a person has a check made out to her and she gets it\ncashed at the drawer\xe2\x80\x99s bank.\n\nWarranties Made by One Who Presents Something Other Than an Unaccepted\nDraft\nIn all other cases, there is only one warranty made by the presenter: that he or she is a person entitled to\nenforce the instrument or obtain payment on it.\n\nThis applies to the presentment of accepted drafts, to the presentment of dishonored drafts made to the\ndrawer or an indorser, and to the presentment of notes. For example, Maker makes a note payable to\nPayee; Payee indorses the note to Indorsee, Indorsee indorses and negotiates the note to Subsequent\nParty. Subsequent Party presents the note to Maker for payment. The Subsequent Party warrants to\nMaker that she is entitled to obtain payment. If she is paid and is notentitled to payment, Maker can sue\nher for breach of that warranty. If the reason she isn\xe2\x80\x99t entitled to payment is because Payee\xe2\x80\x99s signature\nwas forged by Thief, then Maker can go after Thief: the UCC says that \xe2\x80\x9cthe person obtaining payment\n[Subsequent Party] and a prior transferor [Thief] warrant to the person making payment in good faith\n[Maker] that the warrantor [Subsequent Party] is entitled to enforce the instrument.\xe2\x80\x9d\n\n[5]\n\nOr, again, Drawer\n\nmakes the check out to Payee; Payee attempts to cash or deposit the check, but it is dishonored. Payee\npresents the check to Drawer to make it good: Payee warrants he is entitled to payment on it.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n755\n\n\x0cWarranties cannot be disclaimed in the case of checks (because, as UCC Section 3-417, Comment 7, puts\nit, \xe2\x80\x9cit is not appropriate to allow disclaimer of warranties appearing on checks that normally will not be\nexamined by the payor bank\xe2\x80\x9d\xe2\x80\x94they\xe2\x80\x99re machine read). But a disclaimer of warranties is permitted as to\nother instruments, just as disclaimers of warranty are usually OK under general contract law. The reason\npresentment warranties 2 and 3 don\xe2\x80\x99t apply to makers and drawers (they apply to drawees) is because\nmakers and drawers are going to know their own signatures and the terms of the instruments; indorsers\nalready warranted the wholesomeness of their transfer (transfer warranties), and acceptors should\nexamine the instruments when they accept them.\n\nPayment by Mistake\nSometimes a drawee pays a draft (most familiarly, again, a bank pays a check) or accepts a draft by\nmistake. The UCC says that if the mistake was in thinking that there was no stop-payment order on it\n(when there was), or that the drawer\xe2\x80\x99s signature was authorized (when it was not), or that there were\nsufficient funds in the drawer\xe2\x80\x99s account to pay it (when there were not), \xe2\x80\x9cthe drawee may recover the\namount paid\xe2\x80\xa6or in the case of acceptance, may revoke the acceptance.\xe2\x80\x9d\n\n[6]\n\nExcept\xe2\x80\x94and it\xe2\x80\x99s a big\n\nexception\xe2\x80\x94such a recovery of funds does not apply \xe2\x80\x9cagainst a person who took the instrument in good\n[7]\n\nfaith and for value.\xe2\x80\x9d The drawee in that case would have to go after the forger, the unauthorized signer,\nor, in the case of insufficient funds, the drawer. Example: Able draws a check to Baker. Baker deposits the\ncheck in her bank account, and Able\xe2\x80\x99s bank mistakenly pays it even though Able doesn\xe2\x80\x99t have enough\nmoney in his account to cover it. Able\xe2\x80\x99s bank cannot get the money back from Baker: it has to go after\nAble. To rephrase, in most cases, the remedy of restitution will not be available to a bank that pays or\naccepts a check because the person receiving payment of the check will have given value for it in good\nfaith.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n756\n\n\x0cK E Y TA K EA WAY\nA transferor of a negotiable instrument warrants to the transferee five things: (1)\nentitled to enforce, (2) authentic and authorized signatures, (3) no alteration, (4)\nno defenses, and (5) no knowledge of insolvency. If the transfer is by delivery, the\nwarranties run only to the immediate transferee; if by indorsement, to any\nsubsequent good-faith holder. Presenters who obtain payment of an instrument\nand all prior transferors make three presenter\xe2\x80\x99s warranties: (1) entitled to enforce,\n(2) no alteration, (3) genuineness of drawer\xe2\x80\x99s signature. These warranties run to\nany good-faith payor or acceptor. If a person pays or accepts a draft by mistake, he\nor she can recover the funds paid out unless the payee took the instrument for\nvalue and in good faith.\n\nE XE R C IS ES\n1. What does it mean to say that the transferor of a negotiable instrument\nwarrants things to the transferee, and what happens if the warranties are\nbreached? What purpose do the warranties serve?\n2. What is a presenter, and to whom does such a person make warranties?\n3. Under what circumstances would suing for breach of warranties be useful\ncompared to suing on the contract obligation represented by the instrument?\n4. Why are the rules governing mistaken payment not very often useful to a\nbank?\n[1] Uniform Commercial Code, Section 3-416, Official Comment 4.\n[2] Uniform Commercial Code, Section 3-417.\n[3] Uniform Commercial Code, Section 3-417, Comment 2.\n[4] Uniform Commercial Code, Sections 3-417(2) and (b).\n[5] Uniform Commercial Code, Section 3-417(d).\n[6] Uniform Commercial Code, Section 3-418.\n[7] Uniform Commercial Code, Section 3-418(c).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n757\n\n\x0c16.4 Discharge\nL EA R N IN G O B JEC T IV E\n1. Understand how the obligations represented by commercial paper may be\ndischarged.\n\nOverview\nNegotiable instruments eventually die. The obligations they represent are discharged (terminated) in two\ngeneral ways: (1) according to the rules stated in Section 3-601 of the Uniform Commercial Code (UCC) or\n(2) by an act or agreement that would discharge an obligation to pay money under a simple contract (e.g.,\ndeclaring bankruptcy).\n\nDischarge under the Uniform Commercial Code\nThe UCC provides a number of ways by which an obligor on an instrument is discharged from liability,\nbut notwithstanding these several ways, under Section 3-601, no discharge of any party provided by the\nrules presented in this section operates against a subsequent holder in due course unless she has notice\nwhen she takes the instrument.\n\nDischarge in General\nDischarge by Payment\nA person primarily liable discharges her liability on an instrument to the extent of payment by paying or\notherwise satisfying the holder, and the discharge is good even if the payor knows that another has claim\nto the instrument. However, discharge does not operate if the payment is made in bad faith to one who\nunlawfully obtained the instrument (and UCC Section 3-602(b) lists two other exceptions).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n758\n\n\x0cDischarge by Tender\nA person who tenders full payment to a holder on or after the date due discharges any subsequent liability\nto pay interest, costs, and attorneys\xe2\x80\x99 fees (but not liability for the face amount of the instrument). If the\nholder refuses to accept the tender, any party who would have had a right of recourse against the party\nmaking the tender is discharged. Mario makes a note payable to Carol, who indorses it to Ed. On the date\nthe payment is due, Mario (the maker) tenders payment to Ed, who refuses to accept the payment; he\nwould rather collect from Carol. Carol is discharged: had she been forced to pay as indorser in the event of\nMario\xe2\x80\x99s refusal, she could have looked to him for recourse. Since Mario did tender, Ed can no longer look\nto Carol for payment.\n\n[1]\n\nDischarge by Cancellation and Renunciation\nThe holder may discharge any party, even without consideration, by marking the face of the instrument or\nthe indorsement in an unequivocal way, as, for example, by intentionally canceling the instrument or the\nsignature by destruction or mutilation or by striking out the party\xe2\x80\x99s signature. The holder may also\nrenounce his rights by delivering a signed writing to that effect or by surrendering the instrument itself.\n\n[2]\n\nDischarge by Material and Fraudulent Alteration\nUnder UCC Section 3-407, if a holder materially and fraudulently alters an instrument, any party whose\ncontract is affected by the change is discharged. A payor bank or drawee paying a fraudulently altered\ninstrument or a person taking it for value, in good faith, and without notice of the alteration, may enforce\nrights with respect to the instrument according to its original terms or, if the incomplete instrument was\naltered by unauthorized completion, according to its terms as completed.\n\n\xe2\x80\xa2\n\nExample 1: Marcus makes a note for $100 payable to Pauline. Pauline fraudulently raises the\namount to $1,000 without Marcus\xe2\x80\x99s negligence and negotiates it to Ned, who qualifies as a holder\nin due course (HDC). Marcus owes Ned $100.\n\n\xe2\x80\xa2\n\nExample 2: Charlene writes a check payable to Lumber Yard and gives it to Contractor to buy\nmaterial for a deck replacement. Contractor fills it in for $1,200: $1,000 for the decking and $200\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n759\n\n\x0cfor his own unauthorized purposes. Lumber Yard, if innocent of any wrongdoing, could enforce\nthe check for $1,200, and Charlene must go after Contractor for the $200.\n\nDischarge by Certification\nAs we have noted, where a drawee certifies a draft for a holder, the drawer and all prior indorsers are\ndischarged.\n\nDischarge by Acceptance Varying a Draft\nIf the holder assents to an acceptance varying the terms of a draft, the obligation of the drawer and any\nindorsers who do not expressly assent to the acceptance is discharged.\n\n[3]\n\nDischarge of Indorsers and Accommodation Parties\nThe liability of indorsers and accommodation parties is discharged under the following three\ncircumstances.\n\n[4]\n\nExtension of Due Date\nIf the holder agrees to an extension of the due date of the obligation of the obligor, the extension\ndischarges an indorser or accommodation party having a right of recourse against the obligor to the extent\nthe indorser or accommodation party proves that the extension caused her loss with respect to the right of\nrecourse.\n\nMaterial Modification of Obligation\nIf the holder agrees to a material modification of the obligor\xe2\x80\x99s obligation, other than an extension of the\ndue date, the modification discharges the obligation of an indorser or accommodation party having a right\nof recourse against the obligor to the extent the modification causes her loss with respect to the right of\nrecourse.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n760\n\n\x0cImpairment of Collateral\nIf the obligor\xe2\x80\x99s duty to pay is secured by an interest in collateral and the holder impairs the value of the\ninterest in collateral, the obligation of an indorser or accommodation party having a right of recourse\nagainst the obligor is discharged to the extent of the impairment.\n\nThe following explanatory paragraph from UCC Section 3-605, Official Comment 1, may be helpful:\n\nBank lends $10,000 to Borrower who signs a note under which she (in suretyship law, the \xe2\x80\x9cPrincipal\nDebtor\xe2\x80\x9d) agrees to pay Bank on a date stated. But Bank insists that an accommodation party also become\nliable to pay the note (by signing it as a co-maker or by indorsing the note). In suretyship law, the\naccommodation party is a \xe2\x80\x9cSurety.\xe2\x80\x9d Then Bank agrees to a modification of the rights and obligations\nbetween it and Principal Debtor, such as agreeing that she may pay the note at some date after the due\ndate, or that she may discharge her $10,000 obligation to pay the note by paying Bank $3,000, or the\nBank releases collateral she gave it to secure the note. Surety is discharged if changes like this are made by\nBank (the creditor) without Surety\xe2\x80\x99s consent to the extent Surety suffers loss as a result. Section 3-605 is\nconcerned with this kind of problem with Principal Debtor and Surety. But it has a wider scope: it also\napplies to indorsers who are not accommodation parties. Unless an indorser signs without recourse, the\nindorser\xe2\x80\x99s liability under section 3-415(a) is that of a surety. If Bank in our hypothetical case indorsed the\nnote and transferred it to Second Bank, Bank has rights given to an indorser under section 3-605 if it is\nSecond Bank that modifies rights and obligations of Borrower.\n\nDischarge by Reacquisition\nSuppose a prior party reacquires the instrument. He may\xe2\x80\x94but does not automatically\xe2\x80\x94cancel any\nindorsement unnecessary to his title and may also reissue or further negotiate the instrument. Any\nintervening party is thereby discharged from liability to the reacquiring party or to any subsequent holder\nnot in due course. If an intervening party\xe2\x80\x99s indorsement is cancelled, she is not liable even to an HDC.\n\nSaylor URL: http://www.saylor.org/books\n\n[5]\n\nSaylor.org\n761\n\n\x0cDischarge by Unexcused Delay in Presentment or Notice of Dishonor\nIf notice of dishonor is not excused under UCC Section 3-504, failure to give it discharges drawers and\nindorsers.\n\nK E Y TA K EA WAY\nThe potential liabilities arising from commercial paper are discharged in several ways.\nAnything that would discharge a debt under common contract law will do so. More\nspecifically as to commercial paper, of course, payment discharges the obligation. Other\nmethods include tender of payment, cancellation or renunciation, material and\nfraudulent alteration, certification, acceptance varying a draft, reacquisition, and\xe2\x80\x94in\nsome cases\xe2\x80\x94unexcused delay in giving notice of presentment or dishonor. Indorsers and\naccommodation parties\xe2\x80\x99 liability may be discharged by the same means that a surety\xe2\x80\x99s\nliability is discharged, to the extent that alterations in the agreement between the\ncreditor and the holder would be defenses to a surety because right of recourse is\nimpaired to the surety.\n\nE XE R C IS ES\n1. What is the most common way that obligations represented by commercial paper\nare discharged?\n2. Parents loan Daughter $6,000 to attend college, and she gives them a promissory\nnote in return. At her graduation party, Parents ceremoniously tear up the note. Is\nDaughter\xe2\x80\x99s obligation terminated?\n3. Juan signs Roberta\xe2\x80\x99s note to Creditor as an accommodation party, agreeing to serve\nin that capacity for two years. At the end of that term, Roberta has not paid\nCreditor, who\xe2\x80\x94without Juan\xe2\x80\x99s knowledge\xe2\x80\x94gives Roberta an extra six months to\npay. She fails to do so. Does Creditor still have recourse against Juan?\n[1] Uniform Commercial Code, Section 3-603(b).\n[2] Uniform Commercial Code, Section 3-604.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n762\n\n\x0c[3] Uniform Commercial Code, Section 3-410.\n[4] Uniform Commercial Code, Section 3-605.\n[5] Uniform Commercial Code, Section 3-207.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n763\n\n\x0c16.5 Cases\nBreach of Presentment Warranties and Conduct Precluding Complaint\nabout Such Breach\nBank of Nichols Hills v. Bank of Oklahoma\n\n196 P.3d 984 (Okla. Civ. App. 2008)\n\nGabbard, J.\n\nPlaintiff, Bank of Nichols Hills (BNH), appeals a trial court judgment for Defendant, Bank of Oklahoma\n(BOK), regarding payment of a forged check. The primary issue on appeal is whether BOK presented\nsufficient proof to support the trial court\xe2\x80\x99s finding that the [UCC] \xc2\xa7 3-406 preclusion defense applied. We\nfind that it did, and affirm.\n\nFacts\nMichael and Stacy Russell owned a mobile home in Harrah, Oklahoma. The home was insured by\nOklahoma Farm Bureau Mutual Insurance Company (Farm Bureau). The insurance policy provided that\nin case of loss, Farm Bureau \xe2\x80\x9cwill pay you unless another payee is named on the Declarations page,\xe2\x80\x9d that\n\xe2\x80\x9cLoss shall be payable to any mortgagee named in the Declarations,\xe2\x80\x9d and that one of Farm Bureau\xe2\x80\x99s duties\nwas to \xe2\x80\x9cprotect the mortgagee\xe2\x80\x99s interests in the insured building.\xe2\x80\x9d The Declarations page of the policy\nlisted Conseco Finance as the mortgagee. Conseco had a mortgage security interest in the home.\n\nIn August 2002, a fire completely destroyed the mobile home. The Russells submitted an insurance claim\nto Farm Bureau. Farm Bureau then negotiated a $69,000 settlement with the Russells, issued them a\ncheck in this amount payable to them and Conseco jointly, and mailed the check to the Russells. Neither\nthe Russells nor Farm Bureau notified Conseco of the loss, the settlement, or the mailing of the check.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n764\n\n\x0cThe check was drawn on Farm Bureau\xe2\x80\x99s account at BNH. The Russells deposited the check into their\naccount at BOK. The check contains an endorsement by both Russells, and a rubber stamp endorsement\nfor Conseco followed by a signature of a Donna Marlatt and a phone number. It is undisputed that\nConseco\xe2\x80\x99s endorsement was forged. Upon receipt, BOK presented the check to BNH. BNH paid the\n$69,000 check and notified Farm Bureau that the check had been paid from its account.\n\nAbout a year later, Conseco learned about the fire and the insurance payoff. Conseco notified Farm\nBureau that it was owed a mortgage balance of more than $50,000. Farm Bureau paid off the balance and\nnotified BNH of the forgery. BNH reimbursed Farm Bureau the amount paid to Conseco. BNH then sued\nBOK.\n\nBoth banks relied on the Uniform Commercial Code. BNH asserted that under \xc2\xa7 4-208, BOK had\nwarranted that all the indorsements on the check were genuine. BOK asserted an affirmative defense\nunder \xc2\xa7 3-406, alleging that Farm Bureau\xe2\x80\x99s own negligence contributed to the forgery. After a non-jury\ntrial, the court granted judgment to BOK, finding as follows:\n\xe2\x80\xa2\n\nConseco\xe2\x80\x99s endorsement was a forgery, accomplished by the Russells;\n\n\xe2\x80\xa2\n\nFarm Bureau was negligent in the manner and method it used to process the claim and pay the\nsettlement without providing any notice or opportunity for involvement in the process to\nConseco;\n\n\xe2\x80\xa2\n\nFarm Bureau\xe2\x80\x99s negligence substantially contributed to the Russells\xe2\x80\x99 conduct in forging Conseco\xe2\x80\x99s\nendorsement; and\n\n\xe2\x80\xa2\n\nBOK proved its affirmative defense under \xc2\xa7 3-406 by the greater weight of the evidence.\n\nFrom this judgment, BNH appeals.\n\nAnalysis\nIt cannot be disputed that BOK breached its presentment warranty to BNH under \xc2\xa7 4-208.\n\n[1]\n\nThus the\n\nprimary issue raised is whether BOK established a preclusion defense under 3-406 [that BNH is\nprecluded from complaining about BOK\xe2\x80\x99s breach of presentment warranty because of its own\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n765\n\n\x0cnegligence].\n\n[2]\n\nBNH asserts that the evidence fails to establish this defense because the mailing of its\n\ncheck to and receipt by the insured \xe2\x80\x9cis at most an event of opportunity and has nothing to do with the\nactual forgery.\xe2\x80\x9d\n\nSection 3-406 requires less stringent proof than the \xe2\x80\x9cdirect and proximate cause\xe2\x80\x9d test for general\nnegligence.\n\n[3]\n\nConduct is a contributing cause of an alteration or forgery if it is a substantial factor in\n\nbringing it about, or makes it \xe2\x80\x9ceasier for the wrongdoer to commit his wrong.\xe2\x80\x9d The UCC Comment to \xc2\xa7 3406 notes that the term has the meaning as used by the Pennsylvania court in Thompson [Citation].\n\nIn Thompson, an independent logger named Albers obtained blank weighing slips, filled them out to show\nfictitious deliveries of logs for local timber owners, delivered the slips to the company, accepted checks\nmade payable to the timber owners, forged the owners\xe2\x80\x99 signatures, and cashed the checks at the bank.\nWhen the company discovered the scheme, it sued the bank and the bank raised \xc2\xa7 3-406 as a defense. The\ncourt specifically found that the company\xe2\x80\x99s negligence did not have to be the direct and proximate cause\nof the bank\xe2\x80\x99s acceptance of the forged checks. Instead, the defense applied because the company left blank\nlogging slips readily accessible to haulers, the company had given Albers whole pads of blank slips, the\nslips were not consecutively numbered, haulers were allowed to deliver both the original and duplicate\nslips to the company\xe2\x80\x99s office, and the company regularly entrusted the completed checks to the haulers for\ndelivery to the payees without the payees\xe2\x80\x99 consent. The court noted:\n\nWhile none of these practices, in isolation, might be sufficient to charge the plaintiff [the company] with\nnegligence within the meaning of \xc2\xa7 3-406, the company\xe2\x80\x99s course of conduct, viewed in its entirety, is\nsurely sufficient to support the trial judge\xe2\x80\x99s determination that it substantially contributed to the making\nof the unauthorized signatures.\xe2\x80\xa6[T]hat conduct was \xe2\x80\x98no different than had the plaintiff simply given\nAlbers a series of checks signed in blank for his unlimited, unrestrictive use.\xe2\x80\x99\n\nThe UCC Comment to \xc2\xa7 3-406 gives three examples of conduct illustrating the defense. One example\ninvolves an employer who leaves a rubber stamp and blank checks accessible to an employee who later\ncommits forgery; another example involves a company that issues a ten dollar check but leaves a blank\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n766\n\n\x0cspace after the figure which allows the payee to turn the amount into ten thousand dollars; and the third\nexample involves an insurance company that mails a check to one policyholder whose name is the same as\nanother policyholder who was entitled to the check. In each case, the company\xe2\x80\x99s negligence substantially\ncontributed to the alterations or forgeries by making it easier for the wrongdoer to commit the\nmalfeasance.\n\nIn the present case, we find no negligence in Farm Bureau\xe2\x80\x99s delivery of the check to the Russells. There is\nnothing in the insurance policy that prohibits the insurer from making the loss-payment check jointly\npayable to the Russells and Conseco. Furthermore, under \xc2\xa7 3-420, if a check is payable to more than one\npayee, delivery to one of the payees is deemed to be delivery to all payees. The authority cited by BOK, in\nwhich a check was delivered to one joint payee who then forged the signature of the other, involve cases\nwhere the drawer knew or should have known that the wrongdoer was not entitled to be a payee in the\nfirst place. See [Citations].\n\nWe also find no negligence in Farm Bureau\xe2\x80\x99s violation of its policy provisions requiring the protection of\nthe mortgage holder. Generally, violation of contract provisions and laxity in the conduct of the business\naffairs of the drawer do not per se establish negligence under this section. See [Citations].\n\nHowever, evidence was presented that the contract provision merely reflected an accepted and customary\ncommercial standard in the insurance industry. Failure to conform to the reasonable commercial\nstandards of one\xe2\x80\x99s business has been recognized by a number of courts as evidence of negligence. See, e.g.,\n[Citations].\n\nHere, evidence was presented that Farm Bureau did not act in a commercially reasonable manner or in\naccordance with reasonable commercial standards of its business when it issued the loss check to the\ninsured without notice to the mortgagee. BOK\xe2\x80\x99s expert testified that it is standard practice in the industry\nto notify the lender of a loss this size, in order to avoid exactly the result that occurred here. Mortgagees\noften have a greater financial stake in an insurance policy than do the mortgagors. That was clearly true in\nthis case. While there was opinion testimony to the contrary, the trial court was entitled to conclude that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n767\n\n\x0cFarm Bureau did not act in a commercially reasonably manner and that this failure was negligence which\nsubstantially contributed to the forgery, as contemplated by \xc2\xa7 3-406.\n\nWe find the trial court\xe2\x80\x99s judgment supported by the law and competent evidence. Accordingly, the trial\ncourt\xe2\x80\x99s decision is affirmed. Affirmed.\n\nC A SE QU ES TIO NS\n1. How did BOK breach its presentment warranty to BNH?\n2. What part of the UCC did BOK point to as why it should not be liable for that\nbreach?\n3. In what way was Farm Bureau Mutual Insurance Co. negligent in this case, and\nwhat was the consequence?\n\nPresentment, Acceptance, Dishonor, and Warranties\nMessing v. Bank of America\n\n821 A.2d 22 (Md. 2003)\n\nAt some point in time prior to 3 August 2000, Petitioner, as a holder, came into possession of a check in\nthe amount of Nine Hundred Seventy-Six Dollars ($976.00) (the check) from Toyson J. Burruss, the\ndrawer, doing business as Prestige Auto Detail Center. Instead of depositing the check into his account at\nhis own bank, Petitioner elected to present the check for payment at a branch of Mr. Burruss\xe2\x80\x99 bank, Bank\nof America, the drawee.\n\n[4]\n\nOn 3 August 2000, Petitioner approached a teller at Bank of America\xe2\x80\xa6in\n\nBaltimore City and asked to cash the check. The teller, by use of a computer, confirmed the availability of\nfunds on deposit, and placed the check into the computer\xe2\x80\x99s printer slot. The computer stamped certain\ndata on the back of the check, including the time, date, amount of the check, account number, and teller\nnumber. The computer also effected a hold on the amount of $976.00 in the customer\xe2\x80\x99s account. The\nteller gave the check back to the Petitioner, who endorsed it. The teller then asked for Petitioner\xe2\x80\x99s\nidentification. Petitioner presented his driver\xe2\x80\x99s license and a major credit card. The teller took the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n768\n\n\x0cindorsed check from Petitioner and manually inscribed the driver\xe2\x80\x99s license information and certain credit\ncard information on the back of the check.\n\nAt some point during the transaction, the teller counted out $976.00 in cash from her drawer in\nanticipation of completing the transaction. She asked if the Petitioner was a customer of Bank of America.\nThe Petitioner stated that he was not. The teller returned the check to Petitioner and requested, consistent\nwith bank policy when cashing checks for non-customers, that Petitioner place his thumbprint on the\ncheck. [The thumbprint identification program was designed by various banking and federal agencies to\nreduce check fraud.] Petitioner refused and the teller informed him that she would be unable to complete\nthe transaction without his thumbprint.\n\n\xe2\x80\xa6Petitioner presented the check to the branch manager and demanded that the check be cashed\nnotwithstanding Petitioner\xe2\x80\x99s refusal to place his thumbprint on the check. The branch manager examined\nthe check and returned it to the Petitioner, informing him that, because Petitioner was a non-customer,\nBank of America would not cash the check without Petitioner\xe2\x80\x99s thumbprint on the instrument.\xe2\x80\xa6Petitioner\nleft the bank with the check in his possession.\xe2\x80\xa6\n\nRather than take the check to his own bank and deposit it there, or returning it to Burruss, the drawer, as\ndishonored and demanding payment, Petitioner,\xe2\x80\xa6[sued] Bank of America (the Bank)\xe2\x80\xa6Petitioner claimed\nthat the Bank had violated the Maryland Uniform Commercial Code (UCC) and had violated his personal\nprivacy when the teller asked Petitioner to place an \xe2\x80\x9cinkless\xe2\x80\x9d thumbprint on the face of the check at\nissue.\xe2\x80\xa6\n\n\xe2\x80\xa6[T]he Circuit Court heard oral arguments\xe2\x80\xa6, entered summary judgment in favor of the Bank, dismissing\nthe Complaint with prejudice. [The special appeals court affirmed. The Court of Appeals\xe2\x80\x94this court\xe2\x80\x94\naccepted the appeal.]\n\n[Duty of Bank on Presentment and Acceptance]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n769\n\n\x0cPetitioner argues that he correctly made \xe2\x80\x9cpresentment\xe2\x80\x9d of the check to the Bank pursuant to \xc2\xa7 3-111 and \xc2\xa7\n3-501(a), and demands that, as the person named on the instrument and thus entitled to enforce the\ncheck, the drawee Bank pay him.\xe2\x80\xa6In a continuation, Petitioner contends that the teller, by placing the\ncheck in the slot of her computer, and the computer then printing certain information on the back of the\ncheck, accepted the check as defined by \xc2\xa7 3-409(a).\xe2\x80\xa6Thus, according to Petitioner, because the Bank\xe2\x80\x99s\ncomputer printed information on the back of the check, under \xc2\xa7 3-401(b) the Bank \xe2\x80\x9csigned\xe2\x80\x9d the check,\nsaid \xe2\x80\x9csignature\xe2\x80\x9d being sufficient to constitute acceptance under \xc2\xa7 3-409(a).\n\nPetitioner\xe2\x80\x99s remaining arguments line up like so many dominos. According to Petitioner, having\nestablished that under his reading of \xc2\xa7 3-409(a) the Bank accepted the check, Petitioner advances that the\nBank is obliged to pay him, pursuant to \xc2\xa7 3-413(a)\xe2\x80\xa6Petitioner extends his line of reasoning by arguing\nthat the actions of the Bank amounted to a conversion under \xc2\xa7 3-420,\xe2\x80\xa6Petitioner argues that because the\nBank accepted the check, an act which, according to Petitioner, discharged the drawer, he no longer had\nenforceable rights in the check and only had a right to the proceeds. Petitioner\xe2\x80\x99s position is that the Bank\nexercised unauthorized dominion and control over the proceeds of the check to the complete exclusion of\nthe Petitioner after the Bank accepted the check and refused to distribute the proceeds, counted out by the\nteller, to him.\n\nWe turn to the Bank\xe2\x80\x99s obligations, or lack thereof, with regard to the presentment of a check by someone\nnot its customer. Bank argues, correctly, that it had no duty to the Petitioner, a non-customer and a\nstranger to the Bank, and that nothing in the Code allows Petitioner to force Bank of America to act as a\ndepository bank\xe2\x80\xa6\n\nAbsent a special relationship, a non-customer has no claim against a bank for refusing to honor a\npresented check. [Citations] This is made clear by \xc2\xa7 3-408, which states:\n\nA check or other draft does not of itself operate as an assignment of funds in the hands of the drawee\navailable for its payment, and the drawee is not liable on the instrument until the drawee accepts it.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n770\n\n\x0cOnce a bank accepts a check, under \xc2\xa7 3-409, it is obliged to pay on the check under \xc2\xa7 3-413. Thus, the\nrelevant question in terms of any rights Petitioner had against the Bank [regarding presentment] turns\nnot on the reasonableness of the thumbprint identification, but rather upon whether the Bank accepted\nthe check when presented as defined by \xc2\xa7 3-409. As will be seen infra [below] the question of the\nthumbprint identification is relevant only to the issue of whether the Bank\xe2\x80\x99s refusal to pay the instrument\nconstituted dishonor under \xc2\xa7 3-502, a determination which has no impact in terms of any duty allegedly\nowed by the Bank to the Petitioner.\n\nThe statute clearly states that acceptance becomes effective when the presenter is notified of that fact. The\nfacts demonstrate that at no time did the teller notify Petitioner that the Bank would pay on the check.\nRather, the facts show that:\n\n[T]he check was given back to [Petitioner] by the teller so that he could put his thumbprint signature on it,\nnot to notify or give him rights on the purported acceptance. After appellant declined to put his\nthumbprint signature on the check, he was informed by both the teller and the branch manager that it was\nagainst bank policy to honor the check without a thumbprint signature. Indignant, [Petitioner] walked out\nof the bank with the check.\n\nAs the intermediate appellate court correctly pointed out, the negotiation of the check is in the nature of a\ncontract, and there can be no agreement until notice of acceptance is received. As a result, there was never\nacceptance as defined by \xc2\xa7 3-409(a), and thus the Bank, pursuant to \xc2\xa7 3-408 never was obligated to pay\nthe check under \xc2\xa7 3-413(a). Thus, the answer to Petitioner\xe2\x80\x99s second question [Did the lower court err in\nfinding the Bank did not accept the\xe2\x80\xa6check at issue, as \xe2\x80\x9cacceptance\xe2\x80\x9d is defined in UCC Section 3-409?] is\n\xe2\x80\x9cno.\xe2\x80\x9d\n\n\xe2\x80\x9cConversion\xe2\x80\x9d under \xc2\xa7 3-420.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n771\n\n\x0cBecause it never accepted the check, Bank of America argues that the intermediate appellate court also\ncorrectly concluded that the Bank did not convert the check or its proceeds under \xc2\xa7 3-420. Again, we must\nagree. The Court of Special Appeals stated:\n\n\xe2\x80\x9cConversion,\xe2\x80\x9d we have held, \xe2\x80\x9crequires not merely temporary interference with property rights, but the\nexercise of unauthorized dominion and control to the complete exclusion of the rightful possessor.\xe2\x80\x9d\n[Citation] At no time did [Respondent] exercise \xe2\x80\x9cunauthorized dominion and control [over the check] to\nthe complete exclusion of the rightful possessor,\xe2\x80\x9d [Petitioner].\n\n[Petitioner] voluntarily gave the check to [Respondent\xe2\x80\x99s] teller. When [Petitioner] indicated to the teller\nthat he was not an account holder, she gave the check back to him for a thumbprint signature in\naccordance with bank policy. After being informed by both [Respondent\xe2\x80\x99s] teller and branch manager that\nit was [Respondent\xe2\x80\x99s] policy not to cash a non-account holder\xe2\x80\x99s check without a thumbprint signature,\n[Petitioner] left the bank with the check in hand.\n\nBecause [Petitioner] gave the check to the teller, [Respondent\xe2\x80\x99s] possession of that check was anything but\n\xe2\x80\x9cunauthorized,\xe2\x80\x9d and having returned the check, within minutes of its receipt, to [Petitioner] for his\nthumbprint signature, [Respondent] never exercised \xe2\x80\x9cdominion and control [over it] to the complete\nexclusion of the rightful possessor,\xe2\x80\x9d [Petitioner]. In short, there was no conversion.\n\nD. \xe2\x80\x9cReasonable Identification\xe2\x80\x9d under \xc2\xa7 3-501(b)(2)(ii) and \xe2\x80\x9cDishonor\xe2\x80\x9d under \xc2\xa7 3-502\n\nWe now turn to the issue of whether the Bank\xe2\x80\x99s refusal to accept the check as presented constituted\ndishonor under \xc2\xa7 3-501 and \xc2\xa7 3-502 as Petitioner contends. Petitioner\xe2\x80\x99s argument that Bank of America\ndishonored the check under \xc2\xa7 3-502(d) fails because that section applies to dishonor of an accepted draft.\nWe have determined, supra, [above] that Bank of America never accepted the draft. Nevertheless, the\nquestion remains as to whether Bank of America dishonored the draft under \xc2\xa7 3-502(b)\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n772\n\n\x0c(2) Upon demand of the person to whom presentment is made, the person making presentment must (i)\nexhibit the instrument, (ii) give reasonable identification\xe2\x80\xa6\n\n(3) Without dishonoring the instrument, the party to whom presentment is made may (i) return the\ninstrument for lack of a necessary indorsement, or (ii) refuse payment or acceptance for failure of the\npresentment to comply with the terms of the instrument, an agreement of the parties, or other applicable\nlaw or rule.\n\nThe question is whether requiring a thumbprint constitutes a request for \xe2\x80\x9creasonable identification\xe2\x80\x9d\nunder \xc2\xa7 3-501(b)(2)(ii). If it is \xe2\x80\x9creasonable,\xe2\x80\x9d then under \xc2\xa7 3-501(b)(3)(ii) the refusal of the Bank to accept\nthe check from Petitioner did not constitute dishonor. If, however, requiring a thumbprint is not\n\xe2\x80\x9creasonable\xe2\x80\x9d under \xc2\xa7 3-501(b)(2)(ii), then the refusal to accept the check may constitute dishonor under \xc2\xa7\n3-502(b)(2). The issue of dishonor is arguably relevant because Petitioner has no cause of action against\nany party, including the drawer, until the check is dishonored.\n\nRespondent Bank of America argues that its relationship with its customer is contractual, [Citations] and\nthat in this case, its contract with its customer, the drawer, authorizes the Bank\xe2\x80\x99s use of the Thumbprint\nSignature Program as a reasonable form of identification.\n\nAccording to Respondent, this contractual agreement allowed it to refuse to accept the check, without\ndishonoring it pursuant to \xc2\xa7 3-501(b)(3)(ii), because the Bank\xe2\x80\x99s refusal was based upon the presentment\nfailing to comply with \xe2\x80\x9can agreement of the parties.\xe2\x80\x9d The intermediate appellate court agreed. We,\nhowever, do not.\n\n\xe2\x80\xa6Bank and its customer cannot through their contract define the meaning of the term \xe2\x80\x9creasonable\xe2\x80\x9d and\nimpose it upon parties who are not in privity with that contract. Whether requiring a thumbprint\nconstitutes \xe2\x80\x9creasonable identification\xe2\x80\x9d within the meaning of \xc2\xa7 3-501(b)(2)(ii) is therefore a broader\npolicy consideration, and not, as argued in this case, simply a matter of contract. We reiterate that the\ncontract does not apply to Petitioner and, similarly, does not give him a cause of action against the Bank\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n773\n\n\x0cfor refusing to accept the check. This also means that the Bank cannot rely on the contract as a defense\nagainst the Petitioner, on the facts presented here, to say that it did not dishonor the check.\n\nPetitioner, as noted, argues that requiring a thumbprint violates his privacy, and further argues that a\nthumbprint is not a reasonable form of identification because it does not prove contemporaneously the\nidentity of an over the counter presenter at the time presentment is made. According to Petitioner, the\npurpose of requiring \xe2\x80\x9creasonable identification\xe2\x80\x9d is to allow the drawee bank to determine that the\npresenter is the proper person to be paid on the instrument. Because a thumbprint does not provide that\ninformation at the time presentment and payment are made, Petitioner argues that a thumbprint cannot\nbe read to fall within the meaning of \xe2\x80\x9creasonable identification\xe2\x80\x9d for the purposes of \xc2\xa7 3-501(b)(2)(ii).\n\nBank of America argues that the requirement of a thumbprint has been upheld, in other non-criminal\ncircumstances, not to be an invasion of privacy, and is a reasonable and necessary industry response to\nthe growing problem of check fraud. The intermediate appellate court agreed, pointing out that the form\nof identification was not defined by the statute, but that the Code itself recognized a thumbprint as a form\nof signature, \xc2\xa7 1-201(39), and observing that requiring thumbprint or fingerprint identification has been\nfound to be reasonable and not to violate privacy rights in a number of non-criminal contexts.\xe2\x80\xa6\n\nWe agree with [Petitioner] that a thumbprint cannot be used, in most instances, to confirm the identity of\na non-account checkholder at the time that the check is presented for cashing, as his or her thumbprint is\nusually not on file with the drawee at that time. We disagree, however, with [Petitioner\xe2\x80\x99s] conclusion that\na thumbprint signature is therefore not \xe2\x80\x9creasonable identification\xe2\x80\x9d for purposes of \xc2\xa7 3-501(b)(2).\n\nNowhere does the language of \xc2\xa7 3-501(b)(2) suggest that \xe2\x80\x9creasonable identification\xe2\x80\x9d is limited to\ninformation [Bank] can authenticate at the time presentment is made. Rather, all that is required is that\nthe \xe2\x80\x9cperson making presentment must\xe2\x80\xa6give reasonable identification.\xe2\x80\x9d \xc2\xa7 3-501(b)(2). While providing a\nthumbprint signature does not necessarily confirm identification of the checkholder at presentment\xe2\x80\x94\nunless of course the drawee bank has a duplicate thumbprint signature on file\xe2\x80\x94it does assist in the\nidentification of the checkholder should the check later prove to be bad. It therefore serves as a powerful\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n774\n\n\x0cdeterrent to those who might otherwise attempt to pass a bad check. That one method provides\nidentification at the time of presentment and the other identification after the check may have been\nhonored, does not prevent the latter from being \xe2\x80\x9creasonable identification\xe2\x80\x9d for purposes of \xc2\xa7 3-501(b)(2)\n[Citation].\n\n[So held the lower courts.] We agree, and find this conclusion to be compelled, in fact, by our State\xe2\x80\x99s\nCommercial Law Article.\n\nThe reason has to do with warranties. The transfer of a check for consideration creates both transfer\nwarranties (\xc2\xa7 3-416(a) and (c)) and presentment warranties (\xc2\xa7 3-417(a) and (e)) which cannot be\ndisclaimed. The warranties include, for example, that the payee is entitled to enforce the instrument and\nthat there are no alterations on the check. The risk to banks is that these contractual warranties may be\nbreached, exposing the accepting bank to a loss because the bank paid over the counter on an item which\nwas not properly payable.\xe2\x80\xa6In such an event, the bank would then incur the expense to find the presenter,\nto demand repayment, and legal expenses to pursue the presenter for breach of his warranties.\n\nIn short, when a bank cashes a check over the counter, it assumes the risk that it may suffer losses for\ncounterfeit documents, forged endorsements, or forged or altered checks. Nothing in the Commercial Law\nArticle forces a bank to assume such risks. See [Citations] To the extent that banks are willing to cash\nchecks over the counter, with reasonable identification, such willingness expands and facilitates the\ncommercial activities within the State.\xe2\x80\xa6\n\nBecause the reduction of risk promotes the expansion of commercial practices, we\xe2\x80\xa6 conclude that a\nbank\xe2\x80\x99s requirement of a thumbprint placed upon a check presented over the counter by a non-customer is\nreasonable. [Citations] As the intermediate appellate court well documented, the Thumbprint Program is\npart of an industry wide response to the growing threat of check fraud. Prohibiting banks from taking\nreasonable steps to protect themselves from losses could result in banks refusing to cash checks of noncustomers presented over the counter at all, a result which would be counter to the direction of \xc2\xa7 1102(2)(b).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n775\n\n\x0cAs a result of this conclusion, Bank of America in the present case did not dishonor the check when it\nrefused to accept it over the counter. Under \xc2\xa7 3-501(b)(3)(ii), Bank of America \xe2\x80\x9crefused payment or\nacceptance for failure of the presentment to comply with\xe2\x80\xa6other applicable law or rule.\xe2\x80\x9d The rule not\ncomplied with by the Petitioner-presenter was \xc2\xa7 3-502(b)(2)(ii), in that he refused to give what we have\ndetermined to be reasonable identification. Therefore, there was no dishonor of the check by Bank of\nAmerica\xe2\x80\x99s refusal to accept it. The answer to Petitioner\xe2\x80\x99s third question is therefore \xe2\x80\x9cno,\xe2\x80\x9d [Did Bank\ndishonor the check?]\xe2\x80\xa6\n\nJudgment of the court of special appeals affirmed; costs to be paid by petitioner.\n\nEldridge, J., concurring in part and dissenting in part.\n\nI cannot agree with the majority\xe2\x80\x99s holding that, after the petitioner presented his driver\xe2\x80\x99s license and a\nmajor credit card, it was \xe2\x80\x9creasonable\xe2\x80\x9d to require the petitioner\xe2\x80\x99s thumbprint as identification.\n\nToday, honest citizens attempting to cope in this world are constantly being required to show or give\ndrivers\xe2\x80\x99 licenses, photo identification cards, social security numbers, the last four digits of social security\nnumbers, mothers\xe2\x80\x99 \xe2\x80\x9cmaiden names,\xe2\x80\x9d 16 digit account numbers, etc. Now, the majority takes the position\nthat it is \xe2\x80\x9creasonable\xe2\x80\x9d for banks and other establishments to require, in addition, thumbprints and\nfingerprints. Enough is enough. The most reasonable thing in this case was petitioner\xe2\x80\x99s \xe2\x80\x9cirritation with the\nBank of America\xe2\x80\x99s Thumbprint Signature Program.\xe2\x80\x9d Chief Judge Bell has authorized me to state that he\njoins this concurring and dissenting opinion.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n776\n\n\x0cC A SE QU ES TIO NS\n1. Petitioner claimed (a) he made a valid presentment, (b) Bank accepted the\ninstrument, (c) Bank dishonored the acceptance, and (d) Bank converted the\nmoney and owes it to him. What did the court say about each assertion?\n2. There was no dispute that there was enough money in the drawer\xe2\x80\x99s account\nto pay the check, so why didn\xe2\x80\x99t Petitioner just deposit it in his own account\n(then he wouldn\xe2\x80\x99t have been required to give a thumbprint)?\n3. What part of UCC Article 3 became relevant to the question of whether it was\nreasonable for Bank to demand Petitioner\xe2\x80\x99s thumbprint?\n4. How do the presentment and transfer warranties figure into the majority\nopinion?\n5. What did the dissenting judges find fault with in the majority\xe2\x80\x99s opinion? What\nresult would have obtained if the minority side had prevailed?\n\nBreach of Transfer Warranties and the Bank\xe2\x80\x99s Obligation to Act in\nGood Faith\nPNC Bank v. Robert L. Martin\n\n2010 WL 3271725, U.S. Dist. Ct. (Ky. 2010)\n\nCoffman, J.\n\nThis matter is before the court on plaintiff PNC Bank\xe2\x80\x99s motion for summary judgment. The court will\ngrant the motion as to liability and damages, because the defendant, Robert L. Martin, fails to raise any\ngenuine issue of material fact, and the evidence establishes that Martin breached his transfer warranties\nand account agreement with PNC.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n777\n\n\x0cI. Background\nMartin, an attorney, received an e-mail message on August 16, 2008, from a person who called himself\nRoman Hidotashi. Hidotashi claimed that he was a representative of Chipang Lee Song Manufacturing\nCompany and needed to hire a lawyer to collect millions of dollars from past-due accounts of North\nAmerican customers. Martin agreed to represent the company.\n\nOn September 8, 2008, Martin received a check for $290,986.15 from a purported Chipang Lee Song\nManufacturing Company customer, even though Martin had yet to commence any collections work. The\ncheck, which was drawn on First Century Bank USA, arrived in an envelope with a Canadian postmark\nand no return address. The check was accompanied by an undated transmittal letter. Martin endorsed the\ncheck and deposited it in his client trust account at PNC. Martin then e-mailed Hidotashi, reported that\nhe had deposited the check, and stated that he would await further instructions.\n\nHidotashi responded to Martin\xe2\x80\x99s e-mail message on September 9, 2008. Hidotashi stated that he had an\n\xe2\x80\x9cimmediate need for funds\xe2\x80\x9d and instructed Martin to wire $130,600 to a bank account in Tokyo. Martin\nwent to PNC\xe2\x80\x99s main office in Louisville the next morning and met with representative Craig Friedman.\nAccording to Martin, Friedman advised that the check Martin deposited had cleared. Martin instructed\nFriedman to wire $130,600 to the Tokyo account.\n\nMartin returned to PNC later the same day. According to Martin, Friedman accessed Martin\xe2\x80\x99s account\ninformation and said, \xe2\x80\x9cI don\xe2\x80\x99t understand this. The check was cleared yesterday. Let me go find out what\nis going on.\xe2\x80\x9d Friedman returned with PNC vice president and branch manager Sherry Jennewein, who\ninformed Martin that the check was fraudulent. According to Martin, Jennewein told him that she wished\nhe had met with her instead of Friedman because she never would have authorized the wire transfer.\n\nFirst Century Bank, on which the check was drawn, dishonored the check. PNC charged Martin\xe2\x80\x99s account\nfor $290,986.15. PNC, however, could not recover the $130,600 the bank had wired to the Tokyo account.\nMartin\xe2\x80\x99s account, as a result, was left overdrawn by $124,313.01.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n778\n\n\x0cPNC commenced this action. PNC asserts one count for Martin\xe2\x80\x99s alleged breach of the transfer warranties\nprovided in Kentucky\xe2\x80\x99s version of the Uniform Commercial Code and one count for breach of Martin\xe2\x80\x99s\naccount agreement. PNC moves for summary judgment on both counts.\n\nII. Discussion\nA. Breach of transfer warranties\nPNC is entitled to summary judgment on its breach-of-transfer-warranties claim because the undisputed\nfacts establish Martin\xe2\x80\x99s liability.\n\nTransfer warranties trigger when a person transfers an instrument for consideration. UCC \xc2\xa7 3-416(a)). A\ntransfer, for purposes of the statute, occurs when an instrument is delivered by a person other than its\nissuer for the purpose of giving to the person receiving delivery the right to enforce the instrument. \xc2\xa7 3203(a). Martin transferred an instrument to PNC when he endorsed the check and deposited it in his\naccount, thereby granting PNC the right to enforce the check. [Citation] Consideration, for purposes of the\nstatute, need only be enough to support a simple contract. [Citation] Martin received consideration from\nPNC because PNC made the funds provisionally available before confirming whether First Century Bank\nwould honor the check.\n\nAs a warrantor, Martin made a number of representations to PNC, including representations that he was\nentitled to enforce the check and that all signatures on the check were authentic and authorized. [UCC] \xc2\xa7\n3-416(a). Martin breached his warranties twofold. First, he was not entitled to enforce the check because\nthe check was a counterfeit and, as a result, Martin had nothing to enforce. Second, the drawer\xe2\x80\x99s signature\nwas not authentic because the check was a counterfeit.\n\nMartin does not dispute these facts. Instead, Martin argues, summary judgment is inappropriate because\nFriedman and Jennewein admitted that PNC made a mistake when Friedman said that he thought the\ncheck cleared and Jennewein said that she never would have authorized the wire transfer. Friedman\xe2\x80\x99s and\nJennewein\xe2\x80\x99s statements are immaterial facts. The transfer warranties placed the risk of loss on Martin,\nregardless of whether PNC, Martin, or both of them were at fault. [Citation] Martin, in any event, fails to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n779\n\n\x0csupport Friedman\xe2\x80\x99s and Jennewein\xe2\x80\x99s statements with firsthand deposition testimony or affidavits, so the\nstatements do not qualify as competent evidence. [Citation]\n\nMartin claims that the risk of loss falls on the bank. But the cases Martin cites in support of that\nproposition suffer from two defects. First, all but one of the cases were decided before the Kentucky\nGeneral Assembly adopted the Uniform Commercial Code. Martin fails to argue, much less demonstrate,\nthat his cases are good law. Second, Martin\xe2\x80\x99s cases are inapposite even if they are good law. [UCC] \xc2\xa7 3416(a) addresses whether a transferor or transferee bears the risk of loss. Martin\xe2\x80\x99s cases address who\nbears the risk of loss as between other players: a drawee bank and a collecting agent [Citation]; a drawer\nand a drawee bank [Citation]; and an execution creditor and drawee bank [Citation\xe2\x80\x94all of these cases are\nfrom 1910\xe2\x80\x931930]. The one modern case that Martin cites is also inapposite because the case involves a\ndrawer and a drawee bank. [Citation]\n\nIn sum, the court must grant summary judgment in PNC\xe2\x80\x99s favor on the breach-of-transfer-warranties\nclaim because the parties do not contest any material facts, which establish Martin\xe2\x80\x99s liability.\n\nB. Breach of Contract\nPNC is also entitled to summary judgment on its breach-of-contract claim because the undisputed facts\nestablish Martin\xe2\x80\x99s liability.\n\nTo support its allegation that a contract existed, PNC filed copies of Martin\xe2\x80\x99s account agreement and\nMartin\xe2\x80\x99s accompanying signature card. Under the agreement\xe2\x80\x99s terms, Martin agreed to bind himself to the\nagreement by signing the signature card. Martin does not dispute that the account agreement was a\nbinding contract, and he does not dispute the account agreement\xe2\x80\x99s terms.\n\nMartin\xe2\x80\x99s account agreement authorized PNC to charge Martin\xe2\x80\x99s account for the value of any item returned\nto PNC unpaid or any item on which PNC did not receive payment. If PNC\xe2\x80\x99s charge-back created an\noverdraft, Martin was required to pay PNC the amount of the overdraft immediately.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n780\n\n\x0cThe scam of which Martin was a victim falls squarely within the charge-back provision of the account\nagreement. The check was returned to PNC unpaid. PNC charged Martin\xe2\x80\x99s account, leaving it with an\noverdraft. Martin was obliged to pay PNC immediately.\n\nAs with the breach-of-transfer-warranties claim, Martin cannot defend against the breach-of-contract\nclaim by arguing that PNC made a mistake. The account agreement authorized PNC to charge back\nMartin\xe2\x80\x99s account \xe2\x80\x9ceven if the amount of the item has already been made available to you.\xe2\x80\x9d The account\nagreement, as a result, placed the risk of loss on Martin. Any mistake on PNC\xe2\x80\x99s part was immaterial\nbecause PNC always had the right to charge back Martin\xe2\x80\x99s account. [Citation]\n\nC. Martin\xe2\x80\x99s Counterclaims\nMartin has asserted counterclaims for violations of various Uniform Commercial Code provisions;\nnegligence and failure to exercise ordinary care; negligent misrepresentation; breach of contract and\nbreach of the implied covenants of good faith and fair dealing; detrimental reliance; conversion; and\nnegligent retention and supervision. Martin argues that \xe2\x80\x9c[t]o the extent that either party should be\nentitled to summary judgment in this case, it would be Martin with respect to his counterclaims against\nPNC.\xe2\x80\x9d Martin, however, has not moved for summary judgment on his counterclaims, and the court does\nnot address them on PNC\xe2\x80\x99s motion.\n\nD. Damages\nPNC\xe2\x80\x99s recovery under both theories of liability is contingent on PNC\xe2\x80\x99s demonstrating that it acted in good\nfaith. PNC may recover for breach of the transfer warranties only if it took the check in good faith. \xc2\xa7 3416(b). Moreover, PNC must satisfy the implied covenant of good faith and fair dealing, which Kentucky\nlaw incorporates in the account agreement. [Citation] Good faith, under both theories, means honesty in\nfact and the observance of reasonable commercial standards of fair dealing. That means \xe2\x80\x9ccontracts impose\non the parties thereto a duty to do everything necessary to carry them out.\xe2\x80\x9d [Citation]\n\nThe undisputed evidence establishes that PNC acted in good faith. PNC accepted deposit of Martin\xe2\x80\x99s\ncheck, attempted to present the check for payment at First Century Bank, and charged back Martin\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n781\n\n\x0caccount when the check was dishonored. Martin cannot claim that PNC lacked good faith and fair dealing\nwhen PNC took actions permitted under the contract. [Citation] Although PNC might have had the ability\nto investigate the authenticity of the check before crediting Martin\xe2\x80\x99s account, PNC bore no such obligation\nbecause Martin warranted that the check was authentic. [UCC] \xc2\xa7 3-416(a). Friedman\xe2\x80\x99s and Jennewein\xe2\x80\x99s\nstatements do not impute a lack of good faith to PNC, even if Martin could support the statements with\ncompetent evidence. The Uniform Commercial Code and the account agreement place the risk of loss on\nMartin, even if PNC made a mistake.\n\nMartin suggests that an insurance carrier might have already reimbursed PNC for the loss. Martin,\nhowever, presents no evidence of reimbursement, which PNC, presumably, would have disclosed in\ndiscovery.\n\nPNC, therefore, may recover from Martin the overdraft value of $124,313.01, which is the loss PNC\nsuffered as a result of Martin\xe2\x80\x99s breach of the transfer warranties and breach of contract. [UCC] \xc2\xa7 3416(b)\xe2\x80\xa6\n\nIII. Conclusion\nFor the foregoing reasons, IT IS ORDERED that PNC\xe2\x80\x99s motion for summary judgment is granted\xe2\x80\xa6to the\nextent that\xe2\x80\xa6PNC is permitted to recover $124,313.01 from Martin.\xe2\x80\xa6\n\nC A SE QU ES TIO NS\n1. How did Martin come to have an overdraft of $124,313.01 in his account?\n2. Under what UCC provision did the court hold Martin liable for this amount?\n3. The contract liability the court discusses was not incurred by Martin on\naccount of his signature on the check (though he did indorse it); what was the\ncontract liability?\n4. If the bank had not taken the check in good faith (honesty in fact and\nobserving reasonable commercial standards), what would the consequence\nhave been, and why?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n782\n\n\x0c5. Is a reader really constrained here to say that Mr. Martin got totally scammed,\nor was his behavior reasonable under the circumstances?\n[1] Section 4-208 provides as follows: \xe2\x80\x9c(a) If an unaccepted draft is presented [in this case, by\nBOK] to the drawee [BNH] for payment or acceptance and the drawee pays or accepts the\ndraft,(i) the person obtaining payment or acceptance, at the time of presentment, and(ii) a\nprevious transferor of the draft, at the time of transfer, warrant to the drawee that pays or\naccepts the draft in good faith, that:(1) The warrantor is, or was, at the time the warrantor\ntransferred the draft, a person entitled to enforce the draft or authorized to obtain payment or\nacceptance of the draft on behalf of a person entitled to enforce the draft;(2) The draft has not\nbeen altered; and(3) The warrantor has no knowledge that the signature of the purported\ndrawer of the draft is unauthorized.(b) A drawee making payment may recover from a\nwarrantor damages for breach of warranty.\xe2\x80\xa6(c) If a drawee asserts a claim for breach of\nwarranty under subsection (a) of this section based on an unauthorized indorsement of the\ndraft or an alteration of the draft, the warrantor may defend by proving that\xe2\x80\xa6the drawer [here,\nFarm Bureau] is precluded under Section 3-406 or 4-406 of this title from asserting against the\ndrawee the unauthorized indorsement or alteration.\xe2\x80\x9d\n[2] (a) A person whose failure to exercise ordinary care substantially contributes to an\nalteration of an instrument or to the making of a forged signature on an instrument is\nprecluded from asserting the alteration or the forgery against a person who, in good faith, pays\nthe instrument or takes it for value or for collection.\n[3] The parties do not address Section 3-406(b), which states that the person asserting\npreclusion may be held partially liable under comparative negligence principles for failing to\nexercise ordinary care in paying or taking the check. They also do not address any possible\nnegligence by either bank in accepting the forged check without confirming the legitimacy of\nConseco\xe2\x80\x99s indorsement.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n783\n\n\x0c[4] Petitioner\xe2\x80\x99s choice could be viewed as an attempt at risk shifting. Petitioner, an attorney,\nmay have known that he could have suffered a fee charged by his own bank if he deposited a\ncheck into his own account and then the bank on which it was drawn returned it for insufficient\nfunds, forged endorsement, alteration, or the like. Petitioner\xe2\x80\x99s action, viewed against that\nbackdrop, would operate as a risk-shifting strategy, electing to avoid the risk of a returnedcheck fee by presenting in person the check for acceptance at the drawee bank.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n784\n\n\x0c16.6 Summary and Exercises\nSummary\nAs a general rule, one who signs a note as maker or a draft as drawer is personally liable unless he or she\nsigns in a representative capacity and either the instrument or the signature shows that the signing has\nbeen made in a representative capacity. Various rules govern the permutations of signatures when an\nagent and a principal are involved.\n\nThe maker of a note and the acceptor of a draft have primary contract liability on the instruments.\nSecondarily liable are drawers and indorsers. Conditions precedent to secondary liability are presentment,\ndishonor, and notice of dishonor. Under the proper circumstances, any of these conditions may be waived\nor excused.\n\nPresentment is a demand for payment made on the maker, acceptor, or drawee, or a demand for\nacceptance on the drawee. Presentment must be made (1) at the time specified in the instrument unless\nno time is specified, in which case it must be at the time specified for payment, or (2) within a reasonable\ntime if a sight instrument.\n\nDishonor occurs when acceptance or payment is refused after presentment, at which time a holder has the\nright of recourse against secondary parties if he has given proper notice of dishonor.\n\nA seller-transferor of any commercial paper gives five implied warranties, which become valuable to a\nholder seeking to collect in the event that there has been no indorsement or the indorsement has been\nqualified. These warranties are (1) good title, (2) genuine signatures, (3) no material alteration, (4) no\ndefenses by other parties to the obligation to pay the transferor, and (5) no knowledge of insolvency of\nmaker, acceptor, or drawer.\n\nA holder on presentment makes certain warranties also: (1) entitled to enforce the instrument, (2) no\nknowledge that the maker\xe2\x80\x99s or drawer\xe2\x80\x99s signature is unauthorized, and (3) no material alteration.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n785\n\n\x0cAmong the ways in which the parties may be discharged from their contract to honor the instrument are\nthe following: (1) payment or satisfaction, (2) tender of payment, (3) cancellation and renunciation, (4)\nimpairment of recourse or of collateral, (5) reacquisition, (6) fraudulent and material alteration, (7)\ncertification, (8) acceptance varying a draft, and (9) unexcused delay in presentment or notice of\ndishonor.\n\nE XE R C IS ES\n1. Howard Corporation has the following instrument, which it purchased in good\nfaith and for value from Luft Manufacturing, Inc.\nFigure 16.2\n\nJudith Glen indorsed the instrument on the back in her capacity as president of\nLuft when it was transferred to Howard on July 15, 2012.\na. Is this a note or a draft?\nb. What liability do McHugh and Luft have to Howard? Explain.\nAn otherwise valid negotiable bearer note is signed with the forged signature of\nDarby. Archer, who believed he knew Darby\xe2\x80\x99s signature, bought the note in good\nfaith from Harding, the forger. Archer transferred the note without indorsement\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n786\n\n\x0cto Barker, in partial payment of a debt. Barker then sold the note to Chase for 80\npercent of its face amount and delivered it without indorsement. When Chase\npresented the note for payment at maturity, Darby refused to honor it, pleading\nforgery. Chase gave proper notice of dishonor to Barker and to Archer.\na. Can Chase hold Barker liable? Explain.\nb. Can Chase hold Archer liable? Explain.\nc. Can Chase hold Harding liable? Explain.\nMarks stole one of Bloom\xe2\x80\x99s checks, already signed by Bloom and made payable to\nDuval, drawn on United Trust Company. Marks forged Duval\xe2\x80\x99s signature on the back of\nthe check and cashed it at Check Cashing Company, which in turn deposited it with its\nbank, Town National. Town National proceeded to collect on the check from United.\nNone of the parties was negligent. Who will bear the loss, assuming Marks cannot be\nfound?\nRobb stole one of Markum\xe2\x80\x99s blank checks, made it payable to himself, and forged\nMarkum\xe2\x80\x99s signature on it. The check was drawn on the Unity Trust Company. Robb\ncashed the check at the Friendly Check Cashing Company, which in turn deposited it with\nits bank, the Farmer\xe2\x80\x99s National. Farmer\xe2\x80\x99s National proceeded to collect on the check\nfrom Unity. The theft and forgery were quickly discovered by Markum, who promptly\nnotified Unity. None of the parties mentioned was negligent. Who will bear the loss,\nassuming the amount cannot be recovered from Robb? Explain.\nPat stole a check made out to the order of Marks, forged the name of Marks on the\nback, and made the instrument payable to herself. She then negotiated the check to\nHarrison for cash by signing her own name on the back of the instrument in Harrison\xe2\x80\x99s\npresence. Harrison was unaware of any of the facts surrounding the theft or forged\nindorsement and presented the check for payment. Central County Bank, the drawee\nbank, paid it. Disregarding Pat, who will bear the loss? Explain.\nAmerican Music Industries, Inc., owed Disneyland Records over $340,000. As\nevidence of the debt, Irv Schwartz, American\xe2\x80\x99s president, issued ten promissory notes,\nsigning them himself. There was no indication they were obligations of the corporation,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n787\n\n\x0cAmerican Music Industries, Inc., or that Irv Schwartz signed them in a representative\ncapacity, but Mr. Schwartz asserted that Disneyland knew the notes were corporate\nobligations, not his personally. American paid four of the notes and then defaulted, and\nDisneyland sued him personally on the notes. He asserted he should be allowed to prove\nby parol evidence that he was not supposed to be liable. Is he personally liable?\nExplain. [1]\nAlice Able hired Betty Baker as a bookkeeper for her seamstress shop. Baker\xe2\x80\x99s duties\nincluded preparing checks for Able to sign and reconciling the monthly bank statements.\nBaker made out several checks to herself, leaving a large space to the left of the amount\nwritten, which Able noticed when she signed the checks. Baker took the signed checks,\naltered the amount by adding a zero to the right of the original amount, and cashed\nthem at First Bank, the drawee. Able discovered the fraud, Baker was sent to prison, and\nAble sued First Bank, claiming it was liable for paying out on altered instruments. What is\nthe result?\nChristina Reynolds borrowed $16,000 from First Bank to purchase a used Ford\nautomobile. Bank took a note and a secured interest in the car (the car is collateral for\nthe loan). It asked for further security, so Christina got her sister Juanita to sign the note\nas an accommodation maker. Four months later, Christina notified Bank that she wished\nto sell the Ford for $14,000 in order to get a four-wheel drive Jeep, and Bank released its\nsecurity interest. When Christina failed to complete payment on the note for the Ford,\nBank turned to Juanita. What, if anything, does Juanita owe?\n\nS EL F -T E ST QU EST IO N S\n1. Drawers and indorsers have\na. primary contract liability\nb. secondary liability\nc. no liability\nd. none of the above\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n788\n\n\x0cConditions(s) needed to establish secondary liability include\na. presentment\nb. dishonor\nc. notice of dishonor\nd. all of the above\nA demand for payment made on a maker, acceptor, or drawee is called\na. protest\nb. notice\nc. presentment\nd. certification\nAn example of an implied warranty given by a seller of commercial paper\nincludes a warranty\na. of good title\nb. that there are no material alterations\nc. that signatures are genuine\nd. covering all of the above\nUnder UCC Article 3, discharge may result from\na. cancellation\nb. impairment of collateral\nc. fraudulent alteration\nd. all of the above\n\nS EL F -T E ST A NSW E R S\n1. b\n2. d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n789\n\n\x0c3. c\n4. d\n5. d\n[1] Schwartz v. Disneyland Vista Records, 383 So.2d 1117 (Fla. App. 1980).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n790\n\n\x0cChapter 17\nLegal Aspects of Banking\nL EA R N IN G O B JEC T IV ES\nAfter reading this chapter, you should understand the following:\n1. Banks\xe2\x80\x99 relationships with their customers for payment or nonpayment of checks;\n2. Electronic funds transfers and how the Electronic Fund Transfer Act affects the\nbank-consumer relationship;\n3. What a wholesale funds transfer is and the scope of Article 4A;\n4. What letters of credit are and how they are used.\n\nTo this point we have examined the general law of commercial paper as found in Article 3 of the UCC.\nCommercial paper\xe2\x80\x94notwithstanding waves of digital innovation\xe2\x80\x94still passes through bank collection\nprocesses by the ton every day, and Article 3 applies to this flow. But there is also a separate article in the\nUCC, Article 4, \xe2\x80\x9cBank Deposits and Collections.\xe2\x80\x9d In case of conflict with Article 3 rules, those of Article 4\ngovern.\n\nA discussion of government regulation of the financial services industry is beyond the scope of this book.\nOur focus is narrower: the laws that govern the operations of the banking system with respect to its\ndepositors and customers. Although histories of banking dwell on the relationship between banks and the\nnational government, the banking law that governs the daily operation of checking accounts is state\nbased\xe2\x80\x94Article 4 of the UCC. The enormous increase in noncheck banking has given rise to the Electronic\nFund Transfer Act, a federal law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n791\n\n\x0c17.1 Banks and Their Customers\nL EA R N IN G O B JEC T IV ES\n1. Understand how checks move, both traditionally and electronically.\n2. Know how Article 4 governs the relationship between a bank and its customers.\n\nThe Traditional Bank Collection Process\nThe Traditional System in General\nOnce people mostly paid for things with cash: actual bills. That is obviously not very convenient or safe: a\nlost ten-dollar bill is almost certainly gone, and carrying around large quantities of cash is dangerous\n(probably only crooks do much of that). Today a person might go for weeks without reaching for a bill\n(except maybe to get change for coins to put in the parking meter). And while it is indisputable that\nelectronic payment is replacing paper payment, the latter is still very significant. Here is an excerpt from a\nFederal Reserve Report on the issue:\n\nIn 2008, U.S. consumers had more payment instruments to choose from than ever before: four types of\npaper instruments\xe2\x80\x94cash, check, money order, and travelers checks; three types of payment cards\xe2\x80\x94debit,\ncredit, and prepaid; and two electronic instruments\xe2\x80\x94online banking bill payment (OBBP) and electronic\nbank account deductions (EBAD) using their bank account numbers. The average consumer had 5.1 of the\nnine instruments in 2008, and used 4.2 instruments in a typical month. Consumers made 52.9 percent of\ntheir monthly payments with a payment card. More consumers now have debit cards than credit cards\n(80.2 percent versus 78.3 percent), and consumers use debit cards more often than cash, credit cards, or\nchecks individually. However, paper instruments are still popular and account for 36.5 percent of\nconsumer payments. Most consumers have used newer electronic payments at some point, but these only\naccount for 9.7 percent of consumer payments. Security and ease of use are the characteristics of payment\ninstruments that consumers rate as most important.\nSaylor URL: http://www.saylor.org/books\n\n[1]\n\nSaylor.org\n792\n\n\x0cAmericans still wrote some thirty billion checks in 2006.\n\n[2]\n\nYou can readily imagine how complex the\n\nbank collection process must be to cope with such a flood of paper. Every check written must eventually\ncome back to the bank on which it is drawn, after first having been sent to the landlord, say, to pay rent,\nthen to the landlord\xe2\x80\x99s bank, and from there through a series of intermediate banks and collection centers.\n\nTerminology\nTo trace the traditional check-collection process, it is necessary to understand the terminology used. The\nbank upon which a check is written is the payor bank (the drawee bank). The depository bank is the\none the payee deposits the check into. Two terms are used to describe the various banks that may handle\nthe check after it is written: collecting banks and intermediary banks. All banks that handle the check\xe2\x80\x94\nexcept the payor bank\xe2\x80\x94are collecting banks(including the depository bank); intermediary banks are\nall the collecting banks except the payor and depository banks. A bank can take on more than one role:\nRoger in Seattle writes a check on his account at Seattle Bank and mails it to Julia in Los Angeles in\npayment for merchandise; Julia deposits it in her account at Bank of L.A. Bank of L.A. is a depository\nbank and a collecting bank. Any other bank through which the check travels (except the two banks already\nmentioned) is an intermediary bank.\n\nCollection Process between Customers of the Same Bank\nIf the depository bank is also the payor bank (about 30% of all checks), the check is called an \xe2\x80\x9con-us\xe2\x80\x9d item\nand UCC 4-215(e)(2) provides that\xe2\x80\x94if the check is not dishonored\xe2\x80\x94it is available by the payee \xe2\x80\x9cat the\nopening of the bank\xe2\x80\x99s second banking day following receipt of the item.\xe2\x80\x9d Roger writes a check to Matthew,\nboth of whom have accounts at Seattle Bank; Matthew deposits the check on Monday. On Wednesday the\ncheck is good for Matthew (he may have been given \xe2\x80\x9cprovisional credit\xe2\x80\x9d before then, as discussed below,\nthe bank could subtract the money from his account if Roger didn\xe2\x80\x99t have enough to cover the check).\n\nCollection Process between Customers of Different Banks\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n793\n\n\x0cRoger in Seattle writes a check on Seattle Bank payable to Julia in L.A. Julia deposits it in her account at\nL.A. Bank, the depository bank. L.A. Bank must somehow present the check to Seattle Bank either directly\nor through intermediary banks. If the collecting banks (again, all of them except Seattle Bank) act before\nthe midnight deadline following receipt, they have acted \xe2\x80\x9cseasonably\xe2\x80\x9d according to UCC 4-202. When the\npayor bank\xe2\x80\x94Seattle Bank\xe2\x80\x94gets the check it must pay it, unless the check is dishonored or returned (UCC\n4-302).\n\nPhysical Movement of Checks\nThe physical movement of checks\xe2\x80\x94such as it still occurs\xe2\x80\x94is handled by three possible systems.\n\nThe Federal Reserve System\xe2\x80\x99s regional branches process checks for banks holding accounts with them.\nThe Feds charge for the service, and prior to 2004 it regularly included check collection, air\ntransportation of checks to the Reserve Bank (hired out to private contractors) and ground transportation\ndelivery of checks to paying banks. Reserve Banks handle about 27 percent of US checks, but the air\nservice is decreasing with \xe2\x80\x9cCheck 21,\xe2\x80\x9d a federal law discussed below, that allows electronic transmission of\nchecks.\n\nCorrespondent banks are banks that have formed \xe2\x80\x9cpartnerships\xe2\x80\x9d with other banks in order to\nexchange checks and payments directly, bypassing the Federal Reserve and its fees. Outside banks may go\nthrough a correspondent bank to exchange checks and payments with one of its partners.\n\nCorrespondent banks may also form a clearinghouse corporation, in which members exchange\nchecks and payments in bulk, instead of on a check-by-check basis, which can be inefficient considering\nthat each bank might receive thousands of checks in a day. The clearinghouse banks save up the checks\ndrawn on other members and exchange them on a daily basis. The net payments for these checks are often\nsettled through Fedwire, a Federal Reserve Board electronic funds transfer (EFT) system that handles\nlarge-scale check settlement among US banks. Correspondent banks and clearinghouse corporations\nmake up the private sector of check clearing, and together they handle about 43 percent of US checks.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n794\n\n\x0cThe Electronic System: Check 21 Act\nRationale for the \xe2\x80\x9cCheck Clearing for the 21st Century Act\xe2\x80\x9d\nAfter the events of September 11, 2001, Congress felt with renewed urgency that banks needed to present\nand clear checks in a way not dependent upon the physical transportation of the paper instruments by air\nand ground, in case such transportation facilities were disrupted. The federal Check Clearing for the 21st\nCentury Act (Public Law 108-100)\xe2\x80\x94more commonly referred to as \xe2\x80\x9cCheck 21 Act\xe2\x80\x9d\xe2\x80\x94became effective in\n2004.\n\nBasic Idea of Check 21 Act\nCheck 21 Act provides the legal basis for the electronic transportation of check data. A bank scans the\ncheck. The data on the check is already encoded in electronically readable numbers and the data, now\nseparated (\xe2\x80\x9ctruncated\xe2\x80\x9d) from the paper instrument (which may be destroyed), is transmitted for\nprocessing. \xe2\x80\x9cThe Act authorizes a new negotiable instrument, called a substitute check, to replace the\noriginal check. A substitute check is a paper reproduction of the original check that is suitable for\nautomated processing in the same manner as the original check. The Act permits banks to provide\nsubstitute checks in place of original checks to subsequent parties in the check processing stream.\xe2\x80\xa6Any\nfinancial institution in the check clearing process can truncate the original check and create a substitute\ncheck.\n\n[3]\n\nHowever, in the check collection process it is not required that the image be converted to a\n\nsubstitute check: the electronic image itself may suffice.\n\nFor example, suppose Roger in Seattle writes a check on Seattle Bank payable to Julia in L.A. and mails it\nto her. Julia deposits it in her account at L.A. Bank, the depository bank. L.A. Bank truncates the check\n(again, scans it and destroys the original) and transmits the data to Seattle Bank for presentation and\npayment. If for any reason Roger, or any appropriate party, wants a paper version, a substitute check will\nbe created (see Figure 17.1 "Substitute Check Front and Back"). Most often, though, that is not necessary:\nRoger does not receive the actual cancelled checks he wrote in his monthly statement as he did formerly.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n795\n\n\x0cHe receives instead a statement listing paid checks he\xe2\x80\x99s written and a picture of the check (not a substitute\ncheck) is available to him online through his bank\xe2\x80\x99s website. Or he may receive his monthly statement\nitself electronically, with pictures of the checks he wrote available with a mouse click. Roger may also\ndispense with mailing the check to Julia entirely, as noted in the discussion of electronic funds transfers.\n\nFigure 17.1 Substitute Check Front and Back\n\nFront and back of a substitute check (not actual size).\nImages from Federal Reserve Board:http://www.federalreserve.gov/pubs/check21/consumer_guide\n\nSubstitute checks are legal negotiable instruments. The act provides certain warranties to protect\nrecipients of substitute checks that are intended to protect recipients against losses associated with the\ncheck substitution process. One of these warranties provides that \xe2\x80\x9c[a] bank that transfers, presents, or\nreturns a substitute check\xe2\x80\xa6for which it receives consideration warrants\xe2\x80\xa6that\xe2\x80\xa6[t]he substitute check\nmeets the requirements of legal equivalence\xe2\x80\x9d (12 CFR \xc2\xa7 229.52(a)(1)). The Check 21 Act does not replace\nexisting state laws regarding such instruments. The Uniform Commercial Code still applies, and we turn\nto it next.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n796\n\n\x0cTwo notable consequences of the Check 21 Act are worth mentioning. The first is that a check may be\npresented to the payor bank for payment very quickly, perhaps in less than an hour: the customer\xe2\x80\x99s \xe2\x80\x9cfloat\xe2\x80\x9d\ntime is abbreviated. That means be sure you have enough money in your account to cover the checks that\nyou write. The second consequence of Check 21 Act is that it is now possible for anybody\xe2\x80\x94you at home or\nthe merchant from whom you are buying something\xe2\x80\x94to scan a check and deposit it instantly. \xe2\x80\x9cRemote\ndeposit capture\xe2\x80\x9d allows users to transmit a scanned image of a check for posting and clearing using a webconnected computer and a check scanner. The user clicks to send the deposit to the desired existing bank\naccount. Many merchants are using this system: that\xe2\x80\x99s why if you write a check at the hardware store you\nmay see it scanned and returned immediately to you. The digital data are transmitted, and the scanned\nimage may be retrieved, if needed, as a \xe2\x80\x9csubstitute check.\xe2\x80\x9d\n\nUCC Article 4: Aspects of Bank Operations\nReason for Article 4\nOver the years, the states had begun to enact different statutes to regulate the check collection process.\nEighteen states adopted the American Bankers Association Bank Collection Code; many others enacted\nDeferred Posting statutes. Not surprisingly, a desire for uniformity was the principal reason for the\nadoption of UCC Article 4. Article 4 absorbed many of the rules of the American Bankers Association Code\nand of the principles of the Deferred Posting statutes, as well as court decisions and common customs not\npreviously codified.\n\nBanks Covered\nArticle 4 covers three types of banks: depository banks, payor banks, and collecting banks. These terms\xe2\x80\x94\nalready mentioned earlier\xe2\x80\x94are defined in UCC Section 4-105. A depositary bank is the first bank to which\nan item is transferred for collection. Section 4-104 defines \xe2\x80\x9citem\xe2\x80\x9d as \xe2\x80\x9can instrument or a promise or order\nto pay money handled by a bank for collection or payment[,]\xe2\x80\xa6not including a credit or debit card slip.\xe2\x80\x9d A\npayor bank is any bank that must pay a check because it is drawn on the bank or accepted there\xe2\x80\x94the\ndrawee bank (a depositary bank may also be a payor bank). A collecting bank is any bank except the payor\nbank that handles the item for collection.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n797\n\n\x0cTechnical Rules\nDetailed coverage of Parts 2 and 3 of Article 4, the substantive provisions, is beyond the scope of this\nbook. However, Article 4 answers several specific questions that bank customers most frequently ask.\n\n1.\n\nWhat is the effect of a \xe2\x80\x9cpay any bank\xe2\x80\x9d indorsement? The moment these words are indorsed on a\ncheck, only a bank may acquire the rights of a holder. This restriction can be lifted whenever (a)\nthe check has been returned to the customer initiating collection or (b) the bank specially\nindorses the check to a person who is not a bank (4-201).\n\n2. May a depositary bank supply a missing indorsement? It may supply any indorsement of the\ncustomer necessary to title unless the check contains words such as \xe2\x80\x9cpayee\xe2\x80\x99s indorsement\nrequired.\xe2\x80\x9d If the customer fails to indorse a check when depositing it in his account, the bank\xe2\x80\x99s\nnotation that the check was deposited by a customer or credited to his account takes effect as the\ncustomer\xe2\x80\x99s indorsement. (Section 4-205(1)).\n3. Are any warranties given in the collection process? Yes. They are identical to those provided in\nArticle 3, except that they apply only to customers and collecting banks (4-207(a)). The customer\nor collecting bank that transfers an item and receives a settlement or other consideration\nwarrants (1) he is entitled to enforce the item; (2) all signatures are authorized authentic; (3) the\nitem has not been altered; (4) the item is not subject to a defense or claim in recoupment; (5) he\nhas no knowledge of insolvency proceedings regarding the maker or acceptor or in the case of an\nunaccepted draft, the drawer. These warranties cannot be disclaimed as to checks.\n4. Does the bank have the right to a charge-back against a customer\xe2\x80\x99s account, or refund? The\nanswer turns on whether the settlement was provisional or final. A settlement is the proper\ncrediting of the amount ordered to be paid by the instrument. Someone writes you a check for\n$1,000 drawn on First Bank, and you deposit it in Second Bank. Second Bank will make a\n\xe2\x80\x9cprovisional settlement\xe2\x80\x9d with you\xe2\x80\x94that is, it will provisionally credit your account with $1,000,\nand that settlement will be final when First Bank debits the check writer\xe2\x80\x99s account and credits\nSecond Bank with the funds. Under Section 4-212(1), as long as the settlement was still\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n798\n\n\x0cprovisional, a collecting bank has the right to a \xe2\x80\x9ccharge-back\xe2\x80\x9d or refund if the check \xe2\x80\x9cbounces\xe2\x80\x9d (is\ndishonored). However, if settlement was final, the bank cannot claim a refund.\n\nWhat determines whether settlement is provisional or final? Section 4-213(1) spells out four\nevents (whichever comes first) that will convert a payor bank\xe2\x80\x99s provisional settlement into final\nsettlement: When it (a) pays the item in cash; (b) settles without reserving a right to revoke and\nwithout having a right under statute, clearinghouse rule, or agreement with the customer; finishes\nposting the item to the appropriate account; or (d) makes provisional settlement and fails to\nrevoke the settlement in the time and manner permitted by statute, clearinghouse rule, or\nagreement. All clearinghouses have rules permitting revocation of settlement within certain time\nperiods. For example an item cleared before 10 a.m. may be returned and the settlement revoked\nbefore 2 p.m. From this section it should be apparent that a bank generally can prevent a\nsettlement from becoming final if it chooses to do so.\n\nRelationship with Customers\nThe relationship between a bank and its customers is governed by UCC Article 4. However, Section 4103(1) permits the bank to vary its terms, except that no bank can disclaim responsibility for failing to act\nin good faith or to exercise ordinary care. Most disputes between bank and customer arise when the bank\neither pays or refuses to pay a check. Under several provisions of Article 4, the bank is entitled to pay,\neven though the payment may be adverse to the customer\xe2\x80\x99s interest.\n\nCommon Issues Arising between Banks and Their Customers\nPayment of Overdrafts\nSuppose a customer writes a check for a sum greater than the amount in her account. May the bank pay\nthe check and charge the customer\xe2\x80\x99s account? Under Section 4-401(1), it may. Moreover, it may pay on an\naltered check and charge the customer\xe2\x80\x99s account for the original tenor of the check, and if a check was\ncompleted it may pay the completed amount and charge the customer\xe2\x80\x99s account, assuming the bank acted\nin good faith without knowledge that the completion was improper.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n799\n\n\x0cPayment of Stale Checks\nSection 4-404 permits a bank to refuse to pay a check that was drawn more than six months before being\npresented. Banks ordinarily consider such checks to be \xe2\x80\x9cstale\xe2\x80\x9d and will refuse to pay them, but the same\nsection gives them the option to pay if they choose. A corporate dividend check, for example, will be\npresumed to be good more than six months later. The only exception to this rule is for certified checks,\nwhich must be paid whenever presented, since the customer\xe2\x80\x99s account was charged when the check was\ncertified.\n\nPayment of Deceased\xe2\x80\x99s or Incompetent\xe2\x80\x99s Checks\nSuppose a customer dies or is adjudged to be incompetent. May the bank honor her checks? Section 4-405\npermits banks to accept, pay, and collect an item as long as it has no notice of the death or declaration of\nincompetence, and has no reasonable opportunity to act on it. Even after notice of death, a bank has ten\ndays to payor certify checks drawn on or prior to the date of death unless someone claiming an interest in\nthe account orders it to refrain from doing so.\n\nStop Payment Orders\nSection 4-403 expressly permits the customer to order the bank to \xe2\x80\x9cstop payment\xe2\x80\x9d on any check payable\nfor her account, assuming the stop order arrives in enough time to reasonably permit the bank to act on it.\nAn oral stop order is effective for fourteen days; a follow-up written confirmation within that time is\neffective for six months and can be renewed in writing. But if a stop order is not renewed, the bank will\nnot be liable for paying the check, even one that is quite stale (e.g.,Granite Equipment Leasing Corp. v.\nHempstead Bank, 326 N.Y.S. 2d 881 (1971)).\n\nWrongful Dishonor\nIf a bank wrongfully dishonors an item, it is liable to the customer for all damages that are a direct\nconsequence of (\xe2\x80\x9cproximately caused by\xe2\x80\x9d) the dishonor. The bank\xe2\x80\x99s liability is limited to the damages\nactually proved; these may include damages for arrest and prosecution. SeeSection 17.4 "Cases" under\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n800\n\n\x0c\xe2\x80\x9cBank\xe2\x80\x99s Liability for Paying over Customer\xe2\x80\x99s \xe2\x80\x98Stop Payment\xe2\x80\x99 Order\xe2\x80\x9d (Meade v. National Bank of Adams\nCounty).\n\nCustomers\xe2\x80\x99 Duties\nIn order to hold a bank liable for paying out an altered check, the customer has certain duties under\nSection 4-406. Primarily, the customer must act promptly in examining her statement of account and\nmust notify the bank if any check has been altered or her signature has been forged. If the customer fails\nto do so, she cannot recover from the bank for an altered signature or other term if the bank can show that\nit suffered a loss because of the customer\xe2\x80\x99s slowness. Recovery may also be denied when there has been a\nseries of forgeries and the customer did not notify the bank within two weeks after receiving the first\nforged item. See Section 17.4 "Cases" under \xe2\x80\x9cCustomer\xe2\x80\x99s Duty to Inspect Bank Statements\xe2\x80\x9d (the Planters\nBank v. Rogers case).\n\nThese rules apply to a payment made with ordinary care by the bank. If the customer can show that the\nbank negligently paid the item, then the customer may recover from the bank, regardless of how dilatory\nthe customer was in notifying the bank\xe2\x80\x94with two exceptions: (1) from the time she first sees the\nstatement and item, the customer has one year to tell the bank that her signature was unauthorized or\nthat a term was altered, and (2) she has three years to report an unauthorized indorsement.\n\nThe Expedited Funds Availability Act\nIn General\nIn addition to UCC Article 4 (again, state law), the federal Expedited Funds Availability Act\xe2\x80\x94also referred\nto as \xe2\x80\x9cRegulation CC\xe2\x80\x9d after the Federal Reserve regulation that implements it\xe2\x80\x94addresses an aspect of the\nrelationship between a bank and its customers. It was enacted in 1988 in response to complaints by\nconsumer groups about long delays before customers were allowed access to funds represented by checks\nthey had deposited. It has nothing to do with electronic transfers, although the increasing use of electronic\ntransfers does speed up the system and make it easier for banks to comply with Regulation CC.\n\nThe Act\xe2\x80\x99s Provisions\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n801\n\n\x0cThe act provides that when a customer deposits a cashier\xe2\x80\x99s check, certified check, or a check written on an\naccount in the same bank, the funds must be available by the next business day. Funds from other local\nchecks (drawn on institutions within the same Federal Reserve region) must be available within two\nworking days, while there is a maximum five-day wait for funds from out-of-town checks. In order for\nthese time limits to be effective, the customer must endorse the check in a designated space on the back\nside. The FDIC sets out the law at its website: http://www.fdic.gov/regulations/laws/rules/65003210.html.\n\nK E Y TA K EA WAY\nThe bank collection process is the method by which checks written on one bank are\ntransferred by the collecting bank to a clearing house. Traditionally this has been a\nprocess of physical transfer by air and ground transportation from the depository bank\nto various intermediary banks to the payor bank where the check is presented. Since\n2004 the Check 21 Act has encouraged a trend away from the physical transportation of\nchecks to the electronic transportation of the check\xe2\x80\x99s data, which is truncated (stripped)\nfrom the paper instrument and transmitted. However, if a paper instrument is required,\na \xe2\x80\x9csubstitute check\xe2\x80\x9d will recreate it. The UCC\xe2\x80\x99s Article 4 deals generally with aspects of\nthe bank-customer relationship, including warranties on payment or collection of checks,\npayment of overdrafts, stop orders, and customers\xe2\x80\x99 duties to detect irregularities. The\nExpedited Funds Availability Act is a federal law governing customer\xe2\x80\x99s access to funds in\ntheir accounts from deposited checks.\n\nE XE R C IS ES\n1. Describe the traditional check-collection process from the drawing of the check to\nits presentation for payment to the drawee (payor) bank\n2. Describe how the Check 21 Act has changed the check-collection process.\n3. Why was Article 4 developed, and what is its scope of coverage?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n802\n\n\x0c[1] Kevin Foster, et al., The 2008 Survey of Consumer Payment Choice, Federal Reserve Bank of\nBoston, Public Policy Discussion Paper No. 09-10, p. 2 (April\n2010), http://www.bos.frb.org/economic/ppdp/2009/ppdp0910.pdf.\n[2] Scott Schuh, Overview of the Survey of Consumer Payment Choice (SCPC) Program, Federal\nReserve Bank of Boston, p. 5 (May\n2010).http://www.bos.frb.org/economic/cprc/presentations/2010/Schuh050610.pdf.\n[3] United States Treasury, The Check Clearing for the 21st Century Act: Frequently Asked\nQuestions, October\n2004,http://www.justice.gov/ust/eo/private_trustee/library/chapter07/docs/check21/Check21\nFAQs-final.pdf.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n803\n\n\x0c17.2 Electronic Funds Transfers\nL EA R N IN G O B JEC T IV ES\n1. Understand why electronic fund transfers have become prevalent.\n2. Recognize some typical examples of EFTs.\n3. Know that the EFT Act of 1978 protects consumers, and recognize what some of\nthose protections\xe2\x80\x94and liabilities\xe2\x80\x94are.\n4. Understand when financial institutions will be liable for violating the act, and some\nof the circumstances when the institutions will not be liable.\n\nBackground to Electronic Fund Transfers\nIn General\nDrowning in the yearly flood of billions of checks, eager to eliminate the \xe2\x80\x9cfloat\xe2\x80\x9d that a bank customer gets\nby using her money between the time she writes a check and the time it clears, and recognizing that better\ncustomer service might be possible, financial institutions sought a way to computerize the check collection\nprocess. What has developed is electronic fund transfer (EFT), a system that has changed how customers\ninteract with banks, credit unions, and other financial institutions. Paper checks have their advantages,\nbut their use is decreasing in favor of EFT.\n\nIn simplest terms, EFT is a method of paying by substituting an electronic signal for checks. A \xe2\x80\x9cdebit\ncard,\xe2\x80\x9d inserted in the appropriate terminal, will authorize automatically the transfer of funds from your\nchecking account, say, to the account of a store whose goods you are buying.\n\nTypes of EFT\nYou are of course familiar with some forms of EFT:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n804\n\n\x0c\xe2\x80\xa2\n\nThe automated teller machine (ATM) permits you to electronically transfer funds between\nchecking and savings accounts at your bank with a plastic ID card and a personal identification\nnumber (PIN), and to obtain cash from the machine.\n\n\xe2\x80\xa2\n\nTelephone transfers or computerized transfers allow customers to access the bank\xe2\x80\x99s computer\nsystem and direct it to pay bills owed to a third party or to transfer funds from one account to\nanother.\n\n\xe2\x80\xa2\n\nPoint of sale terminals located in stores let customers instantly debit their bank accounts and\ncredit the merchant\xe2\x80\x99s account.\n\n\xe2\x80\xa2\n\nPreauthorized payment plans permit direct electronic deposit of paychecks, Social Security\nchecks, and dividend checks.\n\n\xe2\x80\xa2\n\nPreauthorized withdrawals from customers\xe2\x80\x99 bank accounts or credit card accounts allow paperless\npayment of insurance premiums, utility bills, automobile or mortgage payments, and property tax\npayments.\n\nThe \xe2\x80\x9cshort circuit\xe2\x80\x9d that EFT permits in the check processing cycle is illustrated in Figure 17.2 "How EFT\nReplaces Checks".\n\nFigure 17.2 How EFT Replaces Checks\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n805\n\n\x0cUnlike the old-fashioned check collection process, EFT is virtually instantaneous: at one instant a\ncustomer has a sum of money in her account; in the next, after insertion of a plastic card in a machine or\nthe transmission of a coded message by telephone or computer, an electronic signal automatically debits\nher bank checking account and posts the amount to the bank account of the store where she is making a\npurchase. No checks change hands; no paper is written on. It is quiet, odorless, smudge proof. But errors\nare harder to trace than when a paper trail exists, and when the system fails (\xe2\x80\x9cour computer is down\xe2\x80\x9d) the\nfinancial mess can be colossal. Obviously some sort of law is necessary to regulate EFT systems.\n\nElectronic Fund Transfer Act of 1978\nPurpose\nBecause EFT is a technology consisting of several discrete types of machines with differing purposes, its\ngrowth has not been guided by any single law or even set of laws. The most important law governing\nconsumer transactions is the Electronic Fund Transfer Act of 1978,\n\n[1]\n\nwhose purpose is \xe2\x80\x9cto provide a\n\nbasic framework establishing the rights, liabilities, and responsibilities of participants in electronic fund\ntransfer systems. The primary objective of [the statute], however, is the provision of individual consumer\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n806\n\n\x0crights.\xe2\x80\x9d This federal statute has been implemented and supplemented by the Federal Reserve Board\xe2\x80\x99s\nRegulation E, Comptroller of the Currency guidelines on EFT, and regulations of the Federal Home Loan\nBank Board. (Wholesale transactions are governed by UCC Article 4A, which is discussed later in this\nchapter.)\n\nThe EFT Act of 1978 is primarily designed to disclose the terms and conditions of electronic funds\ntransfers so the customer knows the rights, costs and liabilities associated with EFT, but it does not\nembrace every type of EFT system. Included are \xe2\x80\x9cpoint-of-sale transfers, automated teller machine\ntransactions, direct deposits or withdrawal of funds, and transfers initiated by telephone or computer\xe2\x80\x9d\n(EFT Act Section 903(6)). Not included are such transactions as wire transfer services, automatic\ntransfers between a customer\xe2\x80\x99s different accounts at the same financial institution, and \xe2\x80\x9cpayments made\nby check, draft, or similar paper instrument at electronic terminals\xe2\x80\x9d (Reg. E, Section 205.2(g)).\n\nConsumer Protections Afforded by the Act\nFour questions present themselves to the mildly wary consumer facing the advent of EFT systems: (1)\nWhat record will I have of my transaction? (2) How can I correct errors? (3) What recourse do I have if a\nthief steals from my account? (4) Can I be required to use EFT? The EFT Act, as implemented by\nRegulation E, answers these questions as follows.\n\n1.\n\nProof of transaction. The electronic terminal itself must be equipped to provide a receipt of\ntransfer, showing date, amount, account number, and certain other information. Perhaps more\nimportantly, the bank or other financial institution must provide you with a monthly statement\nlisting all electronic transfers to and from the account, including transactions made over the\ncomputer or telephone, and must show to whom payment has been made.\n\n2. Correcting errors. You must call or write the financial institution whenever you believe an error\nhas been made in your statement. You have sixty days to do so. If you call, the financial institution\nmay require you to send in written information within ten days. The financial institution has\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n807\n\n\x0cforty-five days to investigate and correct the error. If it takes longer than ten days, however, it\nmust credit you with the amount in dispute so that you can use the funds while it is investigating.\nThe financial institution must either correct the error promptly or explain why it believes no error\nwas made. You are entitled to copies of documents relied on in the investigation.\n3. Recourse for loss or theft. If you notify the issuer of your EFT card within two business days after\nlearning that your card (or code number) is missing or stolen, your liability is limited to $50. If\nyou fail to notify the issuer in this time, your liability can go as high as $500. More daunting is the\nprospect of loss if you fail within sixty days to notify the financial institution of an unauthorized\ntransfer noted on your statement: after sixty days of receipt, your liability is unlimited. In other\nwords, a thief thereafter could withdraw all your funds and use up your line of credit and you\nwould have no recourse against the financial institution for funds withdrawn after the sixtieth\nday, if you failed to notify it of the unauthorized transfer.\n4. Mandatory use of EFT. Your employer or a government agency can compel you to accept a salary\npayment or government benefit by electronic transfer. But no creditor can insist that you repay\noutstanding loans or pay off other extensions of credit electronically. The act prohibits a financial\ninstitution from sending you an EFT card \xe2\x80\x9cvalid for use\xe2\x80\x9d unless you specifically request one or it is\nreplacing or renewing an expired card. The act also requires the financial institution to provide\nyou with specific information concerning your rights and responsibilities (including how to report\nlosses and thefts, resolve errors, and stop payment of preauthorized transfers). A financial\ninstitution may send you a card that is \xe2\x80\x9cnot valid for use\xe2\x80\x9d and that you alone have the power to\nvalidate if you choose to do so, after the institution has verified that you are the person for whom\nthe card was intended.\n\nLiability of the Financial Institution\nThe financial institution\xe2\x80\x99s failure to make an electronic fund transfer, in accordance with the terms and\nconditions of an account, in the correct amount or in a timely manner when properly instructed to do so\nby the consumer makes it liable for all damages proximately caused to the consumer, except where\n\n1) the consumer\xe2\x80\x99s account has insufficient funds;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n808\n\n\x0c2) the funds are subject to legal process or other encumbrance restricting such transfer;\n\n3) such transfer would exceed an established credit limit;\n\n4) an electronic terminal has insufficient cash to complete the transaction; or\n\n5) a circumstance beyond its control, where it exercised reasonable care to prevent such an occurrence, or\nexercised such diligence as the circumstances required.\n\nEnforcement of the Act\nA host of federal regulatory agencies oversees enforcement of the act. These include the Comptroller of the\nCurrency (national banks), Federal Reserve District Bank (state member banks), Federal Deposit\nInsurance Corporation regional director (nonmember insured banks), Federal Home Loan Bank Board\nsupervisory agent (members of the FHLB system and savings institutions insured by the Federal Savings\n& Loan Insurance Corporation), National Credit Union Administration (federal credit unions), Securities\n& Exchange Commission (brokers and dealers), and the Federal Trade Commission (retail and\ndepartment stores) consumer finance companies, all nonbank debit card issuers, and certain other\nfinancial institutions. Additionally, consumers are empowered to sue (individually or as a class) for actual\ndamages caused by any EFT system, plus penalties ranging from $100 to $1,000. Section 17.4 "Cases",\nunder \xe2\x80\x9cCustomer\xe2\x80\x99s Duty to Inspect Bank Statements\xe2\x80\x9d (Commerce Bank v. Brown), discusses the bank\xe2\x80\x99s\nliability under the act.\n\nK E Y TA K EA WAY\nEager to reduce paperwork for both themselves and for customers, and to speed up the\ncheck collection process, financial institutions have for thirty years been moving away\nfrom paper checks and toward electronic fund transfers. These EFTs are ubiquitous,\nincluding ATMs, point-of-sale systems, direct deposits and withdrawals and online\nbanking of various kinds. Responding to the need for consumer protection, Congress\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n809\n\n\x0cadopted the Electronic Fund Transfers Act, effective in 1978. The act addresses many\ncommon concerns consumers have about using electronic fund transfer systems, sets\nout liability for financial institutions and customers, and provides an enforcement\nmechanism.\n\nE XE R C IS ES\n1. Why have EFTs become very common?\n2. What major issues are addressed by the EFTA?\n3. If you lose your credit card, what is your liability for unauthorized charges?\n[1] FDIC, \xe2\x80\x9cElectronic Fund Transfer Act of\n1978,\xe2\x80\x9dhttp://www.fdic.gov/regulations/laws/rules/6500-1350.html.\n\n17.3 Wholesale Transactions and Letters of Credit\nL EA R N IN G O B JEC T IV ES\n1. Understand what a \xe2\x80\x9cwholesale transaction\xe2\x80\x9d is; recognize that UCC Article 4A\ngoverns such transactions, and recognize how the Article addresses three\ncommon issues.\n2. Know what a \xe2\x80\x9cletter of credit\xe2\x80\x9d (LC) is, the source of law regarding LCs, and\nhow such instruments are used.\n\nWholesale Funds Transfers\nAnother way that money is transferred is by commercial fund transfers or wholesale funds transfers,\nwhich is by far the largest segment of the US payment system measured in amounts of money transferred.\nIt is trillions of dollars a day. Wholesale transactions are the transfers of funds between businesses or\nfinancial institutions.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n810\n\n\x0cBackground and Coverage\nIt was in the development of commercial \xe2\x80\x9cwholesale wire transfers\xe2\x80\x9d of money in the nineteeth and early\ntwentieth centuries that businesses developed the processes enabling the creation of today\xe2\x80\x99s consumer\nelectronic funds transfers. Professor Jane Kaufman Winn described the development of uniform law\ngoverning commercial funds transfers:\n\nAlthough funds transfers conducted over funds transfer facilities maintained by the Federal Reserve\nBanks were subject to the regulation of the Federal Reserve Board, many funds transfers took place over\nprivate systems, such as the Clearing House for Interbank Payment Systems (\xe2\x80\x9cCHIPS\xe2\x80\x9d). The entire\nwholesale funds transfer system was not governed by a clear body of law until U.C.C. Article 4A was\npromulgated in 1989 and adopted by the states shortly thereafter. The Article 4A drafting process resulted\nin many innovations, even though it drew heavily on the practices that had developed among banks and\ntheir customers during the 15 years before the drafting committee was established. While a consensus was\nnot easy to achieve, the community of interests shared by both the banks and their customers permitted\nthe drafting process to find workable compromises on many thorny issues.\n\n[1]\n\nAll states and US territories have adopted Article 4A. Consistent with other UCC provisions, the rights and\nobligations under Article 4A may be varied by agreement of the parties. Article 4A does not apply if any\nstep of the transaction is governed by the Electronic Fund Transfer Act. Although the implication may be\notherwise, the rules in Article 4A apply to any funds transfer, not just electronic ones (i.e., transfers by\nmail are covered, too). Certainly, however, electronic transfers are most common, and\xe2\x80\x94as the Preface to\nArticle 4A notes\xe2\x80\x94a number of characteristics of them influenced the Code\xe2\x80\x99s rules. These transactions are\ncharacterized by large amounts of money\xe2\x80\x94multimillions of dollars; the parties are sophisticated\nbusinesses or financial institutions; funds transfers are completed in one day, they are highly efficient\nsubstitutes for paper delivery; they are usually low cost\xe2\x80\x94a few dollars for the funds transfer charged by\nthe sender\xe2\x80\x99s bank.\n\nOperation of Article 4A\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n811\n\n\x0cThe UCC \xe2\x80\x9cPrefatory Note\xe2\x80\x9d to Article 4A observes that \xe2\x80\x9cthe funds transfer that is covered by Article 4A is\nnot a complex transaction.\xe2\x80\x9d To illustrate the operation of Article 4A, assume that Widgets International\nhas an account with First Bank. In order to pay a supplier, Supplies Ltd., in China, Widgets instructs First\nBank to pay $6 million to the account of Supplies Ltd. in China Bank. In the terminology of Article 4A,\nWidgets\xe2\x80\x99 instruction to its bank is a \xe2\x80\x9cpayment order.\xe2\x80\x9d Widgets is the \xe2\x80\x9csender\xe2\x80\x9d of the payment order, First\nBank is the \xe2\x80\x9creceiving bank,\xe2\x80\x9d and Supplies Ltd. is the \xe2\x80\x9cbeneficiary\xe2\x80\x9d of the order.\n\nWhen First Bank performs the purchase order by instructing China Bank to credit the account of Supplies\nLimited, First Bank becomes a sender of a payment order, China Bank becomes a receiving bank, and\nSupplies Ltd. is still the beneficiary. This transaction is depicted in Figure 17.3 "Funds Transfer". In some\ntransactions there may also be one or more \xe2\x80\x9cintermediary banks\xe2\x80\x9d between First and Second Bank.\n\nFigure 17.3 Funds Transfer\n\nFrequently Occurring Legal Issues in Funds Transfers\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n812\n\n\x0cThree legal issues that frequently arise in funds transfer litigation are addressed in Article 4A and might\nbe mentioned here.\n\nResponsibility for Unauthorized Payments\nFirst, who is responsible for unauthorized payment orders? The usual practice is for banks and their\ncustomers to agree to security procedures for the verification of payment orders. If a bank establishes a\ncommercially reasonable procedure, complies with that procedure, and acts in good faith and according to\nits agreement with the customer, the customer is bound by an unauthorized payment order. There is,\nhowever, an important exception to this rule. A customer will not be liable when the order is from a\nperson unrelated to its business operations.\n\nError by Sender\nSecond, who is responsible when the sender makes a mistake\xe2\x80\x94for instance, in instructing payment\ngreater than what was intended? The general rule is that the sender is bound by its own error. But in cases\nwhere the error would have been discovered had the bank complied with its security procedure, the\nreceiving bank is liable for the excess over the amount intended by the sender, although the bank is\nallowed to recover this amount from the beneficiary.\n\nBank Mistake in Transferring Funds\nThird, what are the consequences when the bank makes a mistake in transferring funds? Suppose, for\nexample, that Widgets (in the previous situation) instructed payment of $2 million but First Bank in turn\ninstructed payment of $20 million. First Bank would be entitled to only $2 million from Widgets and\nwould then attempt to recover the remaining $18 million from Supplies Ltd. If First Bank had instructed\npayment to the wrong beneficiary, Widgets would have no liability and the bank would be responsible for\nrecovering the entire payment. Unless the parties agree otherwise, however, a bank that improperly\nexecutes a payment order is not liable for consequential damages.\n\nLetters of Credit\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n813\n\n\x0cBecause international trade involves risks not usually encountered in domestic trade\xe2\x80\x94government control\nof exports, imports, and currency; problems in verifying goods\xe2\x80\x99 quality and quantity; disruptions caused\nby adverse weather, war; and so on\xe2\x80\x94merchants have over the years devised means to minimize these\nrisks, most notably the letter of credit (\xe2\x80\x9cLC\xe2\x80\x9d). Here are discussed the definition of letters of credit, the\nsource of law governing them, how they work as payments for exports and as payments for imports.\n\nDefinition\nA letter of credit is a statement by a bank (or other financial institution) that it will pay a specified sum\nof money to specific persons if certain conditions are met. Or, to rephrase, it is a letter issued by a bank\nauthorizing the bearer to draw a stated amount of money from the issuing bank (or its branches, or other\nassociated banks or agencies). Originally, a letter of credit was quite literally that\xe2\x80\x94a letter addressed by\nthe buyer\xe2\x80\x99s bank to the seller\xe2\x80\x99s bank stating that the former could vouch for their good customer, the\nbuyer, and that it would pay the seller in case of the buyer\xe2\x80\x99s default. An LC is issued by a bank on behalf of\nits creditworthy customers, whose application for the credit has been approved by that bank.\n\nSource of Law\nLetters of credit are governed by both international and US domestic law.\n\nInternational Law\nMany countries (including the United States) have bodies of law governing letters of credit. Sophisticated\ntraders will agree among themselves by which body of law they choose to be governed. They can agree to\nbe bound by the UCC, or they may decide they prefer to be governed by the Uniform Customs and Practice\nfor Commercial Documentary Credits (UCP), a private code devised by the Congress of the International\nChamber of Commerce. Suppose the parties do not stipulate a body of law for the agreement, and the\nvarious bodies of law conflict, what then? Julius is in New York and Rochelle is in Paris; does French law\nor New York law govern? The answer will depend on the particulars of the dispute. An American court\nmust determine under the applicable principles of the law of \xe2\x80\x9cconflicts of law\xe2\x80\x9d whether New York or\nFrench law applies.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n814\n\n\x0cDomestic Law\nThe principal body of law applicable to the letter of credit in the United States is Article 5 of the UCC.\nSection 5-103 declares that Article 5 \xe2\x80\x9capplies to letters of credit and to certain rights and obligations\narising out of transactions involving letters of credit.\xe2\x80\x9d The Official Comment to 5-101 observes, \xe2\x80\x9cA letter of\ncredit is an idiosyncratic form of undertaking that supports performance of an obligation incurred in a\nseparate financial, mercantile, or other transaction or arrangement.\xe2\x80\x9d And\xe2\x80\x94as is the case in other parts of\nthe Code\xe2\x80\x94parties may, within some limits, agree to \xe2\x80\x9cvariation by agreement in order to respond to and\naccommodate developments in custom and usage that are not inconsistent with the essential definitions\nand mandates of the statute.\xe2\x80\x9d Although detailed consideration of Article 5 is beyond the scope of this\nbook, a distinction between guarantees and letters of credit should be noted: Article 5 applies to the latter\nand not the former.\n\nLetters of Credit as Payment for Exports\nThe following discussion presents how letters of credit work as payment for exports, and a sample letter of\ncredit is presented at Figure 17.4 "A Letter of Credit".\n\nFigure 17.4 A Letter of Credit\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n815\n\n\x0cJulius desires to sell fine quality magic wands and other stage props to Rochelle\xe2\x80\x99s Gallery in Paris.\nRochelle agrees to pay by letter of credit\xe2\x80\x94she will, in effect, get her bank to inform Julius that he will get\npaid if the goods are right. She does so by \xe2\x80\x9copening\xe2\x80\x9d a letter of credit at her bank\xe2\x80\x94the issuing bank\xe2\x80\x94the\nBanque de Rue de Houdini where she has funds in her account, or good credit. She tells the bank the\nterms of sale, the nature and quantity of the goods, the amount to be paid, the documents she will require\nas proof of shipment, and an expiration date. Banque de Rue de Houdini then directs its correspondent\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n816\n\n\x0cbank in the United States, First Excelsior Bank, to inform Julius that the letter of credit has been opened:\nRochelle is good for it. For Julius to have the strongest guarantee that he will be paid, Banque de Rou de\nHoudini can ask First Excelsior to confirm the letter of credit, thus binding both Banque de Rue de\nHoudini and Excelsior to pay according to the terms of the letter.\n\nOnce Julius is informed that the letter of credit has been issued and confirmed, he can proceed to ship the\ngoods and draw a draft to present (along with the required documents such as commercial invoice, bill of\nlading, and insurance policy) to First Excelsior, which is bound to follow exactly its instructions from\nBanque de Rue de Houdini. Julius can present the draft and documents directly, through correspondent\nbanks, or by a representative at the port from which he is shipping the goods. On presentation, First\nExcelsior may forward the documents to Banque de Rue de Houdini for approval and when First Excelsior\nis satisfied it will take the draft and pay Julius immediately on a sight draft or will stamp the draft\n\xe2\x80\x9caccepted\xe2\x80\x9d if it is a time draft (payable in thirty, sixty, or ninety days). Julius can discount an accepted\ntime draft or hold it until it matures and cash it in for the full amount. First Excelsior will then forward\nthe draft through international banking channels to Banque de Rue de Houdini to debit Rochelle\xe2\x80\x99s\naccount.\n\nAs Payment for Imports\nUS importers\xe2\x80\x94buyers\xe2\x80\x94also can use the letter of credit to pay for goods bought from abroad. The\nimporter\xe2\x80\x99s bank may require that the buyer put up collateral to guarantee it will be reimbursed for\npayment of the draft when it is presented by the seller\xe2\x80\x99s agents. Since the letter of credit ordinarily will be\nirrevocable, the bank will be bound to pay the draft when presented (assuming the proper documents are\nattached), regardless of deficiencies ultimately found in the goods. The bank will hold the bill of lading\nand other documents and could hold up transfer of the goods until the importer pays, but that would\nsaddle the bank with the burden of disposing of the goods if the importer failed to pay. If the importer\xe2\x80\x99s\ncredit rating is sufficient, the bank could issue a trust receipt. The goods are handed over to the importer\nbefore they are paid for, but the importer then becomes trustee of the goods for the bank and must hold\nthe proceeds for the bank up to the amount owed\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n817\n\n\x0cK E Y TA K EA WAY\nWholesale funds transfers are a mechanism by which businesses and financial\ninstitutions can transmit large sums of money\xe2\x80\x94millions of dollars\xe2\x80\x94between each\nother, usually electronically, from and to their clients\xe2\x80\x99 accounts. Article 4A of the\nUCC governs these transactions. A letter of credit is a promise by a buyer\xe2\x80\x99s bank\nthat upon presentation of the proper paperwork it will pay a specified sum to the\nidentified seller. Letters of credit are governed by domestic and international law.\n\nNext\n\n[1] Jane Kaufman Winn, Clash of the Titans: Regulating the Competition between Established\nand Emerging Electronic Payment\nSystems,http://www.law.washington.edu/Directory/docs/Winn/Clash%20of%20the%20Titans.\nhtm.\n\n17.4 Cases\nBank\xe2\x80\x99s Liability for Paying over Customer\xe2\x80\x99s \xe2\x80\x9cStop Payment\xe2\x80\x9d Order\nMeade v. National Bank of Adams County\n\n2002 WL 31379858 (Ohio App. 2002)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n818\n\n\x0cKline, J.\n\nThe National Bank of Adams County appeals the Adams County Court\xe2\x80\x99s judgment finding that it\nimproperly paid a check written by Denton Meade, and that Meade incurred $3,800 in damages as a\nresult of that improper payment.\xe2\x80\xa6\n\nI.\nDenton Meade maintained a checking account at the Bank. In 2001, Meade entered into an agreement\nwith the Adams County Lumber Company to purchase a yard barn for $2,784 and paid half the cost as a\ndeposit. On the date of delivery, Friday, March 9, 2001, Meade issued a check to the Lumber Company for\nthe remaining amount he owed on the barn, $1,406.79.\n\nMeade was not satisfied with the barn. Therefore, at 5:55 p.m. on March 9, 2001, Meade called the Bank\nto place a stop payment order on his check. Jacqueline Evans took the stop payment order from Meade.\nShe received all the information and authorization needed to stop payment on the check at that time.\n\nBank employees are supposed to enter stop payments into the computer immediately after taking them.\nHowever, Evans did not immediately enter the stop payment order into the computer because it was 6:00\np.m. on Friday, and the Bank closes at 6:00 p.m. on Fridays. Furthermore, the Bank\xe2\x80\x99s policy provides that\nany matters that are received after 2:00 p.m. on a Friday are treated as being received on the next\nbusiness day, which was Monday, March 12, 2001 in this instance.\nOn the morning of Saturday, March 10, 2001, Greg Scott, an officer of the Lumber Company, presented\nthe check in question for payment at the Bank. The Bank paid the check. On Monday, the Bank entered\nMeade\xe2\x80\x99s stop payment into the computer and charged Meade a $15 stop payment fee. Upon realizing that\nit already paid the check, on Tuesday the Bank credited the $15 stop payment fee back to Meade\xe2\x80\x99s\naccount. On Thursday, the Bank deducted the amount of the check, $1,406.79, from Meade\xe2\x80\x99s account.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n819\n\n\x0cIn the meanwhile, Meade contacted Greg Scott at the Lumber Company regarding his dissatisfaction with\nthe barn. Scott sent workers to repair the barn on Saturday, March 10 and on Monday, March 12.\nHowever, Meade still was not satisfied. In particular, he was unhappy with the runners supporting the\nbarn. Although his order with the Lumber Company specifically provided for 4 x 6\xe2\x80\x9d runner boards, the\nLumber Company used 2 x 6\xe2\x80\x9d boards. The Lumber Company \xe2\x80\x9claminated\xe2\x80\x9d the two by six-inch boards to\nmake them stronger. However, carpenter Dennis Baker inspected the boards and determined that the\nboards were not laminated properly.\n\nMeade hired Baker to repair the barn. Baker charged Meade approximately three hundred dollars to make\nthe necessary repairs. Baker testified that properly laminated two by six-inch boards are just as strong as\nfour by six-inch boards.\n\nMeade filed suit against the Bank in the trial court seeking $5,000 in damages. The Bank filed a motion\nfor summary judgment, which the trial court denied. At the subsequent jury trial the court permitted\nMeade to testify, over the Bank\xe2\x80\x99s objections, to the amount of his court costs, attorney fees, and deposition\ncosts associated with this case. The Bank filed motions for directed verdict at the close of Meade\xe2\x80\x99s case\nand at the close of evidence, which the trial court denied.\n\nThe jury returned a general verdict finding the Bank liable to Meade in the amount of $3,800. The Bank\nfiled motions for a new trial and for judgment notwithstanding the verdict, which the trial court denied.\nThe Bank now appeals, asserting the following five assignments of error.\xe2\x80\xa6\n\nII.\nIn its first assignment of error, the Bank contends that the trial court erred in denying its motion for\nsummary judgment. Specifically, the Bank asserts that Meade did not issue the stop payment order within\na reasonable time for the Bank to act upon it, and therefore that the trial court should have granted\nsummary judgment in favor of the Bank.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n820\n\n\x0cSummary judgment is appropriate only when it has been established: (1) that there is no genuine issue as\nto any material fact; (2) that the moving party is entitled to judgment as a matter of law; and (3) that\nreasonable minds can come to only one conclusion, and that conclusion is adverse to the nonmoving\nparty. [Citation]\n\n[UCC 4-403(A)] provides that a customer may stop payment on any item drawn on the customer\xe2\x80\x99s\naccount by issuing an order to the bank that describes the item with reasonable certainty and is received\nby the bank \xe2\x80\x9cat a time and in a manner that affords the bank a reasonable opportunity to act on it before\nany action by the bank with respect to the item.\xe2\x80\x9d What constitutes a reasonable time depends upon the\nfacts of the case. See Chute v. Bank One of Akron, (1983) [Citation]\n\nIn Chute, Bank One alleged that its customer, Mr. Chute, did not give it a reasonable opportunity to act\nupon his stop payment order when he gave an oral stop payment at one Bank One branch office, and a\ndifferent Bank One branch office paid the check the following day. In ruling that Bank One had a\nreasonable opportunity to act upon Mr. Chute\xe2\x80\x99s order before it paid the check, the court considered the\nteller\xe2\x80\x99s testimony that stop payment orders are entered onto the computer upon receipt, where they are\nvirtually immediately accessible to all Bank One tellers.\n\nIn this case, as in Chute, Meade gave notice one day, and the Bank paid the check the following day.\nAdditionally, in this case, the same branch that took the stop payment order also paid the check.\nMoreover, Evans testified that the Bank\xe2\x80\x99s policy for stop payment orders is to enter them into the\ncomputer immediately, and that Meade\xe2\x80\x99s stop payment order may have shown up on the computer on\nSaturday if she had entered it on Friday. Based on this information, and construing the facts in the light\nmost favorable to Meade, reasonable minds could conclude that Meade provided the Bank with the stop\npayment order within time for the Bank to act upon the stop payment order. Accordingly, we overrule the\nBank\xe2\x80\x99s first assignment of error.\n\nIII.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n821\n\n\x0cIn its second assignment of error, the Bank contends that the trial court erred in permitting Meade to\ntestify regarding the amount he spent on court costs, attorney fees, and taking depositions. Meade\ncontends that because he incurred these costs as a result of the Bank paying his check over a valid stop\npayment order, the costs are properly recoverable.\n\nAs a general rule, the costs and expenses of litigation, other than court costs, are not recoverable in an\naction for damages. [Citations]\n\nIn this case, the statute providing for damages, [UCC 4-403(c)], provides that a customer\xe2\x80\x99s recoverable\nloss for a bank\xe2\x80\x99s failure to honor a valid stop payment order \xe2\x80\x9cmay include damages for dishonor of\nsubsequent items * * *.\xe2\x80\x9d The statute does not provide for recouping attorney fees and costs. Meade did not\nallege that the Bank acted in bad faith or that he is entitled to punitive damages. Additionally, although\nMeade argues that the Bank caused him to lose his bargaining power with the Lumber Company, Meade\ndid not present any evidence that he incurred attorney fees or costs by engaging in litigation with the\nLumber Company.\n\nAbsent statutory authority or an allegation of bad faith, attorney fees are improper in a compensatory\ndamage award.\xe2\x80\xa6Therefore, the trial court erred in permitting the jury to hear evidence regarding Meade\xe2\x80\x99s\nexpenditures for his attorney fees and costs. Accordingly, we sustain the Bank\xe2\x80\x99s second assignment of\nerror.\xe2\x80\xa6\n\nIV.\nIn its third assignment of error, the Bank contends that the trial court erred when it overruled the Bank\xe2\x80\x99s\nmotion for a directed verdict. The Bank moved for a directed verdict both at the conclusion of Meade\xe2\x80\x99s\ncase and at the close of evidence.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n822\n\n\x0cThe Bank first asserts that the record does not contain sufficient evidence to show that Meade issued a\nstop payment order that provided it with a reasonable opportunity to act as required by [the UCC]. Meade\npresented evidence that he gave the Bank his stop payment order prior to 6:00 p.m. on Friday, and that\nthe Bank paid the check the following day.\xe2\x80\xa6We find that this constitutes sufficient evidence that Meade\ncommunicated the stop payment order to the Bank in time to allow the Bank a reasonable opportunity to\nact upon it.\n\nThe Bank also asserts that the record does not contain sufficient evidence that Meade incurred some loss\nresulting from its payment of the check. Pursuant to [UCC 4-403(c)] \xe2\x80\x9c[t]he burden of establishing the fact\nand amount of loss resulting from the payment of an item contrary to a stop payment order or order to\nclose an account is on the customer.\xe2\x80\x9d Establishing the fact and amount of loss, \xe2\x80\x9cthe customer must show\nsome loss other than the mere debiting of the customer\xe2\x80\x99s account.\xe2\x80\x9d [Citation]\n\n\xe2\x80\xa6Baker testified that he charged Meade between two hundred-eighty and three hundred dollars to\nproperly laminate the runners and support the barn. Based upon these facts, we find that the record\ncontains sufficient evidence that Meade sustained some loss beyond the mere debiting of his account as a\nresult of the Bank paying his check. Accordingly, we overrule the Bank\xe2\x80\x99s third assignment of error.\n\nV.\n\xe2\x80\xa6In its final assignment of error, the Bank contends that the trial court erred in denying its motions for\njudgment notwithstanding the verdict and for a new trial.\xe2\x80\xa6\n\n[U]nlike our consideration of the Bank\xe2\x80\x99s motions for a directed verdict, in considering the Bank\xe2\x80\x99s motion\nfor judgment notwithstanding the verdict, we also must consider whether the amount of the jury\xe2\x80\x99s award\nis supported by sufficient evidence. The Bank contends the jury\xe2\x80\x99s general verdict, awarding Meade\n$3,800, is not supported by evidence in the record.\n\nA bank customer seeking damages for the improper payment of a check over a valid stop payment order\ncarries the burden of proving \xe2\x80\x9cthe fact and amount of loss.\xe2\x80\x9d [UCC 4-403(C).] To protect banks and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n823\n\n\x0cprevent unjust enrichment to customers, the mere debiting of the customer\xe2\x80\x99s account does not constitute\na loss. [Citation]\n\nIn this case, the Bank\xe2\x80\x99s payment of Meade\xe2\x80\x99s $1,406.79 check to the Lumber Company discharged Meade\xe2\x80\x99s\ndebt to the Lumber Company in the same amount. Therefore, the mere debiting of $1,406.79 from\nMeade\xe2\x80\x99s account does not constitute a loss.\n\nMeade presented evidence that he incurred $300 in repair costs to make the barn satisfactory. Meade also\nnotes that he never got the four by six-inch runners he wanted. However, Meade\xe2\x80\x99s carpenter, Baker,\ntestified that since he properly laminated the two by six-inch runners, they are just as strong or stronger\nthan the four by six-inch runners would have been.\n\nMeade also presented evidence of his costs and fees. However, as we determined in our review of the\nBank\xe2\x80\x99s second assignment of error, only the court may award costs and fees, and therefore this evidence\nwas improperly admitted. Thus, the evidence cannot support the damage award. Meade did not present\nany other evidence of loss incurred by the Bank\xe2\x80\x99s payment of his check.\xe2\x80\xa6Therefore, we find that the trial\ncourt erred in declining to enter a judgment notwithstanding the verdict on the issue of damages. Upon\nremand, the trial court should grant in part the Bank\xe2\x80\x99s motion for judgment notwithstanding the verdict\nas it relates to damages and consider the Bank\xe2\x80\x99s motion for a new trial only on the issue of damages[.\xe2\x80\xa6]\nAccordingly, we sustain the Banks fourth and fifth assignments of error in part.\n\nVI.\nIn conclusion, we find that the trial court did not err in denying the Bank\xe2\x80\x99s motions for summary\njudgment and for directed verdict. However, we find that the trial court erred in permitting Meade to\ntestify as to his court costs, attorney fees and deposition costs. Additionally, we find that the trial court\nerred in totally denying the Bank\xe2\x80\x99s motion for judgment notwithstanding the verdict, as the amount of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n824\n\n\x0cdamages awarded by the jury is not supported by sufficient evidence in the record. Accordingly, we affirm\nthe judgment of the trial court as to liability, but reverse the judgment of the trial court as to the issue of\ndamages, and remand this cause for further proceedings consistent with this opinion.\n\nC A SE QU ES TIO NS\n1. What did the bank do wrong here?\n2. Why did the court deny Meade damages for his attorneys\xe2\x80\x99 fees?\n3. Why did the court conclude that the jury-awarded damages were not supported by\nevidence presented at trial? What damages did the evidence support?\n\nCustomer\xe2\x80\x99s Duty to Inspect Bank Statements\nUnion Planters Bank, Nat. Ass\xe2\x80\x99n v. Rogers\n\n912 So.2d 116 (Miss. 2005)\n\nWaller, J.\n\nThis appeal involves an issue of first impression in Mississippi\xe2\x80\x94the interpretation of [Mississippi\xe2\x80\x99s UCC\n4-406], which imposes duties on banks and their customers insofar as forgeries are concerned.\n\nFacts\nNeal D. and Helen K. Rogers maintained four checking accounts with the Union Planters Bank in\nGreenville, Washington County, Mississippi.\xe2\x80\xa6The Rogers were both in their eighties when the events\nwhich gave rise to this lawsuit took place.\n\n[1]\n\nAfter Neal became bedridden, Helen hired Jackie Reese to\n\nhelp her take care of Neal and to do chores and errands.\n\nIn September of 2000, Reese began writing checks on the Rogers\xe2\x80\x99 four accounts and forged Helen\xe2\x80\x99s name\non the signature line. Some of the checks were made out to \xe2\x80\x9ccash,\xe2\x80\x9d some to \xe2\x80\x9cHelen K. Rogers,\xe2\x80\x9d and some\nto \xe2\x80\x9cJackie Reese.\xe2\x80\x9d The following chart summarizes the forgeries to each account:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n825\n\n\x0cAccount Number Beginning\n\nEnding\n\nNumber of Checks Amount of Checks\n\n54282309\n\n11/27/2000 6/18/2001 46\n\n$16,635.00\n\n0039289441\n\n9/27/2000\n\n1/25/2001 10\n\n$2,701.00\n\n6100110922\n\n11/29/2000 8/13/2001 29\n\n$9,297.00\n\n6404000343\n\n11/20/2000 8/16/2001 83\n\n$29,765.00\n\nTotal\n\n168\n\n$58,398.00\n\nNeal died in late May of 2001. Shortly thereafter, the Rogers\xe2\x80\x99 son, Neal, Jr., began helping Helen with\nfinancial matters. Together they discovered that many bank statements were missing and that there was\nnot as much money in the accounts as they had thought. In June of 2001, they contacted Union Planters\nand asked for copies of the missing bank statements. In September of 2001, Helen was advised by Union\nPlanters to contact the police due to forgeries made on her accounts. More specific dates and facts leading\nup to the discovery of the forgeries are not found in the record.\n\nSubsequently, criminal charges were brought against Reese. (The record does not reveal the disposition of\nthe criminal proceedings against Reese.) In the meantime, Helen filed suit against Union Planters,\nalleging conversion (unlawful payment of forged checks) and negligence. After a trial, the jury awarded\nHelen $29,595 in damages, and the circuit court entered judgment accordingly. From this judgment,\nUnion Planters appeals.\n\nDiscussion\n\xe2\x80\xa6II. Whether Rogers\xe2\x80\x99 Delay in Detecting the Forgeries Barred Suit against Union Planters.\nThe relationship between Rogers and Union Planters is governed by Article 4 of the Uniform Commercial\nCode. [UCC] 4-406(a) and (c) provide that a bank customer has a duty to discover and report\n\xe2\x80\x9cunauthorized signatures\xe2\x80\x9d; i.e., forgeries. [The section] reflects an underlying policy decision that furthers\nthe UCC\xe2\x80\x99s \xe2\x80\x9cobjective of promoting certainty and predictability in commercial transactions.\xe2\x80\x9d The UCC\nfacilitates financial transactions, benefiting both consumers and financial institutions, by allocating\nresponsibility among the parties according to whomever is best able to prevent a loss. Because the\ncustomer is more familiar with his own signature, and should know whether or not he authorized a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n826\n\n\x0cparticular withdrawal or check, he can prevent further unauthorized activity better than a financial\ninstitution which may process thousands of transactions in a single day.\xe2\x80\xa6The customer\xe2\x80\x99s duty to exercise\nthis care is triggered when the bank satisfies its burden to provide sufficient information to the customer.\nAs a result, if the bank provides sufficient information, the customer bears the loss when he fails to detect\nand notify the bank about unauthorized transactions. [Citation]\n\nA. Union Planters\xe2\x80\x99 Duty to Provide Information under 4-406(a).\nThe court admitted into evidence copies of all Union Planters statements sent to Rogers during the\nrelevant time period. Enclosed with the bank statements were either the cancelled checks themselves or\ncopies of the checks relating to the period of time of each statement. The evidence shows that all bank\nstatements and cancelled checks were sent, via United States Mail, postage prepaid, to all customers at\ntheir \xe2\x80\x9cdesignated address\xe2\x80\x9d each month. Rogers introduced no evidence to the contrary. We therefore find\nthat the bank fulfilled its duty of making the statements available to Rogers and that the remaining\nprovisions of 4-406 are applicable to the case at bar.\xe2\x80\xa6\n\nIn defense of her failure to inspect the bank statements, Rogers claims that she never received the bank\nstatements and cancelled checks. Even if this allegation is true,\n\n[2]\n\nit does not excuse Rogers from failing to\n\nfulfill her duties under 4-406(a) & (c) because the statute clearly states a bank discharges its duty in\nproviding the necessary information to a customer when it \xe2\x80\x9csends\xe2\x80\xa6to a customer a statement of account\nshowing payment of items.\xe2\x80\x9d\xe2\x80\xa6The word \xe2\x80\x9creceive\xe2\x80\x9d is absent. The customer\xe2\x80\x99s duty to inspect and report does\nnot arise when the statement is received, as Rogers claims; the customer\xe2\x80\x99s duty to inspect and report\narises when the bank sends the statement to the customer\xe2\x80\x99s address. A reasonable person who has not\nreceived a monthly statement from the bank would promptly ask the bank for a copy of the statement.\nHere, Rogers claims that she did not receive numerous statements. We find that she failed to act\nreasonably when she failed to take any action to replace the missing statements.\n\nB. Rogers\xe2\x80\x99 Duty to Report the Forgeries under 4-406(d).\n[Under UCC 4-406] a customer who has not promptly notified a bank of an irregularity may be precluded\nfrom bringing certain claims against the bank:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n827\n\n\x0c\xe2\x80\x9c(d) If the bank proves that the customer failed, with respect to an item, to comply with the duties\nimposed on the customer by subsection (c), the customer is precluded from asserting against the bank:\n\n(1) The customer\xe2\x80\x99s unauthorized signature\xe2\x80\xa6on the item,\xe2\x80\xa6\n\nAlso, when there is a series of forgeries, 406(d)(2) places additional duties on the customer, [who is\nprecluded from asserting against the bank]:\n\n(2) The customer\xe2\x80\x99s unauthorized signature\xe2\x80\xa6by the same wrongdoer on any other item paid in good faith\nby the bank if the payment was made before the bank received notice from the customer of the\nunauthorized signature\xe2\x80\xa6and after the customer had been afforded a reasonable period of time, not\nexceeding thirty (30) days, in which to examine the item or statement of account and notify the bank.\n\nAlthough there is no mention of a specific date, Rogers testified that she and her son began looking for the\nstatements in late May or early June of 2001, after her husband had died.\xe2\x80\xa6When they discovered that\nstatements were missing, they notified Union Planters in June of 2001 to replace the statements. At this\ntime, no mention of possible forgery was made, even though Neal, Jr., thought that \xe2\x80\x9csomething was\nwrong.\xe2\x80\x9d In fact, Neal, Jr., had felt that something was wrong as far back as December of 2000, but failed\nto do anything. Neal, Jr., testified that neither he nor his mother knew that Reese had been forging checks\nuntil September of 2001.\n\n[3]\n\nRogers is therefore precluded from making claims against Union Planters because (1) under 4-406(a),\nUnion Planters provided the statements to Rogers, and (2) under 4-406(d)(2), Rogers failed to notify\nUnion Planters of the forgeries within 30 days of the date she should have reasonably discovered the\nforgeries.\xe2\x80\xa6\n\nConclusion\nThe circuit court erred in denying Union Planters\xe2\x80\x99 motion for JNOV because, under 4-406, Rogers is\nprecluded from recovering amounts paid by Union Planters on any of the forged checks because she failed\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n828\n\n\x0cto timely detect and notify the bank of the unauthorized transactions and because she failed to show that\nUnion Planters failed to use ordinary care in its processing of the forged checks. Therefore, we reverse the\ncircuit court\xe2\x80\x99s judgment and render judgment here that Rogers take nothing and that the complaint and\nthis action are finally dismissed with prejudice. Reversed.\n\nC A SE QU ES TIO NS\n1. If a bank pays out over a forged drawer\xe2\x80\x99s signature one time, and the customer\n(drawer) reports the forgery to the bank within thirty days, why does the bank take\nthe loss?\n2. Who forged the checks?\n3. Why did Mrs. Rogers think she should not be liable for the forgeries?\n4. In the end, who probably really suffered the loss here?\n\nCustomer\xe2\x80\x99s Duty to Inspect Bank Statements\nCommerce Bank of Delaware v. Brown\n\n2007 WL 1207171 (Del. Com. Pl. 2007)\n\nI. Procedural Posture\nPlaintiff, Commerce Bank/Delaware North America (\xe2\x80\x9cCommerce\xe2\x80\x9d) initially filed a civil complaint against\ndefendant Natasha J. Brown (\xe2\x80\x9cBrown\xe2\x80\x9d) on October 28, 2005. Commerce seeks judgment in the amount of\n$4.020.11 plus costs and interest and alleges that Brown maintained a checking account with Commerce\nand has been unjustly enriched by $4,020.11.\xe2\x80\xa6\n\nThe defendant, Brown\xe2\x80\xa6denied all allegations of the complaint. As an affirmative defense Brown claims\nthe transaction for which plaintiff seeks to recover a money judgment were made by means of an ATM\nMachine using a debit card issued by the defendant. On January 16, 2005 Brown asserts that she became\naware of the fraudulent transactions and timely informed the plaintiff of the facts on January 16, 2005.\nBrown asserts that she also requested Commerce in her answer to investigate the matter and to close her\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n829\n\n\x0caccount. Based upon these facts, Brown asserts a maximum liability on her own part from $50.00 to\n$500.00 in accordance with the Electronic Fund Transfer Act (\xe2\x80\x9cEFTA\xe2\x80\x9d) 15 U.S.C. \xc2\xa7 1693(g) and regulation\n(e), 12 CFR 205.6. [Commerce Bank withdrew its complaint at trial, leaving only the defendant\xe2\x80\x99s counterclaim in issue.]\n\nDefendant Brown asserts [that] defendant failed to investigate and violated EFTA and is therefore liable\nto the plaintiff for money damages citing [EFTA].\n\nII. The Facts\nBrown was the only witness called at trial. Brown is twenty-seven years old and has been employed by\nWilmington Trust as an Administrative Assistant for the past three years. Brown previously opened a\nchecking account with Commerce and was issued a debit/ATM card by Commerce which was in her\npossession in December 2004. Brown, on or about January 14, 2005 went to Commerce to charge a $5.00\ndebit to the card at her lunch-break was informed that there was a deficiency balance in the checking\naccount. Brown went to the Talleyville branch of Commerce Bank and spoke with \xe2\x80\x9cCarla\xe2\x80\x9d who agreed to\ninvestigate these unauthorized charges, as well as honor her request to close the account. Defendant\xe2\x80\x99s\nExhibit No.: 1 is a Commerce Bank electronic filing and/or e-mail which details a visit by defendant on\nJanuary 16, 2005 to report her card loss. The \xe2\x80\x9cDescription of Claim\xe2\x80\x9d indicates as follows:\n\nCustomer came into speak with a CSR \xe2\x80\x9cCarla Bernard\xe2\x80\x9d on January 16, 2005 to report her card loss. At this\ntime her account was only showing a negative $50.00 balance. She told Ms. Bernard that this was not her\ntransaction and to please close this account. Ms. Bernard said that she would do this and that there would\nbe an investigation on the unauthorized transactions. It was at this time also that she had Ms. Bernard\nchange her address. In the meantime, several transactions posted to the account causing a balance of\nnegative $3,948.11 and this amount has since been charged off on 1/27/05. Natasha Brown never received\nany notification of this until she received a letter from one of our collection agencies. She is now here to\nget this resolved.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n830\n\n\x0cOn the back of defendant\xe2\x80\x99s Exhibit No.: 1 were 26 separate unauthorized transactions at different\nmercantile establishments detailing debits with the pin number used on Brown\xe2\x80\x99s debit card charged to\nCommerce Bank. The first charge was $501.75 on January 13, 2005.\xe2\x80\xa6Brown asserts at trial that she\ntherefore timely gave notice to Commerce to investigate and requested Commerce to close the debit\nchecking account on January 16, 2005.\n\nAt trial Brown also testified she \xe2\x80\x9cnever heard\xe2\x80\x9d from Commerce again until she received a letter in\nDecember 2005 citing a $4,000.00 deficiency balance.\xe2\x80\xa6\n\nOn cross-examination Brown testified she received a PIN number from Commerce and \xe2\x80\x9cgave the PIN\nnumber to no other person.\xe2\x80\x9d In December 2004 she resided with Charles Williams, who is now her\nhusband. Brown testified on cross-examination that she was the only person authorized as a PIN user and\nno one else knew of the card, \xe2\x80\x98used the card,\xe2\x80\x99 or was provided orally or in writing of the PIN number.\nBrown spoke with Carla Bernard at the Commerce Bank at the Talleyville branch. Although Brown did not\ninitially fill out a formal report, she did visit Commerce on January 16, 2005 the Talleyville branch and\nchanged her address with Carla. Brown does not recall the last time she ever received a statement from\nCommerce Bank on her checking account. Brown made no further purchases with the account and she\nwas unaware of all the \xe2\x80\x9cincidents of unauthorized debit charges on her checking account\xe2\x80\x9d until she was\nactually sued by Commerce Bank in the Court of Common Pleas.\n\nIII. The Law\n15 U.S.C. \xc2\xa7 1693(g). Consumer Liability:\n\n(a) Unauthorized electronic fund transfers; limit. A consumer shall be liable for any unauthorized\nelectronic fund transfer.\xe2\x80\xa6In no event, however, shall a consumer\xe2\x80\x99s liability for an unauthorized transfer\nexceed the lesser of\xe2\x80\x94\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n831\n\n\x0c(1) $ 50; or\n\n(2) the amount of money or value of property or services obtained in such unauthorized electronic fund\ntransfer prior to the time the financial institution is notified of, or otherwise becomes aware of,\ncircumstances which lead to the reasonable belief that an unauthorized electronic fund transfer involving\nthe consumer\xe2\x80\x99s account has been or may be affected. Notice under this paragraph is sufficient when such\nsteps have been taken as may be reasonably required in the ordinary course of business to provide the\nfinancial institution with the pertinent information, whether or not any particular officer, employee, or\nagent of the financial institution does in fact receive such information.\n\n15 U.S.C. \xc2\xa7 1693(m) Civil Liability:\n\n(a) [A]ction for damages; amount of award.\xe2\x80\xa6[A]ny person who fails to comply with any provision of this\ntitle with respect to any consumer, except for an error resolved in accordance with section 908, is liable to\nsuch consumer in an amount equal to the sum of\xe2\x80\x94\n\n(1) any actual damage sustained by such consumer as a result of such failure;\n\n(2) in the case of an individual action, an amount not less than $ 100 nor greater than $\n1,000; or\xe2\x80\xa6\n(3) in the case of any successful action to enforce the foregoing liability, the costs of the action, together\nwith a reasonable attorney\xe2\x80\x99s fee as determined by the court.\n12 C.F.R. \xc2\xa7 205.6 Liability of consumer for unauthorized transfers.\n\n(b) Limitations on amount of liability. A consumer\xe2\x80\x99s liability for an unauthorized electronic fund transfer\nor a series of related unauthorized transfers shall be determined as follows:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n832\n\n\x0c(1) Timely notice given. If the consumer notifies the financial institution within two business days after\nlearning of the loss or theft of the access device, the consumer\xe2\x80\x99s liability shall not exceed the lesser of $ 50\nor the amount of unauthorized transfers that occur before notice to the financial institution.\n\n(2) Timely notice not given. If the consumer fails to notify the financial institution within two business\ndays after learning of the loss or theft of the access device, the consumer\xe2\x80\x99s liability shall not exceed the\nlesser of $ 500 or the sum of:\n\n(i) $ 50 or the amount of unauthorized transfers that occur within the two business days, whichever is\nless; and\n\n(ii) The amount of unauthorized transfers that occur after the close of two business days and before notice\nto the institution, provided the institution establishes that these transfers would not have occurred had\nthe consumer notified the institution within that two-day period.\n\nIV. Opinion and Order\nThe Court finds based upon the testimony presented herein that defendant in her counter-claim has\nproven by a preponderance of evidence damages in the amount of $1,000.00 plus an award of attorney\xe2\x80\x99s\nfees. Clearly, Commerce failed to investigate the unauthorized charges pursuant to 15 U.S.C. \xc2\xa7 1693(h).\nNor did Commerce close the account as detailed in Defendant\xe2\x80\x99s Exhibit No. 1. Instead, Commerce sued\nBrown and then withdrew its claim at trial. The Court finds $50.00 is the appropriate liability for Brown\nfor the monies charged on her account as set forth within the above statute because she timely notified, in\nperson, Commerce on January 16, 2005. Brown also requested Commerce to close her checking account.\nBased upon the trial record, defendant has proven by a preponderance of the evidence damages of\n$1,000.00 as set forth in the above statute, 15 U.S.C. \xc2\xa7 1693(m).\n\nC A SE QU ES TIO NS\n1. Why\xe2\x80\x94apparently\xe2\x80\x94did the bank withdraw its complaint against Brown at the time\nof trial?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n833\n\n\x0c2. Why does the court mention Ms. Brown\xe2\x80\x99s occupation, and that she was at the time\nof the incident living with the man who was\xe2\x80\x94at the time of trial\xe2\x80\x94her husband?\n3. What is the difference between the United States Code (USC) and the Code of\nFederal Regulations (CFR), both of which are cited by the court?\n4. What did the bank do wrong here?\n5. What damages did Ms. Brown suffer for which she was awarded $1,000? What else\ndid she get by way of an award that is probably more important?\n\n[1] Neal Rogers died prior to the institution of this lawsuit. Helen Rogers died after Union\nPlanters filed this appeal. We have substituted Helen\xe2\x80\x99s estate as appellee.\n[2] Since there was a series of forged checks, it is reasonable to assume that Reese intercepted\nthe bank statements before Rogers could inspect them. However, Union Planters cannot be\nheld liable for Reese\xe2\x80\x99s fraudulent concealment.\n[3] Actually, it was Union Planters that notified Rogers that there had been forgeries, as\nopposed to Rogers\xe2\x80\x99 discovering the forgeries herself\n\n17.5 Summary and Exercises\nSummary\nTraditionally when a customer wrote a check (on the payor bank) and the payee deposited it into his\naccount (at the depository bank), the check was physically routed by means of ground and air\ntransportation to the various intermediary banks until it was physically presented to the payor bank for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n834\n\n\x0cfinal settlement. The federal Check 21 Act (2004) promotes changes in this process by allowing banks to\nprocess electronic images of customers\xe2\x80\x99 checks instead of the actual paper instrument: the data on the\ncheck is truncated (stripped) from the instrument and the data are transmitted. The original check can be\ndigitally recreated by the making of a \xe2\x80\x9csubstitute check.\xe2\x80\x9d Merchants\xe2\x80\x94indeed, anyone with a check scanner\nand a computer\xe2\x80\x94can also process electronic data from checks to debit the writer\xe2\x80\x99s account and credit the\nmerchant\xe2\x80\x99s instantly.\n\nIn addition to Check 21 Act, the Electronic Fund Transfer Act of 1978 also facilitates electronic banking. It\nprimarily addresses the uses of credit and debit cards. Under this law, the electronic terminal must\nprovide a receipt of transfer. The financial institution must follow certain procedures on being notified of\nerrors, the customer\xe2\x80\x99s liability is limited to $50 if a card or code number is wrongfully used and the\ninstitution has been notified, and an employer or government agency can compel acceptance of salary or\ngovernment benefits by EFT.\n\nArticle 4 of the UCC\xe2\x80\x94state law, of course\xe2\x80\x94governs a bank\xe2\x80\x99s relationship with its customers. It permits a\nbank to pay an overdraft, to pay an altered check (charging the customer\xe2\x80\x99s account for the original tenor of\nthe check), to refuse to pay a six-month-old check, to pay or collect an item of a deceased person (if it has\nno notice of death) and obligates it to honor stop payment orders. A bank is liable to the customer for\ndamages if it wrongfully dishonors an item. The customer also has duties; primarily, the customer must\ninspect each statement of account and notify the bank promptly if the checks have been altered or\nsignatures forged. The federal Expedited Funds Availability Act requires that, within some limits, banks\nmake customers\xe2\x80\x99 funds available quickly.\nWholesale funds transactions, involving tens of millions of dollars, were originally made by telegraph\n(\xe2\x80\x9cwire transfers\xe2\x80\x9d). The modern law governing such transactions is, in the United States, UCC Article 4A.\n\nA letter of credit is a statement by a bank or other financial institution that it will pay a specified sum of\nmoney to specified persons when certain conditions are met. Its purpose is to facilitate nonlocal sales\ntransactions by ensuring that the buyer will not get access to the goods until the seller has proper access to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n835\n\n\x0cthe buyer\xe2\x80\x99s money. In the US letters of credit are governed by UCC Article 5, and in international\ntransactions they may be covered by a different internationally recognized law.\n\nE XE R C IS ES\n1. On March 20, Al gave Betty a check for $1,000. On March 25, Al gave Carl a\ncheck for $1,000, which Carl immediately had certified. On October 24, when\nAl had $1,100 in his account, Betty presented her check for payment and the\nbank paid her $1,000. On October 25, Carl presented his check for payment\nand the bank refused to pay because of insufficient funds. Were the bank\xe2\x80\x99s\nactions proper?\n2. Winifred had a balance of $100 in her checking account at First Bank. She\nwrote a check payable to her landlord in the amount of $400. First Bank\ncashed the check and then attempted to charge her account. May it? Why?\n3. Assume in Exercise 2 that Winifred had deposited $4,000 in her account a\nmonth before writing the check to her landlord. Her landlord altered the\ncheck by changing the amount from $400 to $4,000 and then cashed the\ncheck at First Bank. May the bank charge Winifred\xe2\x80\x99s account for the check?\nWhy?\n4. Assume in Exercise 2 that Winifred had deposited $5,000 in her account a\nmonth before writing the check but the bank misdirected her deposit, with\nthe result that her account showed a balance of $100. Believing the landlord\xe2\x80\x99s\ncheck to be an overdraft, the bank refused to pay it. Was the refusal justified?\nWhy?\n5. Assume in Exercise 2 that, after sending the check to the landlord, Winifred\ndecided to stop payment because she wanted to use the $300 in her account\nas a down payment on a stereo. She called First Bank and ordered the bank to\nstop payment. Four days later the bank mistakenly paid the check. Is the bank\nliable to Winifred? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n836\n\n\x0c6. Assume in Exercise 5 that the landlord negotiated the check to a holder in due\ncourse, who presented the check to the bank for payment. Is the bank\nrequired to pay the holder in due course after the stop payment order? Why?\n7. On Wednesday, August 4, Able wrote a $1,000 check on his account at First\nBank. On Saturday, August 7, the check was cashed, but the Saturday activity\nwas not recorded by the bank until Monday, August 9. On that day at 8:00\na.m., Able called in a stop payment order on the check and he was told the\ncheck had not cleared; at 9:00 he went to the bank and obtained a printed\nnotice confirming the stop payment, but shortly thereafter the Saturday\nactivity was recorded\xe2\x80\x94Able\xe2\x80\x99s account had been debited. He wants the $1,000\nrecredited. Was the stop payment order effective? Explain.\n8. Alice wrote a check to Carl\xe2\x80\x99s Contracting for $190 on April 23, 2011. Alice was\nnot satisfied with Carl\xe2\x80\x99s work. She called, leaving a message for him to return\nthe call to discuss the matter with her. He did not do so, but when she\nreconciled her checks upon receipt of her bank statement, she noticed the\ncheck to Carl did not appear on the April statement. Several months went by.\nShe figured Carl just tore the check up instead of bothering to resolve any\ndispute with her. The check was presented to Alice\xe2\x80\x99s bank for payment on\nMarch 20, 2012, and Alice\xe2\x80\x99s bank paid it. May she recover from the bank?\n9. Fitting wrote a check in the amount of $800. Afterwards, she had second\nthoughts about the check and contacted the bank about stopping payment. A\nbank employee told her a stop payment order could not be submitted until\nthe bank opened the next day. She discussed with the employee what would\nhappen if she withdrew enough money from her account that when the $800\ncheck was presented, there would be insufficient funds to cover it. The\nemployee told her that in such a case the bank would not pay the check.\nFitting did withdraw enough money to make the $800 an overdraft, but the\nbank paid it anyway, and then sued her for the amount of the overdraft. Who\nwins and why? Continental Bank v. Fitting, 559 P.2d 218 (1977).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n837\n\n\x0c10. Plaintiff\xe2\x80\x99s executive secretary forged plaintiff\xe2\x80\x99s name on number checks by\nsigning his name and by using a rubber facsimile stamp of his signature: of\nfourteen checks that were drawn on her employer\xe2\x80\x99s account, thirteen were\ndeposited in her son\xe2\x80\x99s account at the defendant bank, and one was deposited\nelsewhere. Evidence at trial was presented that the bank\xe2\x80\x99s system of\ncomparing its customer\xe2\x80\x99s signature to the signature on checks was the same\nas other banks in the area. Plaintiff sued the bank to refund the amount of the\nchecks paid out over a forged drawer\xe2\x80\x99s signature. Who wins and why? Read v.\nSouth Carolina National Bank, 335 S.E.2d 359 (S.C., 1965).\n11. On Tuesday morning, Reggie discovered his credit card was not in his wallet.\nHe realized he had not used it since the previous Thursday when he\xe2\x80\x99d bought\ngroceries. He checked his online credit card account register and saw that\nsome $1,700 had been charged around the county on his card. He\nimmediately notified his credit union of the lost card and unauthorized\ncharges. For how much is Reggie liable?\n\nS EL F -T E ST QU EST IO N S\n1. Article 4 of the UCC permits a bank to pay\na. an overdraft\nb. an altered check\nc. an item of a deceased person if it has no notice of death\nd. all of the above\n\nThe type of banks covered by Article 4 include\na. depository banks\nb. payor banks\nc. both of the above\nd. none of the above\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n838\n\n\x0cA bank may\na. refuse to pay a check drawn more than six months before being\npresented\nb. refuse to pay a check drawn more than sixty days before being\npresented\nc. not refuse to pay a check drawn more than six months before\nbeing presented\nd. do none of the above\nForms of electronic fund transfer include\na. automated teller machines\nb. point of sale terminals\nc. preauthorized payment plans\nd. all of the above\n\nS EL F -T E ST A NSW E R S\n1. d\n2. c\n3. a\n4. d\n\nChapter 18\nConsumer Credit Transactions\nL EA R N IN G O B JEC T IV ES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n839\n\n\x0cAfter reading this chapter, you should understand the following:\n1. How consumers enter into credit transactions and what protections they are\nafforded when they do\n2. What rights consumers have after they have entered into a consumer\ntransaction\n3. What debt collection practices third-party collectors may pursue\nThis chapter and the three that follow are devoted to debtor-creditor relations. In this chapter, we focus\non the consumer credit transaction.Chapter 19 "Secured Transactions and Suretyship" and Chapter 20\n"Mortgages and Nonconsensual Liens" explore different types of security that a creditor might\nrequire. Chapter 21 "Bankruptcy"examines debtors\xe2\x80\x99 and creditors\xe2\x80\x99 rights under bankruptcy law.\nThe amount of consumer debt, or household debt, owed by Americans to mortgage lenders, stores,\nautomobile dealers, and other merchants who sell on credit is difficult to ascertain. One reads that the\naverage household credit card debt (not including mortgages, auto loans, and student loans) in 2009 was\nalmost $16,000.\n\n[1]\n\nOr maybe it was $10,000.\n\n[2]\n\nOr maybe it was $7,300.\n\n[3]\n\nBut probably focusing on\n\nthe average household debt is not very helpful: 55 percent of households have no credit card debt at all,\nand the median debt is $1,900.\n\n[4]\n\nIn 2007, the total household debt owed by Americans was $13.3 trillion, according to the Federal Reserve\nBoard. That is really an incomprehensible number: suffice it to say, then, that the availability of credit is\nan important factor in the US economy, and not surprisingly, a number of statutes have been enacted over\nthe years to protect consumers both before and after signing credit agreements.\nThe statutes tend to fall within three broad categories. First, several statutes are especially important\nwhen a consumer enters into a credit transaction. These include laws that regulate credit costs, the credit\napplication, and the applicant\xe2\x80\x99s right to check a credit record. Second, after a consumer has contracted for\ncredit, certain statutes give a consumer the right to cancel the contract and correct billing mistakes. Third,\nif the consumer fails to pay a debt, the creditor has several traditional debt collection remedies that today\nare tightly regulated by the government.\n\n[1] Ben Woolsey and Matt Schulz, Credit Card Statistics, Industry Statistics, Debt\nStatistics, August 24, 2010, http://www.creditcards.com/credit-card-news/credit-card-industrySaylor URL: http://www.saylor.org/books\n\nSaylor.org\n840\n\n\x0cfacts-personal-debt-statistics-1276.php. This is \xe2\x80\x9ccalculated by dividing the total revolving debt\nin the U.S. ($852.6 billion as of March 2010 data, as listed in the Federal Reserve\xe2\x80\x99s May 2010\nreport on consumer credit) by the estimated number of households carrying credit card debt\n(54 million).\xe2\x80\x9d\n[2] Deborah Fowles, \xe2\x80\x9cYour Monthly Credit Card Minimum Payments May Double,\xe2\x80\x9d About.com\nFinancial Planning,http://financialplan.about.com/od/creditcarddebt/a/CCMinimums.htm.\n[3] Index Credit Cards, Credit Card Debt, February 9,\n2010,http://www.indexcreditcards.com/creditcarddebt.\n[4] Liz Pulliam Weston, \xe2\x80\x9cThe Big Lie about Credit Card Debt,\xe2\x80\x9d MSN Money, July 30,\n2007,http://articles.moneycentral.msn.com/Banking/CreditCardSmarts/TheBigLieAboutCreditC\nardDebt.aspx.\n\n18.1 Entering into a Credit Transaction\nL EA R N IN G O B JEC T IV ES\n1. Understand what statutes regulate the cost of credit, and the exceptions.\n2. Know how the cost of credit is expressed in the Truth in Lending Act.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n841\n\n\x0c3. Recognize that there are laws prohibiting discrimination in credit granting.\n4. Understand how consumers\xe2\x80\x99 credit records are maintained and may be\ncorrected.\n\nThe Cost of Credit\nLenders, whether banks or retailers, are not free to charge whatever they wish for credit. Usury laws\nestablish a maximum rate of lawful interest. The penalties for violating usury laws vary from state to state.\nThe heaviest penalties are loss of both principal and interest, or loss of a multiple of the interest the\ncreditor charged. The courts often interpret these laws stringently, so that even if the impetus for a\nusurious loan comes from the borrower, the contract can be avoided, as demonstrated in Matter of Dane\xe2\x80\x99s\nEstate (Section 18.3 "Cases").\n\nSome states have eliminated interest rate limits altogether. In other states, usury law is riddled with\nexceptions, and indeed, in many cases, the exceptions have pretty much eaten up the general rule. Here\nare some common exceptions:\n\n\xe2\x80\xa2\n\nBusiness loans. In many states, businesses may be charged any interest rate, although some states\nlimit this exception to incorporated businesses.\n\n\xe2\x80\xa2\n\nMortgage loans. Mortgage loans are often subject to special usury laws. The allowable interest\nrates vary, depending on whether a first mortgage or a subordinate mortgage is given, or whether\nthe loan is insured or provided by a federal agency, among other variables.\n\n\xe2\x80\xa2\n\nSecond mortgages and home equity loans by licensed consumer loan companies.\n\n\xe2\x80\xa2\n\nCredit card and other retail installment debt. The interest rate for these is governed by the law of\nthe state where the credit card company does business. (That\xe2\x80\x99s why the giant Citibank, otherwise\nheadquartered in New York City, runs its credit card division out of South Dakota, which has no\nusury laws for credit cards.)\n\n\xe2\x80\xa2\n\nConsumer leasing.\n\n\xe2\x80\xa2\n\n\xe2\x80\x9cSmall loans\xe2\x80\x9d such as payday loans and pawnshop loans.\n\n\xe2\x80\xa2\n\nLease-purchases on personal property. This is the lease-to-own concept.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n842\n\n\x0c\xe2\x80\xa2\n\nCertain financing of mobile homes that have become real property or where financing is insured\nby the federal government.\n\n\xe2\x80\xa2\n\nLoans a person takes from her tax-qualified retirement plan.\n\n\xe2\x80\xa2\n\nCertain loans from stockbrokers and dealers.\n\n\xe2\x80\xa2\n\nInterest and penalties on delinquent property taxes.\n\n\xe2\x80\xa2\n\nDeferred payment of purchase price (layaway loans).\n\n\xe2\x80\xa2\n\nStatutory interest on judgments.\n\nAnd there are others. Moreover, certain charges are not considered interest, such as fees to record\ndocuments in a public office and charges for services such as title examinations, deed preparation, credit\nreports, appraisals, and loan processing. But a creditor may not use these devices to cloak what is in fact a\nusurious bargain; it is not the form but the substance of the agreement that controls.\nAs suggested, part of the difficulty here is that governments at all levels have for a generation attempted to\npromote consumption to promote production; production is required to maintain politically acceptable\nlevels of employment. If consumers can get what they want on credit, consumerism increases. Also,\ncertainly, tight limits on interest rates cause creditors to deny credit to the less creditworthy, which may\nnot be helpful to the lower classes. That\xe2\x80\x99s the rationale for the usury exceptions related to pawnshop and\npayday loans.\n\nDisclosure of Credit Costs\nSetting limits on what credit costs\xe2\x80\x94as usury laws do\xe2\x80\x94is one thing. Disclosing the cost of credit is another.\n\nThe Truth in Lending Act\nUntil 1969, lenders were generally free to disclose the cost of money loaned or credit extended in any way\nthey saw fit\xe2\x80\x94and they did. Financing and credit terms varied widely, and it was difficult and sometimes\nimpossible to understand what the true cost was of a particular loan, much less to comparison shop. After\nyears of failure, consumer interests finally persuaded Congress to pass a national law requiring disclosure\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n843\n\n\x0cof credit costs in 1968. Officially called the Consumer Credit Protection Act, Title I of the law is more\npopularly known as the Truth in Lending Act (TILA). The act only applies toconsumer credit\ntransactions, and it only protects natural-person debtors\xe2\x80\x94it does not protect business organization\ndebtors.\n\nThe act provides what its name implies: lenders must inform borrowers about significant terms of the\ncredit transaction. The TILA does not establish maximum interest rates; these continue to be governed by\nstate law. The two key terms that must be disclosed are the finance charge and the annual percentage rate.\nTo see why, consider two simple loans of $1,000, each carrying interest of 10 percent, one payable at the\nend of twelve months and the other in twelve equal installments. Although the actual charge in each is the\nsame\xe2\x80\x94$100\xe2\x80\x94the interest rate is not. Why? Because with the first loan you will have the use of the full\n$1,000 for the entire year; with the second, for much less than the year because you must begin repaying\npart of the principal within a month. In fact, with the second loan you will have use of only about half the\nmoney for the entire year, and so the actual rate of interest is closer to 15 percent. Things become more\ncomplex when interest is compounded and stated as a monthly figure, when different rates apply to\nvarious portions of the loan, and when processing charges and other fees are stated separately. The act\nregulates open-end credit (revolving credit, like charge cards) and closed-end credit (like a car loan\xe2\x80\x94\nextending for a specific period), and\xe2\x80\x94as amended later\xe2\x80\x94it regulates consumer leases and credit card\ntransactions, too.\n\nFigure 18.1 Credit Disclosure Form\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n844\n\n\x0cBy requiring that the finance charge and the annual percentage rate be disclosed on a uniform basis, the\nTILA makes understanding and comparison of loans much easier. The finance charge is the total of all\nmoney paid for credit; it includes the interest paid over the life of the loan and all processing charges. The\nannual percentage rate is the true rate of interest for money or credit actually available to the borrower.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n845\n\n\x0cThe annual percentage rate must be calculated using the total finance charge (including all extra fees).\nSee Figure 18.1 "Credit Disclosure Form" for an example of a disclosure form used by creditors.\n\nConsumer Leasing Act of 1988\nThe Consumer Leasing Act (CLA) amends the TILA to provide similar full disclosure for consumers who\nlease automobiles or other goods from firms whose business it is to lease such goods, if the goods are\nvalued at $25,000 or less and the lease is for four months or more. All material terms of the lease must be\ndisclosed in writing.\n\nFair Credit and Charge Card Disclosure\nIn 1989, the Fair Credit and Charge Card Disclosure Act went into effect. This amends the TILA by\nrequiring credit card issuers to disclose in a uniform manner the annual percentage rate, annual fees,\ngrace period, and other information on credit card applications.\n\nCredit Card Accountability, Responsibility, and Disclosure Act of 2009\nThe 1989 act did make it possible for consumers to know the costs associated with credit card use, but the\ncard companies\xe2\x80\x99 behavior over 20 years convinced Congress that more regulation was required. In 2009,\nCongress passed and President Obama signed the Credit Card Accountability, Responsibility, and\nDisclosure Act of 2009 (the Credit Card Act). It is a further amendment of the TILA. Some of the salient\nparts of the act are as follows:\n\xe2\x80\xa2\n\nRestricts all interest rate increases during the first year, with some exceptions. The purpose is to\nabolish \xe2\x80\x9cteaser\xe2\x80\x9d rates.\n\n\xe2\x80\xa2\n\nIncreases notice for rate increase on future purchases to 45 days.\n\n\xe2\x80\xa2\n\nPreserves the ability to pay off on the old terms, with some exceptions.\n\n\xe2\x80\xa2\n\nLimits fees and penalty interest and requires statements to clearly state the required due date and\nlate payment penalty.\n\n\xe2\x80\xa2\n\nRequires fair application of payments. Amounts in excess of the minimum payment must be\napplied to the highest interest rate (with some exceptions).\n\n\xe2\x80\xa2\n\nProvides sensible due dates and time to pay.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n846\n\n\x0c\xe2\x80\xa2\n\nProtects young consumers. Before issuing a card to a person under the age of twenty-one, the card\nissuer must obtain an application that contains either the signature of a cosigner over the age of\ntwenty-one or information indicating an independent means of repaying any credit extended.\n\n\xe2\x80\xa2\n\nRestricts card issuers from providing tangible gifts to students on college campuses in exchange\nfor filling out a credit card application.\n\n\xe2\x80\xa2\n\nRequires colleges to publicly disclose any marketing contracts made with a card issuer.\n\n\xe2\x80\xa2\n\nRequires enhanced disclosures.\n\n\xe2\x80\xa2\n\nRequires issuers to disclose the period of time and the total interest it will take to pay off the card\nbalance if only minimum monthly payments are made.\n\n\xe2\x80\xa2\n\nEstablishes gift card protections.\n\n[1]\n\nThe Federal Reserve Board is to issue implementing rules.\nCreditors who violate the TILA are subject to both criminal and civil sanctions. Of these, the most\nimportant are the civil remedies open to consumers. If a creditor fails to disclose the required\ninformation, a customer may sue to recover twice the finance charge, plus court costs and reasonable\nattorneys\xe2\x80\x99 fees, with some limitations. As to the Credit Card Act of 2009, the issuing companies were not\nhappy with the reforms. Before the law went into effect, the companies\xe2\x80\x94as one commentator put it\xe2\x80\x94\nunleashed a \xe2\x80\x9cfrenzy of retaliation,\xe2\x80\x9d\n\n[2]\n\nby repricing customer accounts, changing fixed rates to variable\n\nrates, lowering credit limits, and increasing fees.\n\nState Credit Disclosure Laws\nThe federal TILA is not the only statute dealing with credit disclosures. A uniform state act, the Uniform\nConsumer Credit Code, as amended in 1974, is now on the books in twelve US jurisdictions,\n\n[3]\n\nthough its\n\neffect on the development of modern consumer credit law has been significant beyond the number of\nstates adopting it. It is designed to protect consumers who buy goods and services on credit by\nsimplifying, clarifying, and updating legislation governing consumer credit and usury.\n\nGetting Credit\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n847\n\n\x0cDisclosure of credit costs is a good thing. After discovering how much credit will cost, a person might\ndecide to go for it: get a loan or a credit card. The potential creditor, of course, should want to know if the\napplicant is a good risk; that requires a credit check. And somebody who knows another person\xe2\x80\x99s\ncreditworthiness has what is usually considered confidential information, the possession of which is\nsubject to abuse, and thus regulation.\n\nEqual Credit Opportunity Act\nThrough the 1960s, banks and other lending and credit-granting institutions regularly discriminated\nagainst women. Banks told single women to find a cosigner for loans. Divorced women discovered that\nthey could not open store charge accounts because they lacked a prior credit history, even though they had\ncontributed to the family income on which previous accounts had been based. Married couples found that\nthe wife\xe2\x80\x99s earnings were not counted when they sought credit; indeed, families planning to buy homes\nwere occasionally even told that the bank would grant a mortgage if the wife would submit to a\nhysterectomy! In all these cases, the premise of the refusal to treat women equally was the unstated\xe2\x80\x94and\nusually false\xe2\x80\x94belief that women would quit work to have children or simply to stay home.\n\nBy the 1970s, as women became a major factor in the labor force, Congress reacted to the manifest\nunfairness of the discrimination by enacting (as part of the Consumer Credit Protection Act) the Equal\nCredit Opportunity Act (ECOA) of 1974. The act prohibits any creditor from discriminating \xe2\x80\x9cagainst any\napplicant on the basis of sex or marital status with respect to any aspect of a credit transaction.\xe2\x80\x9d In 1976,\nCongress broadened the law to bar discrimination (1) on the basis of race, color, religion, national origin,\nand age; (2) because all or a part of an applicant\xe2\x80\x99s income is from a public assistance program; or (3)\nbecause an applicant has exercised his or her rights under the Consumer Credit Protection Act.\n\nUnder the ECOA, a creditor may not ask a credit applicant to state sex, race, national origin, or religion.\nAnd unless the applicant is seeking a joint loan or account or lives in a community-property state, the\ncreditor may not ask for a statement of marital status or, if you have voluntarily disclosed that you are\nmarried, for information about your spouse, nor may one spouse be required to cosign if the other is\ndeemed independently creditworthy. All questions concerning plans for children are improper. In\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n848\n\n\x0cassessing the creditworthiness of an applicant, the creditor must consider all sources of income, including\nregularly received alimony and child support payments. And if credit is refused, the creditor must, on\ndemand, tell you the specific reasons for rejection. See Rosa v. Park West Bank & Trust Co. in Section\n18.3 "Cases" for a case involving the ECOA.\n\nThe Home Mortgage Disclosure Act, 1975, and the Community Reinvestment Act (CRA), 1977, get at\nanother type of discrimination: redlining. This is the practice by a financial institution of refusing to grant\nhome loans or home-improvement loans to people living in low-income neighborhoods. The act requires\nthat financial institutions within its purview report annually by transmitting information from their Loan\nApplication Registers to a federal agency. From these reports it is possible to determine what is happening\nto home prices in a particular area, whether investment in one neighborhood lags compared with that in\nothers, if the racial or economic composition of borrowers changed over time, whether minorities or\nwomen had trouble accessing mortgage credit, in what kinds of neighborhoods subprime loans are\nconcentrated, and what types of borrowers are most likely to receive subprime loans, among others.\n\xe2\x80\x9cArmed with hard facts, users of all types can better execute their work: Advocates can launch consumer\neducation campaigns in neighborhoods being targeted by subprime lenders, planners can better tailor\nhousing policy to market conditions, affordable housing developers can identify gentrifying\nneighborhoods, and activists can confront banks with poor lending records in low income\ncommunities.\xe2\x80\x9d\n\n[4]\n\nUnder the CRA, federal regulatory agencies examine banking institutions for CRA\n\ncompliance and take this information into consideration when approving applications for new bank\nbranches or for mergers or acquisitions.\n\nFair Credit Reporting Act of 1970: Checking the Applicant\xe2\x80\x99s Credit Record\nIt is in the interests of all consumers that people who would be bad credit risks not get credit: if they do\nand they default (fail to pay their debts), the rest of us end up paying for their improvidence. Because\ncredit is such a big business, a number of support industries have grown up around it. One of the most\nimportant is the credit-reporting industry, which addresses this issue of checking creditworthiness.\nCertain companies\xe2\x80\x94credit bureaus\xe2\x80\x94collect information about borrowers, holders of credit cards, store\naccounts, and installment purchasers. For a fee, this information\xe2\x80\x94currently held on tens of millions of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n849\n\n\x0cAmericans\xe2\x80\x94is sold to companies anxious to know whether applicants are creditworthy. If the information\nis inaccurate, it can lead to rejection of a credit application that should be approved, and it can wind up in\nother files where it can live to do more damage. In 1970, Congress enacted, as part of the Consumer Credit\nProtection Act, the Fair Credit Reporting Act (FCRA) to give consumers access to their credit files in order\nto correct errors.\n\nUnder this statute, an applicant denied credit has the right to be told the name and address of the credit\nbureau (called \xe2\x80\x9cconsumer reporting agency\xe2\x80\x9d in the act) that prepared the report on which the denial was\nbased. (The law covers reports used to screen insurance and job applicants as well as to determine\ncreditworthiness.) The agency must list the nature and substance of the information (except medical\ninformation) and its sources (unless they contributed to an investigative-type report). A credit report lists\nsuch information as name, address, employer, salary history, loans outstanding, and the like. An\ninvestigative-type report is one that results from personal interviews and may contain nonfinancial\ninformation, like drinking and other personal habits, character, or participation in dangerous sports.\nSince the investigators rely on talks with neighbors and coworkers, their reports are usually subjective and\ncan often be misleading and inaccurate.\n\nThe agency must furnish the consumer the information free if requested within thirty days of rejection\nand must also specify the name and address of anyone who has received the report within the preceding\nsix months (two years if furnished for employment purposes).\n\nIf the information turns out to be inaccurate, the agency must correct its records; if investigative material\ncannot be verified, it must be removed from the file. Those to whom it was distributed must be notified of\nthe changes. When the agency and the consumer disagree about the validity of the information, the\nconsumer\xe2\x80\x99s version must be placed in the file and included in future distributions of the report. After\nseven years, any adverse information must be removed (ten years in the case of bankruptcy). A person is\nentitled to one free copy of his or her credit report from each of the three main national credit bureaus\nevery twelve months. If a reporting agency fails to correct inaccurate information in a reasonable time, it\nis liable to the consumer for $1,000 plus attorneys\xe2\x80\x99 fees.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n850\n\n\x0cUnder the FCRA, any person who obtains information from a credit agency under false pretenses is\nsubject to criminal and civil penalties. The act is enforced by the Federal Trade Commission. See Rodgers\nv. McCullough in Section 18.3 "Cases" for a case involving use of information from a credit report.\n\nK E Y TA K EA WAY\nCredit is an important part of the US economy, and there are various laws\nregulating its availability and disclosure. Usury laws prohibit charging excessive\ninterest rates, though the laws are riddled with exceptions. The disclosure of\ncredit costs is regulated by the Truth in Lending Act of 1969, the Consumer Leasing\nAct of 1988, the Fair Credit and Charge Card Disclosure Act of 1989, and the Credit\nCard Accountability, Responsibility, and Disclosure Act of 2009 (these latter three\nare amendments to the TILA). Some states have adopted the Uniform Consumer\nCredit Code as well. Two major laws prohibit invidious discrimination in the\ngranting of credit: the Equal Credit Opportunity Act of 1974 and the Home\nMortgage Disclosure Act of 1975 (addressing the problem of redlining). The Fair\nCredit Reporting Act of 1970 governs the collection and use of consumer credit\ninformation held by credit bureaus.\n\nE XE R C IS ES\n1. The penalty for usury varies from state to state. What are the two typical\npenalties?\n2. What has the TILA done to the use of interest as a term to describe how much\ncredit costs, and why?\n3. What is redlining?\n4. What does the Fair Credit Reporting Act do, in general?\n[1] Consumers Union, \xe2\x80\x9cUpcoming Credit Card\nProtections,\xe2\x80\x9dhttp://www.creditcardreform.org/pdf/dodd-summary-509.pdf.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n851\n\n\x0c[2] Liz Pulliam Weston, \xe2\x80\x9cCredit Card Lenders Go on a Rampage,\xe2\x80\x9d MSN Money, November 25,\n2009,http://articles.moneycentral.msn.com/Banking/YourCreditRating/weston-credit-cardlenders-go-on-a-rampage.aspx.\n[3] States adopting the Uniform Consumer Credit Code are the following: Colorado, Idaho,\nIndiana, Iowa, Kansas, Maine, Oklahoma, South Carolina, Utah, Wisconsin, Wyoming, and\nGuam. Cornell University Law School, \xe2\x80\x9cUniform\nLaws.\xe2\x80\x9d http://www.law.cornell.edu/uniform/vol7.html#concc.\n[4] Kathryn L.S. Pettit and Audrey E. Droesch, \xe2\x80\x9cA Guide to Home Mortgage Disclosure Act Data,\xe2\x80\x9d\nThe Urban Institute, December 2008,http://www.urban.org/uploadedpdf/1001247_hdma.pdf.\n\n18.2 Consumer Protection Laws and Debt Collection\nPractices\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n852\n\n\x0cL EA R N IN G O B JEC T IV ES\n1. Understand that consumers have the right to cancel some purchases made on\ncredit.\n2. Know how billing mistakes may be corrected.\n3. Recognize that professional debt collectors are governed by some laws\nrestricting certain practices.\n\nCancellation Rights\nOrdinarily, a contract is binding when signed. But consumer protection laws sometimes provide an escape\nvalve. For example, a Federal Trade Commission (FTC) regulation gives consumers three days to cancel\ncontracts made with door-to-door salespersons. Under this cooling-off provision, the cancellation is\neffective if made by midnight of the third business day after the date of the purchase agreement. The\nsalesperson must notify consumers of this right and supply them with two copies of a cancellation form,\nand the sales agreement must contain a statement explaining the right. The purchaser cancels by\nreturning one copy of the cancellation form to the seller, who is obligated either to pick up the goods or to\npay shipping costs. The three-day cancellation privilege applies only to sales of twenty-five dollars or more\nmade either in the home or away from the seller\xe2\x80\x99s place of business; it does not apply to sales made by\nmail or telephone, to emergency repairs and certain other home repairs, or to real estate, insurance, or\nsecurities sales.\n\nThe Truth in Lending Act (TILA) protects consumers in a similar way. For certain big-ticket purchases\n(such as installations made in the course of major home improvements), sellers sometimes require a\nmortgage (which is subordinate to any preexisting mortgages) on the home. The law gives such customers\nthree days to rescind the contract. Many states have laws similar to the FTC\xe2\x80\x99s three-day cooling-off period,\nand these may apply to transactions not covered by the federal rule (e.g., to purchases of less than twentyfive dollars and even to certain contracts made at the seller\xe2\x80\x99s place of business).\n\nCorrecting Billing Mistakes\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n853\n\n\x0cBilling Mistakes\nIn 1975, Congress enacted the Fair Credit Billing Act as an amendment to the Consumer Credit\nProtection Act. It was intended to put to an end the phenomenon, by then a standard part of any\ncomedian\xe2\x80\x99s repertoire, of the many ways a computer could insist that you pay a bill, despite errors and\ndespite letters you might have written to complain. The act, which applies only to open-end credit and not\nto installment sales, sets out a procedure that creditors and customers must follow to rectify claimed\nerrors. The customer has sixty days to notify the creditor of the nature of the error and the amount. Errors\ncan include charges not incurred or those billed with the wrong description, charges for goods never\ndelivered, accounting or arithmetic errors, failure to credit payments or returns, and even charges for\nwhich you simply request additional information, including proof of sale. During the time the creditor is\nreplying, you need not pay the questioned item or any finance charge on the disputed amount.\n\nThe creditor has thirty days to respond and ninety days to correct your account or explain why your belief\nthat an error has been committed is incorrect. If you do turn out to be wrong, the creditor is entitled to all\nback finance charges and to prompt payment of the disputed amount. If you persist in disagreeing and\nnotify the creditor within ten days, it is obligated to tell all credit bureaus to whom it sends notices of\ndelinquency that the bill continues to be disputed and to tell you to whom such reports have been sent;\nwhen the dispute has been settled, the creditor must notify the credit bureaus of this fact. Failure of the\ncreditor to follow the rules, an explanation of which must be provided to each customer every six months\nand when a dispute arises, bars it from collecting the first fifty dollars in dispute, plus finance charges,\neven if the creditor turns out to be correct.\n\nDisputes about the Quality of Goods or Services Purchased\nWhile disputes over the quality of goods are not \xe2\x80\x9cbilling errors,\xe2\x80\x9d the act does apply to unsatisfactory goods\nor services purchased by credit card (except for store credit cards); the customer may assert against the\ncredit card company any claims or defenses he or she may have against the seller. This means that under\ncertain circumstances, the customer may withhold payments without incurring additional finance\ncharges. However, this right is subject to three limitations: (1) the value of the goods or services charged\nmust be in excess of fifty dollars, (2) the goods or services must have been purchased either in the home\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n854\n\n\x0cstate or within one hundred miles of the customer\xe2\x80\x99s current mailing address, and (3) the consumer must\nmake a good-faith effort to resolve the dispute before refusing to pay. If the consumer does refuse to pay,\nthe credit card company would acquiesce: it would credit her account for the disputed amount, pass the\nloss down to the merchant\xe2\x80\x99s bank, and that bank would debit the merchant\xe2\x80\x99s account. The merchant\nwould then have to deal with the consumer directly.\n\nDebt Collection Practices\nBanks, financial institutions, and retailers have different incentives for extending credit\xe2\x80\x94for some, a loan\nis simply a means of making money, and for others, it is an inducement to buyers. But in either case,\ncredit is a risk because the consumer may default; the creditor needs a means of collecting when the\ncustomer fails to pay. Open-end credit is usually given without collateral. The creditor can, of course, sue,\nbut if the consumer has no assets, collection can be troublesome. Historically, three different means of\nrecovering the debt have evolved: garnishment, wage assignment, and confession of judgment.\n\nGarnishment\nGarnishment is a legal process by which a creditor obtains a court order directing the debtor\xe2\x80\x99s employer\n(or any party who owes money to the debtor) to pay directly to the creditor a certain portion of the\nemployee\xe2\x80\x99s wages until the debt is paid. Until 1970, garnishment was regulated by state law, and its effects\ncould be devastating\xe2\x80\x94in some cases, even leading to suicide. In 1970, Title III of the Consumer Credit\nProtection Act asserted federal control over garnishment proceedings for the first time. The federal wagegarnishment law limits the amount of employee earnings that may be withheld in any one pay date to the\nlesser of 25 percent of disposable (after-tax) earnings or the amount by which disposable weekly earnings\nexceed thirty times the highest current federal minimum wage. The federal law covers everyone who\nreceives personal earnings, including wages, salaries, commissions, bonuses, and retirement income\n(though not tips), but it allows courts to garnish above the federal maximum in cases involving support\npayments (e.g., alimony), in personal bankruptcy cases, and in cases where the debt owed is for state or\nfederal tax.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n855\n\n\x0cThe federal wage-garnishment law also prohibits an employer from firing any worker solely because the\nworker\xe2\x80\x99s pay has been garnished for one debt (multiple garnishments may be grounds for discharge). The\npenalty for violating this provision is a $1,000 fine, one-year imprisonment, or both. But the law does not\nsay that an employee fired for having one debt garnished may sue the employer for damages. In a 1980\ncase, the Fifth Circuit Court of Appeals denied an employee the right to sue, holding that the statute places\nenforcement exclusively in the hands of the federal secretary of labor.\n\n[1]\n\nThe l970 federal statute is not the only limitation on the garnishment process. Note that the states can\nalso still regulate garnishment so long as the state regulation is not in conflict with federal law: North\nCarolina, Pennsylvania, South Carolina, and Texas prohibit most garnishments, unless it is the\ngovernment doing the garnishment. And there is an important constitutional limitation as well. Many\nstates once permitted a creditor to garnish the employee\xe2\x80\x99s wage even before the case came to court: a\nsimple form from the clerk of the court was enough to freeze a debtor\xe2\x80\x99s wages, often before the debtor\nknew a suit had been brought. In 1969, the US Supreme Court held that this prejudgment garnishment\nprocedure was unconstitutional.\n\n[2]\n\nWage Assignment\nA wage assignment is an agreement by an employee that a creditor may take future wages as security\nfor a loan or to pay an existing debt. With a wage assignment, the creditor can collect directly from the\nemployer. However, in some states, wage assignments are unlawful, and an employer need not honor the\nagreement (indeed, it would be liable to the employee if it did). Other states regulate wage assignments in\nvarious ways\xe2\x80\x94for example, by requiring that the assignment be a separate instrument, not part of the\nloan agreement, and by specifying that no wage assignment is valid beyond a certain period of time (two\nor three years).\n\nConfession of Judgment\nBecause suing is at best nettlesome, many creditors have developed forms that allow them to sidestep the\ncourthouse when debtors have defaulted. As part of the original credit agreement, the consumer or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n856\n\n\x0cborrower waives his right to defend himself in court by signing a confession of judgment. This written\ninstrument recites the debtor\xe2\x80\x99s agreement that a court order be automatically entered against him in the\nevent of default. The creditor\xe2\x80\x99s lawyer simply takes the confession of judgment to the clerk of the court,\nwho enters it in the judgment book of the court without ever consulting a judge. Entry of the judgment\nentitles the creditor to attach the debtor\xe2\x80\x99s assets to satisfy the debt. Like prejudgment garnishment, a\nconfession of judgment gives the consumer no right to be heard, and it has been banned by statute or\ncourt decisions in many states.\n\nFair Debt Collection Practices Act of 1977\nMany stores, hospitals, and other organizations attempt on their own to collect unpaid bills, but\nthousands of merchants, professionals, and small businesses rely on collection agencies to recover\naccounts receivable. The debt collection business employed some 216,000 people in 2007 and collected\nover $40 billion in debt.\n\n[3]\n\nFor decades, some of these collectors used harassing tactics: posing as\n\ngovernment agents or attorneys, calling at the debtor\xe2\x80\x99s workplace, threatening physical harm or loss of\nproperty or imprisonment, using abusive language, publishing a deadbeats list, misrepresenting the size\nof the debt, and telling friends and neighbors about the debt. To provide a remedy for these abuses,\nCongress enacted, as part of the Consumer Credit Protection Act, the Fair Debt Collection Practices Act\n(FDCPA) in 1977.\n\nThis law regulates the manner by which third-party collection agencies conduct their business. It covers\ncollection of all personal, family, and household debts by collection agencies. It does not deal with\ncollection by creditors themselves; the consumer\xe2\x80\x99s remedy for abusive debt collection by the creditor is in\ntort law.\n\nUnder the FDCPA, the third-party collector may contact the debtor only during reasonable hours and not\nat work if the debtor\xe2\x80\x99s employer prohibits it. The debtor may write the collector to cease contact, in which\ncase the agency is prohibited from further contact (except to confirm that there will be no further contact).\nA written denial that money is owed stops the bill collector for thirty days, and he can resume again only\nafter the debtor is sent proof of the debt. Collectors may no longer file suit in remote places, hoping for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n857\n\n\x0cdefault judgments; any suit must be filed in a court where the debtor lives or where the underlying\ncontract was signed. The use of harassing and abusive tactics, including false and misleading\nrepresentations to the debtor and others (e.g., claiming that the collector is an attorney or that the debtor\nis about to be sued when that is not true), is prohibited. Unless the debtor has given the creditor her cell\nphone number, calls to cell phones (but not to landlines) are not allowed.\n\n[4]\n\nIn any mailings sent to the\n\ndebtor, the return address cannot indicate that it is from a debt collection agency (so as to avoid\nembarrassment from a conspicuous name on the envelope that might be read by third parties).\n\nCommunication with third parties about the debt is not allowed, except when the collector may need to\ntalk to others to trace the debtor\xe2\x80\x99s whereabouts (though the collector may not tell them that the inquiry\nconcerns a debt) or when the collector contacts a debtor\xe2\x80\x99s attorney, if the debtor has an attorney. The\nfederal statute gives debtors the right to sue the collector for damages for violating the statute and for\ncausing such injuries as job loss or harm to reputation.\n\nK E Y TA K EA WAY\nSeveral laws regulate practices after consumer credit transactions. The FTC\nprovides consumers with a three-day cooling-off period for some in-home sales,\nduring which time the consumer-purchaser may cancel the sale. The TILA and\nsome state laws also have some cancellation provisions. Billing errors are\naddressed by the Fair Credit Billing Act, which gives consumers certain rights. Debt\ncollection practices such as garnishment, wage assignments, and confessions of\njudgment are regulated (and in some states prohibited) by federal and state law.\nDebt collection practices for third-party debt collectors are constrained by the Fair\nDebt Collection Practices Act.\n\nE XE R C IS ES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n858\n\n\x0c1. Under what circumstances may a consumer have three days to avoid a\ncontract?\n2. How does the Fair Credit Billing Act resolve the problem that occurs when a\nconsumer disputes a bill and \xe2\x80\x9cargues\xe2\x80\x9d with a computer about it?\n3. What is the constitutional problem with garnishment as it was often practiced\nbefore 1969?\n4. If Joe of Joe\xe2\x80\x99s Garage wants to collect on his own the debts he is owed, he is\nnot constrained by the FDCPA. What limits are there on his debt collection\npractices?\n[1] Smith v. Cotton Brothers Baking Co., Inc., 609 F.2d 738 (5th Cir. 1980).\n[2] Sniadach v. Family Finance Corp., 395 U.S. 337 (1969).\n[3] PricewaterhouseCoopers LLP, Value of Third-Party Debt Collection to the U.S. Economy in\n2007: Survey And Analysis, June\n2008,http://www.acainternational.org/files.aspx?p=/images/12546/pwc2007-final.pdf.\n[4] Federal Communications Commission, \xe2\x80\x9cIn the Matter of Rules and Regulations\nImplementing the Telephone Consumer Protection Act of\n1991,\xe2\x80\x9dhttp://fjallfoss.fcc.gov/edocs_public/attachmatch/FCC-07-232A1.txt. (This document\nshows up best with Adobe Acrobat.)\n\n18.3 Cases\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n859\n\n\x0cUsury\nMatter of Dane\xe2\x80\x99s Estate\n\n390 N.Y.S.2d 249 (N.Y.A.D. 1976)\n\nMAHONEY, J.\n\nOn December 17, 1968, after repeated requests by decedent [Leland Dane] that appellant [James Rossi]\nloan him $10,500 [about $64,000 in 2010 dollars] the latter drew a demand note in that amount and with\ndecedent\xe2\x80\x99s consent fixed the interest rate at 7 1/2% Per annum, the then maximum annual interest\npermitted being 7 1/4%. Decedent executed the note and appellant gave him the full amount of the note in\ncash.\xe2\x80\xa6[The estate] moved for summary judgment voiding the note on the ground that it was a usurious\nloan, the note having been previously rejected as a claim against the estate. The [lower court] granted the\nmotion, voided the note and enjoined any prosecution on it thereafter. Appellant\xe2\x80\x99s cross motion to enforce\nthe claim was denied.\n\nNew York\xe2\x80\x99s usury laws are harsh, and courts have been reluctant to extend them beyond cases that fall\nsquarely under the statutes [Citation]. [New York law] makes any note for which more than the legal rate\nof interests is \xe2\x80\x98reserved or taken\xe2\x80\x99 or \xe2\x80\x98agreed to be reserved or taken\xe2\x80\x99 void. [The law] commands\ncancellation of a note in violation of [its provisions]. Here, since both sides concede that the note\nevidences the complete agreement between the parties, we cannot aid appellant by reliance upon the\npresumption that he did not make the loan at a usurious rate [Citation]. The terms of the loan are not in\ndispute. Thus, the note itself establishes, on its face, clear evidence of usury. There is no requirement of a\nspecific intent to violate the usury statute. A general intent to charge more than the legal rate as evidenced\nby the note, is all that is needed. If the lender intends to take and receive a rate in excess of the legal\npercentage at the time the note is made, the statute condemns the act and mandates its cancellation\n[Citation]. The showing, as here, that the note reserves to the lender an illegal rate of interest satisfies\nrespondents\xe2\x80\x99 burden of proving a usurious loan.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n860\n\n\x0cNext, where the rate of interest on the face of a note is in excess of the legal rate, it cannot be argued that\nsuch a loan may be saved because the borrower prompted the loan or even set the rate. The usury statutes\nare for the protection of the borrower and [their] purpose would be thwarted if the lender could avoid its\nconsequences by asking the borrower to set the rate. Since the respondents herein asserted the defense of\nusury, it cannot be said that the decedent waived the defense by setting or agreeing to the 7 1/2% Rate of\ninterest.\n\nFinally, equitable considerations cannot be indulged when, as here, a statute specifically condemns an act.\nThe statute fixes the law, and it must be followed.\n\nThe order should be affirmed, without costs.\n\nC A SE QU ES TIO NS\n1. What is the consequence to the lender of charging usurious rates in New\nYork?\n2. The rate charged here was one-half of one percent in excess of the allowable\nlimit. Who made the note, the borrower or the lender? That makes no\ndifference, but should it?\n3. What \xe2\x80\x9cequitable considerations\xe2\x80\x9d were apparently raised by the creditor?\n\nDiscrimination under the ECOA\nRosa v. Park West Bank & Trust Co.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n861\n\n\x0c214 F.3d 213, C.A.1 (Mass. 2000)\n\nLynch, J.\n\nLucas Rosa sued the Park West Bank & Trust Co. under the Equal Credit Opportunity Act (ECOA), 15\nU.S.C. \xc2\xa7\xc2\xa7 1691\xe2\x80\x931691f, and various state laws. He alleged that the Bank refused to provide him with a loan\napplication because he did not come dressed in masculine attire and that the Bank\xe2\x80\x99s refusal amounted to\nsex discrimination under the Act. The district court granted the Bank\xe2\x80\x99s motion to dismiss the ECOA\nclaim\xe2\x80\xa6\n\nI.\nAccording to the complaint, which we take to be true for the purpose of this appeal, on July 21, 1998, Mr.\nLucas Rosa came to the Bank to apply for a loan. A biological male, he was dressed in traditionally\nfeminine attire. He requested a loan application from Norma Brunelle, a bank employee. Brunelle asked\nRosa for identification. Rosa produced three forms of photo identification: (1) a Massachusetts\nDepartment of Public Welfare Card; (2) a Massachusetts Identification Card; and (3) a Money Stop Check\nCashing ID Card. Brunelle looked at the identification cards and told Rosa that she would not provide him\nwith a loan application until he \xe2\x80\x9cwent home and changed.\xe2\x80\x9d She said that he had to be dressed like one of\nthe identification cards in which he appeared in more traditionally male attire before she would provide\nhim with a loan application and process his loan request.\n\nII.\nRosa sued the Bank for violations of the ECOA and various Massachusetts antidiscrimination statutes.\nRosa charged that \xe2\x80\x9c[b]y requiring [him] to conform to sex stereotypes before proceeding with the credit\ntransaction, [the Bank] unlawfully discriminated against [him] with respect to an aspect of a credit\ntransaction on the basis of sex.\xe2\x80\x9d He claims to have suffered emotional distress, including anxiety,\ndepression, humiliation, and extreme embarrassment. Rosa seeks damages, attorney\xe2\x80\x99s fees, and injunctive\nrelief.\nWithout filing an answer to the complaint, the Bank moved to dismiss.\xe2\x80\xa6The district court granted the\nBank\xe2\x80\x99s motion. The court stated:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n862\n\n\x0c[T]he issue in this case is not [Rosa\xe2\x80\x99s] sex, but rather how he chose to dress when applying for a loan.\nBecause the Act does not prohibit discrimination based on the manner in which someone dresses, Park\nWest\xe2\x80\x99s requirement that Rosa change his clothes does not give rise to claims of illegal discrimination.\nFurther, even if Park West\xe2\x80\x99s statement or action were based upon Rosa\xe2\x80\x99s sexual orientation or perceived\nsexual orientation, the Act does not prohibit such discrimination.\n\nPrice Waterhouse v. Hopkins (U.S. Supreme Court, 1988), which Rosa relied on, was not to the contrary,\naccording to the district court, because that case \xe2\x80\x9cneither holds, nor even suggests, that discrimination\nbased merely on a person\xe2\x80\x99s attire is impermissible.\xe2\x80\x9d\n\nOn appeal, Rosa says that the district court \xe2\x80\x9cfundamentally misconceived the law as applicable to the\nPlaintiff\xe2\x80\x99s claim by concluding that there may be no relationship, as a matter of law, between telling a\nbank customer what to wear and sex discrimination.\xe2\x80\x9d \xe2\x80\xa6The Bank says that Rosa loses for two reasons.\nFirst, citing cases pertaining to gays and transsexuals, it says that the ECOA does not apply to\ncrossdressers. Second, the Bank says that its employee genuinely could not identify Rosa, which is why\nshe asked him to go home and change.\n\nIII.\n\xe2\x80\xa6In interpreting the ECOA, this court looks to Title VII case law, that is, to federal employment\ndiscrimination law.\xe2\x80\xa6The Bank itself refers us to Title VII case law to interpret the ECOA.\n\nThe ECOA prohibits discrimination, \xe2\x80\x9cwith respect to any aspect of a credit transaction[,] on the basis of\nrace, color, religion, national origin, sex or marital status, or age.\xe2\x80\x9d 15 U.S.C. \xc2\xa7 1691(a). Thus to prevail, the\nalleged discrimination against Rosa must have been \xe2\x80\x9con the basis of\xe2\x80\xa6sex.\xe2\x80\x9d See [Citation.] The ECOA\xe2\x80\x99s sex\ndiscrimination prohibition \xe2\x80\x9cprotects men as well as women.\xe2\x80\x9d\nWhile the district court was correct in saying that the prohibited bases of discrimination under the ECOA\ndo not include style of dress or sexual orientation, that is not the discrimination alleged. It is alleged that\nthe Bank\xe2\x80\x99s actions were taken, in whole or in part, \xe2\x80\x9con the basis of\xe2\x80\xa6 [the appellant\xe2\x80\x99s] sex.\xe2\x80\x9d The Bank, by\nseeking dismissal under Rule 12(b)(6), subjected itself to rigorous standards. We may affirm dismissal\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n863\n\n\x0c\xe2\x80\x9conly if it is clear that no relief could be granted under any set of facts that could be proved consistent with\nthe allegations.\xe2\x80\x9d [Citations] Whatever facts emerge, and they may turn out to have nothing to do with sexbased discrimination, we cannot say at this point that the plaintiff has no viable theory of sex\ndiscrimination consistent with the facts alleged.\n\nThe evidence is not yet developed, and thus it is not yet clear why Brunelle told Rosa to go home and\nchange. It may be that this case involves an instance of disparate treatment based on sex in the denial of\ncredit. See [Citation]; (\xe2\x80\x9c\xe2\x80\x98Disparate treatment\xe2\x80\x99\xe2\x80\xa6is the most easily understood type of discrimination. The\nemployer simply treats some people less favorably than others because of their\xe2\x80\xa6sex.\xe2\x80\x9d); [Citation]\n(invalidating airline\xe2\x80\x99s policy of weight limitations for female \xe2\x80\x9cflight hostesses\xe2\x80\x9d but not for similarly\nsituated male \xe2\x80\x9cdirectors of passenger services\xe2\x80\x9d as impermissible disparate treatment); [Citation]\n(invalidating policy that female employees wear uniforms but that similarly situated male employees need\nwear only business dress as impermissible disparate treatment); [Citation] (invalidating rule requiring\nabandonment upon marriage of surname that was applied to women, but not to men). It is reasonable to\ninfer that Brunelle told Rosa to go home and change because she thought that Rosa\xe2\x80\x99s attire did not accord\nwith his male gender: in other words, that Rosa did not receive the loan application because he was a\nman, whereas a similarly situated woman would have received the loan application. That is, the Bank may\ntreat, for credit purposes, a woman who dresses like a man differently than a man who dresses like a\nwoman. If so, the Bank concedes, Rosa may have a claim. Indeed, under Price Waterhouse, \xe2\x80\x9cstereotyped\nremarks [including statements about dressing more \xe2\x80\x98femininely\xe2\x80\x99] can certainly be evidence that gender\nplayed a part.\xe2\x80\x9d [Citation.] It is also reasonable to infer, though, that Brunelle refused to give Rosa the loan\napplication because she thought he was gay, confusing sexual orientation with cross-dressing. If so, Rosa\nconcedes, our precedents dictate that he would have no recourse under the federal Act. See [Citation]. It is\nreasonable to infer, as well, that Brunelle simply could not ascertain whether the person shown in the\nidentification card photographs was the same person that appeared before her that day. If this were the\ncase, Rosa again would be out of luck. It is reasonable to infer, finally, that Brunelle may have had mixed\nmotives, some of which fall into the prohibited category.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n864\n\n\x0cIt is too early to say what the facts will show; it is apparent, however, that, under some set of facts within\nthe bounds of the allegations and non-conclusory facts in the complaint, Rosa may be able to prove a\nclaim under the ECOA.\xe2\x80\xa6\n\nWe reverse and remand for further proceedings in accordance with this opinion.\n\nC A SE QU ES TIO NS\n1. Could the bank have denied Mr. Rosa a loan because he was gay?\n2. If a woman had applied for loan materials dressed in traditionally masculine\nattire, could the bank have denied her the materials?\n3. The Court offers up at least three possible reasons why Rosa was denied the\nloan application. What were those possible reasons, and which of them would\nhave been valid reasons to deny him the application?\n4. To what federal law does the court look in interpreting the application of the\nECOA?\n5. Why did the court rule in Mr. Rosa\xe2\x80\x99s favor when the facts as to why he was\ndenied the loan application could have been interpreted in several different\nways?\n\nUses of Credit Reports under the FCRA\nRodgers v. McCullough\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n865\n\n\x0c296 F.Supp.2d 895 (W.D. Tenn. 2003)\n\nBackground\nThis case concerns Defendants\xe2\x80\x99 receipt and use of Christine Rodgers\xe2\x80\x99 consumer report. The material facts\ndo not seem to be disputed. The parties agree that Ms. Rodgers gave birth to a daughter, Meghan, on May\n4, 2001. Meghan\xe2\x80\x99s father is Raymond Anthony. Barbara McCullough, an attorney, represented Mr.\nAnthony in a child custody suit against Ms. Rodgers in which Mr. Anthony sought to obtain custody and\nchild support from Ms. Rodgers. Ms. McCullough received, reviewed, and used Ms. Rodgers\xe2\x80\x99 consumer\nreport in connection with the child custody case.\n\nOn September 25, 2001, Ms. McCullough instructed Gloria Christian, her secretary, to obtain Ms.\nRodgers\xe2\x80\x99 consumer report. Ms. McCullough received the report on September 27 or 28 of 2001. She\nreviewed the report in preparation for her examination of Ms. Rodgers during a hearing to be held in\njuvenile court on October 23, 2001. She also used the report during the hearing, including attempting to\nmove the document into evidence and possibly handing it to the presiding judge.\n\nThe dispute in this case centers around whether Ms. McCullough obtained and used Ms. Rodgers\xe2\x80\x99\nconsumer report for a purpose permitted under the Fair Credit Reporting Act (the \xe2\x80\x9cFCRA\xe2\x80\x9d). Plaintiff\ncontends that Ms. McCullough, as well as her law firm, Wilkes, McCullough & Wagner, a partnership, and\nher partners, Calvin J. McCullough and John C. Wagner, are liable for the unlawful receipt and use of Ms.\nRodgers\xe2\x80\x99 consumer report in violation 15 U.S.C. \xc2\xa7\xc2\xa7 1681 o(negligent failure to comply with the FCRA) and\n1681n (willful failure to comply with the FCRA or obtaining a consumer report under false pretenses).\nPlaintiff has also sued Defendants for the state law tort of unlawful invasion of privacy.\xe2\x80\xa6\n\nAnalysis\nPlaintiff has moved for summary judgment on the questions of whether Defendants failed to comply with\nthe FCRA (i.e. whether Defendants had a permissible purpose to obtain Ms. Rodgers\xe2\x80\x99 credit report),\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n866\n\n\x0cwhether Defendants\xe2\x80\x99 alleged failure to comply was willful, and whether Defendants\xe2\x80\x99 actions constituted\nunlawful invasion of privacy. The Court will address the FCRA claims followed by the state law claim for\nunlawful invasion of privacy.\n\nA. Permissible Purpose under the FCRA\nPursuant to the FCRA, \xe2\x80\x9cA person shall not use or obtain a consumer report for any purpose unless (1) the\nconsumer report is obtained for a purpose for which the consumer report is authorized to be furnished\nunder this section.\xe2\x80\xa6\xe2\x80\x9d [Citation.] Defendants do not dispute that Ms. McCullough obtained and used Ms.\nRodgers\xe2\x80\x99 consumer report.\n\n[The act] provides a list of permissible purposes for the receipt and use of a consumer report, of which the\nfollowing subsection is at issue in this case:\n\n[A]ny consumer reporting agency may furnish a consumer report under the following circumstances and\nno other:\xe2\x80\xa6\n\n(3) To a person which it has reason to believe-\n\n(A) intends to use the information in connection with a credit transaction involving the consumer on\nwhom the information is to be furnished and involving the extension of credit to, or review or collection of\nan account of, the consumer\xe2\x80\xa6\n\n[Citation.] Defendants concede that Ms. McCullough\xe2\x80\x99s receipt and use of Ms. Rodgers\xe2\x80\x99 consumer report\ndoes not fall within any of the other permissible purposes enumerated in [the act].\n\nMs. Rodgers requests summary judgment in her favor on this point, relying on the plain text of the\nstatute, because she was not in arrears on any child support obligation at the time Ms. McCullough\nrequested the consumer report, nor did she owe Ms. McCullough\xe2\x80\x99s client any debt. She notes that Mr.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n867\n\n\x0cAnthony did not have custody of Meghan Rodgers and that an award of child support had not even been\nset at the time Ms. McCullough obtained her consumer report.\n\nDefendants maintain that Ms. McCullough obtained Ms. Rodgers\xe2\x80\x99 consumer report for a permissible\npurpose, namely to locate Ms. Rodgers\xe2\x80\x99 residence and set and collect child support obligations.\nDefendants argue that 15 U.S.C. \xc2\xa7 1681b(a)(3)(A) permits the use of a credit report in connection with\n\xe2\x80\x9ccollection of an account\xe2\x80\x9d and, therefore, Ms. McCullough was permitted to use Ms. Rodgers\xe2\x80\x99 credit report\nin connection with the collection of child support.\n\n[1]\n\nThe cases Defendants have cited in response to the motion for summary judgment are inapplicable to the\npresent facts. In each case cited by Defendants, the person who obtained a credit report did so in order to\ncollect on an outstanding judgment or an outstanding debt.See, e.g., [Citation] (finding that collection of\na judgment of arrears in child support is a permissible purpose under [the act]; [Citation] (holding that\ndefendant had a permissible purpose for obtaining a consumer report where plaintiff owed an\noutstanding debt to the company).\n\nHowever, no such outstanding debt or judgment existed in this case. At the time Ms. McCullough\nobtained Ms. Rodgers\xe2\x80\x99 consumer report, Ms. Rodgers\xe2\x80\x99 did not owe money to either Ms. McCullough or her\nclient, Mr. Anthony. Defendants have provided no evidence showing that Ms. McCullough believed Ms.\nRodgers owed money to Mr. Anthony at the time she requested the credit report. Indeed, Mr. Anthony\nhad not even been awarded custody of Meghan Rodgers at the time Ms. McCullough obtained and used\nthe credit report. Ms. McCullough acknowledged each of the facts during her deposition. Moreover, in\nresponse to Plaintiff\xe2\x80\x99s request for admissions, Ms. McCullough admitted that she did not receive the credit\nreport for the purpose of collecting on an account from Ms. Rodgers.\n\nThe evidence before the Court makes clear that Ms. McCullough was actually attempting, on behalf of Mr.\nAnthony, to secure custody of Meghan Rodgers and obtain a future award of child support payments from\nMs. Rodgers by portraying Ms. Rodgers as irresponsible to the court. These are not listed as permissible\npurposes under [FCRA]. Defendants have offered the Court no reason to depart from the plain language\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n868\n\n\x0cof the statute, which clearly does not permit an individual to obtain a consumer report for the purposes of\nobtaining child custody and instituting child support payments. Moreover, the fact that the Juvenile Court\nlater awarded custody and child support to Mr. Anthony does not retroactively provide Ms. McCullough\nwith a permissible purpose for obtaining Ms. Rodgers\xe2\x80\x99 consumer report. Therefore, the Court GRANTS\nPlaintiff\xe2\x80\x99s motion for partial summary judgment on the question of whether Defendants had a permissible\npurpose to obtain Ms. Rodgers\xe2\x80\x99 credit report.\n\nB. Willful Failure to Comply with the FCRA\nPursuant to [the FCRA], \xe2\x80\x9cAny person who willfully fails to comply with any requirement imposed under\nthis subchapter with respect to any consumer is liable to that consumer\xe2\x80\x9d for the specified damages.\n\n\xe2\x80\x9cTo show willful noncompliance with the FCRA, [the plaintiff] must show that [the defendant] \xe2\x80\x98knowingly\nand intentionally committed an act in conscious disregard for the rights of others,\xe2\x80\x99 but need not show\n\xe2\x80\x98malice or evil motive.\xe2\x80\x99\xe2\x80\x9d [Citation.] \xe2\x80\x9cUnder this formulation the defendant must commit the act that\nviolates the Fair Credit Reporting Act with knowledge that he is committing the act and with intent to do\nso, and he must also be conscious that his act impinges on the rights of others.\xe2\x80\x9d \xe2\x80\x9cThe statute\xe2\x80\x99s use of the\nword \xe2\x80\x98willfully\xe2\x80\x99 imports the requirement that the defendant know his or her conduct is unlawful.\xe2\x80\x9d\n[Citation.] A defendant can not be held civilly liable under [the act] if he or she obtained the plaintiff\xe2\x80\x99s\ncredit report \xe2\x80\x9cunder what is believed to be a proper purpose under the statute but which a court\xe2\x80\xa6later\nrules to be impermissible legally under [Citation].\n\nMs. McCullough is an attorney who signed multiple service contracts with Memphis Consumer Credit\nAssociation indicating that the primary purpose for which credit information would be ordered was \xe2\x80\x9cto\ncollect judgments.\xe2\x80\x9d Ms. McCullough also agreed in these service contracts to comply with the FCRA. Her\ndeposition testimony indicates that she had never previously ordered a consumer report for purposes of\ncalculating child support. This evidence may give rise to an inference that Ms. McCullough was aware that\nshe did not order Ms. Rodgers\xe2\x80\x99 consumer report for a purpose permitted under the FCRA.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n869\n\n\x0cDefendants argue in their responsive memorandum that if Ms. McCullough had suspected that she had\nobtained Ms. Rodgers\xe2\x80\x99 credit report in violation of the FCRA, it is unlikely that she would have attempted\nto present the report to the Juvenile Court as evidence during the custody hearing for Meghan Rodgers.\nMs. McCullough also testified that she believed she had a permissible purpose for obtaining Ms. Rodgers\xe2\x80\x99\nconsumer report (i.e. to set and collect child support obligations).\n\nViewing the evidence in the light most favorable to the nonmoving party, Defendants have made a\nsufficient showing that Ms. McCullough may not have understood that she lacked a permissible purpose\nunder the FCRA to obtain and use Ms. Rodgers\xe2\x80\x99 credit report.\n\nIf Ms. McCullough was not aware that her actions might violate the FCRA at the time she obtained and\nused Ms. Rodgers\xe2\x80\x99 credit report, she would not have willfully failed to comply with the FCRA. The\nquestion of Ms. McCullough\xe2\x80\x99s state of mind at the time she obtained and used Ms. Rodgers\xe2\x80\x99 credit report\nis an issue best left to a jury. [Citation] (\xe2\x80\x9cstate of mind is typically not a proper issue for resolution on\nsummary judgment\xe2\x80\x9d). The Court DENIES Plaintiff\xe2\x80\x99s motion for summary judgment on the question of\nwillfulness under [the act].\n\nC. Obtaining a Consumer Report under False Pretenses or Knowingly without a\nPermissible Purpose\n\xe2\x80\xa6For the same reasons the Court denied Plaintiff\xe2\x80\x99s motion for summary judgment on the question of\nwillfulness, the Court also DENIES Plaintiff\xe2\x80\x99s motion for summary judgment on the question of whether\nMs. McCullough obtained and used Ms. Rodgers\xe2\x80\x99 credit report under false pretenses or knowingly without\na permissible purpose.\n\n[Discussion of the invasion of privacy claim omitted.]\n\nConclusion\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n870\n\n\x0cFor the foregoing reasons, the Court GRANTS Plaintiff\xe2\x80\x99s Motion for Partial Summary Judgment\nRegarding Defendants\xe2\x80\x99 Failure to Comply with the Fair Credit Reporting Act [having no permissible\npurpose]. The Court DENIES Plaintiff\xe2\x80\x99s remaining motions for partial summary judgment.\n\nC A SE QU ES TIO NS\n1. Why did the defendant, McCullough, order her secretary to obtain Ms.\nRodgers\xe2\x80\x99s credit report? If Ms. McCullough is found liable, why would her law\nfirm partners also be liable?\n2. What \xe2\x80\x9cpermissible purpose\xe2\x80\x9d did the defendants contend they had for\nobtaining the credit report? Why did the court determine that purpose was\nnot permissible?\n3. Why did the court deny the plaintiff\xe2\x80\x99s motion for summary judgment on the\nquestion of whether the defendant \xe2\x80\x9cwillfully\xe2\x80\x9d failed to comply with the act? Is\nthe plaintiff out of luck on that question, or can it be litigated further?\n[1] Defendants also admit that Ms. McCullough used the credit report to portray Ms. Rodgers\nas irresponsible, financially unstable, and untruthful about her residence and employment\nhistory to the Juvenile Court. Defendants do not allege that these constitute permissible\npurposes under the FCRA.\n\n18.4 Summary and Exercises\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n871\n\n\x0cSummary\nConsumers who are granted credit have long received protection through usury laws (laws that establish a\nmaximum interest rate). The rise in consumer debt in recent years has been matched by an increase in\nfederal regulation of consumer credit transactions. The Truth in Lending Act requires disclosure of credit\nterms; the Equal Credit Opportunity Act prohibits certain types of discrimination in the granting of credit;\nthe Fair Credit Reporting Act gives consumers access to their credit dossiers and prohibits unapproved\nuse of credit-rating information. After entering into a credit transaction, a consumer has certain\ncancellation rights and may use a procedure prescribed by the Fair Credit Billing Act to correct billing\nerrors. Traditional debt collection practices\xe2\x80\x94garnishment, wage assignments, and confession of judgment\nclauses\xe2\x80\x94are now subject to federal regulation, as are the practices of collection agencies under the Fair\nDebt Collection Practices Act.\n\nE XE R C IS ES\n1. Carlene Consumer entered into an agreement with Rent to Buy, Inc., to rent a\ncomputer for $20 per week. The agreement also provided that if Carlene chose to\nrent the computer for fifty consecutive weeks, she would own it. She then\nasserted that the agreement was not a lease but a sale on credit subject to the\nTruth in Lending Act, and that Rent to Buy, Inc., violated the act by failing to state\nthe annual percentage rate. Is Carlene correct?\n2. Carlos, a resident of Chicago, was on a road trip to California when he heard a\nnoise under the hood of his car. He took the car to a mechanic for repair. The\nmechanic overhauled the power steering unit and billed Carlos $600, which he\ncharged on his credit card. Later that day\xe2\x80\x94Carlos having driven about fifty miles\xe2\x80\x94\nthe car made the same noise, and Carlos took it to another mechanic, who\ndiagnosed the problem as a loose exhaust pipe connection at the manifold. Carlos\nwas billed $300 for this repair, with which he was satisfied. Carlos returned to\nChicago and examined his credit card statement. What rights has he as to the $600\ncharge on his card?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n872\n\n\x0c3. Ken was the owner of Scrimshaw, a company that manufactured and sold carvings\nmade on fossilized ivory. He applied for a loan from Bank. Bank found him\ncreditworthy, but seeking additional security for repayment, it required his wife,\nLinda, to sign a guaranty as well. During a subsequent recession, demand for\nscrimshaw fell, and Ken\xe2\x80\x99s business went under. Bank filed suit against both Ken\nand Linda. What defense has Linda?\n4. The FCRA requires that credit-reporting agencies \xe2\x80\x9cfollow reasonable procedures to\nassure maximum possible accuracy of the information.\xe2\x80\x9d In October of 1989, Renie\nGuimond became aware of, and notified the credit bureau Trans Union about,\ninaccuracies in her credit report: that she was married (and it listed a Social\nSecurity number for this nonexistent spouse), that she was also known as Ruth\nGuimond, and that she had a Saks Fifth Avenue credit card. About a month later,\nTrans Union responded to Guimond\xe2\x80\x99s letter, stating that the erroneous\ninformation had been removed. But in March of 1990, Trans Union again\npublished the erroneous information it purportedly had removed. Guimond then\nrequested the source of the erroneous information, to which Trans Union\nresponded that it could not disclose the identity of the source because it did not\nknow its source. The disputed information was eventually removed from\nGuimond\xe2\x80\x99s file in October 1990. When Guimond sued, Trans Union defended that\nshe had no claim because no credit was denied to her as a result of the\ninaccuracies in her credit file. The lower court dismissed her case; she appealed.\nTo what damages, if any, is Guimond entitled?\n5. Plaintiff incurred a medical debt of $160. She received two or three\ntelephone calls from Defendant, the collection agency; each time she\ndenied any money owing. Subsequently she received this letter:\nYou have shown that you are unwilling to work out a friendly settlement\nwith us to clear the above debt. Our field investigator has now been\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n873\n\n\x0cinstructed to make an investigation in your neighborhood and to personally\ncall on your employer.\nThe immediate payment of the full amount, or a personal visit to this office,\nwill spare you this embarrassment.\nThe top of the letter notes the creditor\xe2\x80\x99s name and the amount of the\nalleged debt. The letter was signed by a \xe2\x80\x9ccollection agent.\xe2\x80\x9d The envelope\ncontaining that letter presented a return address that included Defendant\xe2\x80\x99s\nfull name: \xe2\x80\x9cCollection Accounts Terminal, Inc.\xe2\x80\x9d What violations of the Fair\nDebt Collection Practices Act are here presented?\n\n6. Eric and Sharaveen Rush filed a claim alleging violations of the Fair Credit\nReporting Act arising out of an allegedly erroneous credit report prepared by a\ncredit bureau from information, in part, from Macy\xe2\x80\x99s, the department store. The\nerror causes the Rushes to be denied credit. Macy\xe2\x80\x99s filed a motion to dismiss. Is\nMacy\xe2\x80\x99s liable? Discuss.\n\nS EL F -T E ST QU EST IO N S\n1. An example of a loan that is a common exception to usury law is\na. a business loan\nb. a mortgage loan\nc. an installment loan\nd. all of the above\n\nUnder the Fair Credit Reporting Act, an applicant denied credit\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n874\n\n\x0ca. has a right to a hearing\nb. has the right to be told the name and address of the credit bureau\nthat prepared the credit report upon which denial was based\nc. always must pay a fee for information regarding credit denial\nd. none of the above\nGarnishment of wages\na. is limited by federal law\nb. involves special rules for support cases\nc. is a legal process where a creditor obtains a court order directing\nthe debtor\xe2\x80\x99s employer to pay a portion of the debtor\xe2\x80\x99s wages\ndirectly to the creditor\nd. involves all of the above\nA wage assignment is\na. an example of garnishment\nb. an example of confession of judgment\nc. an exception to usury law\nd. an agreement that a creditor may take future wages as security for\na loan\nThe Truth-in-Truth in Lending Act requires disclosure of\na. the annual percentage rate\nb. the borrower\xe2\x80\x99s race\nc. both of the above\nd. neither of the above\n\nS EL F -T E ST A NSW E R S\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n875\n\n\x0c1. d\n2. b\n3. d\n4. d\n5. a\n\nChapter 19\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n876\n\n\x0cSecured Transactions and Suretyship\nL EA R N IN G O B JEC T IV ES\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\n7. The relationship between surety and principal\n8. Rights among cosureties\n\n19.1 Introduction to Secured Transactions\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n877\n\n\x0cL EA R N IN G O B JEC T IV ES\n1. Recognize, most generally, the two methods by which debtors\xe2\x80\x99 obligations\nmay be secured.\n2. Know the source of law for personal property security.\n3. Understand the meaning of security interest and other terminology necessary\nto discuss the issues.\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 security at\nall, and\xe2\x80\x94as it is oral\xe2\x80\x94it is difficult to prove. A signature loan is merely a written promise by the debtor\nto repay, but the creditor stuck holding a promissory note with a signature loan only\xe2\x80\x94while he may sue a\ndefaulting debtor\xe2\x80\x94will get nothing if the debtor is insolvent. Again, that\xe2\x80\x99s no security at all. Real security\nfor the creditor comes in two forms: by agreement with the debtor or by operation of law without an\nagreement.\n\nBy Agreement with the Debtor\nSecurity obtained through agreement comes in three major types: (1) personal property security (the most\ncommon form of security); (2) suretyship\xe2\x80\x94the willingness of a third party to pay if the primarily obligated\nparty 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 \xe2\x80\x9cstring\xe2\x80\x9d or\n\xe2\x80\x9ctie,\xe2\x80\x9d a lien is the legal hold that a creditor has over the property of another in order to secure payment or\ndischarge an obligation.\n\nIn this chapter, we take up security interests in personal property and suretyship. In the next chapter, we\nlook at mortgages and nonconsensual liens.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n878\n\n\x0cBasics of Secured Transactions\nThe law of secured transactions consists of five principal components: (1) the nature of property that can\nbe the subject of a security interest; (2) the methods of creating the security interest; (3) the perfection of\nthe security interest against claims of others; (4) priorities among secured and unsecured creditors\xe2\x80\x94that\nis, who will be entitled to the secured property if more than one person asserts a legal right to it; and (5)\nthe rights of creditors when the debtor defaults. After considering the source of the law and some key\nterminology, we examine each of these components in turn.\n\nHere is the simplest (and most common) scenario: Debtor borrows money or obtains credit from Creditor,\nsigns a note and security agreement putting up collateral, and promises to pay the debt or, upon Debtor\xe2\x80\x99s\ndefault, let Creditor (secured party) take possession of (repossess) the collateral and sell it. Figure 19.1\n"The Grasping Hand"illustrates this scenario\xe2\x80\x94the grasping hand is Creditor\xe2\x80\x99s reach for the collateral, but\nthe hand will not close around the collateral and take it (repossess) unless Debtor defaults.\n\nFigure 19.1 The Grasping Hand\n\nSource of Law and Definitions\nSource of Law\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n879\n\n\x0cArticle 9 of the Uniform Commercial Code (UCC) governs security interests in personal property. The\nUCC defines the scope of the article (here slightly truncated):\n\n[1]\n\nThis chapter applies to the following:\n\n1.\n\nA transaction, regardless of its form, that creates a security interest in personal property or\nfixtures by contract;\n\n2. An agricultural lien;\n3. A sale of accounts, chattel paper, payment intangibles, or promissory notes;\n4. A consignment\xe2\x80\xa6\n\nDefinitions\nAs always, it is necessary to review some definitions so that communication on the topic at hand is\npossible. The secured transaction always involves a debtor, a secured party, a security agreement, a\nsecurity interest, and collateral.\n\nArticle 9 applies to any transaction \xe2\x80\x9cthat creates a security interest.\xe2\x80\x9d The UCC in Section 1-201(35)\ndefines security interest as \xe2\x80\x9can interest in personal property or fixtures which secures payment or\nperformance of an obligation.\xe2\x80\x9d\n\nSecurity agreement is \xe2\x80\x9can agreement that creates or provides for a security interest.\xe2\x80\x9d It is the contract\nthat sets up the debtor\xe2\x80\x99s duties and the creditor\xe2\x80\x99s rights in event the debtor defaults.\n\nCollateral \xe2\x80\x9cmeans the property subject to a security interest or agricultural lien.\xe2\x80\x9d\n\n[2]\n\n[3]\n\nPurchase-money security interest (PMSI) is the simplest form of security interest. Section 9-103(a)\nof the UCC defines \xe2\x80\x9cpurchase-money collateral\xe2\x80\x9d as \xe2\x80\x9cgoods or software that secures a purchase-money\nobligation with respect to that collateral.\xe2\x80\x9d A PMSI arises where the debtor gets credit to buy goods and the\ncreditor takes a secured interest in those goods. Suppose you want to buy a big hardbound textbook on\ncredit at your college bookstore. The manager refuses to extend you credit outright but says she will take\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n880\n\n\x0cback a PMSI. In other words, she will retain a security interest in the book itself, and if you don\xe2\x80\x99t pay,\nyou\xe2\x80\x99ll have to return the book; it will be repossessed. Contrast this situation with a counteroffer you might\nmake: because she tells you not to mark up the book (in the event that she has to repossess it if you\ndefault), you would rather give her some other collateral to hold\xe2\x80\x94for example, your gold college signet\nring. Her security 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 book and\ngave the lender a security interest in the book.\n\nWhether a transaction is a lease or a PMSI is an issue that frequently arises. The answer depends on the\nfacts of each case. However, a security interest is created if (1) the lessee is obligated to continue payments\nfor the term of the lease; (2) the lessee cannot terminate the obligation; and (3) one of several economic\ntests, which are listed in UCC Section 1-201 (37), is met. For example, one of the economic tests is that\n\xe2\x80\x9cthe lessee has an option to become owner of the goods for no additional consideration or nominal\nadditional consideration upon compliance with the lease agreement.\xe2\x80\x9d\n\nThe issue of lease versus security interest gets litigated because of the requirements of Article 9 that a\nsecurity interest be perfected in certain ways (as we will see). If the transaction turns out to be a security\ninterest, a lessor who fails to meet these requirements runs the risk of losing his property to a third party.\nAnd consider this example. Ferrous Brothers Iron Works \xe2\x80\x9cleases\xe2\x80\x9d a $25,000 punch press to Millie\xe2\x80\x99s\nMachine Shop. Under the terms of the lease, Millie\xe2\x80\x99s must pay a yearly rental of $5,000 for five years,\nafter which time Millie\xe2\x80\x99s may take title to the machine outright for the payment of $1. During the period of\nthe rental, title remains in Ferrous Brothers. Is this \xe2\x80\x9clease\xe2\x80\x9d really a security interest? Since ownership\ncomes at nominal charge when the entire lease is satisfied, the transaction would be construed as one\ncreating a security interest. What difference does this make? Suppose Millie\xe2\x80\x99s goes bankrupt in the third\nyear of the lease, 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 (unless\nthe trustee assumed the lease). But if the lease is really intended as a device to create a security interest,\nthen Ferrous Brothers can recover its collateral only if it has otherwise complied with the obligations of\nArticle 9\xe2\x80\x94for example, by recording its security interest, as we will see.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n881\n\n\x0cNow we return to definitions.\n\nDebtor is \xe2\x80\x9ca person (1) having an interest in the collateral other than a security interest or a lien; (2) a\nseller of accounts, chattel paper, payment intangibles, or promissory notes; or (3) a consignee.\xe2\x80\x9d\n\n[4]\n\nObligor is \xe2\x80\x9ca person that, with respect to an obligation secured by a security interest in or an agricultural\nlien on the collateral, (i) owes payment or other performance of the obligation, (ii) has provided property\nother than the collateral to secure payment or other performance of the obligation, or (iii) is otherwise\naccountable in whole or in part for payment or other performance of the obligation.\xe2\x80\x9d\n\n[5]\n\nHere is example 1\n\nfrom the Official Comment to UCC Section 9-102: \xe2\x80\x9cBehnfeldt borrows money and grants a security\ninterest in her Miata to secure the debt. Behnfeldt is a debtor and an obligor.\xe2\x80\x9d\n\nBehnfeldt is a debtor because she has an interest in the car\xe2\x80\x94she owns it. She is an obligor because she\nowes payment to the creditor. Usually the debtor is the obligor.\n\nA secondary obligor is \xe2\x80\x9can obligor to the extent that: (A) [the] obligation is secondary; or (b) [the person]\nhas a right of recourse with respect to an obligation secured by collateral against the debtor, another\nobligor, or property of either.\xe2\x80\x9d\n\n[6]\n\nThe secondary obligor is a guarantor (surety) of the debt, obligated to\n\nperform if the primary obligor defaults. Consider example 2 from the Official Comment to Section 9-102:\n\xe2\x80\x9cBehnfeldt borrows money and grants a security interest in her Miata to secure the debt. Bruno cosigns a\nnegotiable note as maker. As before, Behnfeldt is the debtor and an obligor. As an accommodation party,\nBruno is a secondary obligor. Bruno has this status even if the note states that her obligation is a primary\nobligation and that she waives all suretyship defenses.\xe2\x80\x9d\n\nAgain, usually the debtor is the obligor, but consider example 3 from the same Official Comment:\n\xe2\x80\x9cBehnfeldt borrows money on an unsecured basis. Bruno cosigns the note and grants a security interest in\nher Honda to secure her [Behnfeldt\xe2\x80\x99s] obligation. Inasmuch as Behnfeldt does not have a property interest\nin the Honda, Behnfeldt is not a debtor. Having granted the security interest, Bruno is the debtor. Because\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n882\n\n\x0cBehnfeldt is a principal obligor, she is not a secondary obligor. Whatever the outcome of enforcement of\nthe security interest against the Honda or Bruno\xe2\x80\x99s secondary obligation, Bruno will look to Behnfeldt for\nher losses. The enforcement will not affect Behnfeldt\xe2\x80\x99s aggregate obligations.\xe2\x80\x9d\n\nSecured party is \xe2\x80\x9ca person in whose favor a security interest is created or provided for under a security\nagreement,\xe2\x80\x9d and it includes people to whom accounts, chattel paper, payment intangibles, or promissory\nnotes have been sold; consignors; and others under Section 9-102(a)(72).\n\nChattel mortgage means \xe2\x80\x9ca debt secured against items of personal property rather than against land,\nbuildings and fixtures.\xe2\x80\x9d\n\n[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\x94property that\nis subject to the security interest. It can be divided into four broad categories: goods, intangible property,\nindispensable paper, and other types of collateral.\n\nGoods\nTangible property as collateral is goods. Goods means \xe2\x80\x9call things that are movable when a security interest\nattaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and removed under a\nconveyance or contract for sale, (iii) the unborn young of animals, (iv) crops grown, growing, or to be\ngrown, even if the crops are produced on trees, vines, or bushes, and (v) manufactured homes. The term\nalso includes a computer program embedded in goods.\xe2\x80\x9d\n\n[8]\n\nGoods are divided into several subcategories;\n\nsix 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\n\n[9]\n\nInventory\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n883\n\n\x0c\xe2\x80\x9cGoods, other than farm products, held by a person for sale or lease or consisting of raw materials, works\nin progress, or material consumed in a business.\xe2\x80\x9d\n\n[10]\n\nFarm Products\n\xe2\x80\x9cCrops, livestock, or other supplies produced or used in farming operations,\xe2\x80\x9d including aquatic goods\nproduced in aquaculture.\n\n[11]\n\nEquipment\nThis is the residual category, defined as \xe2\x80\x9cgoods other than inventory, farm products, or consumer\ngoods.\xe2\x80\x9d\n\n[12]\n\nFixtures\nThese are \xe2\x80\x9cgoods that have become so related to particular real property that an interest in them arises\nunder real property law.\xe2\x80\x9d\n\n[13]\n\nExamples would be windows, furnaces, central air conditioning, and\n\nplumbing fixtures\xe2\x80\x94items that, if removed, would be a cause for significant reconstruction.\n\nAccession\nThese are \xe2\x80\x9cgoods that are physically united with other goods in such a manner that the identity of the\noriginal goods is lost.\xe2\x80\x9d\n\n[14]\n\nA 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 intangibles.\n\nAccounts\nThis type of intangible property includes accounts receivable (the right to payment of money), insurance\npolicy proceeds, energy provided or to be provided, winnings in a lottery, health-care-insurance\nreceivables, promissory notes, securities, letters of credit, and interests in business entities.\n\n[15]\n\nOften there\n\nis something in writing to show the existence of the right\xe2\x80\x94such as a right to receive the proceeds of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n884\n\n\x0csomebody else\xe2\x80\x99s insurance payout\xe2\x80\x94but the writing is merely evidence of the right. The paper itself doesn\xe2\x80\x99t\nhave to be delivered for the transfer of the right to be effective; 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 accounts,\ncommercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-ofcredit rights, letters of credit, money, and oil, gas, or other minerals before extraction.\xe2\x80\x9d General\nintangibles include payment intangibles and software.\n\n[16]\n\nIndispensable Paper\nThis oddly named category is the middle ground between goods\xe2\x80\x94stuff you can touch\xe2\x80\x94and intangible\nproperty. It\xe2\x80\x99s called \xe2\x80\x9cindispensable\xe2\x80\x9d because although the right to the value\xe2\x80\x94such as a warehouse\nreceipt\xe2\x80\x94is embodied in a written paper, the paper itself is indispensable for the transferee to access the\nvalue. For example, suppose Deborah Debtor borrows $3,000 from Carl Creditor, and Carl takes a\nsecurity interest in four designer chairs Deborah owns that are being stored in a warehouse. If Deborah\ndefaults, Carl has the right to possession of the warehouse receipt: he takes it to the warehouser and is\nentitled to take the chairs and sell them to satisfy the obligation. The warehouser will not let Carl have the\nchairs without the warehouse receipt\xe2\x80\x94it\xe2\x80\x99s indispensable paper. There are four kinds of indispensable\npaper.\n\nChattel Paper\nChattel is another word for goods. Chattel paper is a record (paper or electronic) that demonstrates both\n\xe2\x80\x9ca monetary obligation and a security interest either in certain goods or in a lease on certain\ngoods.\xe2\x80\x9d\n\n[17]\n\nThe paper represents a valuable asset and can itself be used as collateral. For example, Creditor\n\nCar Company sells David Debtor an automobile and takes back a note and security agreement (this is a\npurchase-money security agreement; the note and security agreement is chattel paper). The chattel paper\nis not yet collateral; the automobile is. Now, though, Creditor Car Company buys a new hydraulic lift from\nLift Co., and grants Lift Co. a security interest in Debtor\xe2\x80\x99s chattel paper to secure Creditor Car\xe2\x80\x99s debt to\nLift Co. The chattel paper is now collateral. Chattel paper can be tangible (actual paper) or electronic.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n885\n\n\x0cDocuments\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) or any\nother writing that evidences a right to the payment of a monetary obligation, is not itself a security\nagreement or lease, and is of a type that in the ordinary course of business is transferred by delivery with\nany necessary indorsement or assignment.\xe2\x80\x9d \xe2\x80\x9cInstrument\xe2\x80\x9d does not include (i) investment property, (ii)\nletters of credit, or (iii) writings that evidence a right to payment arising out of the use of a credit or\ncharge card or information contained on or for use with the card.\n\n[18]\n\nInvestment Property\nThis includes securities (stock, bonds), security accounts, commodity accounts, and commodity\ncontracts.\n\n[19]\n\ncertificate).\n\nSecurities may be certified (represented by a certificate) or uncertified (not represented by a\n\n[20]\n\nOther Types of Collateral\nAmong possible other types of collateral that may be used as security is the floating lien. This is a\nsecurity interest in property that was not in the possession of the debtor when the security agreement was\nexecuted. The floating lien creates an interest that floats on the river of present and future collateral and\nproceeds held by\xe2\x80\x94most often\xe2\x80\x94the business debtor. It is especially useful in loans to businesses that sell\ntheir collateralized inventory. Without the floating lien, the lender would find its collateral steadily\ndepleted as the borrowing business sells its products to its customers. Pretty soon, there\xe2\x80\x99d be no security\nat all. The floating lien includes the following:\n\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\n886\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.\n\nHere are examples of future advances:\no\n\nExample 1: A debtor enters into a security agreement with a creditor that contains a\nfuture advances clause. The agreement gives the creditor a security interest in a\n$700,000 inventory-picking robot to secure repayment of a loan made to the debtor. The\nparties contemplate that the debtor will, from time to time, borrow more money, and\nwhen the debtor does, the machine will stand as collateral to secure the further\nindebtedness, without new paperwork.\n\no\n\nExample 2: A debtor signs a security agreement with a bank to buy a car. The security\nagreement contains a future advances clause. A few years later, the bank sends the debtor\na credit card. Two years go by: the car is paid for, but the credit card is in default. The\nbank seizes the car. \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,\n\xe2\x80\x9cbut it was collateral for all future indebtedness you ran up with us. Check out your loan\nagreement with us and UCC Section 9-204(c), especially Comment 5.\xe2\x80\x9d\n\nSee Figure 19.2 "Tangibles and Intangibles as Collateral".\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n887\n\n\x0cFigure 19.2 Tangibles and Intangibles as Collateral\n\nAttachment of the Security Interest\nIn General\nAttachment is the term used to describe when a security interest becomes enforceable against the debtor\nwith respect to the collateral. In Figure 19.1 "The Grasping Hand", \xe2\x80\x9dAttachment\xe2\x80\x9d is the outreached hand\nthat is prepared, if the debtor defaults, to grasp the collateral.\n\n[21]\n\nRequirements for Attachment\nThere are three requirements for attachment: (1) the secured party gives value; (2) the debtor has rights in\nthe collateral or the power to transfer rights in it to the secured party; (3) the parties have a security\nagreement \xe2\x80\x9cauthenticated\xe2\x80\x9d (signed) by the debtor, or the creditor has possession of the collateral.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n888\n\n\x0cCreditor Gives Value\nThe creditor, or secured party, must give \xe2\x80\x9cvalue\xe2\x80\x9d for the security interest to attach. The UCC, in Section 1204, provides that\na person gives \xe2\x80\x98value\xe2\x80\x99 for rights if he acquires them\n\n(1) in return for a binding commitment to extend credit or for the extension of immediately available\ncredit whether or not drawn upon and whether or not a charge-back is provided for in the event of\ndifficulties in collection; or\n\n(2) as security for or in total or partial satisfaction of a pre-existing claim; or\n\n(3) by accepting delivery pursuant to a pre-existing contract for purchase; or\n\n(4) generally, in return for any consideration sufficient to support a simple contract.\n\nSuppose Deborah owes Carl $3,000. She cannot repay the sum when due, so she agrees to give Carl a\nsecurity interest in her automobile to the extent of $3,000 in return for an extension of the time to pay.\nThat 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 has some\nownership interest in it). The rights need not necessarily be the immediate right to possession, but they\nmust be rights that can be conveyed.\n\n[22]\n\nA person can\xe2\x80\x99t put up as collateral property 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 debtor\n[must have] authenticated a security agreement that provides a description of the collateral.\xe2\x80\xa6\xe2\x80\x9d\n\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 recognition of electronic\ncommercial transactions, \xe2\x80\x9cto execute or otherwise adopt a symbol, or encrypt or similarly process a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n889\n\n\x0crecord\xe2\x80\xa6with the present intent of the authenticating person to identify the person and adopt or accept a\nrecord.\xe2\x80\x9d The \xe2\x80\x9crecord\xe2\x80\x9d is the modern UCC\xe2\x80\x99s substitution for the term \xe2\x80\x9cwriting.\xe2\x80\x9d It includes information\nelectronically stored or on paper.\n\n[23]\n\nThe \xe2\x80\x9cauthenticating record\xe2\x80\x9d (the signed security agreement) is notrequired in some cases. It is not\nrequired if the debtor makes a pledgeof the collateral\xe2\x80\x94that is, delivers it to the creditor for the creditor to\npossess. For example, upon a creditor\xe2\x80\x99s request of a debtor for collateral to secure a loan of $3,000, the\ndebtor offers up his stamp collection. The creditor says, \xe2\x80\x9cFine, have it appraised (at your expense) and\nshow me the appraisal. If it comes in at $3,000 or more, I\xe2\x80\x99ll take your stamp collection and lock it in my\nsafe until you\xe2\x80\x99ve repaid me. If you don\xe2\x80\x99t repay me, I\xe2\x80\x99ll sell it.\xe2\x80\x9d A creditor could take possession of any\ngoods and various kinds of paper, tangible or intangible. In commercial transactions, it would be common\nfor the creditor to have possession of\xe2\x80\x94actually or virtually\xe2\x80\x94certified securities, deposit accounts,\nelectronic chattel paper, investment property, or other such paper or electronic evidence of value.\n\n[24]\n\nAgain, Figure 19.1 "The Grasping Hand" diagrams the attachment, showing the necessary elements: the\ncreditor gives value, the debtor has rights in collateral, and there is a security agreement signed\n(authenticated) by the debtor. If the debtor defaults, the creditor\xe2\x80\x99s \xe2\x80\x9chand\xe2\x80\x9d will grab (repossess) the\ncollateral.\n\nPerfection of the Security Interest\nAs between the debtor and the creditor, attachment is fine: if the debtor defaults, the creditor will\nrepossess the goods and\xe2\x80\x94usually\xe2\x80\x94sell them to satisfy the outstanding obligation. But unless an additional\nset of steps is taken, the rights of the secured party might be subordinated to the rights of other secured\nparties, certain lien creditors, bankruptcy trustees, and buyers who give value and who do not know of the\nsecurity interest. Perfection is the secured party\xe2\x80\x99s way of announcing the security interest to the rest of\nthe world. It is the secured party\xe2\x80\x99s claim on the collateral.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n890\n\n\x0cThere are five ways a creditor may perfect a security interest: (1) by filing a financing statement, (2) by\ntaking or retaining possession of the collateral, (3) by taking control of the collateral, (4) by taking control\ntemporarily as specified by the UCC, or (5) by taking control automatically.\n\nPerfection by Filing\n\xe2\x80\x9cExcept as otherwise provided\xe2\x80\xa6a financing statement must be filed to perfect all security agreements.\xe2\x80\x9d\n\n[25]\n\nThe Financing Statement\nA financing statement is a simple notice showing the creditor\xe2\x80\x99s general interest in the collateral. It is\nwhat\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 the UCC,\nbut most commonly it is much less detailed than the security agreement: it \xe2\x80\x9cindicates merely that a person\nmay have a security interest in the collateral[.]\xe2\x80\xa6Further inquiry from the parties concerned will be\nnecessary to disclose the full state of affairs.\xe2\x80\x9d\n\n[26]\n\nThe financing statement must provide the following\n\ninformation:\n\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.\n\n[27]\n\nIt may describe the\n\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 the\nfinancing statement).\n\n[28]\n\nIf the collateral is real-property-related, covering timber to be cut or\n\nfixtures, it must include a description of the real property to which the collateral is related.\n\n[29]\n\nThe form of the financing statement may vary from state to state, but see Figure 19.3 "UCC-1 Financing\nStatement" for a typical financing statement. Minor errors or omissions on the form will not make it\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n891\n\n\x0cineffective, but the debtor\xe2\x80\x99s signature is required unless the creditor is authorized by the debtor to make\nthe filing without a signature, which facilitates paperless filing.\n\n[30]\n\nFigure 19.3 UCC-1 Financing Statement\n\nDuration of the Financing Statement\nGenerally, the financing statement is effective for five years; a continuation statement may be filed\nwithin six months before the five-year expiration date, and it is good for another five\nyears.\n\n[31]\n\nManufactured-home filings are good for thirty years. When the debtor\xe2\x80\x99s obligation is satisfied,\n\nthe secured party files a termination statement if the collateral was consumer goods; otherwise\xe2\x80\x94upon\ndemand\xe2\x80\x94the secured party sends the debtor a termination statement.\n\nSaylor URL: http://www.saylor.org/books\n\n[32]\n\nSaylor.org\n892\n\n\x0cDebtor Moves out of State\nThe UCC also has rules for continued perfection of security interests when the debtor\xe2\x80\x94whether an\nindividual or an association (corporation)\xe2\x80\x94moves from one state to another. Generally, an interest\nremains perfected until the earlier of when the perfection would have expired or for four months after the\ndebtor moves to a new jurisdiction.\n\n[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 fixtures\xe2\x80\x94\nthe place to file is with the local office that files mortgages, typically the county auditor\xe2\x80\x99s office.\n\n[34]\n\nFor\n\nother collateral, the filing place is as duly authorized by the state. In some states, that is the office of the\nSecretary of State; in others, it is the Department of Licensing; or it might be a private party that\nmaintains the state\xe2\x80\x99s filing system.\n\n[35]\n\nThe filing should be made in the state where the debtor has his or\n\nher primary residence for individuals, and in the state where the debtor is organized if it is a registered\norganization.\n\n[36]\n\nThe point is, creditors need to know where to look to see if the collateral offered up is\n\nalready encumbered. In any event, filing the statement in more than one place can\xe2\x80\x99t hurt. The filing office\nwill provide instructions on how to file; these are available online, and electronic filing is usually available\nfor at least some types of collateral.\n\nExemptions\nSome transactions are exempt from the filing provision. The most important category of exempt collateral\nis that covered by state certificate of title laws. For example, many states require automobile owners to\nobtain a certificate of title from the state motor vehicle office. Most of these states provide that it is not\nnecessary to file a financing statement in order to perfect a security interest in an automobile. The reason\nis that the motor vehicle regulations require any security interests to be stated on the title, so that anyone\nattempting to buy a car in which a security interest had been created would be on notice when he took the\nactual title certificate.\n\n[37]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n893\n\n\x0cTemporary Perfection\nThe UCC provides that certain types of collateral are automatically perfected but only for a while: \xe2\x80\x9cA\nsecurity interest in certificated securities, or negotiable documents, or instruments is perfected without\nfiling or the taking of possession for a period of twenty days from the time it attaches to the extent that it\narises for new value given under an authenticated security agreement.\xe2\x80\x9d\n\n[38]\n\nSimilar temporary perfection\n\ncovers negotiable documents or goods in possession of a bailee, and when a security certificate or\ninstrument is delivered to the debtor for sale, exchange, presentation, collection, enforcement, renewal, or\nregistration.\n\n[39]\n\nAfter the twenty-day period, perfection would have to be by one of the other methods\n\nmentioned 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.\n\n[40]\n\nThis is a pledge\n\nof assets (mentioned in the example of the stamp collection). No security agreement is required for\nperfection by possession.\n\nA variation on the theme of pledge is field warehousing. When the pawnbroker lends money, he takes\npossession of the goods\xe2\x80\x94the watch, the ring, the camera. But when large manufacturing concerns wish to\nborrow against their inventory, taking physical possession is not necessarily so easy. The bank does not\nwish to have shipped to its Wall Street office several tons of copper mined in Colorado. Bank employees\nperhaps could go west to the mine and take physical control of the copper, but banks are unlikely to\nemploy people and equipment necessary to build a warehouse on the spot. Thus this so-called field pledge\nis rare.\n\nMore common is the field warehouse. The field warehouse can take one of two forms. An independent\ncompany can go to the site and put up a temporary structure\xe2\x80\x94for example, a fence around the copper\xe2\x80\x94\nthus establishing physical control of the collateral. Or the independent company can lease the warehouse\nfacilities of the debtor and post signs indicating that the goods inside are within its sale custody. Either\nway, the goods are within the physical possession of the field warehouse service. The field warehouse then\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n894\n\n\x0csegregates the goods secured to the particular bank or finance company and issues a warehouse receipt to\nthe lender for those goods. The lender is thus assured of a security interest in the collateral.\n\nPerfection by Control\n\xe2\x80\x9cA security interest in investment property, deposit accounts, letter-of-credit rights, or electronic chattel\npaper may be perfected by control of the collateral.\xe2\x80\x9d\n\n[41]\n\n\xe2\x80\x9cControl\xe2\x80\x9d depends on what the collateral is. If it\xe2\x80\x99s a\n\nchecking account, for example, the bank with which the deposit account is maintained has \xe2\x80\x9ccontrol\xe2\x80\x9d: the\nbank gets a security interest automatically because, as Official Comment 3 to UCC Section 9-104 puts it,\n\xe2\x80\x9call actual and potential creditors of the debtor are always on notice that the bank with which the debtor\xe2\x80\x99s\ndeposit account is maintained may assert a claim against the deposit account.\xe2\x80\x9d \xe2\x80\x9cControl\xe2\x80\x9d of electronic\nchattel paper of investment property, and of letter-of-credit rights is detailed in Sections 9-105, 9-106,\nand 9-107. Obtaining \xe2\x80\x9ccontrol\xe2\x80\x9d means that the creditor has taken whatever steps are necessary, given the\nmanner in which the items are held, to place itself in a position where it can have the items sold, without\nfurther action by the owner.\n\n[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 here is\nautomatic perfection of a purchase-money security interest given in consumer goods. If a seller of\nconsumer goods takes a PMSI in the goods sold, then perfection of the security interest is automatic. But\nthe seller may file a financial statement and faces a risk if he fails to file and the consumer debtor sells the\ngoods. Under Section 9-320(b), a buyer of consumer goods takes free of a security interest, even though\nperfected, if he buys without knowledge of the interest, pays value, and uses the goods for his personal,\nfamily, or household purposes\xe2\x80\x94unless the secured party had first filed a financing statement covering the\ngoods.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n895\n\n\x0cFigure 19.4 Attachment and Perfection\n\nK E Y TA K EA WAY\nA creditor may be secured\xe2\x80\x94allowed to take the debtor\xe2\x80\x99s property upon debtor\xe2\x80\x99s\ndefault\xe2\x80\x94by agreement between the parties or by operation of law. The law\ngoverning agreements for personal property security is Article 9 of the UCC. The\ncreditor\xe2\x80\x99s first step is to attach the security interest. This is usually accomplished\nwhen the debtor, in return for value (a loan or credit) extended from the creditor,\nputs up as collateral some valuable asset in which she has an interest and\nauthenticates (signs) a security agreement (the contract) giving the creditor a\nsecurity interest in collateral and allowing that the creditor may take it if the\ndebtor defaults. The UCC lists various kinds of assets that can be collateralized,\nranging from tangible property (goods), to assets only able to be manifested by\npaper (indispensable paper), to intangible assets (like patent rights). Sometimes\nno security agreement is necessary, mostly if the creditor takes possession of the\ncollateral. After attachment, the prudent creditor will want to perfect the security\ninterest to make sure no other creditors claim an interest in the collateral.\nPerfection 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\ncan also be achieved by a pledge (possession by the secured creditor) or by\n\xe2\x80\x9ccontrol\xe2\x80\x9d of certain assets (having such control over them as to be able to sell\nthem if the debtor defaults). Perfection is automatic temporarily for some items\n(certified securities, instruments, and negotiable documents) but also upon mere\nattachment to purchase-money security interests in consumer goods.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n896\n\n\x0cE XE R C IS ES\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\ncontributing one-third of its cost. Elaine was compelled to file for bankruptcy.\nThe computer store claimed it had perfected its interest by mere attachment,\nand the bankruptcy trustee claimed the computer as an asset of Elaine\xe2\x80\x99s\nbankruptcy estate. Who wins, and why?\n3. What is the general rule governing where financing statements should be\nfiled?\n4. If the purpose of perfection is to alert the world to the creditor\xe2\x80\x99s claim in the\ncollateral, why is perfection accomplishable by possession alone in some\ncases?\n5. Contractor pawned a power tool and got a $200 loan from Pawnbroker. Has\nthere been a perfection 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/32302EC381D5-47DF-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).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n897\n\n\x0c[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\nsecurity agreement online: Docstoc, \xe2\x80\x9cFree Business Templates\xe2\x80\x94Sample Open-Ended Security\nAgreement,\xe2\x80\x9dhttp://www.docstoc.com/docs/271920/Free-Business-Templates\xe2\x80\x94-Sample-OpenEnded-Security-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,\nComment 3.\n[31] Uniform Commercial Code, Section 9-515.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n898\n\n\x0c[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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n899\n\n\x0c19.2 Priorities\nL EA R N IN G O B JEC T IV ES\n1. Understand the general rule regarding who gets priority among competing\nsecured 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\nPriorities: this is the money question. Who gets what when a debtor defaults? Depending on how the\npriorities in the collateral were established, even a secured creditor may walk away with the collateral or\nwith 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 general, the\none who wins \xe2\x80\x9cgets there firstest with the mostest.\xe2\x80\x9d The first to do the best job of perfecting wins. The\nUniform Commercial Code (UCC) creates a race of diligence among competitors.\n\nApplication of the Rule\nIf both parties have perfected, the first to perfect wins. If one has perfected and one attached, the\nperfected party wins. If both have attached without perfection, the first to attach wins. If neither has\nattached, they are unsecured creditors. Let\xe2\x80\x99s test this general rule against the following situations:\n\n1.\n\nRosemary, 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 first,\neven though Erika actually first extended the loan, which was perfected when made (because she\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n900\n\n\x0chad already filed). This result is dictated by the rule even though Rosemary may have known of\nErika\xe2\x80\x99s interest when she subsequently made her loan.\n\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 the\nmoney a week after Rosemary, but Rosemary has not perfected and Erika does not either. A week\nlater, they find out they have each made a loan against the same coat. Who has priority? Whoever\nperfects first: the rule creates a race to the filing office or to Susan\xe2\x80\x99s closet. Whoever can submit\nthe financing statement or actually take possession of the coat first will have priority, and the\noutcome does not depend on knowledge or lack of knowledge that someone else is claiming a\nsecurity interest in the same collateral. But what of the rule that in the absence of perfection,\nwhichever security interest first attached has priority? This is \xe2\x80\x9cthought to be of merely theoretical\ninterest,\xe2\x80\x9d says the UCC commentary, \xe2\x80\x9csince it is hard to imagine a situation where the case would\ncome into litigation without [either party] having perfected his interest.\xe2\x80\x9d And if the debtor filed a\npetition in bankruptcy, neither unperfected security interest could prevail against the bankruptcy\ntrustee.\n\nTo rephrase: An attached security interest prevails over other unsecured creditors (unsecured creditors\nlose to secured creditors, perfected or unperfected). If both parties are secured (have attached the\ninterest), the first to perfect wins.\n\n[1]\n\nIf both parties have perfected, the first to have perfected wins.\n\n[2]\n\nExceptions to the General Rule\nThere are three immediate exceptions to the general rule, and several other exceptions, all of which\xe2\x80\x94\nactually\xe2\x80\x94make some straightforward sense even if it sounds a little complicated to explain them.\n\nImmediate Exceptions\nWe call the following three exceptions \xe2\x80\x9cimmediate\xe2\x80\x9d ones because they allow junior filers immediate\npriority to take their collateral before the debtor\xe2\x80\x99s other creditors get it. They all involve purchase-money\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n901\n\n\x0csecurity interests (PMSIs), so if the debtor defaults, the creditor repossesses the very goods the creditor\nhad sold the debtor.\n\n(1) Purchase-money security interest in goods (other than inventory or livestock). The UCC provides that\n\xe2\x80\x9ca perfected purchase-money security interest in goods other than inventory or livestock has priority over\na conflicting security interest in the same goods\xe2\x80\xa6if the purchase-money security interest is perfected\nwhen debtor receives possession of the collateral or within 20 days thereafter.\xe2\x80\x9d\n\n[3]\n\nThe Official Comment to\n\nthis UCC section observes that \xe2\x80\x9cin most cases, priority will be over a security interest asserted under an\nafter-acquired property clause.\xe2\x80\x9d\n\nSuppose Susan manufactures fur coats. On February 1, Rosemary advances her $10,000 under a security\nagreement covering all Susan\xe2\x80\x99s machinery and containing an after-acquired property clause. Rosemary\nfiles a financing statement that same day. On March 1, Susan buys a new machine from Erika for $5,000\nand gives her a security interest in the machine; Erika files a financing statement within twenty days of\nthe time that the machine is delivered to Susan. Who has priority if Susan defaults on her loan payments?\nUnder the PMSI rule, Erika has priority, because she had a PMSI. Suppose, however, that Susan had not\nbought the machine from Erika but had merely given her a security interest in it. Then Rosemary would\nhave priority, because her filing was prior to Erika\xe2\x80\x99s.\n\nWhat would happen if this kind of PMSI in noninventory goods (here, equipment) did not get priority\nstatus? A prudent Erika would not extend credit to Susan at all, and if the new machine is necessary for\nSusan\xe2\x80\x99s business, she would soon be out of business. That certainly would not inure to the benefit of\nRosemary. It is, mostly, to Rosemary\xe2\x80\x99s advantage that Susan gets the machine: it enhances Susan\xe2\x80\x99s ability\nto make money to pay Rosemary.\n\n(2) Purchase-money security interest in inventory. The UCC provides that a perfected PMSI in inventory\nhas priority over conflicting interests in the same inventory, provided that the PMSI is perfected when the\ndebtor receives possession of the inventory, the PMSI-secured party sends an authenticated notification\nto the holder of the conflicting interest and that person receives the notice within five years before the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n902\n\n\x0cdebtor receives possession of the inventory, and the notice states that the person sending it has or expects\nto acquire a PMSI in the inventory and describes the inventory.\n\n[4]\n\nThe notice requirement is aimed at\n\nprotecting a secured party in the typical situation in which incoming inventory is subject to a prior\nagreement to make advances against it. If the original creditor gets notice that new inventory is subject to\na PMSI, he will be forewarned against making an advance on it; if he does not receive notice, he will have\npriority. It 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 creditor.\n\n(3) Purchase-money security interest in fixtures. Under UCC Section 9-334(e), a perfected security in\nfixtures has priority over a mortgage if the security interest is a PMSI and the security interest is perfected\nby a fixture filing before the goods become fixtures or within twenty days after. A mortgagee is usually a\nbank (the mortgagor is the owner of the real estate, subject to the mortgagee\xe2\x80\x99s interest). The bank\xe2\x80\x99s\nmortgage covers the real estate and fixtures, even fixtures added after the date of the mortgage (afteracquired property clause). In accord with the general rule, then, the mortgagee/bank would normally have\npriority if the mortgage is recorded first, as would a fixture filing if made before the mortgage was\nrecorded. But with the exception noted, the bank\xe2\x80\x99s interest is subordinate to the fixture-seller\xe2\x80\x99s laterperfected PMSI. Example: Susan buys a new furnace from Heating Co. to put in her house. Susan gave a\nbank a thirty-year mortgage on the house ten years before. Heating Co. takes back a PMSI and files the\nappropriate financing statement before or within twenty days of installation. If Susan defaults on her loan\nto the bank, Heating Co. would take priority over the bank. And why not? The mortgagee has, in the long\nrun, benefited from the improvement and modernization of the real estate. (Again, there are further\nnuances in Section 9-334 beyond our scope here.) A non-PMSI in fixtures or PMSIs perfected more than\ntwenty days after goods become a fixture loses out to prior recorded interests in the realty.\n\nOther Exceptions\nWe have noted the three immediate exceptions to the general rule that \xe2\x80\x9cthe firstest with the mostest\xe2\x80\x9d\nprevails. There are some other exceptions.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n903\n\n\x0cThink about how these other exceptions might arise: who might want to take property subject to a security\nagreement (not including thieves)? That is, Debtor gives Creditor a security interest in, say, goods, while\nretaining possession. First, buyers of various sorts might want the goods if they paid for them; they\nusually win. Second, lien creditors might want the goods (a lien creditor is one whose claim is based on\noperation of law\xe2\x80\x94involuntarily against Debtor, and including a trustee in bankruptcy\xe2\x80\x94as opposed to one\nwhose claim is based on agreement); lien creditors may be statutory (landlords, mechanics, bailees) or\njudicial. Third, a bankruptcy trustee representing Debtor\xe2\x80\x99s creditors (independent of the trustee\xe2\x80\x99s role as\na lien creditor) might want to take the goods to sell and satisfy Debtor\xe2\x80\x99s obligations to the creditors.\nFourth, unsecured 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 has many\nfine nuances, not all of which can be taken up here.\n\nFirst we look at buyers who take priority over, or free of, unperfected security interests. Buyers who take\ndelivery of many types of collateral covered by an unperfected security interest win out over the hapless\nsecured party who failed to perfect if they give value and don\xe2\x80\x99t know of the security interest or agricultural\nlien.\n\n[5]\n\nA buyer who doesn\xe2\x80\x99t give value or who knows of the security interest will not win out, nor will a\n\nbuyer prevail if the seller\xe2\x80\x99s creditor files a financing statement before or within twenty days after the\ndebtor receives delivery of the collateral.\n\nNow we look at buyers who take priority over perfected security interests. Sometimes people who buy\nthings even covered by a perfected security interest win out (the perfected secured party loses).\n\n\xe2\x80\xa2\n\nBuyers in the ordinary course of business. \xe2\x80\x9cA buyer in the ordinary course of business, other than\n[one buying farm products from somebody engaged in farming] takes free of a security interest\ncreated by the buyer\xe2\x80\x99s seller, even if the security interest is perfected and the buyer knows\n[it].\xe2\x80\x9d\n\n[6]\n\nHere the buyer is usually purchasing inventory collateral, and it\xe2\x80\x99s OK if he knows the\n\ninventory is covered by a security interest, but it\xe2\x80\x99s not OK if he knows \xe2\x80\x9cthat the sale violates a term\nin an agreement with the secured party.\xe2\x80\x9d\n\n[7]\n\nIt would not be conducive to faith in commercial\n\ntransactions if buyers of inventory generally had to worry whether their seller\xe2\x80\x99s creditors were\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n904\n\n\x0cgoing to repossess the things the buyers had purchased in good faith. For example (based on\nexample 1 to the same comment, UCC 9-320, Official Comment 3), Manufacturer makes\nappliances and owns manufacturing equipment covered by a perfected security agreement in\nfavor of Lender. Manufacturer sells the equipment to Dealer, whose business is buying and selling\nused equipment; Dealer, in turn, sells the stuff to Buyer, a buyer in the ordinary course. Does\nBuyer take free of the security interest? No, because Dealer didn\xe2\x80\x99t create it; Manufacturer did.\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, Tom\nbuys 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 cannot\nrepossess the fridge from Ned. If it wanted to protect itself fully, Sears would have filed a\nfinancing statement; then Ned would be out the fridge when the repo men came.\n\n[8]\n\nThe \xe2\x80\x9cvalue\xe2\x80\x9d\n\nissue is interestingly presented in the Nicolosi case (Section 19.5 "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 farmer\nand again to the lender whom the farmer didn\xe2\x80\x99t pay. As a result, Congress included in its 1985\nFarm Security Act, 7 USC 1631, Section 1324, this language: \xe2\x80\x9cA buyer who in the ordinary course\nof business buys a farm product from a seller engaged in farming operations shall take free of a\nsecurity interest created by the seller, even though the security interest is perfected; and the buyer\nknows of the existence of such interest.\xe2\x80\x9d\n\nThere are some other exceptions, beyond our scope here.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n905\n\n\x0cLien Creditors\nPersons (including bankruptcy trustees) who become lien creditorsbefore the security interest is perfected\nwin out\xe2\x80\x94the unperfected security interest is subordinate to lien creditors. Persons who become lien\ncreditors after the security interest is perfected lose (subject to some nuances in situations where the lien\narises between attachment by the creditor and the filing, and depending upon the type of security interest\nand the type of collateral).\n\n[9]\n\nMore straightforwardly, perhaps, a lien securing payment or performance of\n\nan obligation for services or materials furnished with respect to goods by a person in the ordinary course\nof business has priority over other security interests (unless a statute provides otherwise).\n\n[10]\n\nThis is the\n\nbailee or \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 Bank. Owner\ndoesn\xe2\x80\x99t pay Bank. Bank seeks to repossess the car from Mechanic. It will have to pay the Mechanic first.\nAnd why not? If the car was not running, Bank would have to have it repaired anyway.\n\nBankruptcy Trustee\nTo what extent can the bankruptcy trustee take property previously encumbered by a security interest? It\ndepends. If the security interest was not perfected at the time of filing for bankruptcy, the trustee can take\nthe collateral.\n\n[11]\n\nIf it was perfected, the trustee can\xe2\x80\x99t take it, subject to rules on preferential transfers: the\n\nBankruptcy Act provides that the trustee can avoid a transfer of an interest of the debtor in property\xe2\x80\x94\nincluding a security interest\xe2\x80\x94(1) to or for the benefit of a creditor, (2) on or account of an antecedent debt,\n(3) made while the debtor was insolvent, (4) within ninety days of the bankruptcy petition date (or one\nyear, for \xe2\x80\x9cinsiders\xe2\x80\x9d\xe2\x80\x94like relatives or business partners), (5) which enables the creditor to receive more\nthan it would have in the bankruptcy.\n\n[12]\n\nThere are further bankruptcy details beyond our scope here, but\n\nthe short of 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 account, savings\naccount, money-market account, certificate of deposit) takes priority over security interests in the account\nperfected by other means, and under UCC Section 9-327(3), a bank with which the deposit is made takes\npriority over all other conflicting security agreements.\n\n[13]\n\nFor example, a debtor enters into a security\n\nagreement with his sailboat as collateral. The creditor perfects. The debtor sells the sailboat and deposits\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n906\n\n\x0cthe proceeds in his account with a bank; normally, the creditor\xe2\x80\x99s interest would attach to the proceeds.\nThe debtor next 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 proceeds? The\nbank does. The rationale: \xe2\x80\x9cthis\xe2\x80\xa6enables banks to extend credit to their depositors without the need to\nexamine [records] to determine whether another party might have a security interest in the deposit\naccount.\xe2\x80\x9d\n\n[14]\n\nK E Y TA K EA WAY\nWho among competing creditors gets the collateral if the debtor defaults? The\ngeneral rule on priorities is that the first to secure most completely wins: if all\ncompetitors have perfected, the first to do so wins. If one has perfected and the\nothers have not, the one who perfects wins. If all have attached, the first to attach\nwins. If none have attached, they\xe2\x80\x99re all unsecured creditors. To this general rule\nthere are a number of exceptions. Purchase-money security interests in goods and\ninventory prevail over previously perfected secured parties in the same goods and\ninventory (subject to some requirements); fixture financers who file properly have\npriority over previously perfected mortgagees. Buyers in the ordinary course of\nbusiness take free of a security interest created by their seller, so long as they\ndon\xe2\x80\x99t know their purchase violates a security agreement. Buyers of consumer\ngoods perfected by mere attachment win out over the creditor who declined to\nfile. Buyers in the ordinary course of business of farm products prevail over the\nfarmer\xe2\x80\x99s creditors (under federal law, not the UCC). Lien creditors who become\nsuch before perfection win out; those who become such after perfection usually\nlose. Bailees in possession and material men have priority over previous perfected\nclaimants. Bankruptcy trustees win out over unperfected security interests and\nover perfected ones if they are considered voidable transfers from the debtor to\nthe secured party. Deposit accounts perfected by control prevail over previously\nperfected secured parties in the same deposit accounts.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n907\n\n\x0cE XE R C IS ES\n1. What is the general rule regarding priorities for the right to repossess goods\nencumbered by a security interest when there are competing creditors\nclamoring for that right?\n2. Why does it make good sense to allow purchase-money security creditors in\n(1) inventory, (2) equipment, and (3) fixtures priority over creditors who\nperfected before the PMSI was perfected?\n3. A buyer in the ordinary course of business is usually one buying inventory.\nWhy does it make sense that such a buyer should take free of a security\ninterest 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).\n[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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n908\n\n\x0c19.3 Rights of Creditor on Default and Disposition after\nRepossession\nL EA R N IN G O B JEC T IV ES\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\x94\nrepossess it.\n3. Know how collateral may be disposed of upon repossession: by sale or by\nstrict 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 security\ninterest and bring suit on the underlying debt. But creditors rarely resort to this remedy because it is timeconsuming and costly. Most creditors prefer to repossess the collateral and sell it or retain possession in\nsatisfaction of the debt.\n\nRepossession\nSection 9-609 of the Uniform Commercial Code (UCC) permits the secured party to take possession of the\ncollateral on default (unless the agreement specifies otherwise):\n\n(a) After default, a secured party may (1) take possession of the collateral; and (2) without removal, may\nrender equipment unusable and dispose of collateral on a debtor\xe2\x80\x99s premises.\n\n(b) A secured party may proceed under subsection (a): (1) pursuant to judicial process; or (2) without\njudicial process, if it proceeds without breach of the peace.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n909\n\n\x0cThis language has given rise to the flourishing business of professional \xe2\x80\x9crepo men\xe2\x80\x9d (and women). \xe2\x80\x9cRepo\xe2\x80\x9d\ncompanies are firms that specialize in repossession collateral. They have trained car-lock pickers, inhouse locksmiths, experienced repossession teams, damage-free towing equipment, and the capacity to\ndeliver repossessed collateral to the client\xe2\x80\x99s desired destination. Some firms advertise that they have 360degree video cameras that record every aspect of the repossession. They have \xe2\x80\x9cskip chasers\xe2\x80\x9d\xe2\x80\x94people\nwhose business it is to track down those who skip out on their obligations, and they are trained not to\nbreach the peace.\n\n[1]\n\nSee Pantoja-Cahue v. Ford Motor Credit Co., a case discussing repossession,\n\nin Section 19.5 "Cases".\n\nThe reference in Section 9-609(a)(2) to \xe2\x80\x9crender equipment unusable and dispose of collateral on a\ndebtor\xe2\x80\x99s premises\xe2\x80\x9d gets to situations involving \xe2\x80\x9cheavy equipment [when] the physical removal from the\ndebtor\xe2\x80\x99s plant and the storage of collateral pending disposition may be impractical or unduly\nexpensive.\xe2\x80\xa6Of course\xe2\x80\xa6all aspects of the disposition must be commercially reasonable.\xe2\x80\x9d\n\n[2]\n\nRendering the\n\nequipment unusable would mean disassembling some critical part of the machine\xe2\x80\x94letting it sit there until\nan auction is set up on the premises.\n\nThe creditor\xe2\x80\x99s agents\xe2\x80\x94the repo people\xe2\x80\x94charge for their service, of course, and if possible the cost of\nrepossession comes out of the collateral when it\xe2\x80\x99s sold. A debtor would be better off voluntarily delivering\nthe collateral according to the creditor\xe2\x80\x99s instructions, but if that doesn\xe2\x80\x99t happen, \xe2\x80\x9cself-help\xe2\x80\x9d\xe2\x80\x94\nrepossession\xe2\x80\x94is allowed because, of course, the debtor said it would be allowed in the security agreement,\nso long as the repossession can be accomplished without breach of peace. \xe2\x80\x9cBreach of peace\xe2\x80\x9d is language\nthat can cover a wide variety of situations over which courts do not always agree. For example, some\ncourts interpret a creditor\xe2\x80\x99s taking of the collateral despite the debtor\xe2\x80\x99s clear oral protest as a breach of the\npeace; other courts do not.\n\nDisposition after Repossession\nAfter repossession, the creditor has two options: sell the collateral or accept it in satisfaction of the debt\n(see Figure 19.5 "Disposition after Repossession").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n910\n\n\x0cFigure 19.5 Disposition after Repossession\n\nSale\nSale is the usual method of recovering the debt. Section 9-610 of the UCC permits the secured creditor to\n\xe2\x80\x9csell, lease, license, or otherwise dispose of any or all of the collateral in its present condition or following\nany commercially reasonable preparation or processing.\xe2\x80\x9d The collateral may be sold as a whole or in\nparcels, at one time or at different times. Two requirements limit the creditor\xe2\x80\x99s power to resell: (1) it must\nsend notice to the debtor and secondary obligor, and (unless consumer goods are sold) to other secured\nparties; and (2) all aspects of the sale must be \xe2\x80\x9ccommercially reasonable.\xe2\x80\x9d\n\n[3]\n\nMost frequently the collateral\n\nis auctioned off.\nSection 9-615 of the UCC describes how the proceeds are applied: first, to the costs of the repossession,\nincluding reasonable attorney\xe2\x80\x99s fees and legal expenses as provided for in the security agreement (and it\nwill provide for that!); second, to the satisfaction of the obligation owed; and third, to junior creditors.\nThis again emphasizes the importance of promptly perfecting the security interest: failure to do so\nfrequently subordinates the tardy creditor\xe2\x80\x99s interest to junior status. If there is money left over from\ndisposing of the collateral\xe2\x80\x94a surplus\xe2\x80\x94the debtor gets that back. If there is still money owing\xe2\x80\x94a\ndeficiency\xe2\x80\x94the debtor is liable for that. In Section 9-616, the UCC carefully explains how the surplus or\ndeficiency is calculated; the explanation is required in a consumer goods transaction, and it has to be sent\nto the debtor after the disposition.\n\nStrict Foreclosure\nBecause resale can be a bother (or the collateral is appreciating in value), the secured creditor may wish\nsimply to accept the collateral in full satisfaction or partial satisfaction of the debt, as permitted in UCC\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n911\n\n\x0cSection 9-620(a). This is known as strict foreclosure. The debtor must consent to letting the creditor\ntake the collateral without a sale in a \xe2\x80\x9crecord authenticated after default,\xe2\x80\x9d or after default the creditor can\nsend the debtor a proposal for the creditor to accept the collateral, and the proposal is effective if not\nobjected to within twenty days after it\xe2\x80\x99s sent.\n\nThe strict foreclosure provisions contain a safety feature for consumer goods debtors. If the debtor has\npaid at least 60 percent of the debt, then the creditor may not use strict foreclosure\xe2\x80\x94unless the debtor\nsigns a statement after default renouncing his right to bar strict foreclosure and to force a sale.\n\n[4]\n\nA\n\nconsumer who refuses to sign such a statement thus forces the secured creditor to sell the collateral under\nSection 9-610. Should the creditor fail to sell the goods within ninety days after taking possession of the\ngoods, he is liable to the debtor for the value of the goods in a conversion suit or may incur the liabilities\nset forth in Section 9-625, which provides for minimum damages for the consumer debtor. Recall that the\nUCC imposes a duty to act in good faith and in a commercially reasonable manner, and in most cases with\nreasonable notification.\n\n[5]\n\nSee Figure 19.5 "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 business.\nHowever, when the collateral is intangible\xe2\x80\x94such as accounts receivable, general intangibles, chattel\npaper, or instruments\xe2\x80\x94collection by a secured party after the debtor\xe2\x80\x99s default may proceed without\ninterrupting the business. Section 9-607 of the UCC provides that on default, the secured party is entitled\nto notify the third party\xe2\x80\x94for example, a person who owes money on an account\xe2\x80\x94that payment should be\nmade to him. The secured party is accountable to the debtor for any surplus, and the debtor is liable for\nany deficiency unless the parties have agreed otherwise.\n\nAs always in parsing the UCC here, some of the details and nuances are necessarily omitted because of\nlack of space or because a more detailed analysis is beyond this book\xe2\x80\x99s scope.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n912\n\n\x0cK E Y TA K EA WAY\nUpon default, the creditor may bring a lawsuit against the debtor to collect a\njudgment. But the whole purpose of secured transactions is to avoid this costly\nand time-consuming litigation. The more typical situation is that the creditor\nrepossesses the collateral and then either auctions it off (sale) or keeps it in\nsatisfaction of the debt (strict foreclosure). In the former situation, the creditor\nmay then proceed against the debtor for the deficiency. In consumer cases, the\ncreditor cannot use strict foreclosure if 60 percent of the purchase price has been\npaid.\n\nE XE R C IS ES\n1. Although a creditor could sue the debtor, get a judgment against it, and\ncollect on the judgment, usually the creditor repossesses the collateral. Why is\nrepossession the preferred method of realizing on the security?\n2. Why is repossession allowed so long as it can be done without a breach of the\npeace?\n3. Under what circumstances is strict foreclosure not allowed?\n[1] Here is an example of sophisticated online advertising for a repossession firm: SSR,\n\xe2\x80\x9cSouthern & Central Coast California Repossession\nServices,\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n913\n\n\x0c19.4 Suretyship\nL EA R N IN G O B JEC T IV ES\n1. Understand what a surety is and why sureties are used in commercial\ntransactions.\n2. Know how suretyships are created.\n3. Recognize the general duty owed by the surety to the creditor, and the\nsurety\xe2\x80\x99s defenses.\n4. Recognize the principal obligor\xe2\x80\x99s duty to the surety, and the surety\xe2\x80\x99s rights\nagainst the surety.\n5. Understand the rights among cosureties.\n\nDefinition, Types of Sureties, and Creation of the Suretyship\nDefinition\nSuretyship is the second of the three major types of consensual security arrangements noted at the\nbeginning of this chapter (personal property security, suretyship, real property security)\xe2\x80\x94and a common\none. Creditors frequently ask the owners of small, closely held companies to guarantee their loans to the\ncompany, and parent corporations also frequently are guarantors of their subsidiaries\xe2\x80\x99 debts. The earliest\nsureties were friends or relatives of the principal debtor who agreed\xe2\x80\x94for free\xe2\x80\x94to lend their guarantee.\nToday most sureties in commercial transaction are insurance companies (but insurance is not the same as\nsuretyship).\n\nA surety is one who promises to pay or perform an obligation owed by the principal debtor, and,\nstrictly speaking, the surety is primarily liable on the debt: the creditor can demand payment from the\nsurety when the debt is due. The creditor is the person to whom the principal debtor (and the surety,\nstrictly speaking) owes an obligation. Very frequently, the creditor requires first that the debtor put up\ncollateral to secure indebtedness, and\xe2\x80\x94in addition\xe2\x80\x94that the debtor engage a surety to make extra certain\nthe creditor is paid or performance is made. For example, David Debtor wants Bank to loan his\ncorporation, David Debtor, Inc., $100,000. Bank says, \xe2\x80\x9cOkay, Mr. Debtor, we\xe2\x80\x99ll loan the corporation\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n914\n\n\x0cmoney, but we want its computer equipment as security, and we want you personally to guarantee the\ndebt if the corporation can\xe2\x80\x99t pay.\xe2\x80\x9d Sometimes, though, the surety and the principal debtor may have no\nagreement between each other; the surety might have struck a deal with the creditor to act as surety\nwithout the consent or knowledge of the principal debtor.\n\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 contract and\nsigns her (or his, or its) name to the original agreement along with the surety; the consideration for the\nprincipal\xe2\x80\x99s contract is the same as the surety\xe2\x80\x99s consideration\xe2\x80\x94she is bound on the contract from the very\nstart, and she is also expected to know of the principal debtor\xe2\x80\x99s default so that the creditor\xe2\x80\x99s failure to\ninform her of it does not discharge her of any liability. On the other hand, a guarantor usually does not\nmake his agreement with the creditor at the same time the principal debtor does: it\xe2\x80\x99s a separate contract\nrequiring separate consideration, and if the guarantor is not informed of the principal debtor\xe2\x80\x99s default, the\nguarantor can claim discharge on the obligation to the extent any failure to inform him prejudices him.\nBut, again, as the terms are mostly synonymous, surety is used here to encompass both.\n\nFigure 19.6 Defenses of Principal Debtor and Surety\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n915\n\n\x0cTypes of Suretyship\nWhere there is an interest, public or private, that requires protection from the possibility of a default,\nsureties are engaged. For example, a landlord might require that a commercial tenant not only put up a\nsecurity deposit but also show evidence that it has a surety on line ready to stand for three months\xe2\x80\x99 rent if\nthe tenant defaults. Often, a municipal government will want its road contractor to show it has a surety\navailable in case, for some reason, the contractor cannot complete the project. Many states require general\ncontractors to have bonds, purchased from insurance companies, as a condition of getting a contractor\xe2\x80\x99s\nlicense; the insurance company is the surety\xe2\x80\x94it will pay out if the contractor fails to complete work on the\nclient\xe2\x80\x99s house. These are types of a performance bond. A judge will often require that a criminal\ndefendant put up a bond guaranteeing his appearance in court\xe2\x80\x94that\xe2\x80\x99s a type of suretyship where the bailbonder is the surety\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 steal\nmoney from the bank\xe2\x80\x94the bank teller, in this case, is the principal debtor (a fidelity bond). However, as\nwe will see, sureties do not anticipate financial loss like insurance companies do: the surety expects,\nmostly, to be repaid if it has to perform. The principal debtor goes to an insurance company and buys the\nbond\xe2\x80\x94the suretyship policy. The cost of the premium depends on the surety company, the type of bond\napplied for, and the applicant\xe2\x80\x99s financial history. A sound estimate of premium costs is 1 percent to 4\npercent, but if a surety company classifies an applicant as high risk, the premium falls between 5 percent\nand 20 percent of the bond amount. When the purchaser of real estate agrees to assume the seller\xe2\x80\x99s\nmortgage (promises to pay the mortgage debt), the seller then becomes a surety: unless the mortgagee\nreleases the seller (not likely), 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 suretyship.\nThus a person with the general capacity to contract has the power to become a surety. Consideration is\nrequired for a suretyship contract: if Debtor asks a friend to act as a surety to induce Creditor to make\nDebtor a loan, the consideration Debtor gives Creditor also acts as the consideration Friend gives. Where\nthe suretyship arises after Creditor has already extended credit, new consideration would be required\n[1]\n\n(absent application of the doctrine of promissory estoppel ). You may recall from the chapters on\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n916\n\n\x0ccontracts that the promise by one person to pay or perform for the debts or defaults of another must be\nevidenced by a writing under 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 Federal Trade\nCommission Credit Practices Rule, creditors are prohibited from misrepresenting a surety\xe2\x80\x99s liability.\nCreditors must also give the surety a notice that explains the nature of the obligation and the potential\nliability that can arise if a person cosigns on another\xe2\x80\x99s debt.\n\n[2]\n\nDuties and Rights of the Surety\nDuties of the Surety\nUpon the principal debtor\xe2\x80\x99s default, the surety is contractually obligated to perform unless the principal\nherself or someone on her behalf discharges the obligation. When the surety performs, it must do so in\ngood faith. Because the principal debtor\xe2\x80\x99s defenses are generally limited, and because\xe2\x80\x94as will be noted\xe2\x80\x94\nthe surety has the right to be reimbursed by the debtor, debtors not infrequently claim the surety acted in\nbad faith by doing things like failing to make an adequate investigation (to determine if the debtor really\ndefaulted), overpaying claims, interfering with the contact between the surety and the debtor, and making\nunreasonable refusals to let the debtor complete the project. The case Fidelity and Deposit Co. of\nMaryland v. Douglas Asphalt Co., in Section 19.5 "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 the\nprincipal debtor.\n\nExoneration\nIf, at the time a surety\xe2\x80\x99s obligation has matured, the principal can satisfy the obligation but refuses to do\nso, the surety is entitled to exoneration\xe2\x80\x94a court order requiring the principal to perform. It would be\ninequitable to force the surety to perform and then to have to seek reimbursement from the principal if\nall along the principal is able to perform.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n917\n\n\x0cReimbursement\nIf the surety must pay the creditor because the principal has defaulted, the principal is obligated to\nreimburse the surety. The amount required to be reimbursed includes the surety\xe2\x80\x99s reasonable, good-faith\noutlays, 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 to this\nsatisfaction. Then the surety is entitled to be subrogated to the rights of the creditor against the principal.\nIn other words, the surety stands in the creditor\xe2\x80\x99s shoes and may assert against the principal whatever\nrights the creditor could have asserted had the duty not been discharged. The right of\nsubrogation includes the right to take secured interests that the creditor obtained from the principal to\ncover the duty. Sarah\xe2\x80\x99s Pizzeria owes Martha $5,000, and Martha has taken a security interest in Sarah\xe2\x80\x99s\nChevrolet. Eva is surety for the debt. Sarah defaults, and Eva pays Martha the $5,000. Eva is entitled to\nhave the security interest in the car transferred to her.\n\nContribution\nTwo or more sureties who are bound to answer for the principal\xe2\x80\x99s default and who should share between\nthem the loss caused by the default are known as cosureties. A surety who in performing its own\nobligation to the creditor winds up paying more than its proportionate share is entitled\nto 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, including\nimpossibility, illegality, incapacity, fraud, duress, insolvency, or bankruptcy discharge. However, the\nsurety may contract with the creditor to be liable despite the principal\xe2\x80\x99s defenses, and a surety who has\nundertaken the suretyship with knowledge of the creditor\xe2\x80\x99s fraud or duress remains obligated, even\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n918\n\n\x0cthough the principal debtor will be discharged. When the surety turns to the principal debtor and\ndemands reimbursement, the latter may have defenses against the surety\xe2\x80\x94as noted\xe2\x80\x94for acting in bad\nfaith.\nOne of the main reasons creditors want the promise of a surety is to avoid the risk that the principal\ndebtor will go bankrupt: the debtor\xe2\x80\x99s bankruptcy is a defense to the debtor\xe2\x80\x99s liability, certainly, but that\ndefense cannot be used by the surety. The same is true of the debtor\xe2\x80\x99s incapacity: it is a defense available\nto 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 principal\ndebtor (e.g., creditor\xe2\x80\x99s breach; impossibility or illegality of performance; fraud, duress, or\nmisrepresentation by creditor; statute of limitations; refusal of creditor to accept tender or performance\nfrom either debtor or surety.) Beyond that, the surety has some defenses of its own. Common defenses\nraised by sureties include the following:\n\n\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 the\nsurety. The creditor\xe2\x80\x99s release of the surety, though, does not release the principal debtor because\nthe 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 their\ncontract, a surety who has not consented to the modification is discharged if the surety\xe2\x80\x99s risk is\nmaterially increased (but not if it is decreased). Modifications include extension of the time of\npayment, release of collateral (this releases the surety to the extent of the impairment), change in\nprincipal debtor\xe2\x80\x99s duties, and assignment or delegation of the debtor\xe2\x80\x99s obligations to a third party.\nThe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n919\n\n\x0c\xe2\x80\xa2\n\nStatute of frauds. Suretyship contracts are among those required to be evidenced by some writing\nunder 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 the\ncreditor knows of the fraud perpetrated by the debtor on the surety, the surety may avoid liability.\nSee Figure 19.6 "Defenses of Principal Debtor and Surety".\n\nThe following are defenses of principal debtor only:\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\n\n\xe2\x80\xa2\n\nThe following are defenses of both principal debtor and surety:\n\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\n\n\xe2\x80\xa2\n\nThe following are defenses of surety only:\n\n\xe2\x80\xa2\n\nFraud or duress by creditor on surety\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n920\n\n\x0co\n\nActs of creditor or debtor materially affecting surety\xe2\x80\x99s obligations:\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\nK E Y TA K EA WAY\nCreditors often require not only the security of collateral from the debtor but also\nthat the debtor engage a surety. A contract of suretyship is a type of insurance\npolicy, where the surety (insurance company) promises the creditor that if the\nprincipal debtor fails to perform, the surety will undertake good-faith performance\ninstead. A difference between insurance and suretyship, though, is that the surety\nis entitled to reimbursement by the principal debtor if the surety pays out. The\nsurety is also entitled, where appropriate, to exoneration, subrogation, and\ncontribution. The principal debtor and the surety both have some defenses\navailable: some are personal to the debtor, some are joint defenses, and some are\npersonal to the surety.\n\nE XE R C IS ES\n1. Why isn\xe2\x80\x99t collateral put up by the debtor sufficient security for the creditor\xe2\x80\x94\nwhy is a surety often required?\n2. How can it be said that sureties do not anticipate financial losses like\ninsurance companies do? What\xe2\x80\x99s the difference, and how does the surety\navoid losses?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n921\n\n\x0c3. Why does the creditor\xe2\x80\x99s failure to perfect a security interest discharge the\nsurety from liability? Why doesn\xe2\x80\x99t failure of the creditor to resort first to\nperfected collateral discharge the 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:\nThe Credit Practices Rule,\xe2\x80\x9dhttp://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre12.shtm.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n922\n\n\x0c19.5 Cases\nPerfection by Mere Attachment; Priorities\nIn re NICOLOSI\n\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 possession free\nof liens.\xe2\x80\xa6Even though no pleadings were filed by Rike-Kumler Company, the issue from the briefs is\nwhether or not a valid security interest was perfected in this chattel as consumer goods, superior to the\nstatutory 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 question,\nfor $1237.35 [about $8,500 in 2010 dollars], as an engagement ring for his fianc\xc3\xa9e. He executed a\npurchase money security agreement, which was not filed. Also, no financing statement was filed. The\nchattel was adequately described in the security agreement.\n\nThe controversy is between the trustee in bankruptcy and the party claiming a perfected security interest\nin the property. The recipient of the property has terminated her relationship with the [debtor], and\ndelivered 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 Commercial\nCode as adopted in Ohio, a perfected security interest does not exist.\n\nNo judicial precedents have been cited in the briefs.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n923\n\n\x0cUnder the commercial code, collateral is divided into tangible, intangible, and documentary categories.\nCertainly, a diamond ring falls into the tangible category. The classes of tangible goods are distinguished\nby the primary use intended. Under [the UCC] the four classes [include] \xe2\x80\x9cconsumer goods,\xe2\x80\x9d \xe2\x80\x9cequipment,\xe2\x80\x9d\n\xe2\x80\x9cfarm products\xe2\x80\x9d and \xe2\x80\x9cinventory.\xe2\x80\x9d\n\nThe difficulty is that the code provisions use terms arising in commercial circles which have different\nsemantical values from legal precedents. Does the fact that the purchaser bought the goods as a special\ngift to another person signify that it was not for his own \xe2\x80\x9cpersonal, family or household purposes\xe2\x80\x9d? The\ntrustee urges that these special facts control under the express provisions of the commercial code.\n\nBy a process of exclusion, a diamond engagement ring purchased for one\xe2\x80\x99s fianc\xc3\xa9e is not \xe2\x80\x9cequipment\xe2\x80\x9d\nbought or used in business, \xe2\x80\x9cfarm products\xe2\x80\x9d used in farming operations, or \xe2\x80\x9cinventory\xe2\x80\x9d held for sale, lease\nor service contracts. When the [debtor] purchased the ring, therefore, it could only have been \xe2\x80\x9cconsumer\ngoods\xe2\x80\x9d bought \xe2\x80\x9cprimarily for personal use.\xe2\x80\x9d There could be no judicial purpose to create a special class of\nproperty in derogation of the statutory principles.\n\nAnother problem is implicit, although not covered by the briefs.\n\nBy the foregoing summary analysis, it is apparent that the diamond ring, when the interest of the debtor\nattached, was consumer goods since it could have been no other class of goods. Unless the fianc\xc3\xa9e had a\nspecial status under the code provision protecting a bona fide buyer, without knowledge, for value, of\nconsumer goods, the failure to file a financing statement is not crucial. No evidence has been adduced\npertinent to the scienter question.\n\nIs a promise, as valid contractual consideration, included under the term \xe2\x80\x9cvalue\xe2\x80\x9d? In other words, was the\nring given to his betrothed in consideration of marriage (promise for a promise)? If so, and \xe2\x80\x9cvalue\xe2\x80\x9d has\nbeen given, the transferee is a \xe2\x80\x9cbuyer\xe2\x80\x9d under traditional concepts.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n924\n\n\x0cThe Uniform Commercial Code definition of \xe2\x80\x9cvalue\xe2\x80\x9d\xe2\x80\xa6very definitely covers a promise for a promise. The\ndefinition reads that \xe2\x80\x9ca person gives \xe2\x80\x98value\xe2\x80\x99 for rights if he acquires them\xe2\x80\xa6generally in return for any\nconsideration sufficient to support a simple contract.\xe2\x80\x9d\n\nIt would seem unrealistic, nevertheless, to apply contract law concepts historically developed into the law\nof marriage relations in the context of new concepts developed for uniform commercial practices. They\nare not, in reality, the same juristic manifold. The purpose of uniformity of the code should not be\ndefeated by the obsessions of the code drafters to be all inclusive for secured creditors.\n\nEven if the trustee, in behalf of the unsecured creditors, would feel inclined to insert love, romance and\nmorals into commercial law, he is appearing in the wrong era, and possibly the wrong court.\n\nOrdered, that the Rike-Kumler Company holds a perfected security interest in the diamond engagement\nring, and the security interest attached to the proceeds realized from the sale of the goods by the trustee in\nbankruptcy.\n\nC A SE QU ES TIO NS\n1. Why didn\xe2\x80\x99t the jewelry store, Rike-Kumler, file a financing statement to\nprotect its security interest 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\nring as an asset belonging to the estate of the debtor? What did the court\ndetermine on this issue?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n925\n\n\x0cRepossession and Breach of the Peace\nPantoja-Cahue v. Ford Motor Credit Co.\n\n872 N.E.2d 1039 (Ill. App. 2007)\n\nPlaintiff Mario Pantoja-Cahue filed a six-count complaint seeking damages from defendant Ford Motor\nCredit Company for Ford\xe2\x80\x99s alleged breach of the peace and \xe2\x80\x9cillegal activities\xe2\x80\x9d in repossessing plaintiff\xe2\x80\x99s\nautomobile from his locked garage.\xe2\x80\xa6\n\nIn August 2000, plaintiff purchased a 2000 Ford Explorer from auto dealer Webb Ford. Plaintiff, a native\nSpanish speaker, negotiated the purchase with a Spanish-speaking salesperson at Webb. Plaintiff signed\nwhat he thought was a contract for the purchase and financing of the vehicle, with monthly installment\npayments to be made to Ford. The contract was in English. Some years later, plaintiff discovered the\ncontract was actually a lease, not a purchase agreement. Plaintiff brought suit against Ford and Webb on\nAugust 22, 2003, alleging fraud. Ford brought a replevin action against plaintiff asserting plaintiff was in\ndefault on his obligations 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 removed the\ncar\xe2\x80\xa6\n\nPlaintiff sought damages for Ford and Doe\xe2\x80\x99s \xe2\x80\x9cunlawful activities surrounding the wrongful repossession of\nPlaintiff\xe2\x80\x99s vehicle.\xe2\x80\x9d He alleged Ford and Doe\xe2\x80\x99s breaking into plaintiff\xe2\x80\x99s locked garage to effectuate the\nrepossession and Ford\xe2\x80\x99s repossession of the vehicle knowing that title to the car was the subject of\nongoing litigation variously violated section 2A-525(3) of the [Uniform Commercial] Code (count I against\nFord), the [federal] Fair Debt Collection Practices Act (count II against Doe),\xe2\x80\xa6Ford\xe2\x80\x99s contract with\nplaintiff (count V against Ford) and section 2A-108 of the Code (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 into\nPlaintiff\xe2\x80\x99s locked garage in order to take the vehicle\xe2\x80\x9d and Ford\xe2\x80\x99s agent \xe2\x80\x9crepossessed the subject vehicle by,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n926\n\n\x0camong other things, breaking into Plaintiff\xe2\x80\x99s locked garage and causing substantial damage to Plaintiff\xe2\x80\x99s\npersonal property in violation of [section 2A-525(3)]\xe2\x80\x9d:\n\n\xe2\x80\x9cAfter a default by the lessee under the lease contract * * * or, if agreed, after other default by the lessee,\nthe lessor has the right to take possession of the goods. * * *\n\nThe lessor may proceed under subsection (2) without judicial process if it can be done without breach of\nthe peace or the lessor may proceed by action.\xe2\x80\x9d [emphasis added.]\n\n[U]pon a lessee\xe2\x80\x99s default, a lessor has the right to repossess the leased goods in one of two ways: by using\nthe judicial process or, if repossession could be accomplished without a breach of the peace, by self-help\n[UCC Section 2A-525(3)]. \xe2\x80\x9cIf a breach of the peace is likely, a properly instituted civil action is the\nappropriate remedy.\xe2\x80\x9d [Citation] (interpreting the term \xe2\x80\x9cbreach of the peace\xe2\x80\x9d in the context of section 9503 of the Code, which provides for the same self-help repossession as section 2A-525 but for secured\ncreditors rather than lessors).\n\nTaking plaintiff\xe2\x80\x99s well-pleaded allegations as true, Ford resorted to self-help, by employing an agent to\nrepossess the car and Ford\xe2\x80\x99s agent broke into plaintiff\xe2\x80\x99s locked garage to effectuate the repossession.\nAlthough plaintiff\xe2\x80\x99s count I allegations are minimal, they are sufficient to plead a cause of action for a\nviolation of section 2A-525(3) if breaking into a garage to repossess a car is, as plaintiff alleged, a breach\nof the peace. Accordingly, the question here is whether breaking into a locked garage to effectuate a\nrepossession is a breach of the peace in violation of section 2A-525(3).\n\nThere are no Illinois cases analyzing the meaning of the term \xe2\x80\x9cbreach of the peace\xe2\x80\x9d as used in the lessor\nrepossession context in section 2A-525(3). However, there are a few Illinois cases analyzing the term as\nused in section 9-503 of the Code, which contains a similar provision providing that a secured creditor\nmay, upon default by a debtor, repossess its collateral either \xe2\x80\x9c(1) pursuant to judicial process; or (2)\nwithout judicial process, if it proceeds without breach of the peace.\xe2\x80\x9d The seminal case, and the only one of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n927\n\n\x0cany use in resolving the issue, isChrysler Credit Corp. v. Koontz, 277 Ill.App.3d 1078, 214 Ill.Dec. 726, 661\nN.E.2d 1171 (1996).\n\nIn Koontz, Chrysler, the defendant creditor, sent repossession agents to repossess the plaintiff\xe2\x80\x99s car after\nthe plaintiff defaulted on his payments. The car was parked in the plaintiff\xe2\x80\x99s front yard. The plaintiff heard\nthe repossession in progress and ran outside in his underwear shouting \xe2\x80\x9cDon\xe2\x80\x99t take it\xe2\x80\x9d to the agents. The\nagents did not respond and proceeded to take the car. The plaintiff argued the repossession breached the\npeace and he was entitled to the statutory remedy for violation of section 9-503, denial of a deficiency\njudgment to the secured party, Chrysler.\xe2\x80\xa6\n\nAfter a thorough analysis of the term \xe2\x80\x9cbreach of the peace,\xe2\x80\x9d the court concluded the term \xe2\x80\x9cconnotes\nconduct which incites or is likely to incite immediate public turbulence, or which leads to or is likely to\nlead to an immediate loss of public order and tranquility. Violent conduct is not a necessary element. The\nprobability of violence at the time of or immediately prior to the repossession is\nsufficient.\xe2\x80\x9d\xe2\x80\xa6[The Koontzcourt] held the circumstances of the repossession did not amount to a breach the\npeace.\n\nThe court then considered the plaintiff\xe2\x80\x99s argument that Chrysler breached the peace by repossessing the\ncar under circumstances constituting criminal trespass to property. Looking to cases in other\njurisdictions, the court determined that, \xe2\x80\x9cin general, a mere trespass, standing alone, does not\nautomatically constitute a breach of the peace.\xe2\x80\x9d [Citation] (taking possession of car from private driveway\ndoes not, without more, constitute breach of the peace), [Citation] (no breach of the peace occurred where\ncar repossessed from debtor\xe2\x80\x99s driveway without entering \xe2\x80\x9cany gates, doors, or other barricades to reach\xe2\x80\x9d\ncar), [Citation] (no breach of the peace occurred where car was parked partially under carport and\nundisputed that no door, \xe2\x80\x9cnot even one to a garage,\xe2\x80\x9d on the debtor\xe2\x80\x99s premises was opened, much less\nbroken, to repossess the car), [Citation] (although secured party may not break into or enter homes or\nbuildings or enclosed spaces to effectuate a repossession, repossession of vehicle from parking lot of\ndebtor\xe2\x80\x99s apartment building was not breach of the peace), [Citation] (repossession of car from debtor\xe2\x80\x99s\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n928\n\n\x0cdriveway without entering any gates, doors or other barricades was accomplished without breach of the\npeace).\xe2\x80\xa6\n\nAlthough the evidence showed the plaintiff notified Chrysler prior to the repossession that it was not\npermitted onto his property, the court held Chrysler\xe2\x80\x99s entry onto the property to take the car did not\nconstitute a breach of the peace because there was no evidence Chrysler entered through a barricade or\ndid anything other than drive the car away. [Citation] \xe2\x80\x9cChrysler enjoyed a limited privilege to enter [the\nplaintiff\xe2\x80\x99s] property for the sole and exclusive purpose of effectuating the repossession. So long as the\nentry was limited in purpose (repossession), and so long as no gates, barricades, doors, enclosures,\nbuildings, or chains were breached or cut, no breach of the peace occurred by virtue of the entry onto his\nproperty.\xe2\x80\x9d\n\n\xe2\x80\xa6[W]e come to essentially the same conclusion: where a repossession is effectuated by an actual breaking\ninto the lessee/debtor\xe2\x80\x99s premises or breaching or cutting of chains, gates, barricades, doors or other\nbarriers designed to exclude trespassers, the likelihood that a breach of the peace occurred is high.\n\nDavenport v. Chrysler Credit Corp., [Citation] (Tenn.App.1991), a case analyzing Tennessee\xe2\x80\x99s version of\nsection 9-503 is particularly helpful, holding that \xe2\x80\x9c\xe2\x80\x98[a] breach of the peace is almost certain to be found if\nthe repossession is accompanied by the unauthorized entry into a closed or locked garage.\xe2\x80\x99\xe2\x80\x9d\xe2\x80\xa6This is so\nbecause \xe2\x80\x9cpublic policy favors peaceful, non-trespassory repossessions when the secured party has a free\nright of entry\xe2\x80\x9d and \xe2\x80\x9cforced entries onto the debtor\xe2\x80\x99s property or into the debtor\xe2\x80\x99s premises are viewed as\nseriously detrimental to the ordinary conduct of human affairs.\xe2\x80\x9d Davenport held that the creditor\xe2\x80\x99s\nrepossession of a car by entering a closed garage and cutting a chain that would have prevented it from\nremoving the car amounted to a breach of the peace, \xe2\x80\x9c[d]espite the absence of violence or physical\nconfrontation\xe2\x80\x9d (because the debtor was not at home when the repossession\noccurred). Davenport recognized that the secured creditors\xe2\x80\x99 legitimate interest in obtaining possession of\ncollateral without having to resort to expensive and cumbersome judicial procedures must be balanced\nagainst the debtors\xe2\x80\x99 legitimate interest in being free from unwarranted invasions of their property and\nprivacy interests.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n929\n\n\x0c\xe2\x80\x9cRepossession is a harsh procedure and is, essentially, a delegation of the State\xe2\x80\x99s exclusive prerogative to\nresolve disputes. Accordingly, the statutes governing the repossession of collateral should be construed in\na way that prevents abuse and discourages illegal conduct which might otherwise go unchallenged\nbecause of the debtor\xe2\x80\x99s lack of knowledge of legally proper repossession techniques\xe2\x80\x9d [Citation].\n\nWe agree with [this] analysis of the term \xe2\x80\x9cbreach of the peace\xe2\x80\x9d in the context of repossession and hold,\nwith regard to section 2A-525(3) of the Code, that breaking into a locked garage to effectuate a\nrepossession may constitute a breach of the peace.\n\nHere, plaintiff alleges more than simply a trespass. He alleges Ford, through Doe, broke into his garage to\nrepossess the car. Given our determination that breaking into a locked garage to repossess a car may\nconstitute a breach of the peace, plaintiff\xe2\x80\x99s allegation is sufficient to state a cause of action under section\n2A-525(3) of the Code. The court erred in dismissing count I of plaintiff\xe2\x80\x99s second amended complaint and\nwe 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 violation\nof [the Illinois Consumer Fraud Statute, requiring that the customer verify that the negotiations were\nconducted in the consumer\xe2\x80\x99s native language and that the document was translated so the customer\nunderstood it.]\xe2\x80\xa6Plaintiff does not quote [this] or explain how the agreement violates [it]. Instead, he\nquotes UCC section 2A-108 of the Code, as follows:\n\n\xe2\x80\x9cWith respect to a consumer lease, if the court as a matter of law finds that a lease contract or any clause\nof a lease contract has been induced by unconscionable conduct or that unconscionable conduct has\noccurred in the collection of a claim arising from a lease contract, the court may grant appropriate relief.\n\nBefore making a finding of unconscionability under subsection (1) or (2), the court, on its own motion or\nthat of a party, shall afford the parties a reasonable opportunity to present evidence as to the setting,\npurpose, and effect of the lease contract or clause thereof, or of the conduct.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n930\n\n\x0cHe then, in \xe2\x80\x9cviolation one\xe2\x80\x9d under count VI, alleges the lease was made in violation of [the Illinois\nConsumer Fraud Statute] because it was negotiated in Spanish but he was only given a copy of the\ncontract in English; he could not read the contract and, as a result, Webb Ford was able to trick him into\nsigning a lease, rather than a purchase agreement; such contract was induced by unconscionable conduct;\nand, because it was illegal, the contract was unenforceable.\n\nThis allegation is insufficient to state a cause of action against Ford under section 2A-108.\xe2\x80\xa6First, Ford is\nan entirely different entity than Webb Ford and plaintiff does not assert otherwise. Nor does plaintiff\nassert that Webb Ford was acting as Ford\xe2\x80\x99s agent in inducing plaintiff to sign the lease. Plaintiff asserts no\nbasis on which Ford can be found liable for something Webb Ford did. Second, there is no allegation as to\nhow the contract violates [the statute], merely the legal conclusion that it does, as well as the unsupported\nlegal conclusion that a violation of [it] is necessarily unconscionable.\xe2\x80\xa6[Further discussion omitted.]\n\nFor the reasons stated above, we affirm the trial court\xe2\x80\x99s dismissal of counts IV, V and VI of plaintiff\xe2\x80\x99s\nsecond amended complaint. We reverse the court\xe2\x80\x99s dismissal of count I and remand for further\nproceedings. Affirmed in part and reversed in part; cause remanded.\n\nC A SE QU ES TIO NS\n1. Under what circumstances, if any, would breaking into a locked garage to\nrepossess a car not be considered a breach of the peace?\n2. The court did not decide that a breach of the peace had occurred. What would\ndetermine that such a breach had occurred?\n3. Why did the court dismiss the plaintiff\xe2\x80\x99s claim (under UCC Article 2A) that it\nwas unconscionable of Ford to trick him into signing a lease when he thought\nhe was signing a purchase contract? Would that section of Article 2A make\nbreaking into his garage unconscionable?\n4. What alternatives had Ford besides taking the car from the plaintiff\xe2\x80\x99s locked\ngarage?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n931\n\n\x0c5. If it was determined on remand that a breach of the peace had occurred, what\nhappens to Ford?\n\nDefenses of the Principal Debtor as against Reimbursement to Surety\nFidelity and Deposit Co. of Maryland v. Douglas Asphalt Co.\n\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 Company to\nperform work on an interstate highway. After Douglas Asphalt allegedly failed to pay its suppliers and\nsubcontractors and failed to perform under the contract, GDOT defaulted and terminated Douglas\nAsphalt. Fidelity and Deposit Company of Maryland and Zurich American Insurance Company had\nexecuted payment and performance bonds in connection with Douglas Asphalt\xe2\x80\x99s work on the interstate,\nand after Douglas Asphalt\xe2\x80\x99s default, Fidelity and Zurich spent $15,424,798 remedying the default.\n\nFidelity and Zurich, seeking to recover their losses related to their remedy of the default, brought this suit\nagainst Douglas Asphalt, Joel Spivey, and Ronnie Spivey. The Spiveys and Douglas Asphalt had executed\na General Indemnity Agreement in favor of Fidelity and Zurich.\n\n[2]\n\nAfter a bench trial, the district court entered judgment in favor of Fidelity and Zurich for $16,524,798.\nDouglas Asphalt and the Spiveys now appeal.\nDouglas Asphalt and the Spiveys argue that the district court erred in entering judgment in favor of\nFidelity and Zurich because Fidelity and Zurich acted in bad faith in three ways.\n\nFirst, Douglas Asphalt and the Spiveys argue that the district court erred in not finding that Fidelity and\nZurich acted in bad faith because they claimed excessive costs to remedy the default. Specifically, Douglas\nAsphalt and the Spiveys argue that they introduced evidence that the interstate project was 98% complete,\nand that only approximately $3.6 million was needed to remedy any default. But, the district court found\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n932\n\n\x0cthat the interstate project was only 90%\xe2\x80\x9392% complete and that approximately $2 million needed to be\nspent to correct defective work already done by Douglas Asphalt. Douglas Asphalt and the Spiveys have\nnot shown that the district court\xe2\x80\x99s finding was clearly erroneous, and accordingly, their argument that\nFidelity and Zurich showed bad faith in claiming that the project was only 90% complete and therefore\nrequired over $15 million to remedy the default fails.\n\nSecond, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich acted in bad faith by failing to\ncontest the default. However, the district court concluded that the indemnity agreement required Douglas\nAsphalt and the Spiveys to request a contest of the default, and to post collateral security to pay any\njudgment rendered in the course of contesting the default. The court\xe2\x80\x99s finding that Douglas Asphalt and\nthe Spiveys made no such request and posted no collateral security was not clearly erroneous, and the\nsureties had no independent duty to investigate a default. Accordingly, Fidelity and Zurich\xe2\x80\x99s failure to\ncontest the default does not show bad faith.\n\nFinally, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich\xe2\x80\x99s refusal to permit them to remain\ninvolved with the interstate project, either as a contractor or consultant, was evidence of bad faith. Yet,\nDouglas Asphalt and the Spiveys did not direct the district court or this court to any case law that holds\nthat the refusal to permit a defaulting contractor to continue working on a project is bad faith. As the\ndistrict court concluded, Fidelity and Zurich had a contractual right to take possession of all the work\nunder the contract and arrange for its completion. Fidelity and Zurich exercised that contractual right,\nand, as the district court noted, the exercise of a contractual right is not evidence of bad faith.\n\nFinding no error, we affirm the judgment of the district court.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n933\n\n\x0cC A SE QU ES TIO NS\n1. Why were Douglas Asphalt and the Spiveys supposed to pay the sureties\nnearly $15.5 million?\n2. What did the plaintiffs claim the defendant sureties did wrong as relates to\nhow much money they spent to cure the default?\n3. What is a \xe2\x80\x9ccontest of the default\xe2\x80\x9d?\n4. Why would the sureties probably not want the principal involved in the\nproject?\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\nidentified as the specific author.\n[2] They promised to reimburse the surety for its expenses and hold it harmless for further\nliability.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n934\n\n\x0c19.6 Summary and Exercises\nSummary\nThe law governing security interests in personal property is Article 9 of the UCC, which defines a security\ninterest as an interest in personal property or fixtures that secures payment or performance of an\nobligation. Article 9 lumps together all the former types of security devices, including the pledge, chattel\nmortgage, and conditional sale.\n\nFive types of tangible property may serve as collateral: (1) consumer goods, (2) equipment, (3) farm\nproducts, (4) inventory, and (5) fixtures. Five types of intangibles may serve as collateral: (1) accounts, (2)\ngeneral intangibles (e.g., patents), (3) documents of title, (4) chattel paper, and (5) instruments. Article 9\nexpressly permits the debtor to give a security interest in after-acquired collateral.\n\nTo create an enforceable security interest, the lender and borrower must enter into an agreement\nestablishing the interest, and the lender must follow steps to ensure that the security interest first attaches\nand then is perfected. There are three general requirements for attachment: (1) there must be an\nauthenticated agreement (or the collateral must physically be in the lender\xe2\x80\x99s possession), (2) the lender\nmust have given value, and (3) the debtor must have some rights in the collateral. Once the interest\nattaches, the lender has rights in the collateral superior to those of unsecured creditors. But others may\ndefeat his interest unless he perfects the security interest. The three common ways of doing so are (1)\nfiling a financing statement, (2) pledging collateral, and (3) taking a purchase-money security interest\n(PMSI) in consumer goods.\n\nA financing statement is a simple notice, showing the parties\xe2\x80\x99 names and addresses, the signature of the\ndebtor, and an adequate description of the collateral. The financing statement, effective for five years,\nmust be filed in a public office; the location of the office varies among the states.\n\nSecurity interests in instruments and negotiable documents can be perfected only by the secured party\xe2\x80\x99s\ntaking possession, with twenty-one-day grace periods applicable under certain circumstances. Goods may\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n935\n\n\x0calso be secured through pledging, which is often done through field warehousing. If a seller of consumer\ngoods takes a PMSI in the goods sold, then perfection is automatic and no filing is required, although the\nlender may file and probably should, to avoid losing seniority to a bona fide purchaser of consumer goods\nwithout knowledge of the security interest, if the goods are used for personal, family, or household\npurposes.\n\nThe general priority rule is \xe2\x80\x9cfirst in time, first in right.\xe2\x80\x9d Priority dates from the earlier of two events: (1)\nfiling a financing statement covering the collateral or (2) other perfection of the security interest. Several\nexceptions to this rule arise when creditors take a PMSI, among them, when a buyer in the ordinary\ncourse of business takes free of a security interest created by the seller.\n\nOn default, a creditor may repossess the collateral. For the most part, self-help private repossession\ncontinues to be lawful but risky. After repossession, the lender may sell the collateral or accept it in\nsatisfaction of the debt. Any excess in the selling price above the debt amount must go to the debtor.\n\nSuretyship is a legal relationship that is created when one person contracts to be responsible for the\nproper fulfillment of another\xe2\x80\x99s obligation, in case the latter (the principal debtor) fails to fulfill it. The\nsurety may avail itself of the principal\xe2\x80\x99s contract defenses, but under various circumstances, defenses may\nbe available to the one that are not available to the other. One general defense often raised by sureties is\nalteration of the contract. If the surety is required to perform, it has rights for reimbursement against the\nprincipal, including interest and legal fees; and if there is more than one surety, each standing for part of\nthe obligation, one who pays a disproportionate part may seek contribution from the others.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n936\n\n\x0cE XE R C IS ES\n1. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit shop\nand signed a security agreement listing as collateral the entire present and future\ninventory in the shop, including proceeds from the sale of inventory. Bank filed no\nfinancing statement. A month later, Knittle borrowed $5,000 from Creditor, who\nwas aware of Bank\xe2\x80\x99s security interest. Knittle then declared bankruptcy. Who has\npriority, Bank or Creditor?\n2. Assume the same facts as in Exercise 1, except Creditor\xe2\x80\x94again, aware of Bank\xe2\x80\x99s\nsecurity interest\xe2\x80\x94filed a financing statement to perfect its interest. Who has\npriority, Bank or Creditor?\n3. Harold and Wilma are married. First Bank has a mortgage on their house, and it\ncovers after-acquired property. Because Harold has a new job requiring travel to\nneighboring cities, they purchase a second car for Wilma\xe2\x80\x99s normal household use,\nfinanced by Second Bank. They sign a security agreement; Second Bank files\nnothing. If they were to default on their house payments, First Bank could\nrepossess the house; could it repossess the car, too?\n4.\na. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell\nin her knit shop and signed a security agreement listing her\ncollateral\xe2\x80\x94present and future\xe2\x80\x94as security for the loan. Carlene\nCustomer bought yarn and a tabletop loom from Knittle. Shortly\nthereafter, Knittle declared bankruptcy. Can Bank get the loom\nfrom Customer?\nb. Assume that the facts are similar to those in Exercise 4a, except\nthat the loom that Knittle sold had been purchased from Larry\nLoomaker, who had himself given a secured interest in it (and the\nother looms he manufactured) from Fine Lumber Company (FLC) to\nfinance the purchase of the lumber to make the looms. Customer\nbought the loom from Knittle (unaware of Loomaker\xe2\x80\x99s situation);\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n937\n\n\x0cLoomaker failed to pay FLC. Why can FLC repossess the loom from\nCustomer?\nc. What recourse does Customer have now?\nCreditor loaned Debtor $30,000 with the provision that the loan was callable\nby Creditor with sixty days\xe2\x80\x99 notice to Debtor. Debtor, having been called for\nrepayment, asked for a ninety-day extension, which Creditor assented to, provided\nthat Debtor would put up a surety to secure repayment. Surety agreed to serve as\nsurety. When Debtor defaulted, Creditor turned to Surety for payment. Surety\nasserted that Creditor had given no consideration for Surety\xe2\x80\x99s promise, and\ntherefore Surety was not bound. Is Surety correct?\na. Mrs. Ace said to University Bookstore: \xe2\x80\x9cSell the books to my\ndaughter. I\xe2\x80\x99ll pay for them.\xe2\x80\x9d When University Bookstore presented\nMrs. Ace a statement for $900, she refused to pay, denying she\xe2\x80\x99d\never promised to do so, and she raised the statute of frauds as a\ndefense. Is this a good defense?\nb. Defendant ran a stop sign and crashed into Plaintiff\xe2\x80\x99s car, causing\n$8,000 damage. Plaintiff\xe2\x80\x99s attorney orally negotiated with\nDefendant\xe2\x80\x99s insurance company, Goodhands Insurance, to settle\nthe case. Subsequently, Goodhands denied liability and refused to\npay, and it raised the statute of frauds as a defense, asserting that\nany 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\nclause. Is Goodhands\xe2\x80\x99s defense valid?\na. First Bank has a security interest in equipment owned by Kathy\nKnittle in her Knit Shop. If Kathy defaults on her loan and First Bank\nlawfully repossesses, what are the bank\xe2\x80\x99s options? Explain.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n938\n\n\x0cb. Suppose, instead, that First Bank had a security interest in Kathy\xe2\x80\x99s\nhome knitting machine, worth $10,000. She paid $6,200 on the\nmachine and then defaulted. Now what are the bank\xe2\x80\x99s options?\n\nS EL F -T E ST QU EST IO N S\n1. Creditors may obtain security\na. by agreement with the debtor\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\ncreditor, what other condition is required for attachment of the security\ninterest?\na. A written security agreement must be authenticated by the\ndebtor.\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. file a financing statement\nb. pledge collateral\nc. take a purchase-money security interest in consumer goods\nd. do any of the above\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n939\n\n\x0cPerfection benefits the secured party by\na. keeping the collateral out of the debtor\xe2\x80\x99s reach\nb. preventing another creditor from getting a secured interest in the\ncollateral\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. a purchaser in the ordinary course of business who bought on\nJune 5\nb. mechanic\xe2\x80\x99s lien filed on May 10\nc. purchase-money security interest in after-acquired property who\nfiled on May 15\nd. judgment lien creditor who filed the judgment on June 10\n\nS EL F -T E ST A NSW E R S\n\n1. c\n2. d\n3. d\n4. d\n5. d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n940\n\n\x0c19.7 Summary and Exercises\nSummary\nThe law governing security interests in personal property is Article 9 of the UCC, which\ndefines a security interest as an interest in personal property or fixtures which secures\npayment or performance of an obligation. Article 9 lumps together all the former types\nof security devices, including the pledge, chattel mortgage, and conditional sale.\nFive types of tangible property may serve as collateral: (1) consumer goods, (2)\nequipment, (3) farm products, (4) inventory, and (5) fixtures. Five types of intangibles\nmay serve as collateral: (1) accounts, (2) general intangibles (for example, patents), (3)\ndocuments of title, (4) chattel paper, and (5) instruments. Article 9 expressly permits\nthe debtor to give a security interest in after-acquired 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\nsecurity interest first attaches and then is perfected. There are three general\nrequirements for attachment: (1) there must be an authenticated agreement (or the\ncollateral must physically be in the lender\xe2\x80\x99s possession), (2) the lender must have given\nvalue, and (3) the debtor must have some rights in the collateral. Once the interest\nattaches, the lender has rights in the collateral superior to those of unsecured creditors.\nBut others may defeat his interest unless he perfects the security interest. The three\ncommon ways of doing so are (1) filing a financing statement, (2) pledging collateral,\nand (3) taking a purchase money security interest (PMSI) in consumer goods.\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\nstatement, effective for five years, must be filed in a public office; the location of the\noffice varies among the states.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n941\n\n\x0cSecurity interests in instruments and negotiable documents can be perfected only by the\nsecured party\xe2\x80\x99s raking possession, with twenty-one-day grace periods applicable under\ncertain circumstances. Goods may also be secured through pledging, which is often done\nthrough field warehousing. If a seller of consumer goods takes a purchase money\nsecurity interest in the goods sold, then perfection is automatic and no filing is required,\nalthough the lender may file and probably should to avoid losing seniority to a bona fide\npurchaser of consumer goods without knowledge of the security interest, if the goods are\nused 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\ntwo events: (1) filing a financing statement covering the collateral, or (2) other\nperfection of the security interest. Several exceptions to this rule arise when creditors\ntake a purchase money security interest, among them: a buyer in the ordinary course of\nbusiness takes free of a security interest created by the seller.\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\ndebt amount must go to the debtor.\nSuretyship is a legal relationship that is created when one person contracts to be\nresponsible for the proper fulfillment of another\xe2\x80\x99s obligation, in case the latter (the\nprincipal debtor) fails to fulfill it. The surety may avail itself of the principal\xe2\x80\x99s contract\ndefenses, but under various circumstances, defenses may be available to the one that are\nnot available to the other. One general defense often raised by sureties is alteration of\nthe contract. If the surety is required to perform, it has rights for reimbursement against\nthe principal, including interest and legal fees, and if there is more than one surety, each\nstanding for part of the obligation, one who pays a disproportionate part may seek\ncontribution from the others.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n942\n\n\x0cE XE R C IS ES\n1. Creditors may obtain security:\na. by agreement with the debtor\nb. through operation of law\nc. through both of these\nd. through neither of the above\nUnder UCC Article 9, when the debtor has pledged collateral to the\ncreditor, what other condition is required for attachment of the security\ninterest?\na. A written security agreement must be authenticated by the\ndebtor.\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. file a financing statement\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. keeping the collateral out of the debtor\xe2\x80\x99s reach\nb. preventing another creditor from getting a secured interest in the\ncollateral\nc. obviating the need to file a financing statement\nd. establishing who gets priority if the debtor defaults\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n943\n\n\x0cCreditor filed a security interest in inventory on June 1, 2012. Creditor\xe2\x80\x99s\ninterest takes priority over which of the following?\na. A purchaser in the ordinary course of business who bought on June\n5\nb. Mechanic\xe2\x80\x99s lien filed on May 10\nc. Purchase-money security interest in after-acquired property who\nfiled May 15\nd. Judgment lien creditor who filed the judgment on June 10\nKathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit\nshop and signed a security agreement listing as collateral the entire present and\nfuture inventory in the shop, including proceeds from the sale of inventory. Bank\nfiled no financing statement. A month later Knittle borrowed $5000 from Creditor,\nwho was aware of Bank\xe2\x80\x99s security interest. Knittle then declared bankruptcy. Who\nhas priority, Bank or Creditor?\nSame facts as above, 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\nor Creditor?\nHarold and Wilma are married. First Bank has a mortgage on their house and\nit covers after-acquired property. Because Harold has a new job requiring travel to\nneighboring cities, they purchase a second car for Wilma\xe2\x80\x99s normal household use,\nfinanced by Second Bank. They sign a security agreement; Second Bank files\nnothing. If they were to default on their house payments, First Bank could\nrepossess the house: could it repossess the car, too?\na. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell\nin her knit shop and signed a security agreement listing her\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n944\n\n\x0ccollateral\xe2\x80\x94present and future\xe2\x80\x94as security for the loan. Carlene\nCustomer bought yarn and a tabletop loom from Knittle. Shortly\nthereafter Knittle declared bankruptcy. Can Bank get the loom\nfrom Customer?\nb. Similar to facts as above, except the loom that Knittle sold had\nbeen purchased from Larry Loomaker, who had himself given a\nsecured interest in it (and the other looms he manufactured) from\nFine Lumber Company (FLC) to finance the purchase of the lumber\nto make the looms. Customer bought the loom from Knittle\n(unaware of Loomaker\xe2\x80\x99s situation); Loomaker failed to pay FLC.\nWhy 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\nby Creditor with sixty days\xe2\x80\x99 notice to Debtor. Debtor, having been called for\nrepayment, asked for a ninety-day extension, which Creditor assented to, provided\nDebtor would put up a surety to secure repayment; Surety agreed to serve as\nsurety. When Debtor defaulted, Creditor turned to Surety for payment. Surety\nasserted that Creditor had given no consideration for Surety\xe2\x80\x99s promise and\ntherefore Surety was not bound. Is Surety correct?\na. Mrs. Ace said to University Bookstore: \xe2\x80\x9cSell the books to my\ndaughter. I\xe2\x80\x99ll pay for them.\xe2\x80\x9d When Bookstore presented Mrs. Ace a\nstatement for $900, she refused to pay, denying she\xe2\x80\x99d ever\npromised to do so, and she raised the statute of frauds as a\ndefense. Is this a good defense?\nb. Defendant ran a stop sign and crashed into Plaintiff\xe2\x80\x99s car, causing\n$8,000 damage. Plaintiff\xe2\x80\x99s attorney orally negotiated with\nDefendant\xe2\x80\x99s insurance company, Goodhands Insurance, to settle\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n945\n\n\x0cthe case. Subsequently, Goodhands denied liability and refused to\npay, and it raised the statute of frauds as a defense, asserting that\nany 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\nclause. Is Goodhand\xe2\x80\x99s defense valid?\na. First Bank has a security interest in equipment owned by Kathy\nKnittle in her Knit Shop. If Kathy defaults on her loan and First Bank\nlawfully repossesses, what are the bank\xe2\x80\x99s options? Explain.\nb. Suppose instead First Bank had a security interest in Kathy\xe2\x80\x99s home\nknitting machine, worth $10,000. She paid $6,200 on the machine\nand then defaulted. Now what are the bank\xe2\x80\x99s options?\n\nAnswers\n1. c\n2. d\n3. d\n4. d\n5. d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n946\n\n\x0cChapter 20\nMortgages and Nonconsensual Liens\nL EA R N IN G O B JEC T IV ES\nAfter 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n947\n\n\x0c20.1 Uses, History, and Creation of Mortgages\nL EA R N IN G O B JEC T IV ES\n1. Understand the terminology used in mortgage transactions, and how\nmortgages are used as security devices.\n2. Know a bit about the history of mortgages.\n3. Understand how the mortgage is created.\n\nHaving discussed in Chapter 19 "Secured Transactions and Suretyship"security interests in personal\nproperty and suretyship\xe2\x80\x94two of the three common types of consensual security arrangements\xe2\x80\x94we turn\nnow to the third type of consensual security arrangement, the mortgage. We also discuss briefly various\nforms of nonconsensual liens (see Figure 20.1 "Security Arrangements").\n\nFigure 20.1 Security Arrangements\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n948\n\n\x0cDefinitions\nA mortgage is a means of securing a debt with real estate. A long time ago, the mortgage was considered\nan actual transfer of title, to become void if the debt was paid off. The modern view, held in most states, is\nthat the mortgage is but a lien, giving the holder, in the event of default, the right to sell the property and\nrepay the debt from the proceeds. The person giving the mortgage is the mortgagor, or borrower. In the\ntypical home purchase, that\xe2\x80\x99s the buyer. The buyer needs to borrow to finance the purchase; in exchange\nfor the money with which to pay the seller, the buyer \xe2\x80\x9ctakes out a mortgage\xe2\x80\x9d with, say, a bank. The lender\nis the mortgagee, the person or institution holding the mortgage, with the right to foreclose on the\nproperty if the debt is not timely paid. Although the law of real estate mortgages is different from the set\nof rules in Article 9 of the Uniform Commercial Code (UCC) that we examined in Chapter 19 "Secured\nTransactions and Suretyship", the circumstances are the same, except that the security is real estate rather\nthan personal property (secured transactions) or the promise of another (suretyship).\n\nThe Uses of Mortgages\nMost frequently, we think of a mortgage as a device to fund a real estate purchase: for a homeowner to\nbuy her house, or for a commercial entity to buy real estate (e.g., an office building), or for a person to\npurchase farmland. But the value in real estate can be mortgaged for almost any purpose (a home equity\nloan): a person can take out a mortgage on land to fund a vacation. Indeed, during the period leading up\nto the recession in 2007\xe2\x80\x9308, a lot of people borrowed money on their houses to buy things: boats, new\ncars, furniture, and so on. Unfortunately, it turned out that some of the real estate used as collateral was\novervalued: when the economy weakened and people lost income or their jobs, they couldn\xe2\x80\x99t make the\nmortgage payments. 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 couldn\xe2\x80\x99t\nsell without taking a loss, and they couldn\xe2\x80\x99t make the payments. Some debtors just walked away, leaving\nthe banks with a large number of houses, commercial buildings, and even shopping centers on their\nhands.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n949\n\n\x0cShort History of Mortgage Law\nThe mortgage has ancient roots, but the form we know evolved from the English land law in the Middle\nAges. Understanding that law helps to understand modern mortgage law. In the fourteenth century, the\nmortgage was a deed that actually transferred title to the mortgagee. If desired, the mortgagee could move\ninto the house, occupy the property, or rent it out. But because the mortgage obligated him to apply to the\nmortgage debt whatever rents he collected, he seldom ousted the mortgagor. Moreover, the mortgage set a\nspecific date (the \xe2\x80\x9claw day\xe2\x80\x9d) on which the debt was to be repaid. If the mortgagor did so, the mortgage\nbecame void and the mortgagor was entitled to recover the property. If the mortgagor failed to pay the\ndebt, the property automatically vested in the mortgagee. No further proceedings were necessary.\n\nThis law was severe. A day\xe2\x80\x99s delay in paying the debt, for any reason, forfeited the land, and the courts\nstrictly enforced the mortgage. The only possible relief was a petition to the king, who over time referred\nthese and other kinds of petitions to the courts of equity. At first fitfully, and then as a matter of course\n(by the seventeenth century), the equity courts would order the mortgagee to return the land when the\nmortgagor stood ready to pay the debt plus interest. Thus a new right developed: the equitable right of\nredemption, known for short as the equity of redemption. In time, the courts held that this equity of\nredemption was a form of property right; it could be sold and inherited. This was a powerful right: no\nmatter how many years later, the mortgagor could always recover his land by proffering a sum of money.\n\nUnderstandably, mortgagees did not warm to this interpretation of the law, because their property rights\nwere rendered insecure. They tried to defeat the equity of redemption by having mortgagors waive and\nsurrender it to the mortgagees, but the courts voided waiver clauses as a violation of public policy. Hence\na mortgage, once a transfer of title, became a security for debt. A mortgage as such can never be converted\ninto a deed of title.\n\nThe law did not rest there. Mortgagees won a measure of relief in the development of the foreclosure.\nOn default, the mortgagee would seek a court order giving the mortgagor a fixed time\xe2\x80\x94perhaps six\nmonths or a year\xe2\x80\x94within which to pay off the debt; under the court decree, failure meant that the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n950\n\n\x0cmortgagor was forever foreclosed from asserting his right of redemption. This strict foreclosure gave\nthe mortgagee outright title at the end of the time period.\n\nIn the United States today, most jurisdictions follow a somewhat different approach: the mortgagee\nforecloses by forcing a public sale at auction. Proceeds up to the amount of the debt are the mortgagee\xe2\x80\x99s to\nkeep; surplus is paid over to the mortgagor. Foreclosure by sale is the usual procedure in the United\nStates. At bottom, its theory is that a mortgage is a lien on land. (Foreclosure issues are further discussed\ninSection 20.2 "Priority, Termination of the Mortgage, and Other Methods of Using Real Estate as\nSecurity".)\n\nUnder statutes enacted in many states, the mortgagor has one last chance to recover his property, even\nafter foreclosure. This statutory right of redemption extends the period to repay, often by one year.\n\nCreation of the Mortgage\nStatutory Regulation\nThe 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 (as discussed inChapter 18 "Consumer Credit\nTransactions") have a bearing on the mortgage, including state usury statutes, and the federal Truth in\nLending 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, is the Real\nEstate Settlement Procedures Act (RESPA), aimed at abuses in the settlement process\xe2\x80\x94the process of\nobtaining the mortgage and purchasing a residence. The act covers all federally related first mortgage\nloans secured by residential properties for one to four families. It requires the lender to disclose\ninformation about settlement costs in advance of the closing day: it prohibits the lender from \xe2\x80\x9cspringing\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n951\n\n\x0cunexpected or hidden costs onto the borrower. The RESPA is a US Department of Housing and Urban\nDevelopment (HUD) consumer protection statute designed to help home buyers be better shoppers in the\nhome-buying process, and it is enforced by HUD. It also outlaws what had been a common practice of\ngiving and accepting kickbacks and referral fees. The act prohibits lenders from requiring mortgagors to\nuse a particular company to obtain insurance, and it limits add-on fees the lender can demand to cover\nfuture insurance and tax charges.\n\nRedlining. Several statutes are directed to the practice of redlining\xe2\x80\x94the refusal of lenders to make loans\non property in low-income neighborhoods or impose stricter mortgage terms when they do make loans\nthere. (The term derives from the supposition that lenders draw red lines on maps around ostensibly\nmarginal neighborhoods.) The most important of these is the Community Reinvestment Act (CRA) of\n1977.\n\n[1]\n\nThe act requires the appropriate federal financial supervisory agencies to encourage regulated\n\nfinancial institutions to meet the credit needs of the local communities in which they are chartered,\nconsistent with safe and sound operation. To enforce the statute, federal regulatory agencies examine\nbanking institutions for CRA compliance and take this information into consideration when approving\napplications for new 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 within its\npurview to report annually by transmitting information from their loan application registers to a federal\nagency.\n\nThe Note and the Mortgage Documents\nThe note and the mortgage documents are the contracts that set up the deal: the mortgagor gets credit,\nand 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 closing: the\nnote and the mortgage. We cover notes in Chapter 13 "Nature and Form of Commercial Paper". It is\nenough here to recall that in a note (really a type of IOU), the mortgagor promises to pay a specified\nprincipal sum, plus interest, by a certain date or dates. The note is the underlying obligation for which the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n952\n\n\x0cmortgage serves as security. Without the note, the mortgagee would have an empty document, since the\nmortgage would secure nothing. Without a mortgage, a note is still quite valid, evidencing the debtor\xe2\x80\x99s\npersonal obligation.\n\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, the\nentire principal and interest will become due immediately at the lender\xe2\x80\x99s option. Why an acceleration\nclause? Without it, the lender would be powerless to foreclose the entire mortgage when the mortgagor\ndefaulted but would have to wait until the expiration of the note\xe2\x80\x99s term. Although the acceleration clause\nis routine, it will not be enforced unless the mortgagee acts in an equitable and fair manner. The problem\narises where the mortgagor\xe2\x80\x99s default was the result of some unconscionable conduct of the mortgagee,\nsuch as representing to the mortgagee that she might take a sixty-day \xe2\x80\x9choliday\xe2\x80\x9d from having to make\npayments. In Paul H. Cherry v. Chase Manhattan Mortgage Group (Section 20.4 "Cases"), the equitable\npowers of the court were invoked to prevent acceleration.\n\nThe Mortgage\nUnder the statute of frauds, the mortgage itself must be evidenced by some writing to be enforceable. The\nmortgagor will usually make certain promises and warranties to the mortgagee and state the amount and\nterms of the debt and the mortgagor\xe2\x80\x99s duties concerning taxes, insurance, and repairs. A sample mortgage\nform is presented inFigure 20.2 "Sample Mortgage Form".\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n953\n\n\x0cFigure 20.2 Sample Mortgage Form\n\nK E Y TA K EA WAY\nAs a mechanism of security, a mortgage is a promise by the debtor (mortgagor) to\nrepay the creditor (mortgagee) for the amount borrowed or credit extended, with\nreal estate put up as security. If the mortgagor doesn\xe2\x80\x99t pay as promised, the\nmortgagee may repossess the real estate. Mortgage law has ancient roots and\nbrings with it various permutations on the theme that even if the mortgagor\ndefaults, she may nevertheless have the right to get the property back or at least\nbe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n954\n\n\x0cE XE R C IS ES\n1. What role did the right of redemption play in courts of equity changing the\nsubstance of a mortgage from an actual transfer of title to the mortgagee to a\nmere lien on the property?\n2. What abuses did the federal RESPA address?\n3. What are the two documents most commonly associated with mortgage\ntransactions?\n[1] 12 United States Code, Section 2901.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n955\n\n\x0c20.2 Priority, Termination of the Mortgage, and Other\nMethods of Using Real Estate as Security\nL EA R N IN G O B JEC T IV ES\n1. Understand why it is important that the mortgagee (creditor) record her\ninterest in the debtor\xe2\x80\x99s real estate.\n2. Know the basic rule of priority\xe2\x80\x94who gets an interest in the property first in\ncase of default\xe2\x80\x94and the exceptions to the rule.\n3. Recognize the three ways mortgages can be terminated: payment,\nassumption, and foreclosure.\n4. Be familiar with other methods (besides mortgages) by which real property\ncan be used as security for a creditor.\n\nPriorities in Real Property Security\nYou may recall from Chapter 19 "Secured Transactions and Suretyship" how important it is for a creditor\nto perfect its secured interest in the goods put up as collateral. Absent perfection, the creditor stands a\nchance of losing out to another creditor who took its interest in the goods subsequent to the first creditor.\nThe same problem is presented in real property security: the mortgagee wants to make sure it has first\nclaim on the property in case the mortgagor (debtor) defaults.\n\nThe General Rule of Priorities\nThe general rule of priority is the same for real property security as for personal property security: the\nfirst in time to give notice of the secured interest is first in right. For real property, the notice is by\nrecording the mortgage. Recording is the act of giving public notice of changes in interests in real estate.\nRecording was created by statute; it did not exist at common law. The typical recording statute calls for a\ntransfer of title or mortgage to be placed in a particular county office, usually the auditor, recorder, or\nregister of deeds.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n956\n\n\x0cA mortgage is valid between the parties whether or not it is recorded, but a mortgagee might lose to a\nthird party\xe2\x80\x94another mortgagee or a good-faith purchaser of the property\xe2\x80\x94unless the mortgage is\nrecorded.\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 19 "Secured Transactions and Suretyship", the UCC gives priority to purchase-money security\ninterests 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 are\nobligatory, then the first-in-time rule applies. For example: Bank accepts Debtor\xe2\x80\x99s mortgage (and records\nit) and extends a line of credit on which Debtor draws, up to a certain limit. (Or, as in the construction\nindustry, Bank might make periodic advances to the contractors as work progresses, backed by the\nmortgage.) Second Creditor loans Debtor money\xe2\x80\x94secured by the same property\xe2\x80\x94before Debtor began to\ndraw against the first line of credit. Bank has priority: by searching the mortgage records, Second Creditor\nshould have been on notice that the first mortgage was intended as security for the entire line of credit,\nalthough the line was doled out over time.\n\nHowever, if the future advances are not obligatory, then priority is determined by notice. For example, a\nbank might take a mortgage as security for an original loan and for any future loans that the bank chooses\nto make. A later creditor can achieve priority by notifying the bank with the first mortgage that it is\nmaking an advance. Suppose Jimmy mortgages his property to a wealthy dowager, Mrs. Calabash, in\nreturn for an immediate loan of $20,000 and they agree that the mortgage will serve as security for future\nloans to be arranged. The mortgage is recorded. A month later, before Mrs. Calabash loans him any more\nmoney, Jimmy gives a second mortgage to Louella in return for a loan of $10,000. Louella notifies Mrs.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n957\n\n\x0cCalabash that she is loaning Jimmy the money. A month later, Mrs. Calabash loans Jimmy another\n$20,000. Jimmy 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 recited in\nthe mortgage and the mortgage was recorded. Louella will collect her $10,000 next, because she notified\nthe first mortgage holder of the advance. That leaves Mrs. Calabash in third position to collect what she\ncan of her second advance. Mrs. Calabash could have protected herself 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), or\nforeclosure.\n\nPayment\nUnless they live in the home for twenty-five or thirty years, the mortgagors usually pay off the mortgage\nwhen the property is sold. Occasionally, mortgages are paid off in order to refinance. If the mortgage was\ntaken out at a time of high interest rates and rates later drop, the homeowner might want to obtain a new\nmortgage at the lower rates. In many mortgages, however, this entails extra closing costs and penalties for\nprepaying the original mortgage. Whatever the reason, when a mortgage is paid off, the discharge should\nbe recorded. This is accomplished by giving the mortgagor a copy of, and filing a copy of, a Satisfaction of\nMortgage document. In the Paul H. Cherry v. Chase Manhattan Mortgage Group case (Section 20.4\n"Cases"), the bank mistakenly filed the Satisfaction of Mortgage document, later discovered its mistake,\nretracted the satisfaction, accelerated the loan because the mortgagor stopped making payments (the\nbank, seeing no record of an outstanding mortgage, refused to accept payments), and then tried to\nforeclose on the mortgage, meanwhile having lost the note and mortgage besides.\n\nAssumption\nThe property can be sold without paying off the mortgage if the mortgage is assumed by the new buyer,\nwho agrees to pay the seller\xe2\x80\x99s (the original mortgagor\xe2\x80\x99s) debt. This is a novation if, in approving the\nassumption, the bank releases the old mortgagor and substitutes the buyer as the new debtor.\nThe buyer need not assume the mortgage. If the buyer purchases the property without agreeing to be\npersonally liable, this is a sale \xe2\x80\x9csubject to\xe2\x80\x9d the mortgage (see Figure 20.3 "\xe2\x80\x9cSubject to\xe2\x80\x9d Sales versus\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n958\n\n\x0cAssumption"). In the event of the seller\xe2\x80\x99s subsequent default, the bank can foreclose the mortgage and sell\nthe property that the buyer has purchased, but the buyer is not liable for any deficiency.\n\nFigure 20.3 \xe2\x80\x9cSubject to\xe2\x80\x9d Sales versus Assumption\n\nWhat if mortgage rates are high? Can buyers assume an existing low-rate mortgage from the seller rather\nthan be forced to obtain a new mortgage at substantially higher rates? Banks, of course, would prefer not\nto allow that when interest rates are rising, so they often include in the mortgage a due-on-sale clause,\nby which the entire principal and interest become due when the property is sold, thus forcing the\npurchaser to get financing at the higher rates. The clause is a device for preventing subsequent purchasers\nfrom assuming loans with lower-than-market interest rates. Although many state courts at one time\nrefused to enforce the due-on-sale clause, Congress reversed this trend when it enacted the Garn\xe2\x80\x93St.\nGermain Depository Institutions Act in 1982.\n\n[1]\n\nThe act preempts state laws and upholds the validity of\n\ndue-on-sale clauses. When interest rates are low, banks have no interest in enforcing such clauses, and\nthere are ways to work around the due-on-sale clause.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n959\n\n\x0cForeclosure\nThe third method of terminating the mortgage is by foreclosure when a mortgagor defaults. Even after\ndefault, the mortgagor has the right to exercise his equity of redemption\xe2\x80\x94that is, to redeem the property\nby paying the principal and interest in full. If he does not, the mortgagee may foreclose the equity of\nredemption. Although strict foreclosure is used occasionally, in most cases the mortgagee forecloses by\none of two types of sale (see Figure 20.4 "Foreclosure").\n\nThe first type is judicial sale. The mortgagee seeks a court order authorizing the sale to be conducted by\na public official, usually the sheriff. The mortgagor is entitled to be notified of the proceeding and to a\nhearing. The second type of sale is that conducted under a clause called a power of sale, which many\nlenders insist be contained in the mortgage. This clause permits the mortgagee to sell the property at\npublic auction without first going to court\xe2\x80\x94although by custom or law, the sale must be advertised, and\ntypically a sheriff or other public official conducts the public sale or auction.\n\nFigure 20.4 Foreclosure\n\nOnce the property has been sold, it is deeded to the new purchaser. In about half the states, the mortgagor\nstill has the right to redeem the property by paying up within six months or a year\xe2\x80\x94the statutory\nredemption period. Thereafter, the mortgagor has no further right to redeem. If the sale proceeds exceed\nthe debt, the mortgagor is entitled to the excess unless he has given second and third mortgages, in which\ncase the junior mortgagees are entitled to recover their claims before the mortgagor. If the proceeds are\nless than the debt, the mortgagee is entitled to recover the deficiency from the mortgagor. However, some\nstates have statutorily abolished deficiency judgments.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n960\n\n\x0cOther 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: the deed of\ntrust 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 requires three\nparties: the borrower, the trustee, and the lender. Otherwise, it is at base identical to a mortgage. The\nborrower conveys the land to a third party, the trustee, to hold in trust for the lender until the borrower\npays the debt. (The trustee\xe2\x80\x99s interest is really a kind of legal fiction: that person is expected to have no\ninterest in the property.) The primary benefit to the deed of trust is that it simplifies the foreclosure\nprocess by containing a provision empowering the trustee to sell the property on default, thus doing away\nwith the need for any court filings. The disinterested third party making sure things are done properly\nbecomes the trustee, not a judge. In thirty states and the District of Columbia\xe2\x80\x94more than half of US\njurisdictions\xe2\x80\x94the deed of trust is usually used in lieu of mortgages.\n\n[2]\n\nBut the deed of trust may have certain disadvantages as well. For example, when the debt has been fully\npaid, the trustee will not release the deed of trust until she sees that all notes secured by it have been\nmarked canceled. Should the borrower have misplaced the canceled notes or failed to keep good records,\nhe will need to procure a surety bond to protect the trustee in case of a mistake. This can be an expensive\nprocedure. In many jurisdictions, the mortgage holder is prohibited from seeking a deficiency judgment if\nthe holder chooses to sell the property through nonjudicial means.\n\nAlpha Imperial Building, LLC v. Schnitzer Family Investment, LLC,Section 20.4 "Cases", discusses\nseveral issues involving deeds of trust.\n\nInstallment or Land Contract\nUnder the installment contract or land contract, the purchaser takes possession and agrees to pay\nthe seller over a period of years. Until the final payment, title belongs to the seller. The contract will\nspecify the type of deed to be conveyed at closing, the terms of payment, the buyer\xe2\x80\x99s duty to pay taxes and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n961\n\n\x0cinsure the premises, and the seller\xe2\x80\x99s right to accelerate on default. The buyer\xe2\x80\x99s particular concern in this\ntype of sale is whether the seller in fact has title. The buyers can protect themselves by requiring proof of\ntitle and title insurance when the contract is signed. Moreover, the buyer should record the installment\ncontract to protect against the seller\xe2\x80\x99s attempt to convey title to an innocent third-party purchaser while\nthe contract is in effect.\n\nThe benefit to the land contract is that the borrower need not bank-qualify, so the pool of available buyers\nis larger, and buyers who have inadequate resources at the time of contracting but who have the\nexpectation of a rising income in the future are good candidates for the land contract. Also, the seller gets\nall the interest paid by the buyer, instead of the bank getting it in the usual mortgage. The obvious\ndisadvantage from the seller\xe2\x80\x99s point is that she will not get a big lump sum immediately: the payments\ntrickle in over years (unless she can sell the contract to a third party, but that would be at a discount).\n\nK E Y TA K EA WAY\nThe general rule on priority in real property security is that the first creditor to\nrecord its interest prevails over subsequent creditors. There are some exceptions;\nthe most familiar is that the seller of a fixture on a purchase-money security\ninterest has priority over a previously recorded mortgagee. The mortgage will\nterminate by payment, assumption by a new buyer (with a novation releasing the\nold buyer), and foreclosure. In a judicial-sale foreclosure, a court authorizes the\nproperty\xe2\x80\x99s sale; in a power-of-sale foreclosure, no court approval is required. In\nmost states, the mortgagor whose property was foreclosed is given some period of\ntime\xe2\x80\x94six months or a year\xe2\x80\x94to redeem the property; otherwise, the sale is done,\nbut 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\ntrustee for the benefit of the lender; the trustee sells it upon default, with the\nproceeds (after expenses) going to the lender. Another method of real property\nsecurity is a land contract: title shifts to the buyer only at the end of the term of\npayments.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n962\n\n\x0cE XE R C IS ES\n1. A debtor borrowed $350,000 to finance the purchase of a house, and the bank\nrecorded its interest on July 1. On July 15, the debtor bought $10,000 worth of\nreplacement windows from Window Co.; Window Co. recorded its purchasemoney security interest that day, and the windows were installed. Four years\nlater, the debtor, in hard financial times, declared bankruptcy. As between the\nbank and Windows Co., who will get paid first?\n2. Under what interest rate circumstances would banks insist on a due-on-sale\nclause? Under what interest rate circumstance would banks not object to a\nnew person assuming the mortgage?\n3. What is the primary advantage of the deed of trust? What is the primary\nadvantage of the land contract?\n4. A debtor defaulted on her house payments. Under what circumstances might\na court 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,\nRhode Island, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, West Virginia,\nWisconsin, and Wyoming.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n963\n\n\x0c20.3 Nonconsensual Lien\nL EA R N IN G O B JEC T IV ES\n1. Understand the nonconsensual liens issued by courts\xe2\x80\x94attachment liens and\njudgment liens\xe2\x80\x94and how they are created.\n2. Recognize other types of nonconsensual liens: mechanic\xe2\x80\x99s lien, possessory\nlien, and tax lien.\n\nThe security arrangements discussed so far\xe2\x80\x94security interests, suretyship, mortgages\xe2\x80\x94are all obtained by\nthe creditor with the debtor\xe2\x80\x99s consent. A creditor may obtain certain liens without the debtor\xe2\x80\x99s consent.\n\nCourt-Decreed Liens\nSome nonconsensual liens are issued by courts.\n\nAttachment Lien\nAn attachment lien is ordered against a person\xe2\x80\x99s property\xe2\x80\x94real or personal\xe2\x80\x94to prevent him from\ndisposing of it during a lawsuit. To obtain an attachment lien, the plaintiff must show that the defendant\nlikely will dispose of or hide his property; if the court agrees with the plaintiff, she must post a bond and\nthe court will issue a writ of attachment to the sheriff, directing the sheriff to seize the property.\nAttachments of real property should be recorded. Should the plaintiff win her suit, the court issues a writ\nof execution, directing the sheriff to sell the property to satisfy the judgment.\n\nJudgment Lien\nA judgment lien may be issued when a plaintiff wins a judgment in court if an attachment lien has not\nalready been issued. Like the attachment lien, it provides a method by which the defendant\xe2\x80\x99s property\nmay be seized and sold.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n964\n\n\x0cMechanic\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 can be\nobtained by one who furnishes labor, services, or materials to improve real estate: this is statutory, and\nthe statute must be carefully followed. The \xe2\x80\x9cmechanic\xe2\x80\x9d here is one who works with his or her hands, not\nspecifically one who works on machines. An automobile mechanic could not obtain a mechanic\xe2\x80\x99s lien on a\ncustomer\xe2\x80\x99s house to secure payment of work he did on her car. (The lien to which the automobile\nmechanic is entitled is a \xe2\x80\x9cpossessory lien\xe2\x80\x9d or \xe2\x80\x9cartisan\xe2\x80\x99s lien,\xe2\x80\x9d considered in Section 20.3.3 "Possessory\nLien") To qualify for a mechanic\xe2\x80\x99s lien, the claimant must file a sworn statement describing the work\ndone, the contract made, or the materials furnished that permanently improved the real estate.\n\nA particularly difficult problem crops up when the owner has paid the contractor, who in turn fails to pay\nhis subcontractors. In many states, the subcontractors can file a lien on the owner\xe2\x80\x99s property, thus forcing\nthe owner to pay them (see Figure 20.5 "Subcontractors\xe2\x80\x99 Lien")\xe2\x80\x94and maybe twice. To protect themselves,\nowners can demand a sworn statement from general contractors listing the subcontractors used on the\njob, and from them, owners can obtain a waiver of lien rights before paying the general contractor.\n\nFigure 20.5Subcontractors\xe2\x80\x99 Lien\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 and the\nnature of the improvement. The lienor has a specified period of time (e.g., ninety days) to file from the\ntime the work is finished. Recording as such does not give the lienor an automatic right to the property if\nthe debt remains unpaid. All states specify a limited period of time, usually one year, within which the\nclaimant must file suit to enforce the lien. Only if the court decides the lien is valid may the property be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n965\n\n\x0csold to satisfy the debt. Difficult questions sometimes arise when a lien is filed against a landlord\xe2\x80\x99s\nproperty as a result of improvements and services provided to a tenant, as discussed in F & D Elec.\nContractors, Inc. v. Powder Coaters, Inc., Section 20.4 "Cases".\n\nMechanic\xe2\x80\x99s Liens Priorities\nA mechanic\xe2\x80\x99s lien represents a special risk to the purchaser of real estate or to lenders who wish to take a\nmortgage. In most states, the mechanic\xe2\x80\x99s lien is given priority not from the date when the lien is recorded\nbut from an earlier date\xe2\x80\x94either the date the contractor was hired or the date construction began. Thus a\npurchaser or lender might lose priority to a creditor with a mechanic\xe2\x80\x99s lien who filed after the sale or\nmortgage. A practical solution to this problem is to hold back part of the funds (purchase price or loan) or\nplace them in escrow until the period for recording liens has expired.\n\nPossessory Lien\nThe most common nonconsensual lien on personal property (not real estate) is the possessory lien.\nThis is the right to continue to keep the goods on which work has been performed or for which materials\nhave been supplied until the owner pays for the labor or materials. The possessory lien arises both under\ncommon law and under a variety of statutes. Because it is nonconsensual, the possessory lien is not\ncovered by Article 9 of the UCC, which is restricted to consensual security interests. Nor is it governed by\nthe law of mechanic\xe2\x80\x99s liens, which are nonpossessory and relate only to work done to improve real\nproperty.\n\nThe common-law rule is that anyone who, under an express or implied contract, adds value to another\xe2\x80\x99s\nchattel (personal property) by labor, skill, or materials has a possessory lien for the value of the services.\nMoreover, the lienholder may keep the chattel until her services are paid. For example, the dry cleaner\nshop is not going to release the wool jacket that you took in for cleaning unless you make satisfactory\narrangements to pay for it, and the chain saw store won\xe2\x80\x99t let you take the chain saw that you brought in\nfor a tune-up until you pay for the labor and materials for the tune-up.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n966\n\n\x0cTax Lien\nAn important statutory lien is the federal tax lien. Once the government assesses a tax, the amount due\nconstitutes a lien on the owner\xe2\x80\x99s property, whether real or personal. Until it is filed in the appropriate\nstate office, others take priority, including purchasers, mechanics\xe2\x80\x99 lienors, judgment lien creditors, and\nholders of security interests. But once filed, the tax lien takes priority over all subsequently arising liens.\nFederal law exempts some property from the tax lien; for example, unemployment benefits, books and\ntools of a trade, workers\xe2\x80\x99 compensation, judgments for support of minor children, minimum amounts of\nwages and salary, personal effects, furniture, fuel, and provisions are exempt.\n\nLocal governments also can assess liens against real estate for failure to pay real estate taxes. After some\nperiod of time, the real estate may be sold to satisfy the tax amounts owing.\n\nK E Y TA K EA WAY\nThere are four types of nonconsensual liens: (1) court-decreed liens are\nattachment liens, which prevent a person from disposing of assets pending a\nlawsuit, and judgment liens, which allow the prevailing party in a lawsuit to take\nproperty belonging to the debtor to satisfy the judgment; (2) mechanics\xe2\x80\x99 liens are\nauthorized by statute, giving a person who has provided labor or material to a\nlandowner the right to sell the property to get paid; (3) possessory liens on\npersonal property allow one in possession of goods to keep them to satisfy a claim\nfor 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\nor personal property.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n967\n\n\x0cE XE R C IS ES\n1. The mortgagor\xe2\x80\x99s interests are protected in a judicial foreclosure by a court\xe2\x80\x99s\noversight of the process; how is the mortgagor\xe2\x80\x99s interest protected when a\ndeed 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\nhave enough money to pay for the repairs. May Mike have a mechanic\xe2\x80\x99s lien\non the car? A possessory lien?\n5. Why does federal law exempt unemployment benefits, books and tools of a\ntrade, workers\xe2\x80\x99 compensation, minimum amounts of wages and salary,\npersonal effects, furniture, fuel, and other such items from the sweep of a tax\nlien?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n968\n\n\x0c20.4 Cases\nDenial of Mortgagee\xe2\x80\x99s Right to Foreclose; Erroneous Filings; Lost\nInstruments\nPaul H. Cherry v. Chase Manhattan Mortgage Group\n\n190 F.Supp.2d 1330 (Fed. Dist. Ct. FL 2002)\n\nBackground\n\n[Paul Cherry filed a complaint suing Chase for Fair Debt Collection Practices Act violations and slander of\ncredit.]\xe2\x80\xa6Chase counter-claimed for foreclosure and reestablishment of the lost note.\xe2\x80\xa6\n\n\xe2\x80\xa6Chase held a mortgage on Cherry\xe2\x80\x99s home to which Cherry made timely payments until August 2000.\nCherry stopped making payments on the mortgage after he received a letter from Chase acknowledging\nhis satisfaction of the mortgage. Cherry notified Chase of the error through a customer service\nrepresentative. Cherry, however, received a check dated August 15, 2000, as an escrow refund on the\nmortgage. Chase subsequently recorded a Satisfaction of Mortgage into the Pinellas County public records\non October 19, 2000. On November 14, 2000, Chase sent Cherry a \xe2\x80\x9cLoan Reactivation\xe2\x80\x9d letter with a new\nloan number upon which to make the payments. During this time, Cherry was placing his mortgage\npayments into a bank account, which subsequently were put into an escrow account maintained by his\nattorney. These payments were not, and have not, been tendered to Chase. As a result of the failure to\ntender, Chase sent Cherry an acceleration warning on November 17, 2000, and again on March 16, 2001.\nChase notified the credit bureaus as to Cherry\xe2\x80\x99s default status and moved for foreclosure. In a letter\naddressed to Cherry\xe2\x80\x99s attorney, dated April 24, 2001, Chase\xe2\x80\x99s attorney advised Cherry to make the\nmortgage payments 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 aside; an\nannulment] in the Pinellas County public records on May 3, 2001. Chase signed the vacatur on March 21,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n969\n\n\x0c2001, and had it notarized on March 27, 2001. Chase has also been unable to locate the original note,\ndated October 15, 1997, and deems it to be lost.\xe2\x80\xa6\n\nForeclosure\n\nChase accelerated Cherry\xe2\x80\x99s mortgage debt after determining he was in a default status under the mortgage\nprovisions. Chase claims that the right to foreclose under the note and mortgage is \xe2\x80\x9cabsolute,\xe2\x80\x9d [Citation],\nand that this Court should enforce the security interest in the mortgage though Chase made an\nadministrative error in entering a Satisfaction of Mortgage into the public records.\xe2\x80\xa6\n\nMortgage\n\n\xe2\x80\xa6Chase relies on the Florida Supreme Court decision in United Service Corp. v. Vi-An Const. Corp.,\n[Citation] (Fla.1955), which held that a Satisfaction of Mortgage \xe2\x80\x9cmade through a mistake may be\ncanceled\xe2\x80\x9d and a mortgage reestablished as long as no other innocent third parties have \xe2\x80\x9cacquired an\ninterest in the property.\xe2\x80\x9d Generally the court looks to the rights of any innocent third parties, and if none\nexist, equity will grant relief to a mortgagee who has mistakenly satisfied a mortgage before fully paid.\n[Citation]. Both parties agree that the mortgage was released before the debt was fully paid. Neither party\nhas presented any facts to this Court that implies the possibility nor existence of a third party interest.\nAlthough Cherry argues under Biggs v. Smith, 184 So. 106, 107 (1938), that a recorded satisfaction of\nmortgage is \xe2\x80\x9cprima facie evidence of extinguishment of a mortgage lien,\xe2\x80\x9d Biggs does not apply this\nstandard to mortgage rights affected by a mistake in the satisfaction.\n\nTherefore, on these facts, this Court acknowledges that a vacatur is a proper remedy for Chase to correct\nits unilateral mistake since \xe2\x80\x9cequity will grant relief to those who have through mistake released a\nmortgage.\xe2\x80\x9d [Citation.] Accordingly, this Court holds that an equity action is required to make a vacatur\nenforceable unless the parties consent to the vacatur or a similar remedy during the mortgage\nnegotiation.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n970\n\n\x0cTender\n\nCherry has not made a mortgage payment to Chase since August 2000, but claims to have made these\npayments into an escrow account, which he claims were paid to the escrow account because Chase\nrecorded a satisfaction of his mortgage and, therefore, no mortgage existed. Cherry also claims that\nrepresentatives of Chase rejected his initial attempts to make payments because of a lack of a valid loan\nnumber. Chase, however, correctly argues that payments made to an escrow account are not a proper\ntender of payment. Matthews v. Lindsay, [Citation] (1884) (requiring tender to be made to the court).\nNor did Cherry make the required mortgage payments to the court as provided by [relevant court rules],\nallowing for a \xe2\x80\x9cdeposit with the court all or any part of such sum or thing, whether that party claims all or\nany part of the sum or thing.\xe2\x80\x9d Further, Chase also correctly argues that Cherry\xe2\x80\x99s failure to tender the\npayments from the escrow account or make deposits with the court is more than just a \xe2\x80\x9ctechnical breach\xe2\x80\x9d\nof the mortgage and note. [Citation.]\n\nChase may, therefore, recover the entire amount of the mortgage indebtedness, unless the court finds a\n\xe2\x80\x9climited circumstance\xe2\x80\x9d upon which the request may be denied. [Citation.] Although not presented by\nChase in its discussion of this case, the Court may refuse foreclosure, notwithstanding that the defendant\nestablished a foreclosure action, if the acceleration was unconscionable and the \xe2\x80\x9cresult would be\ninequitable and unjust.\xe2\x80\x9d This Court will analyze the inequitable result test and the limited circumstances\nby which the court may deny foreclosure.\n\nFirst, this Court does not find the mortgage acceleration unconscionable by assuming arguendo [for the\npurposes of argument] that the mortgage was valid during the period that the Satisfaction of Mortgage\nwas entered into the public records. Chase did not send the first acceleration warning until November 14,\n2000, the fourth month of non-payment, followed by the second acceleration letter on March 16, 2001,\nthe eighth month of non-payment. Although Cherry could have argued that a foreclosure action was an\n\xe2\x80\x9cinequitable\xe2\x80\x9d and \xe2\x80\x9cunjust\xe2\x80\x9d result after the Satisfaction of Mortgage was entered on his behalf, the result\ndoes not rise to an unconscionable level since Cherry could have properly tendered the mortgage\npayments to the court.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n971\n\n\x0cSecond, the following \xe2\x80\x9climited circumstances\xe2\x80\x9d will justify a court\xe2\x80\x99s denial of foreclosure: 1) waiver of right\nto accelerate; 2) mortgagee estopped from asserting foreclosure because mortgagor reasonably assumed\nthe mortgagee would not foreclose; 3) mortgagee failed to perform a condition precedent for acceleration;\n4) payment made after default but prior to receiving intent to foreclose; or, 5) where there was intent to\nmake to make timely payment, and it was attempted, or steps taken to accomplish it, but nevertheless the\npayment was not made due to a misunderstanding or excusable neglect, coupled with some conduct of the\nmortgagee which in a measure contributed to the failure to pay when due or within the grace period.\n[Citations.]\n\nChase fails to address this fifth circumstance in its motion, an apparent obfuscation of the case law before\nthe court. This Court acknowledges that Cherry\xe2\x80\x99s facts do not satisfy the first four limited circumstances.\nChase at no time advised Cherry that the acceleration right was being waived; nor is Chase estopped from\nasserting foreclosure on the mortgage because of the administrative error, and Cherry has not relied on\nthis error to his detriment; and since Chase sent the acceleration letter to Cherry and a request for\npayment to his attorney, there can be no argument that Cherry believed Chase would not foreclose. Chase\nhas performed all conditions precedent required by the mortgage provisions prior to notice of the\nacceleration; sending acceleration warnings on November 17, 2000, and March 16, 2001. Cherry also has\nno argument for lack of notice of intent to accelerate after default since he has not tendered a payment\nsince July 2000, thus placing him in default of the mortgage provisions, and he admits receiving the\nacceleration notices.\n\nThis Court finds, however, that this claim fails squarely into the final limited circumstance regarding\nintent to make timely payments. Significant factual issues exist as to the intent of Cherry to make or\nattempt to make timely mortgage payments to Chase. Cherry claims that he attempted to make the\npayments, but was told by a representative of Chase that there was no mortgage loan number upon which\nto apply the payments. As a result, the mortgage payments were placed into an account and later into his\ncounsel\xe2\x80\x99s trust account as a mortgage escrow. Although these payments should have, at a minimum, been\nplaced with the court to ensure tender during the resolution of the mortgage dispute, Cherry did take\nsteps to accomplish timely mortgage payments. Although Cherry, through excusable neglect or a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n972\n\n\x0cmisunderstanding as to what his rights were after the Satisfaction of Mortgage was entered, failed to\ntender the payments, Chase is also not without fault; its conduct in entering a Satisfaction of Mortgage\ninto the Pinellas County public records directly contributed to Cherry\xe2\x80\x99s failure to tender timely payments.\nCherry\xe2\x80\x99s attempt at making the mortgage payments, coupled with Chase\xe2\x80\x99s improper satisfaction of\nmortgage fits squarely within the limited circumstance created to justify a court\xe2\x80\x99s denial of a foreclosure.\nEquity here requires a balancing between Chase\xe2\x80\x99s right to the security interest encumbered by the\nmortgage and Cherry\xe2\x80\x99s attempts to make timely payments. As such, these limited circumstances exist to\nensure that a foreclosure remains an action in equity. In applying this analysis, this Court finds that equity\nrequires that Chase\xe2\x80\x99s request for foreclosure be denied at this juncture.\xe2\x80\xa6\n\nReestablishment of the Lost Note and Mortgage\n\nChase also requests, as part of the foreclosure counterclaim, the reestablishment of the note initially\nassociated with the mortgage, as it is unable to produce the original note and provide by affidavit evidence\nof its loss. Chase has complied with the [necessary statutory] requirements[.]\xe2\x80\xa6This Court holds the note\nto be reestablished and that Chase has the lawful right to enforce the note upon the issuance of this order.\n\nThis Court also agrees that Chase may reestablish the mortgage through a vacatur, revocation, and\ncancellation of satisfaction of mortgage. [Citation] (allowing the Equity Court to reestablish a mortgage\nthat was improperly canceled due to a mistake). However, this Court will deem the vacatur effective as of\nthe date of this order. This Court leaves the status of the vacatur during the disputed period, and\nspecifically since May 3, 2001, to be resolved in subsequent proceedings.\xe2\x80\xa6Accordingly, it is:\n\nORDERED that [Chase cannot foreclose and] the request to reestablish the note and mortgage is hereby\ngranted and effective as of the date of this order. Cherry will tender all previously escrowed mortgage\npayments to the Court, unless the parties agree otherwise, within ten days of this order and shall\nhenceforth, tender future monthly payments to Chase as set out in the reestablished note and mortgage.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n973\n\n\x0cC A SE QU ES TIO NS\n1. When Chase figured out that it had issued a Satisfaction of Mortgage\nerroneously, what did it file to rectify the error?\n2. Cherry had not made any mortgage payments between the time Chase sent\nthe erroneous Satisfaction of Mortgage notice to him and the time of the\ncourt\xe2\x80\x99s decision in this case. The court listed five circumstances in which a\nmortgagee (Chase here) might be denied the right to foreclose on a\ndelinquent 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\nobfuscation did it engage in?\n3. What did Cherry do with the mortgage payments after Chase erroneously told\nhim the mortgage was satisfied? What did the court say he should have done\nwith the payments?\n\nMechanic\xe2\x80\x99s Lien Filed against Landlord for Payment of Tenant\xe2\x80\x99s\nImprovements\nF & D Elec. Contractors, Inc. v. Powder Coaters, Inc.\n\n567 S.E.2d 842 (S.C. 2002)\n\nFactual/ Procedural Background\n\nBG Holding f/k/a Colite Industries, Inc. (\xe2\x80\x9cBG Holding\xe2\x80\x9d) is a one-third owner of about thirty acres of real\nestate in West Columbia, South Carolina. A warehouse facility is located on the property. In September\n1996, Powder Coaters, Inc. (\xe2\x80\x9cPowder Coaters\xe2\x80\x9d) agreed to lease a portion of the warehouse to operate its\nbusiness. Powder Coaters was engaged in the business of electrostatically painting machinery parts and\nequipment and then placing them in an oven to cure. A signed lease was executed between Powder\nCoaters and BG Holding. Prior to signing the lease, Powder Coaters negotiated the terms with Mark\nTaylor, (\xe2\x80\x9cTaylor\xe2\x80\x9d) who was the property manager for the warehouse facility and an agent of BG Holding.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n974\n\n\x0cThe warehouse facility did not have a sufficient power supply to support Powder Coaters\xe2\x80\x99 machinery.\nTherefore, Powder Coaters contracted with F & D Electrical (\xe2\x80\x9cF & D\xe2\x80\x9d) to perform electrical work which\nincluded installing two eight foot strip light fixtures and a two hundred amp load center. Powder Coaters\nnever paid F & D for the services. Powder Coaters was also unable to pay rent to BG Holding and was\nevicted in February 1997. Powder Coaters is no longer a viable company.\n\nIn January 1997, F & D filed a Notice and Certificate of Mechanic\xe2\x80\x99s Lien and Affidavit of Mechanic\xe2\x80\x99s Lien.\nIn February 1997, F & D filed this action against BG Holding foreclosing on its mechanic\xe2\x80\x99s lien pursuant to\nS.C. [statute].\xe2\x80\xa6\n\nA jury trial was held on September 2nd and 3rd, 1998. At the close of F & D\xe2\x80\x99s evidence, and at the close of\nall evidence, BG Holding made motions for directed verdicts, which were denied. The jury returned a\nverdict for F & D in the amount of $8,264.00. The court also awarded F & D attorneys\xe2\x80\x99 fees and cost in the\namount of $8,264.00, for a total award of $16,528.00.\n\nBG Holding appealed. The Court of Appeals, in a two to one decision, reversed the trial court, holding a\ndirected verdict should have been granted to BG Holding on the grounds BG Holding did not consent to\nthe electrical upgrade, as is required by the Mechanic\xe2\x80\x99s Lien Statute. This Court granted F & D\xe2\x80\x99s petition\nfor 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 was devoid\nof any evidence of owner\xe2\x80\x99s consent to materialman\xe2\x80\x99s performance of work on its property as required by\n[the S.C. statute]?\n\nLaw/Analysis\nF & D argues the majority of the Court of Appeals erred in holding the facts of the case failed to establish\nthat BG Holding consented to the work performed by F & D, as is required by the [South Carolina]\nMechanic\xe2\x80\x99s Lien Statute. We agree.\xe2\x80\xa6\n\nSouth Carolina\xe2\x80\x99s Mechanic\xe2\x80\x99s Lien Statute provides:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n975\n\n\x0cA person to whom a debt is due for labor performed or furnished or for materials furnished and actually\nused in the erection, alteration, or repair of a building\xe2\x80\xa6by virtue of an agreement with, or by consent of,\nthe owner of the building or structure, or a person having authority from, or rightfully acting for, the\nowner in procuring or furnishing the labor or materials shall have a lien upon the building or structure\nand upon the interest of the owner of the building or structure \xe2\x80\xa6to secure the payment of the debt due.\n[emphasis added.]\n\nBoth parties in this case concede there was no express \xe2\x80\x9cagreement\xe2\x80\x9d between F & D and BG Holding.\nTherefore, the issue in this appeal turns on the meaning of the word \xe2\x80\x9cconsent\xe2\x80\x9d in the statute, as applied in\nthe landlord-tenant context. This is a novel issue in South Carolina.\n\nThis Court must decide who must give the consent, who must receive consent, and what type of consent\n(general, specific, oral, written) must be given in order to satisfy the statute. Finally, the Court must\ndecide whether the evidence in this case shows BG Holding gave the requisite consent.\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 materialman\n(lien claimant) and the landlord (owner). \xe2\x80\x9cIt is only logical\xe2\x80\xa6that consent under [the relevant section]\nmust\xe2\x80\xa6be between the owner and the entity seeking the lien\xe2\x80\xa6\xe2\x80\x9d [Citation from Court of Appeals]. As stated\npreviously, applying the Mechanic\xe2\x80\x99s Lien Statute in the landlord-tenant context presents a novel issue. We\nfind the consent required by the statute does not have to be between the landlord/owner and the\nmaterialman, as the Court of Appeals\xe2\x80\x99 opinion indicates. A determination that the required consent must\ncome from the owner to the materialman means the materialman can only succeed if he can prove an\nagreement with the owner. Such an interpretation would render meaningless the language of the statute\nthat provides: \xe2\x80\x9c\xe2\x80\xa6by virtue of an agreement with, or by consent of the owner.\xe2\x80\xa6"\n\nTherefore, 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 requested\nimprovements. The landlord/owner may not want to have direct involvement with the materialman or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n976\n\n\x0csub-contractors, but instead may wish to allow the tenant to handle any improvements or upgrades\nhimself. In addition, the landlord/owner may be located far away and may own many properties, making\nit impractical for him to have direct involvement with the materialman. We find the landlord/owner or his\nagent is free to enter into a lease or agreement with a tenant which allows the tenant to direct the\nmodifications to the property which have been specifically consented to by the landlord/owner or his\nagent.\n\nWe hold a landlord/owner or his agent can give his consent to the lessee/tenant, as well as directly to the\nlien 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 more than\na mere acquiescence in a state of things already in existence. It implies an agreement to that which, but for\nthe consent, could not exist, and which the party consenting has a right to forbid.\xe2\x80\x9d [Citations.] However,\nour Mechanics Lien Statute has never been applied in the landlord-tenant context where a third party is\ninvolved.\n\nOther jurisdictions have addressed this issue. The Court of Appeals cited [a Connecticut case, 1987] in\nsupport of its holding. We agree with the Court of Appeals that the Connecticut court\xe2\x80\x99s reasoning is\npersuasive, especially since Connecticut has a similar mechanics lien statute.\xe2\x80\xa6\n\nThe Connecticut courts have stated \xe2\x80\x9cthe consent required from the owner or one acting under the owner\xe2\x80\x99s\nauthority is more than the mere granting of permission for work to be conducted on one\xe2\x80\x99s property; or the\nmere knowledge that work was being performed on one\xe2\x80\x99s land.\xe2\x80\x9d Furthermore, although the Connecticut\ncourts have stated the statute does not require an express contract, the courts have required \xe2\x80\x9cconsent that\nindicates an agreement that the owner of\xe2\x80\xa6the land shall be, or may be, liable for the materials or labor.\xe2\x80\x9d\xe2\x80\xa6\n\nThe reasoning of [Connecticut and other states that have decided this issue] is persuasive. F & D\xe2\x80\x99s brief\nappears to argue that mere knowledge by the landowner that the work needed to be done, coupled with\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n977\n\n\x0cthe landlord\xe2\x80\x99s general \xe2\x80\x9cpermission\xe2\x80\x9d to perform the work, is enough to establish consent under the statute.\nUnder this interpretation, a landlord who knew a tenant needed to improve, upgrade, or add to the leased\npremises would be liable to any contractor and/or subcontractor who performed work on his land. Under\nF & D\xe2\x80\x99s interpretation the landlord would not be required to know the scope, cost, etc. of the work, but\nwould only need to give the tenant general permission to perform upgrades or improvements.\n\nClearly, if the landlord/owner or his agent gives consent directly to the materialman, a lien can be\nestablished. 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 provided in the\ninstant case, the landlord could approve written plans submitted by the tenant). The consent needs to be\nmore than \xe2\x80\x9cmere knowledge\xe2\x80\x9d that the tenant will perform work on the property. There must be some kind\nof express or implied agreement that the landlord may be held liable for the work or material. The\nlandlord/owner or his agent may delegate the project or work to his tenant, but there must be an express\nor implied agreement about the specific work to be done. A general provision in a lease which allows\ntenant to make repairs or improvements is not 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 they\nnever had a conversation with anyone from BG Holding. In fact, until Powder Coaters failed to\npay 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 see\nany 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n978\n\n\x0c\xe2\x80\xa2\n\nPowder Coaters acknowledged it was not authorized to bind BG Holding to pay for the\nmodifications.\n\n\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 informed\nMark Taylor, BG Holding\xe2\x80\x99s property manager and agent, that electrical and gas upgrading would\nbe 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 the\nelectrical since the existing power source was insufficient to run the machinery needed for Powder\nCoaters 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 building\nso 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 work\ndone.\n\nIn the instant case, there is some evidence of consent. However, it does not rise to the level required under\nthe statute.\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n979\n\n\x0cViewing the evidence in the light most favorable to F & D, whether BG Holding gave their consent is a\nclose question. However, we agree with the Court of Appeals, that F & D has not presented enough\nevidence to show: (1) BG Holding gave anything more than general consent to make improvements (as the\nlease could be interpreted to allow); or (2) BG Holding had anything more that \xe2\x80\x9cmere knowledge\xe2\x80\x9d that the\nwork was to be done. Powder Coaters asserted the lease\xe2\x80\x99s addendum evidenced BG Holding\xe2\x80\x99s consent to\nperform the modifications; however, there is no evidence BG Holding expressly or implicitly agreed that it\nmight be liable for the work. In fact, the lease between Powder Coaters and BG Holding expressly\nprovided Powder Coaters was responsible for any alterations made to the property. Even Powder Coaters\nacknowledged it was not authorized to bind BG Holding.\xe2\x80\xa6Therefore, it is impossible to see how the very\ngeneral provision 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 Court of\nAppeals that the mere presence of BG Holding\xe2\x80\x99s agent at the work site is not enough to establish consent.\n\nConclusion\nWe hold consent, as required by the Mechanic\xe2\x80\x99s Lien Statute, is something more than mere knowledge\nwork will be or could be done on the property. The landlord/owner must do more than grant the tenant\ngeneral permission to make repairs or improvements to the leased premises. The landlord/owner or his\nagent must give either his tenant or the materialman express or implied consent acknowledging he may be\nheld liable for the work.\n\nThe Court of Appeals\xe2\x80\x99 opinion is affirmed as modified.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n980\n\n\x0cC A SE QU ES TIO NS\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\ntenant?\n3. What kind of knowledge or acceptance did the court determine the landlordowner needed to have or give before a material man could have a lien on the\nreal 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).\n\n2005 WL 715940, (Wash. Ct. App. 2005)\n\nApplewick, J.\n\nAlpha Imperial LLC challenges the validity of a non-judicial foreclosure sale on multiple grounds. Alpha\nwas the holder of a third deed of trust on the building sold, and contests the location of the sale and the\nadequacy of the sale price. Alpha also claims that the trustee had a duty to re-open the sale, had a duty to\nthe junior lienholder, chilled the bidding, and had a conflict of interest. We find that the location of the\nsale was proper, the price was adequate, bidding was not chilled, and that the trustee had no duty to reopen the sale, [and] no duty to the junior lienholder.\xe2\x80\xa6We affirm.\n\nFacts\nMayur Sheth and another individual formed Alpha Imperial Building, LLC in 1998 for the purpose of\ninvesting in commercial real estate. In February 2000 Alpha sold the property at 1406 Fourth Avenue in\nSeattle (the Property) to Pioneer Northwest, LLC (Pioneer). Pioneer financed this purchase with two loans\nfrom [defendant Schnitzer Family Investment, LLC, II (SFI)]. Pioneer also took a third loan from Alpha at\nthe time of the sale for $1.3 million. This loan from Alpha was junior to the two [other] loans[.]\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n981\n\n\x0cPioneer defaulted and filed for bankruptcy in 2002.\xe2\x80\xa6In October 2002 defendant Blackstone Corporation,\nan entity created to act as a non-judicial foreclosure trustee, issued a Trustee\xe2\x80\x99s Notice of Sale. Blackstone\nis wholly owned by defendant Witherspoon, Kelley, Davenport & Toole (Witherspoon). Defendant\nMichael Currin, a shareholder at Witherspoon, was to conduct the sale on January 10, 2003. Currin and\nWitherspoon represented SFI and 4th Avenue LLC. Sheth received a copy of the Notice of Sale through his\nattorney.\n\nOn January 10, 2003, Sheth and his son Abhi arrived at the Third Avenue entrance to the King County\ncourthouse between 9:30 and 9:45 a.m. They waited for about ten minutes. They noticed two signs posted\nabove the Third Avenue entrance. One sign said that construction work was occurring at the courthouse\nand \xe2\x80\x98all property auctions by the legal and banking communities will be moved to the 4th Avenue entrance\nof the King County Administration Building.\xe2\x80\x99 The other sign indicated that the Third Avenue entrance\nwould remain open during construction. Sheth and Abhi asked a courthouse employee about the sign, and\nwere told that all sales were conducted at the Administration Building.\n\nSheth and Abhi then walked to the Administration Building, and asked around about the sale of the\nProperty. [He was told Michael Currin, one of the shareholders of Blackstone\xe2\x80\x94the trustee\xe2\x80\x94was holding\nthe sale, and was advised] to call Currin\xe2\x80\x99s office in Spokane. Sheth did so, and was told that the sale was at\nthe Third Avenue entrance. Sheth and Abhi went back to the Third Avenue entrance.\n\nIn the meantime, Currin had arrived at the Third Avenue entrance between 9:35 and 9:40 a.m. The head\nof SFI, Danny Schnitzer (Schnitzer), and his son were also present. Currin was surprised to notice that no\nother foreclosure sales were taking place, but did not ask at the information desk about it. Currin did not\nsee the signs directing auctions to occur at the Administration Building. Currin conducted the auction,\nSchnitzer made the only bid, for $2.1 million, and the sale was complete. At this time, the debt owed on\nthe first two deeds of trust totaled approximately $4.1 million. Currin then left the courthouse, but when\nhe received a call from his assistant telling him about Sheth, he arranged to meet Sheth back at the Third\nAvenue entrance. 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 to go to the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n982\n\n\x0cAdministration Building. Currin told Sheth that the notice indicated the sale was to be at the Third\nAvenue entrance, and that the sale had been held at the correct location. Sheth did not ask to re-open the\nbidding.\xe2\x80\xa6\n\nSheth filed the current lawsuit, with Alpha as the sole plaintiff, on February 14, 2003. The lawsuit asked\nfor declaratory relief, restitution, and other damages. The trial court granted the defendants\xe2\x80\x99 summary\njudgment motion on August 8, 2003. Alpha appeals.\n\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 auctions are\nheld at the Administration Building. The letter also stated that personnel were instructed to direct bidders\nand trustees to that location if asked. In addition, Alpha argues that the Third Avenue entrance was not a\n\xe2\x80\x98public\xe2\x80\x99 place, as required by [the statute], since auction sales were forbidden there. We disagree. Alpha\nhas not shown that the Third Avenue entrance was an improper location. The evidence shows that the\ncounty had changed its policy as to where auctions would be held and had posted signs to that effect.\nHowever, the county did not exclude people from the Third Avenue entrance or prevent auctions from\nbeing held there. Street, who frequented sales, stated that auctions were being held in both locations. The\nsale was held 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. The public\nwas free to come and go at that location, and the area was \xe2\x80\x98open and available for all to use.\xe2\x80\x99 Alpha relies\non Morton v. Resolution Trust (S.D. Miss. 1995) to support its contention that the venue of the sale was\nimproper. [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 did not\nrequest that Currin re-open it. The evidence indicates that Currin may have known about Sheth\xe2\x80\x99s interest\nin bidding prior to the day of the sale, due to a conversation with Sheth\xe2\x80\x99s attorney about Sheth\xe2\x80\x99s desire to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n983\n\n\x0cprotect his interest in the Property. But, this knowledge did not create in Currin any affirmative duty to\noffer to re-open the sale.\n\nIn addition, Alpha cites no Washington authority to support the contention that Currin would have been\nobligated to re-open the sale if Sheth had asked him to. The decision to continue a sale appears to be fully\nwithin the discretion of the trustee: \xe2\x80\x9c[t]he trustee may for any cause the trustee deems advantageous,\ncontinue the sale.\xe2\x80\x9d [Citation.] Alpha\xe2\x80\x99s citation to Peterson v. Kansas City Life Ins. Co., Missouri (1936) to\nsupport its contention that Currin should have re-opened the sale is unavailing. In Peterson, the Notice of\nSale indicated that the sale would be held at the \xe2\x80\x98front\xe2\x80\x99 door of the courthouse. But, the courthouse had\nfour doors, and the customary door for sales was the east door. The sheriff, acting as the trustee,\nconducted the sale at the east door, and then re-opened the sale at the south door, as there had been some\nsales at the south door. Alpha contends this shows that Currin should have re-opened the sale when\nlearning of the 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 south\ndoor. This case is not on point.\n\nChilled Bidding\nAlpha contends that Currin chilled the bidding on the Property by telling bidders that he expected a full\ncredit sale price and by holding the sale at the courthouse. Chilled bidding can be grounds for setting\naside a sale. Country Express Stores, Inc. v. Sims, [Washington Court of Appeals] (1997). The Country\nExpress court explained the two types of chilled bidding:\n\nThe first is intentional, occurring where there is collusion for the purpose of holding down the bids. The\nsecond consists of inadvertent and unintentional acts by the trustee that have the effect of suppressing the\nbidding. To establish chilled bidding, the challenger must establish the bidding was actually suppressed,\nwhich can sometimes be shown by an inadequate sale price.\n\nWe hold that there was no chilling. Alpha has not shown that Currin engaged in intentional chilling. There\nis no evidence that Currin knew about the signs indicating auctions were occurring at the Administration\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n984\n\n\x0cBuilding when he prepared the Notice of Sale, such that he intentionally held the sale at a location from\nwhich he knew bidders would be absent. Additionally, Currin\xe2\x80\x99s statement to [an interested person who\nmight bid on the property] that a full credit sale price was expected and that the opening bid would be\n$4.1 million did not constitute intentional chilling. SFI was owed $4.1 million on the Property. SFI could\nthus bid up to 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 bid\namount to potential third party bidders, and for investors to lose interest when they learn of the amount\nof indebtedness on property. It was therefore not a misrepresentation for Currin to state $4.1 million as\nthe opening bid, due to the indebtedness on the Property. Currin\xe2\x80\x99s statements had no chilling effect\xe2\x80\x94they\nmerely informed [interested persons] of the minimum amount necessary to prevail against SFI. Thus,\nCurrin did not intentionally chill the bidding by giving Street that information.\n\nAlpha also argues that the chilled bidding could have been unintended by Currin.\xe2\x80\xa6 [But the evidence is\nthat] Currin\xe2\x80\x99s actions did not intentionally or unintentionally chill the bidding, and the sale will not be set\naside.\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 aside. Alpha\nsubmitted evidence that the property had an \xe2\x80\x98as is\xe2\x80\x99 value of $4.35 million in December 2002, and an\nestimated 2004 value of $5.2 million. The debt owed to SFI on the property was $4.1 million. SFI bought\nthe property for $2.1 million. These facts do not suggest that the sale must be set aside.\n\nWashington case law suggests that the price the property is sold for must be \xe2\x80\x98grossly inadequate\xe2\x80\x99 for a\ntrustee\xe2\x80\x99s sale to be set aside on those grounds alone. In Cox [Citation, 1985], the property was worth\nbetween $200,000 and $300,000, and was sold to the beneficiary for $11,873. The Court held that\namount to be grossly inadequate InSteward [Citation, 1988] the property had been purchased for\napproximately $64,000, and then was sold to a third party at a foreclosure sale for $4,870. This court\nheld that $4,870 was not grossly inadequate. In Miebach [Citation] (1984), the Court noted that a sale for\nless than two percent of the property\xe2\x80\x99s fair market value was grossly inadequate. The Court\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n985\n\n\x0cin Miebach also noted prior cases where the sale had been voided due to grossly inadequate purchase\nprice; the properties in those cases had been sold for less than four percent of the value and less than\nthree percent of the value. In addition, the Restatement indicates that gross inadequacy only exists when\nthe sale price is less than 20 percent of the fair market value\xe2\x80\x94without other defects, sale prices over 20\npercent will not be set aside. [Citation.] The Property was sold for between 40 and 48 percent of its value.\nThese facts do not support a grossly inadequate purchase price.\n\nAlpha cites Miebach for the proposition that \xe2\x80\x98where the inadequacy of price is great the sale will be set\naside with slight indications of fraud or unfairness,\xe2\x80\x99 arguing that such indications existed here. However,\nthe cases cited by the Court in Miebach to support this proposition involved properties sold for less than\nthree and four percent of their value. Alpha has not demonstrated the slightest indication of fraud, nor\nshown that a property that sold for 40 to 48 percent of its value 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 this\nproposition, and, indeed, there is none\xe2\x80\x94Division Two specifically declined to decide this issue in Country\nExpress [Citation]. Alpha acknowledges the lack of language in RCW 61.24 (the deed of trust statute)\nregarding fiduciary duties of trustees to junior lienholders. But Alpha argues that since RCW 61.24\nrequires that the trustee follow certain procedures in conducting the sale, and allows for sales to be\nrestrained by anyone with an interest, a substantive duty from the trustee to a junior lienholder can be\ninferred.\n\nAlpha\xe2\x80\x99s arguments are unavailing. The procedural requirements in RCW 61.24 do not create implied\nsubstantive duties. The structure of the deed of trust sale illustrates that no duty is owed to the junior\nlienholder. The trustee and the junior lienholder have no relationship with each other. The sale is\npursuant to a contract between the grantor, the beneficiary and the trustee. The junior lienholder is not a\nparty to that contract. The case law indicates only that the trustee owes a fiduciary duty to the debtor and\nbeneficiary: \xe2\x80\x9ca trustee of a deed of trust is a fiduciary for both the mortgagee and mortgagor and must act\nimpartially between them.\xe2\x80\x9d Cox [Citation]. The fact that a sale in accordance with that contract can\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n986\n\n\x0cextinguish the junior lienholder\xe2\x80\x99s interest further shows that the grantor\xe2\x80\x99s and beneficiary\xe2\x80\x99s interest in the\ndeed of trust being foreclosed is adverse to the junior lienholder. We conclude the trustee, while having\nduties as fiduciary for the grantor and beneficiary, does not have duties to another whose interest is\nadverse to the grantor 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 [the\nWashington statute]. An appeal is frivolous \xe2\x80\x98if there are no debatable issues upon which reasonable minds\nmight differ and it is so totally devoid of merit that there was no reasonable possibility of reversal.\xe2\x80\x99\n[Citation] Alpha has presented several issues not so clearly resolved by case law as to be frivolous,\nalthough Alpha\xe2\x80\x99s arguments ultimately fail. Thus, Respondents\xe2\x80\x99 request for attorney fees under [state law]\nis denied.\n\nAffirmed.\n\nC A SE QU ES TIO NS\n1. Why did the plaintiff (Alpha) think the sale should have been set aside\nbecause of the location problems?\n2. Why did the court decide the trustee had no duty to
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